Canada: (A Little) More Closing Loopholes And Filling Potholes As The Medals Pile Up

When the host of the Tonight Show, Johnny Carson or Jay Leno (or the soon to be Jimmy Fallon), was on vacation, the producers of the show had a choice – hire a guest host or show "Best of" episodes. With our macro-economic guru off trotting the globe, we are faced with the same choice. Since a guest writer did not seem like a good idea (and we recall what transpired when Conan O'Brien took over the reins of the "Tonight Show" from Jay Leno), we decided to go the "Best of" route and review the highlights from the last few budgets. Two central themes emerge. On the economic side, there has been considerable stimulus, much of it in the form of infrastructure spending highlighted by a $33 billion Building Canada plan in 2007 and a new $53 billion 10 year plan in 2013. On the fiscal front, recent budgets have seen considerable focus on "fairness and integrity" in the tax system and the closing of perceived "loopholes".

The 2010 Budget put an end to foreign tax generators that allowed corporations to claim foreign tax credits for foreign taxes that had not been paid. In 2011, measures were introduced to prevent tax deferral by corporations through the use of partnerships, corporations from creating losses on the redemption of shares and the avoidance of non-resident withholding tax through the use of stripped coupons. Budget 2012 contained rules to restrict the ability to increase or "bump" the cost base of certain partnership interests under paragraph 88(1)(d) of the Income Tax Act (Canada) (the "Act") and to prevent the tax-free sale of such interests to non-residents. That same Budget saw the introduction of the foreign affiliate dumping rules designed to prevent excessive leveraging of Canadian corporations by acquiring shares in foreign affiliates as well as a tightening of the thin capitalization rules. Finally, last year's Budget targeted character conversion transactions using derivative forward agreements, synthetic dispositions, certain leveraged insurance products and loss trading transactions. The 2013 Budget also introduced more changes to the thin capitalization rules – expanding their application to Canadian resident trusts and non-resident corporations and trusts. Over the last five years, the loophole closers at the Department of Finance have certainly been busy.

Anyone who has taken a train into Toronto's Union Station lately knows that more can be spent on infrastructure and although the main focus of the Budget is job creation and the balancing of the budget, Budget 2014 does provide additional funding to municipalities in various regions in Canada for spending on infrastructure. On the tax side, Budget 2014 does not contain the large number of fairness and integrity measures we have seen in past years but there is still a sprinkling of such measures that are discussed below.

INTERNATIONAL TAX MEASURES

Captive Insurance

The foreign accrual property income ("FAPI") rules in the Act contain provisions to prevent Canadian resident corporations from shifting the income earned from the insurance of Canadian risks to an off-shore affiliate and thereby escaping Canadian tax on such income. These rules provide that income from the insurance of Canadian risks is FAPI of a controlled foreign affiliate if more than 10% of the gross premium revenue of the affiliate from the insurance of risks is in respect of the insurance of Canadian risks. Over the years, structures have been developed in which a controlled foreign affiliate of a Canadian resident corporation insures non-Canadian risks and then enters into certain swap arrangements that enable it to earn a return that tracks the return on a similar pool of policies that insure Canadian risks. Under the proposed rule, income from the insurance of the non-Canadian risks in such circumstances will be deemed to be income from a business other than an active business and thereby included in FAPI.

Specifically, the new rule provides that risks (the "foreign policy pool") insured by a foreign affiliate of a taxpayer resident in Canada that would not otherwise be a risk in respect of a person resident in Canada, a property situated in Canada or a business carried on in Canada are deemed to be risks in respect of a person resident in Canada if the affiliate enters into agreements or arrangements in respect of the foreign policy pool and, as a result of such agreements and arrangements, the affiliate's risk of loss or opportunity for gain or profit in respect of the foreign policy pool can reasonably be considered to be determined by reference to certain economic criteria in respect of one or more risks insured by another person where 10% or more of such risks are Canadian risks.

