Impact of Canadian Federal Budget 2016 On Business
Business Income Tax Measures
General Corporate Tax Rate
Budget 2016 does not propose to change the general corporate income tax rate, which remains at 15% at the federal level for 2016.
Small Business Taxation
A “Canadian-controlled private corporation” (CCPC) is a Canadian-incorporated, private corporation that is, throughout the year, not controlled, directly or indirectly, by one or more non-residents of Canada or public corporations (or any combination thereof). A corporation that qualifies as a CCPC for purposes of the Income Tax Act (Canada) (ITA) also qualifies for a number of tax benefits, including access to the small business tax rate on the first $500,000 of active business income.
Small Business Tax Rate
Budget 2016 proposes that the small business tax rate remain at 10.5% for 2016 and future years. This reverses the Conservative government’s prior commitment to reduce the small business tax rate to 9% by 2019. Budget 2016 refers to this as a “deferral” of the rate reductions.
Multiplication of the Small Business Deduction
The small business deduction rules in the ITA reduce the federal corporate income tax rate applicable to the first $500,000 of qualifying active business income of a CCPC to 10.5%. The rules require an allocation of the annual eligible income limit of $500,000 among associated corporations. Similarly, where a business is carried on through a partnership, the members of the partnership share one $500,000 limit in respect of that business.
Budget 2016 proposes rules intended to limit the small business deduction in cases where certain partnership and corporate structures are used to inappropriately multiply access to the small business deduction.
Partnerships
Budget 2016 identifies structures that circumvent the application of the specified partnership income rules by having corporations, which are owned by partnership members and qualify as CCPCs, provide services or property to the partnership (without such corporations actually being or becoming members of the partnership). In so doing, such CCPCs may, respectively, claim the small business deduction, without having to allocate the $500,000 limit amongst all of the partners to the partnership (or other CCPCs owned by members of the partnership that provide services or property to the partnership).
Budget 2016 proposes to extend the specified partnership income rules to partnership structures in which a CCPC provides services or property to a partnership where the CCPC, or a shareholder of the CCPC, is a member of the partnership, or does not deal at arm’s length with a member of the partnership. The rules do not apply to a CCPC that earns all or substantially all of its active business income from providing services or property to arm’s-length persons other than the
partnership.
Where the rules apply, the CCPC will then be deemed to be a member of the partnership and the income from the services or property provided to the partnership will be treated as active business income from the partnership. In calculating the CCPC’s small business deduction, the CCPC will have to calculate its specified partnership income (SPI) limit which will initially be deemed to be nil; however, an actual member of the partnership who does not deal at arm’s length with the CCPC will be entitled to assign any portion of the actual member’s SPI limit (in that regard, an individual member of the partnership will be treated as if they were a corporation for purposes of determining the assignable SPI limit). The intended result is that members of the partnership and CCPCs providing services or property to the partnership (where the shareholders are members of the partnership) will share one $500,000 small business deduction limit.
The proposals include an anti-avoidance provision applicable to tiered partnership and corporate structures intended to circumvent the application of the foregoing measures.
This measure will apply to taxation years that begin on or after March 22, 2016. However, a private corporation will be entitled to assign all or a portion of its unused SPI limit in respect of its taxation year that begins before and ends on or after March 22, 2016.
Corporations
The same types of tax planning described above with respect to partnerships could also be effected by using a corporate vehicle. Such multiplication of the small business deduction could occur where a CCPC earns active business income from providing services or property to a private corporation while one of its shareholders, or a person who does not deal at arm’s length with such shareholder, has an interest in the private corporation.
Budget 2016 proposes to address such structures by treating income from providing services or property to a private corporation as ineligible for the small business deduction. This ineligibility will not apply if all or substantially all of the CCPC’s business income for the year is earned from providing services or property to arm’s-length persons other than the private corporation. A private corporation that is a CCPC will be entitled to assign any portion of its unused business limit to one or more CCPCs that are ineligible for the small business deduction under these proposals.
