Minister of Finance, Bill Morneau, tabled the 2019 Budget today (“Budget Day”). This Thorsteinssons update summarizes some of the main tax takeaways.
The tax measures introduced in the Budget should not impact the vast majority of businesses. As a pre-election budget, the Government appears to have shied away from tax measures that could cause a negative backlash from the business community. By and large, the Government has instead settled for a smattering of tax integrity measures that combat specific planning strategies entered into by a limited number of (mostly institutional) taxpayers.
That said, the Government is proposing a new $200,000 annual cap on preferential tax treatment given to stock options for employees of “large, long-established, mature firms.” Reading between the lines, it may also be clear that the Government is leaving the door open to address “surplus stripping” after the upcoming election – an issue it previously put on ice after the backlash from the 2017 private corporations paper.
Two measures involving transfer pricing can be expected to increase compliance costs for many taxpayers with international activities. In particular, the Government is proposing to codify the Canada Revenue Agency’s (“CRAs”) position that the transfer pricing provisions contained in Part XVI.1 of the Income Tax Act (Canada) (the “Act”) can apply in conjunction with other provisions involved in the computation of Part I income. The Government is also proposing to expand the foreign affiliate dumping (“FAD”) rules to apply to corporations resident in Canada that are controlled by non-resident individuals or trusts.
Employee Stock Options
As many expected, the Government has proposed to amend the employee stock option regime. However, rather than wholesale changes, the proposed measures cap the tax-preferred treatment of certain stock option grants.
Currently, employees who receive stock options are required to include the value of the benefit in income, but effectively receive capital gains treatment by way of a 50% deduction against the income inclusion (the “stock option benefit”). Further benefits are provided to employees who receive options of Canadian-controlled private corporations (“CCPCs”) and transact at arm’s length with their employer, which includes the stock option benefit being deferred until the employee disposes of the shares.
The Government proposes to apply a $200,000 annual cap on employee stock option grants that receive tax-preferred treatment “for employees of large, long-established, mature firms.” The stock option benefit realized by an employee on stock options subject to these new rules will be fully taxed at ordinary rates and deductible for corporate income tax purposes. However, the employee will continue to benefit from the current stock option regime on the exercise of stock options below the $200,000 limit.
The $200,000 annual cap will be based on the fair market value of the underlying shares when the options are granted. The Government has not provided any details as to what constitutes a “large, long-established, mature firm.” Presumably, the definition of a “large, long-established, mature firm” will attempt to satisfy the Government’s stated objective to ensure that the employee stock option benefits remain uncapped for “start-ups and emerging Canadian businesses.”
The Budget does not provide further details of this measure, but promises that it will release details before the summer of 2019.
If enacted, the proposals would not apply to employee stock options granted prior to the announcement of legislative proposals to implement the new measures. Therefore, options granted between the Budget Day and the announcement of legislative proposals in the summer of 2019 will continue to benefit from the current regime.
In July 2017, the Government released a discussion paper on tax planning using private corporations. Among the measures discussed in that paper, the Government proposed new provisions to prevent the conversion of dividend income into capital gains, colloquially known as “surplus stripping.”
In October 2017, in the face of significant pushback to the proposed measures that many viewed as overly-broad, the Government stated that it would not move forward with the proposals due to “several unintended consequences, such as in respect of taxation upon death and potential challenges with intergenerational transfers of businesses.” However, the Government stated that it would “continue its outreach […] to develop proposals to better accommodate intergenerational transfers of businesses while protecting the fairness of the tax system.”
The Budget effectively reiterates this statement. According to the Budget document, the Government “will continue its outreach to farmers, fishers and other business owners throughout 2019 to develop new proposals to better accommodate intergenerational transfers of businesses while protecting the integrity and fairness of the tax system.”
While not entirely clear, the Government appears to be waiting until after the next federal election to propose any measures that would address “surplus stripping”. The July 2017 proposals had the effect of changing the tax rate applicable on the deemed disposition of shares of a private company from capital gain rates (approximately 25%) to dividend rates (approximately 35% to 45%) so this is a very important issue.