This measure is the latest example of rules designed to counter tax planning using derivative transactions following last year's measures aimed at character conversion transactions and synthetic dispositions. These legislative fixes are an indication of the Canada Revenue Agency's apprehension to attempt to apply the general anti-avoidance rule to such transactions. As was the case with last year's changes, the Budget Commentary notes that while the targeted transactions may be challenged under existing rules (including the general anti-avoidance rule), such challenges can be both time consuming and costly and therefore, specific legislation is being enacted to counter the impugned transactions.

This measure will apply to taxation years of taxpayers that begin on or after February 11, 2014 ("Budget Day").

Offshore Regulated Banks

The FAPI rules provide that income from an "investment business" carried on by a foreign affiliate of a taxpayer is included in the affiliate's FAPI. Generally, an "investment business" is defined as a business the principal purpose of which is to derive income from property. There are several exceptions to the definition, one of which excludes certain financial services businesses.

One such exception, known as the regulated foreign financial institution exception, treats certain bona fide financial services businesses carried on by foreign affiliates as active businesses rather than as investment business. Some Canadian taxpayers that are not financial institutions have tried to qualify for this exception by establishing foreign affiliates and electing to have those affiliates subject to regulation under foreign banking and financial laws. However, these foreign affiliates do not facilitate financial transactions for customers, rather the main purpose of such affiliates is to invest or trade in securities on their own account.

Budget 2014 seeks to narrow the conditions for meeting the regulated foreign financial institution exception. The proposals effectively ensure that the status of the Canadian taxpayer will be used as a proxy for whether a foreign affiliate of such taxpayer may be considered to carry on a bona fide regulated financial services business.

Generally, the exception will be available where the following conditions are satisfied: (i) the Canadian taxpayer is a regulated Canadian financial institution (generally defined to mean a Schedule I bank, a trust company, a credit union, an insurance corporation or a trader or deal in securities or commodities that is resident in Canada, and carries on a business the activities of which are supervised by the Superintendent of Financial Institutions or similar provincial regulator), and (ii) more than 50% of the total taxable capital employed in Canada of the Canadian taxpayer and all related Canadian corporations is attributable to taxable capital employed in Canada of regulated Canadian financial institutions. Certain regulated Canadian financial institutions that have equity of at least $2 billion will be deemed to satisfy this second condition.

Budget 2014 notes that satisfying these new conditions will not guarantee that income of a foreign affiliate of a taxpayer from proprietary activities will be considered income from an active business. In order for this result to occur, the affiliate must carry on a regulated foreign financial services business, as required under the existing law, and the proprietary activities must comprise part of that business.

This measure will apply to taxation years of taxpayers that begin after 2014. The Department of Finance is welcoming comments concerning the scope of these new rules.

Back-to-Back Loans

In previous budgets, the Government sought to reform the regulations surrounding the tax treatment of certain interest payments made by taxpayers to non-resident persons. Budget 2012 amended the thin capitalization rules to lower the debt-to-equity ratio "cap" from 2:1 to 1.5:1, to extend the application of the rules to partnerships, and to re-characterize interest expense that is denied under the thin capitalization rules as a dividend for Canadian withholding tax purposes. Budget 2013 extended the thin capitalization rules to apply to Canadian resident trusts and non-resident corporations and trusts, as well as to partnerships of which a Canadian trust, a non-resident corporation or trust, are members.

Budget 2014 continues the reform; this time closing the loophole regarding "back-to-back" loans. These arrangements generally involve interposing a third party (e.g. a foreign bank) between two related taxpayers (such as a foreign parent corporation and its Canadian subsidiary) in an attempt to avoid the application of the thin capitalization rules that would apply if a loan were made, and the interest paid on the loan, directly between the two taxpayers. Budget 2014 proposes the addition of a specific anti-avoidance rule in respect of withholding tax on interest payments, and the amendment of the existing anti-avoidance provision in the thin capitalization rules.