This measure will apply to taxation years that begin on or after March 22, 2016. However, a private corporation will be entitled to assign all or a portion of its unused business limit in respect of its taxation year that begins before and ends on or after March 22, 2016.
Avoidance of the Business Limit and the Taxable Capital Limit
The ITA contains a provision whereby two corporations that would not otherwise be associated will be treated as associated if each of the corporations is associated with a third corporation. Such corporations would then have to allocate one $500,000 limit amongst all of them. However, the ITA provides for an exception to the rule if that third corporation is not a CCPC, or elects not to be associated with the other two corporations for purposes of determining their entitlement to the small business deduction. As a result, the two corporations, which would otherwise not be associated, may each claim a $500,000 small business deduction.
The ITA also contains a rule that treats a CCPC’s investment income as active business income eligible for the small business deduction if that income is derived from the active business of an associated corporation. The exception noted above does not apply in this context. As a result, the two corporations mentioned above could each treat their investment income as active business income because the third corporation is associated with both corporations for purposes of this rule.
Budget 2016 identifies that CCPCs are misusing the election not to be treated as associated. The government is currently challenging such situations under existing specific and general anti-avoidance rules where the small business deduction is being claimed on investment income that is treated as active business income. Budget 2016 notes that any such challenge could be time-consuming and costly, and therefore, the government is introducing specific legislation to address such situations. Budget 2016 proposes to ensure that investment income derived from an associated corporation’s active business will be ineligible for the small business deduction and be taxed at the general rate where the exception to the deemed associated corporation rule applies. The third corporation will continue to be associated with each of the other two corporations for the purpose of applying the $15 million taxable capital limit.
This measure will apply to taxation years beginning on or after March 22, 2016.
Consultation on Active Versus Investment Business
Budget 2015 announced a review of the circumstances in which a business, the principal purpose of which is to earn income from property, should qualify as earning active business income and therefore be potentially eligible for the small business deduction. Budget 2016 announces that the government’s review is complete and it is not proposing any modification to these rules.
Property Regime Repeal of Eligible Capital
Budget 2016 proposes to repeal the rules in the ITA applicable to the treatment of eligible capital property (ECP) and replace those rules with a new class of depreciable property in respect of which capital cost allowance (CCA) may be claimed.
The current ECP regime applies to eligible capital expenditures (ECE) and eligible capital receipts. An ECE is generally a capital expenditure made for the purpose of earning income from business that is not deductible in computing income, and that is not made to acquire a depreciable property in respect of which CCA may be claimed. ECEs include the cost of goodwill on the purchase of a business, as well as other expenditures to acquire certain intangible rights such as customer lists. Under the current rules, 75% of an ECE is added to the cumulative eligible capital (CEC) pool and is deductible at an annual rate of 7% on a declining-balance basis.
An eligible capital receipt is generally a capital receipt for an intangible that is not included in income or in the proceeds of disposition of a capital property. Under the current rules, 75% of an eligible capital receipt is first applied to reduce the CEC pool and then results in the recapture of previously-deducted CEC. Any excess ECP gain is included in income from the business at a 50% inclusion rate, similar to capital gains.
Budget 2016 proposes to repeal the current ECP regime, which is described as having become increasingly complicated, and replace it with a new class of depreciable property for CCA purposes (Class 14.1). Expenditures that are currently added to CEC at a 75% inclusion rate will be included in Class 14.1 at a 100% inclusion rate. The existing CCA rules, such as those relating to recapture, capital gains and depreciation, will generally apply to Class 14.1, which will have a 5% annual depreciation rate on a declining-balance basis.
There will be a separate Class 14.1 pool for each business of a taxpayer, which will generally include existing ECP in respect of the business as of December 31, 2016, property that is acquired after 2016 meeting certain conditions (generally, identifiable intangible property that would receive ECP treatment under the current ECP regime) and “goodwill.”