Transfer Pricing Ordering
The most significant international tax measure for most taxpayers concerns the interaction of Canada’s transfer pricing rules in Part XVI.1 with other provisions in the Act that are relevant to the computation of Part I tax, which can come into conflict in various scenarios.
For example, section 17 can deem interest to be paid on amounts lent by Canadian resident corporations to non-residents, where the amounts are lent for no interest or less than “reasonable” interest. Due to this deeming rule, many taxpayers simply pay the prescribed rate of interest under section 17 without regard to Canada’s transfer pricing rules. The basis for this position is reasonable: section 17 is specific with respect to the rate of interest that should be paid on certain debt, whereas the transfer pricing provisions apply more generally to any transaction involving non-arm’s length non-residents.
The Government is proposing to amend the Act so that the transfer pricing rules in Part XVI.1 apply in priority to the application of other provisions. Therefore, in the above example, it appears that taxpayers will no longer be able to take the position that the prescribed rate under section 17 “trumps” the transfer pricing provisions. The proposed amendments appear to be intended to ensure that taxpayers apply the transfer pricing provisions (including the requirement to obtain contemporaneous documentation) to all transactions involving non-arm’s length non-residents, regardless of whether more specific provisions in the Act that could apply to the transactions.
However, the measures will not apply to the existing exceptions to the application of the transfer pricing rules with respect to amounts owing by, or guarantees in respect of amounts owing by, controlled foreign affiliates of Canadian resident corporations.
This measure will apply to taxation years that begin on or after Budget Day.
Transfer Pricing Reassessment Period
The Budget proposes to broaden subparagraph 152(4)(b)(iii) so that the extended three-year reassessment period applies for all transactions involving a taxpayer and a non-resident with whom the taxpayer does not deal at arm’s length.
As a result, the reassessment period for the Minister to make a transfer pricing adjustment will in all cases be extended to six years (or seven years if the taxpayer is a mutual fund trust or a corporation other than a CCPC).
This measure will apply to taxation years for which the normal reassessment period ends on or after Budget Day.
Trading in Tax-Free Savings Accounts
Under new proposed measures, joint and several liability for tax owing on income from carrying on a business in a tax-free savings account (“TFSA”) will be extended to the TFSA holder. Furthermore, the existing joint and several liability of a trustee of a TFSA at any time in respect of business income earned by a TFSA will be limited to the property held in the TFSA at that time plus the amount of all distributions of property from the TFSA on or after the date that a notice of assessment is sent.
Other International Tax Measures
The Budget proposes additional international tax measures, which are briefly summarized:
- Foreign Affiliate Dumping. The FAD rules will be extended to apply to a corporation resident in Canada (“CRIC”) that is controlled by a non-resident individual or trust. Currently, the FAD rules only apply to CRICs that are controlled by non-resident corporations (or by a related group of non-resident corporations). These changes to the FAD rules are similar to other tax integrity measures contained in recent budgets, which have extended existing anti-avoidance regimes to additional types of entities. For example, Budget 2018 extended the cross-border surplus stripping rules in section 212.1 to account for transactions involving partnerships and trusts.
- Securities Lending Arrangements. New rules are proposed to target fairly complex planning that seeks to avoid Part XIII tax on dividend compensation payments payable by Canadian residents to non-residents under securities lending arrangements (“SLAs”) involving shares of Canadian issuers. The existing rules apply to SLAs that involve a non-resident lending a share to a Canadian resident, and the Canadian resident agreeing to return an identical share to the non-resident in the future. The non-resident retains the same economic exposure as if it had continued to hold the share because the Canadian resident is obligated to make dividend compensation payments as compensation for any dividends paid by the issuer of the lent share. Generally, dividend compensation payments made under a “fully collateralized” SLA are treated as dividends for purposes of the non-resident withholding regime under Part XIII.