Specifically, a back-to-back loan arrangement will exist where the following conditions are met: (i) a taxpayer has an outstanding interest bearing loan to a lender (the intermediary) and (ii) the intermediary (or any non-arm's length person) (a) is pledged a property by a non-resident person as security in respect of the loan (but does not include, in and of itself, a guarantee), (b) is indebted to a non-resident person under a debt for which recourse is limited, or (c) receives a loan from a non-resident person on condition that a loan be made to the taxpayer. If such an arrangement exists, certain amounts will be deemed to be owing by the taxpayer to the non-resident person for purposes of the thin capitalization rules. Generally, the taxpayer will be deemed to owe an amount to the non-resident person (the lesser of (a) the amount owing to the intermediary, and (b) the fair market value of the property pledged, outstanding amount of the debt for which recourse is limited, or the loan made on condition) and the taxpayer will be deemed to have an amount of interest payable to the non-resident person that is equal to the proportion of the interest payable by the taxpayer on the loan owing to the intermediary that the deemed amount owing is on that loan.

More importantly, Part XIII withholding tax will then apply to the arrangement to the extent it would otherwise have been avoided by virtue of the arrangement. The non-resident person and the taxpayer will be jointly and severally (or solidarily) liable to such withholding tax.

This measure will apply (i) in respect of the thin capitalization rules, to taxation years that begin after 2014, and (ii) in respect of Part XIII withholding tax, to amounts paid or credited after 2014.

Consultation on treaty shopping

Budget 2013 announced the Government's concerns regarding the risks posed to the tax base by "treaty shopping", an arrangement whereby a person not entitled to the benefits of a particular tax treaty with Canada uses an entity that is resident of the state with which Canada has concluded the particular treaty so as to obtain Canadian tax benefits. Further to the announcement in Budget 2013 of its intention to consult on possible measures to counter this issue without unduly hindering foreign investment, the Government released a consultation paper on August 12, 2013 to commence discussion and solicit comments aimed at generating a workable solution to the treaty shopping issue.

The Government has, through its consultation paper and the stakeholder comments it has received, explored different approaches that can be used to address treaty shopping, including whether a general or specific rule would be most appropriate, as well as whether the rule should be integrated in Canada's tax treaties or its domestic law. A general rule approach, based on a main purpose test, would deny treaty benefits where one of the main purposes for entering into a transaction is to obtain the benefits in question. A specific rule approach would target specific situations where treaty benefits should be denied (e.g. the limitation on benefits provision under Article XXIX A of the Canada-U.S. tax treaty).

Budget 2014 announces the Government's proposal to adopt a general rule approach to treaty shopping, citing its position that it would prevent a wider range of treaty shopping arrangements, albeit at the expense of greater taxpayer certainty. Budget 2014 also announces the Government's proposal to integrate any adopted rule in its domestic legislation, rather than in its treaties.

Accordingly, the Government's proposed rule to prevent treaty shopping will seek to target broadly defined avoidance transactions and will contain deeming provisions to facilitate its application. In order to afford taxpayers a degree of certainty and predictability, the proposed rule will contain specific elements purporting to set out the ambit of its application. Budget 2014 sets out the main components of the proposed rule as follows:

• Main purpose provision: this component would provide for the denial (subject to the relieving provision) of treaty benefits to a person in respect of an amount of income, profit or gain, where it is reasonable to conclude that one of the main purposes for undertaking a transaction that results in the benefits (or a transaction that is part of a series of transactions or events that results in the benefits), was for the person to obtain the benefits.
• Conduit presumption: to supplement the main purpose provision, this component would provide for a rebuttable presumption that one of the main purposes for undertaking a transaction that results in treaty benefits (or a transaction that is part of a series of transactions or events that results in the benefits) was for a person to obtain the benefits in circumstances where the relevant income, profit or gain is primarily used to pay, distribute or otherwise transfer, directly or indirectly, at any time or in any form, an amount to another person or persons that would not have been entitled to equivalent or more favourable benefits had they received the relevant income, profit or gain directly.
• Safe harbor presumption: subject to the conduit presumption, this component would provide for a rebuttable presumption that none of the main purposes for undertaking a transaction was for a person to obtain a benefit under a tax treaty in respect of relevant income, profit or gain if any of the following apply: − the person (or a related person) carries on an active business (other than managing investments) in the state with which Canada has concluded the relevant treaty and, where the relevant income, profit or gain is derived from activity of a related person in Canada, the active business is substantial compared to such activity;
  
  
  • the person is not controlled, directly or indirectly in any manner whatever, by another person or persons that would not have been entitled to equivalent or more favourable benefits had they received the relevant income, profit or gain directly; or
  • the person is a corporation or trust the securities of which are regularly traded on a recognized stock exchange.
• Relieving provision: this component would provide for the granting of treaty benefits (in whole or in part), despite the application of the main purpose provision, to the extent that it is reasonable having regard to all the circumstances.

Budget 2014 also provides five examples (some of which contain fact patterns which are similar to recent cases where the taxpayer prevailed) illustrating the potential application of its proposed rule to certain types of arrangements:

In July 2013, the Organization for Economic Co-operation and Development (OECD) issued an Action Plan to address, inter alia, treaty shopping. The Action Plan calls for the development of "model treaty provisions and recommendations" to prevent the granting of treaty benefits in treaty shopping circumstances. It should be noted that Budget 2014 acknowledges the relevance of the OECD recommendations in this regard (which are expected to be issued in September 2014) to further developing the Canadian approach to treaty shopping.

Finally, in keeping with the Government's domestic law approach, Budget 2014 proposes to include the proposed rule, if adopted, in the Income Tax Conventions Interpretation Act, so that it would apply in respect of all Canadian tax treaties. The rule would apply to taxation years commencing after the enactment of the rule.

The Government invites comments from interested parties on the components of its proposed treaty shopping rule, on the examples provided in Budget 2014, as well as on whether transitional relief would be appropriate.

Similarly, the Government has proposed the beginning of a consultation process on the broader issue of tax planning by multinational enterprises, more specifically regarding the issue of base erosion and profit shifting.

BUSINESS INCOME TAX MEASURES

Tax Incentives for Clean Energy Generation

Under the current capital cost allowance regime ("CCA") regime, specified clean energy generation and conservation equipment benefit from an accelerated CCA rate of 50% per year on a declining balance basis, providing a financial incentive to their use by deferring taxation. This incentive for investment is premised on the environmental benefits of low-emission or no-emission energy generation equipment and energy conversation equipment. These "Class 43.2" assets include equipment that generate or conserve energy by using a renewable energy source (for example, wind, solar, small hydro) or fuels from waste (for example, landfill gas, wood waste, manure) or makes efficient use of fossil fuels (high efficiency cogeneration systems for example).

Budget 2014 seeks to expand Class 43.2 assets to include water-current energy equipment and equipment used to gasify eligible waste fuel for use in a broader range of applications – the purpose of such proposals being to encourage investment in technologies that can contribute to a reduction in emissions of greenhouse gases and air pollutants. These measures will apply to property acquired on or after Budget Day that has not been used or acquired for use before that date.

Consultation on Eligible Capital Property

In Budget 2014 the Government announced that it would begin a consultation process to discuss overhauling the current eligible capital property ("ECP") regime and incorporating it into the CCA regime. The ECP regime deals with the tax treatment of certain capital expenditures and receipts that are not otherwise accounted for as business revenues or expenses, or dealt with under the CCA regime (which allows for the depreciation of certain capital assets). Under the ECP regime, businesses add expenses made to acquire certain "eligible capital property" (which generally includes intangible property such as goodwill) to a pool called the cumulative eligible capital ("CEC") pool at a rate of 75%. Amounts added to the CEC pool can be deducted on a declining-balance basis at a rate of 7% per year. Proceeds of disposition from the sale of "eligible capital property" reduce the CEC pool at a rate of 75%. Any reduction of the CEC pool past nil will result in recapture of any previously claimed CEC, and then any excess receipt will be included in income from the business at a 50% inclusion rate.