Because goodwill is not considered to be property under existing rules, Budget 2016 proposes new rules that will deem the goodwill of a business to be property, and that will deem each business to have a “single goodwill property.” Generally, outlays or expenses made or incurred in respect of a business that would be eligible capital expenditures under the current ECP regime, and that do not form part of the cost of an identifiable property, will increase the capital cost of the goodwill and consequently, the balance of Class 14.1. Amounts that would be eligible capital receipts under the current regime, and that do not reduce the cost of an identifiable property or contribute to a gain or loss from the disposition of an identifiable property, will (to the extent they exceed any outlays or expenses made or incurred for the purpose of obtaining the receipts) reduce the capital cost of the goodwill in respect of the business and the balance of Class 14.1.
Budget 2016 proposes that the repeal of the ECP regime and the introduction of the new regime for Class 14.1 property will be effective January 1, 2017. CEC pool balances will be transferred to the new CCA class as of that date, and the depreciation rate applicable to expenditures incurred before that date will be 7% for the first ten years. Budget 2016 includes detailed transition rules intended to ensure that receipts received after January 1, 2017 that relate to expenditures incurred before that date do not result in excess recapture.
Budget 2016 also includes special measures targeted to small businesses to simplify the transition to the new CCA regime for ECP. First, until 2027, taxpayers will be permitted as an annual CCA deduction, in respect of expenditures incurred before 2017, the greater of $500 and the amount otherwise deductible. Second, the first $3,000 of incorporation expenses will be permitted as a current deduction rather than included in Class 14.1 and depreciated over time.
Taxation of Switch Fund Shares
“Switch fund” mutual fund corporations have been available to Canadian retail investors for many years. They offer convenient exposure to different types of assets in different funds, with each fund structured as a separate class of shares of a single mutual fund corporation. Investors in switch funds are able to “switch” their exposure among funds by exchanging shares of one class of the mutual fund corporation for shares of another class. Subject to certain exceptions, any gain on such a share exchange is currently tax-deferred.
Budget 2016 proposes to amend the ITA to cause an exchange of shares of a mutual fund corporation or investment corporation that results in the investor “switching between funds” to be a taxable disposition at fair market value. Budget 2016 states that the measure will not apply where the shares received in exchange differ only in respect of management fees or expenses borne by investors and otherwise derive their value from the same portfolio or fund.
In effect, this measure would align the treatment of an investor in a mutual fund corporation with the current treatment of investors in a mutual fund trust. Investors in mutual fund trusts are generally permitted to redesignate their investment between trust unit classes of the same fund without triggering a disposition of their units, provided the only distinction between unit classes relates to fees or expenses. Budget 2016 proposes to apply this measure to dispositions of shares occurring after September 2016. No draft legislation to implement this measure is included in the Budget materials.
Sales of Linked Notes
Linked notes are generally issued by financial institutions, and provide investors with a return linked to the performance of a particular reference asset or index.
Existing rules in the ITA deem interest to accrue on “prescribed debt obligations,” which include certain linked notes on which the maximum amount of interest that could be payable on the note is determinable. A separate existing rule requires interest that has accrued on a debt obligation prior to its sale, and that is not payable until after such sale, to be included in the income of the vendor (and to allow such interest to be deducted in computing the income of the purchaser). Where a linked note is sold prior to the time at which the return on the note is determinable, investors may take the position that no amount in respect of the return on the note is accrued interest on the date of sale for purposes of this rule. Accordingly, on a sale or other transfer of a linked note prior to such time, an investor holding a linked note as capital property may in some circumstances report a capital gain or loss on the disposition of the note.
Budget 2016 proposes amendments to treat any gain realized by a taxpayer on a sale or transfer of a debt obligation (that is at any time a debt obligation, in respect of which the amount of interest to be paid in respect of any taxation year is, under the terms and conditions of the obligation, dependent on a contingency existing after the year) as interest that accrued on the obligation prior to the time of the transfer and that is not payable until after that time. The taxpayer’s gain would be computed for this purpose without regard to fluctuations in the currency in which the debt is denominated, or to an increase in the value of fixed rate interest payments to be received under the debt obligation because of a decrease in market interest rates, since the date of issuance of the obligation.
Budget 2016 proposes to apply this measure to sales of linked notes occurring after September 2016.
