Canada: The Stikeman Elliott Federal Budget Commentary 2021

The more things change, the more they stay the same

Highlights

Business Income Tax Measures

• Limitations on Interest Deductibility
  • Limiting net interest expense to a fixed ratio of "tax EBITDA"
• Mandatory Disclosure Rules
  • Broadening the scope of what constitutes a "reportable transaction"
  • Implementing a mandatory disclosure regime whereby "notifiable transactions" must be reported to the CRA
  • Requirement to disclose "uncertain tax treatments"
• Avoidance of Tax Debts
  • Strengthening the existing rules in the Tax Act which prevent taxpayers from avoiding their tax liabilities by transferring assets to non-arm's length parties
• Supporting clean energy

International Tax Measures

• Limiting the deduction of payments made by Canadian residents under "hybrid mismatch arrangements"
• Consultation on possible changes to transfer pricing rules

Other Tax Measures

• COVID-19 support measures
• Proration of tax on registered investments
• Application of GST/HST to e-commerce
• Proposal to strengthen the general-anti avoidance rule
• Confirmation of proposed changes to stock option rules

For months, there has been widespread speculation as to the measures that Budget 2021 would introduce, given that it has been more than two years since the last federal budget and the COVID-19 pandemic continues to have a significant impact on the economy. One of the most notable aspects of Budget 2021, however, is that it does not include certain measures that many expected would be introduced. More specifically, there is:

• No increase in personal tax rates
• No change to the principal residence exemption
• No wealth tax
• No increase to the tax rate applicable to capital gains
• No substantive changes to the taxation of "Canadian-controlled private corporations"

While some may breathe a sigh of relief, Budget 2021 does contain several measures aimed at curtailing tax avoidance. These measures, as well as other significant proposals contained in Budget 2021, are discussed below.

Business Income Tax Measures

Limitations on Interest Deductibility

Consistent with the recommendations of the Organisation for Economic Co-operation and Development (the "OECD") and previous promises by the Canadian federal government as part of its 2019 pre-election platform, Budget 2021 proposes to introduce, effective for taxation years commencing on or after January 1, 2023, an "earnings-stripping" rule that would limit the amount of net interest expense that a corporation (and certain other types of entities, as described below) may deduct in computing its taxable income to no more than a fixed ratio of the corporation's "tax EBITDA". For these purposes, "tax EBITDA" is the corporation's taxable income before taking into account interest expense, interest income and income tax, and tax deductions for depreciation and amortization. Some key aspects of the proposal are as follows:

• The proposed interest deductibility limitations will apply to corporations, partnerships and trusts and Canadian branches of non-resident taxpayers. Canadian-controlled private corporations that, together with associated corporations, have taxable capital employed in Canada of less than $15 million will be exempt from the proposed regime, as will groups of corporations or trusts whose net interest expense among their Canadian members is $250,000 or less.
• The fixed ratio interest deductibility limitation applicable to "tax EBITDA" would apply to new and existing borrowings and would be phased in, with a fixed ratio of 40% applying to taxation years beginning on or after January 1, 2023 but before January 1, 2024, and a 30% fixed ratio applying for taxation years beginning on or after January 1, 2024.
• Canadian members of a group that have a ratio of net interest to tax EBITDA below the fixed ratio would generally be able to transfer their unused capacity to deduct interest to other Canadian members of the group whose net interest expense deductions would otherwise be limited by the rule.
• In circumstances where a taxpayer is able to demonstrate that the ratio of net third party interest to book EBITDA of its consolidated group implies that a higher deduction limit would be appropriate, the proposed measure also includes a "group ratio" rule that would allow a taxpayer to deduct interest in excess of the fixed ratio of tax EBITDA. The consolidated group, for purposes of the group ratio rule, would generally encompass all of the corporations that are fully consolidated into a parent corporation's audited consolidated financial statements. Such audited consolidated financial statements would generally be used to measure net third party interest expense and book EBITDA for these purposes, subject to "appropriate adjustments" including, among other things, in respect of certain interest payments to creditors that are outside the consolidated group but are related to, or are significant shareholders of, Canadian group entities.
• Interest denied under the earnings-stripping rule would be able to be carried forward for up to 20 years and may be carried back up to 3 years, subject to a number of complex constraints and limitations.
• "tax EBITDA" would exclude dividends to the extent they qualify for the inter-corporate dividend deduction or the deduction for certain dividends received from foreign affiliates.
• Interest expense and interest income would include not only amounts that are legally interest, but also certain payments that are economically equivalent to interest, and other financing-related expenses and income.
• Existing thin-capitalization rules in the Income Tax Act (Canada) (the "Tax Act") will continue to apply, but any interest denied under that regime would not be included as interest expense under the proposed regime.
• Interest expense and interest income related to debts owing between Canadian members of a corporate group would generally be excluded from the proposed regime.
• Budget 2021 also notes that the application of the proposed earnings-stripping regime to financial institutions raises a number of challenges, and accordingly, indicates that (i) banks and life insurance companies will not be permitted to transfer their unused capacity to deduct interest to other members of their corporate groups that are not also regulated banking or insurance entities, and (ii) further consideration will be given to whether there are targeted measures that could address base erosion concerns associated with excessive interest deductions by regulated banks and life insurance companies.

The proposed earnings stripping regime, if enacted, will implement the most significant change to the legislative landscape for the deductibility of interest in modern Canadian history. Draft legislation on the proposal is expected to be released for comment later this year and, undoubtedly, many interpretive issues and areas of uncertainty will be identified upon a detailed review of that draft legislation. However, it is noteworthy that the Budget materials state that: "Consistent with the rationale of the group ratio rule, it is expected that standalone Canadian corporations and Canadian corporations that are members of a group none of whose members is a non-resident would, in most cases, not have their interest expense deductions limited under the proposed rule." Further, Budget 2021 promises that measures "to reduce the compliance burden on these entities and groups will be explored."

Mandatory Disclosure Rules

Budget 2021 proposes to significantly expand the circumstances in which taxpayers or their advisors may be required to report certain aggressive transactions or uncertain tax positions to the Canada Revenue Agency (the "CRA"). The stated purpose of these proposed changes is to allow the government to quickly respond to aggressive tax planning strategies through informed risk assessments, audits and changes to legislation. The proposed rules are in part influenced by or modeled after recommendations made in the Base Erosion and Profit Shifting Project, Action 12: Final Report of the OECD and the Group of 20, as well as some similar rules introduced in other jurisdictions.

There are three specific disclosure regimes that are proposed to be implemented or expanded, each of which is described below. There are two main consequences of failing to comply with any of these proposed disclosure requirements. First, a taxpayer, or if applicable, a tax promoter or advisor, may be subject to material penalties for failing to file the required disclosure by the applicable deadline. Second, the normal reassessment period whereby the CRA may reassess a taxpayer will not start running until the disclosure has been made. Accordingly, the CRA would have an unlimited amount of time to reassess a taxpayer that has failed to properly disclose a transaction or position that should have been disclosed.

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