In an effort to deal with the increasing complexity of the ECP regime, the Government is proposing to start a public consultation in order to consider adding a new CCA class that would replace the ECP regime and apply to expenditures that previously would have been added to the CEC pool. Expenses would be included in the new CCA class at a rate of 100%, but would only be depreciable at a rate of 5% per year. The consultation will also consider new special rules to deal with how goodwill would be accounted for, and to deal with the transition from the ECP regime to the CCA regime. No date has been announced yet for the beginning of the consultation or the release of draft legislation.

PERSONAL TAX MEASURES

Non-resident trusts

Last year, after more than a decade of proposing various changes to the non-resident trust rules, Parliament finally implemented the current non-resident trust rules (the "NRT Rules") in section 94 of the Act. Generally, the NRT Rules deem a non-resident trust to be resident in Canada where a Canadian resident contributes property to the trust. Where the rules apply, a non-resident trust must file a Canadian income tax return and must generally pay tax on its worldwide income (although the trust may be able to elect to only pay Canadian tax on income related to contributions from Canadian residents). The NRT Rules apply where there is a Canadian resident beneficiary to a non-resident trust, subject to several detailed exceptions. Currently, there is an exception in the rules pursuant to which someone who has been resident in Canada for less than 60 months can contribute to a non-resident trust without causing the trust to become subject to the NRT Rules. Budget 2014 proposes to eliminate this exception, such that contributions by new Canadian residents may now cause a non-resident trust to become subject to the NRT Rules. The proposed changes will apply to taxation years that end on or after Budget Day. However, a trust to which the 60-month exemption currently applies will be grandfathered until taxation years ending after 2014, provided that no contributions are made to the trust after Budget Day and before 2015.

Extension of the Mineral Exploration Tax Credit for flow-through share investors

Flow-through shares allow companies to renounce or "flow-through" tax expenses associated with their Canadian exploration activities to investors who can deduct the expenses in calculating their own taxable income. The Mineral Exploration Tax Credit is also available to individuals who invest in flow-through shares, equal to 15 percent of specified mineral exploration expenses incurred in Canada and renounced to flow-through share investors. Budget 2014 proposes to extend eligibility for the Mineral Exploration Tax credit for one year, to flow-through share arrangements entered into on or before March 31, 2015.

Tax on split income

The Canadian income tax system generally imposes tax on individuals separately based on a progressive marginal rate structure. As a result, in the absence of special rules in the Act, a higher-income taxpayer could use income-splitting strategies that would effectively shift income which would otherwise be earned by the taxpayer to related individuals (such as children of the taxpayer) who are subject to lower marginal tax rates. The Act contains rules (a.k.a. the tax on split income or "kiddie tax"), which limit the opportunities for taxpayers to engage in income-splitting practices with their minor children. In general terms, this is achieved by subjecting the "split income" earned by a minor child to the highest federal marginal tax rate (29%) regardless of the marginal rate that the income would otherwise be taxed at in the hands of the child. "Split income" is currently defined in the Act to include:

• taxable dividends received by the minor child (either directly or indirectly through a partnership or trust) on unlisted shares of both Canadian and non-Canadian corporations (other than shares of mutual fund corporations);
• capital gains realized by the minor child on the dispositions of unlisted shares (of the type described above) to persons with whom the minor child does not deal at arm's length; and
• partnership or trust income that is derived from providing property or services to, or in support of, a business carried on by a person related to the minor child or in which the related person participates.