Valuation of Derivatives
Budget 2016 proposes new rules for the valuation of derivatives held on income account that are not mark-to-market property or property of a business that is an adventure or concern in the nature of trade. Budget 2016 suggests this proposal responds to a Tax Court of Canada decision (presumably the decision in Kruger Incorporated v. The Queen, 2015 TCC 119) with a view to protecting the Canadian tax base from the application of traditional inventory valuation rules to derivatives, which have “potentially higher volatility and longer holding periods, as compared to conventional inventory.” The extent to which this approach holds true over the vast breadth of the derivatives market remains unclear. Nonetheless, the proposal would deem a swap agreement, a forward purchase or sale agreement, a forward rate agreement, a futures agreement, an option agreement or any similar agreement not to be inventory of a taxpayer for purposes of the inventory valuation rules. In addition, Budget 2016 would preclude a taxpayer from realizing any reduction in the value of a derivative by using the lower of cost and market method through the addition of a new prohibition against deductibility in subsection 18(1) of the ITA.
These proposals would apply to derivative agreements that are entered into on or after March 22, 2016.
Debt Parking to Avoid Foreign Exchange Gains
The “debt parking” rules in the ITA apply to prevent debtors from avoiding the adverse application of the debt forgiveness rules by arranging for the transfer of a debt obligation to a non-arm’s length person who has no intention of taking steps to collect on the debt. Where applicable, the rules deem the “parked debt” to have been repaid for an amount equal to its cost to the new holder, with any difference between such amount and the original principal amount being treated as a forgiven amount to which the debt forgiveness rules apply.
Budget 2016 proposes to extend the “debt parking” rules in the ITA to debt parking transactions entered into to avoid the realization of foreign exchange gains by the debtor of a foreign-currency denominated debt. The new rule will deem the debtor to realize any accrued foreign exchange gain when the debt becomes a “parked obligation.” The debtor will then be deemed to have made the foreign exchange gain, if any, that it would have otherwise made, if it had paid an amount (expressed in the currency in which the debt is denominated) in satisfaction of the principal amount of the debt equal to:
where the debt becomes a parked obligation as a result of its acquisition by the current holder, the amount for which the debt was issued; and
in other cases, the fair market value of the debt.
A debt becomes a parked obligation where the current holder of the debt does not deal at arm’s length with the debtor or, where the debtor is a corporation, has a significant interest in the corporation (being shares to which 25% or more of the votes or value are attributable) and at any previous time the debt was not held by any such person.
Exceptions will be provided for certain bona fide commercial transactions, where the main purpose of a transaction or series (or of a change in status of a holder of debt) was not to avoid a foreign exchange gain. Related rules will also provide relief for financially distressed debtors with respect to taxes payable on any deemed foreign exchange capital gain, similar to the existing rules that currently provide relief to debtors with respect to a deemed income inclusion under the debt forgiveness rules.
Draft legislation for the new rules was not provided in the Budget 2016 materials.
The new debt parking rules for foreign-currency denominated debts will be effective for debts becoming a parked obligation on or after March 22, 2016 (except – for debts becoming a parked obligation before 2017 – if the status results from a written agreement entered into before March 22, 2016).
Accelerated CCA Expanded to Include Electric Vehicle Charging and Electrical Energy Storage
Classes 43.1 and 43.2 provide accelerated CCA at 30% and 50%, respectively, on a declining balance basis for investments in specified clean energy generation and conservation equipment. Both classes include equipment that generates or conserves energy by using renewable energy sources, by using fuel from waste or by making efficient use of fossil fuels.
Budget 2016 proposes to expand the types of equipment eligible for accelerated CCA under Class 43.1 and Class 43.2 to include electric vehicle charging and electrical energy storage.
These measures will apply in respect of property acquired for use on or after March 22, 2016 that has not been used or acquired for use before March 22, 2016.