The new rules proposed in the Budget are intended to combat planning to avoid the rules that characterize the dividend compensation payments as dividend payments. First, all dividend compensation payments made under a SLA by a Canadian resident will now be treated as a dividend, regardless of whether the SLA is fully collateralized. Second, the dividend characterization rules will now apply to a “specified securities lending arrangement,” which is more broadly defined than an SLA. Additional rules will address other unintended benefits that taxpayers can derive by using SLAs.
Other Tax Integrity Measures
The Budget includes proposals to prevent planning that circumvents various existing tax integrity measures in the Act. These proposals apply to a fairly limited range of planning, and therefore have limited application outside certain institutional taxpayers that sell structured products.
- Mutual Fund Trusts: Allocation to Redeemers Methodology. The Budget contains proposals concerned with tax planning strategies involving redemption of mutual fund trust units. The planning targeted by the measures utilizes the “allocation to redeemers methodology” (a methodology that is intended to eliminate double taxation on the redemption of units in the mutual fund trust) in a way that either produces income deferral or allows the mutual fund trust to convert the returns on an investment that would have the character of ordinary income to capital gains for their remaining unitholders.
- Derivative Forward Agreements. The Budget proposes amendments to the “derivative forward agreement” provisions so that certain investments, that would otherwise be exempt, are caught by the regime. Effectively, the derivative forward agreement rules prevent taxpayers from converting what would otherwise be taxable income on a portfolio of investments into capital gains by entering into a forward purchase agreement for Canadian securities, the value of which was based on the performance of the reference portfolio. The Budget attempts to enhance the integrity of these rules by preventing taxpayers from qualifying for the commercial transaction exception if one of the main purposes of the series of transactions that includes entering the agreement to purchase the securities is to convert an amount paid on the security into a capital gain.
- Individual Pension Plans. The final major tax integrity measure in the Budget focuses on transactions whereby individuals established “individual pension plans” (“IPP”) sponsored by a newly-incorporated private corporation, and transferred the commuted value of their entitlement under a defined benefit plan to the new IPP. This planning allowed the individual to obtain a full tax-free rollover from the defined benefit plan to the IPP, which they controlled. The Budget proposal will effectively limit the rollover from a defined benefit pension plan to an IPP to situations where the employer remains the same.
The Budget provides modest tax incentives for specific areas. The following measures are of particular note:
- The Budget delivers a temporary measure for businesses to deduct the cost of “eligible zero-emission vehicles” on a current basis. This measure will be implemented through a first-year capital cost allowance (“CCA”) rate of 100 per cent for vehicles that fall into two new CCA classes: Class 54 for zero-emission vehicles that would otherwise be included in Class 10 or 10.1; and Class 55 for zero-emission vehicles that would otherwise be included in Class 16. Among other things, vehicles will only be eligible for the enhanced deduction if they are fully electric, a plug-in hybrid with a battery capacity of at least 15 kWh or fully powered by hydrogen. This measure will apply to eligible zero-emission vehicles acquired on or after Budget Day and that become available for use before 2028, subject to a phaseout for vehicles that become available for use after 2023.
- The Home Buyers’ Plan (“HBP”) allows first-time home buyers to withdraw up to $25,000 from their Registered Retirement Savings Plan (“RRSP”) to purchase or build a home, without having to pay tax on the withdrawal. The Budget proposes to increase the HBP withdrawal limit to $35,000 for withdrawals made after Budget Day. Other changes are proposed to the HBP to accommodate breakdowns in marriage or common-law relationships.
- The Budget proposes to add two new types of annuities to qualify as permitted investments under certain registered plans:
- advanced life deferred annuities will be permitted under a RRSP, registered retirement income fund (RRIF), deferred profit sharing plan (DPSP), pooled registered pension plan (PRPP) and defined contribution registered pension plan (RPP); and
- variable payment life annuities will be permitted under a PRPP and defined contribution RPP.