Budget 2014 proposes to expand the definition of "split income" so that it also includes income that is, directly or indirectly, paid or allocated to a minor child from a partnership or trust if: (a) it is derived from a business or rental property, and (b) a person related to the minor (such as a higher-income parent) is either (i) actively engaged on a regular basis in the activities of the partnership or trust to earn income from any business or rental property, or (ii) has, in the case of a partnership, a direct or indirect interest in the partnership.

The expanded definition of "split income" will apply to the 2014 and subsequent taxation years.

Graduated rate taxation of trust and estates

In general terms, the Act imposes tax on the taxable income of a trust at the highest marginal tax rate (i.e., 29%) unless the trust is: (a) a testamentary trust, or (b) a "grandfathered" inter vivos trust created before June 18, 1971 (and which satisfies certain other conditions). Only if the trust fits within one of these exceptions, can it benefit from the progressive marginal tax rate structure in the Act.

In Budget 2013, the Department of Finance announced its intention to consult with the public on possible measures to eliminate the tax benefits enjoyed by testamentary trusts and grandfathered trusts as a result of their ability to utilize the graduated tax rates in the Act. On June 3, 2013, a consultation paper on this issue was released and the related period for public comment expired on December 2, 2013.

Budget 2014 proposes to implement the measures outlined in the consultation paper. Specifically, subject to two exceptions, Budget 2014 proposes to impose the top marginal tax rate of 29% on the taxable income of testamentary trusts and grandfathered trusts. The first exception applies, in general terms, to testamentary trusts (that are estates arising on, or as a consequence of, a death) during the first 36 months of their existence (i.e., measured from the death of the testator). The second exception will apply to trusts that have as their beneficiaries, individuals that are eligible to benefit from the disability tax credit – although details of this exception will be announced by the Department of Finance at a later date.

Budget 2014 also proposes to eliminate a number of rules in the Act which provide special treatment for testamentary trusts and grandfathered trusts including: an exemption from the income tax installment rules, access to the basic exemption from alternative minimum tax, preferential treatment under Part XII.2 of the Act and the ability to have an off-calendar taxation year. In support of the last-mentioned change, Budget 2014 contains rules which will cause testamentary trusts (that do not already have a December 31st taxation year) to have a deemed tax year-end on December 31, 2015 (or in the case of a trust that is an estate created on the death of a taxpayer, the date that is 36 months after the date the trust was created, if such date is after 2015).

These measures will generally apply to the 2016 and subsequent taxation years.

Charities

Budget 2014 proposes to create greater flexibility with respect to the tax treatment of charitable donations made by an individual's estate, beginning in 2016. Currently, where an individual makes a donation to a registered charity by will or through the designation of a Registered Retirement Savings Plan, Registered Retirement Income Fund, Tax-Free Savings Account or life insurance policy, the charitable donation tax credits resulting from the gift can only be used against the individual's income in the year of his or her death. The proposed changes would deem these donations to have been made by the individual's estate, and would allow the estate's trustee to claim the corresponding tax credits in the taxation year of the estate in which the donation is made, an earlier taxation year of the estate, or the last two taxation years of the individual.

In addition, currently, individuals can generally claim a charitable donation tax credit and corporations can claim a charitable donation deduction where they make a gift of property to a registered Canadian charity or other "qualified donee". The amount of the credit or deduction is generally based on the fair market value of the donated property. However, in order to prevent taxpayers from benefiting from abusive tax shelter schemes, normally where the taxpayer has acquired property as part of a tax shelter gifting arrangement, the value of the gift is deemed to be no greater than the taxpayer's cost of the gift. Previously, there was an exception to this rule for donations of "certified cultural property". Budget 2014 proposes to eliminate this exception, such that a taxpayer will no longer be able to obtain a charitable tax credit or deduction in excess of their cost of certified cultural property obtained under a tax shelter gifting arrangement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.