Tax Treatment of Transactions under Emission Allowance Regimes
The ITA currently does not have specific rules to address the tax treatment of transactions under carbon emission trading regimes or the tax treatment of emission allowances provided to certain emitters by a provincial government for no consideration. Under general principles, the receipt of the free emissions allowance may be taxable to the recipient as government assistance, without a corresponding cost adjustment to reflect this income inclusion. This would result in double taxation to the taxpayer on the disposition of the emissions allowance. Furthermore, if the taxpayer is required to include the benefit of the free emissions allowance in its income in the year of receipt, but not entitled to a deduction for emissions incurred until a subsequent year (i.e., the year the regulated substance is emitted or the year the taxpayer becomes liable to remit allowances), this can give rise to cash flow concerns for the taxpayer.
Budget 2016 proposes new rules to address these concerns. Under the new rules, emission allowances will be treated as inventory for all taxpayers; however, the “lower of cost and market” method for the valuation of inventory cannot be used to value emissions allowances. If the recipient of a free emissions allowance is a regulated emitter, there will be no income inclusion on receipt of the allowance.
Taxpayers will be entitled to a deduction for accrued emissions obligations to the extent that the obligation exceeds the cost of any emissions allowances that the taxpayer has acquired and that can be used to offset the obligation. Each year following, and until the emissions obligation is satisfied, the taxpayer is required to include the amount of the prior year’s deduction in income and must evaluate the emissions obligation to determine if a further deduction is available in that year.
If a taxpayer disposes of an emissions allowance otherwise than in satisfaction of an obligation under the emissions allowance regime, any proceeds received in excess of the taxpayer’s cost for the allowance will be included in computing income.
These measures will apply to emissions allowances acquired in taxation years beginning after 2016. It will also apply on an elective basis in respect of emissions allowances acquired in taxation years ending after 2012.
No Intention to Extend Accelerated Capital Cost Allowance for Liquefied Natural Gas Facilities
An accelerated CCA is currently available for certain liquefied natural gas (LNG) facilities. For assets acquired after February 19, 2015 and before 2025, an effective CCA rate of 30% is available for eligible liquefaction equipment and 10% for buildings that are part of facilities used to liquefy natural gas. Budget 2016 indicates that, consistent with its G20 commitment to eliminate fossil fuel subsidies over the medium term, Canada intends to maintain the current accelerated CCA treatment for LNG facilities, but will allow it to expire as scheduled without extension.
Life Insurance Policies
Budget 2016 proposes various measures to address certain income tax results, described as being “inappropriate,” “artificial,” or “unintended,” that may arise from corporate or partnership distributions involving life insurance proceeds, or from transfers of life insurance policies.
First, Budget 2016 proposes measures stated to be required to ensure that an appropriate amount in respect of the policy benefit received by a private corporation or partnership on the death of an individual insured under a life insurance policy is added to the corporation’s capital dividend account or to the adjusted cost base of the partners’ partnership interests. These changes are aimed at certain planning techniques that are said to result in unintended increases in the tax-free portion of life insurance policy benefits received by the corporation or partnership. These changes apply to policy benefits received as a result of a death that occurs on or after March 22, 2016.
Second, Budget 2016 proposes changes to the “policy transfer rule” that applies where a policyholder disposes of an interest in a life insurance policy to a non-arm’s-length person. Budget 2016 indicates that these changes are meant to ensure that certain amounts in respect of a policy benefit are not afforded tax-free treatment more than once. The changes mean that the consideration received by the transferor policyholder in excess of the surrender value of the interest in the life insurance policy is included in the policyholder’s proceeds of disposition (and the transferee’s cost) of the interest. This ensures that the excess is not withdrawn from the corporation without being accounted for by the transferor as part of the proceeds of disposition of the interest and then distributed by the corporation a second time as a distribution of the tax-free portion of the life insurance policy benefits. Similar results may also occur in the partnership context. This measure will apply to dispositions of an interest in a life insurance policy that occur on or after March 22, 2016.
Other measures ensure appropriate adjustments to the capital dividend account for private corporations and the adjusted cost base rules for partnerships in respect of policy benefits are received as a result of deaths that occur on or after March 22, 2016, where the old policy transfer rule applied in respect of the acquisition of the interest in the policy.
