2021 Federal Budget – A Critical Analysis and Overview of the Principal Proposed Income Tax Measures

Authors: Alexander Demner, Tyler Berg, and Gloria Wang

The federal government released its 2021 budget on April 19, 2021. Coming in as the longest budget in Canadian history, Budget 2021 proposes a myriad of income tax measures. This blog provides an overview and critical analysis of the most significant income tax proposals which are of primary relevance to businesses, accountants, and other tax advisors.

This article does not analyze the digital services tax announced in Budget 2021; see our earlier detailed blog on the digital services tax here. For brevity, this article also does not substantively analyze many of the less significant tax measures announced in Budget 2021.

International Tax Measures

Budget 2021 proposes to introduce two significant international income tax measures – rules limiting the deductibility of interest, and provisions addressing so-called “hybrid mismatch” arrangements. Each follows separate Action Reports released by the Organization for Economic Co-Operation and Development (“OECD”) examining base erosion and profit shifting (“BEPS”) concerns. No specific legislation for either measure was provided in Budget 2021.

Interest Deductibility Limits

Budget 2021 expresses concern regarding the deductibility of interest paid by Canadian businesses that “erode the Canadian tax base” – for example, through payments to related non-residents in low-tax jurisdictions or having Canadian businesses bear disproportionate amounts of a multinational group’s third-party borrowings. Existing rules, such as the “thin capitalization” rules, restrict the ability to implement such profit-shifting techniques, but Budget 2021 nevertheless announces the federal government’s intention to introduce an “earnings-stripping” rule (in line with the OECD’s Action 4 Report).

As described, the new rules will essentially limit the net interest expense deductible by a business to 30% of its “tax EBITDA” (or 40% in the first year of the rules’ application). Annex 6 in the budget outlines various special adjustments that would be made in computing tax EBITDA – e.g., deductible intercorporate dividends would be excluded, but payments “economically equivalent to interest” would be included. In our view, the specific formula(e) calculating tax EBITDA will be critical and may determine much of the scope and consequence to this rule.

Proposed exemptions include: (i) Canadian-controlled private corporations (“CCPCs”) that, together with associated companies, have less than $15 million of taxable capital employed in Canada; or (ii) corporate groups whose net Canadian interest expense is $250,000 or less. A “group ratio” rule will also be introduced that may permit otherwise-denied interest to be deducted if a corporate group’s audited consolidated financial statements (subject to certain adjustments) imply that a higher deduction limit would be appropriate. Any denied interest would be subject to complex carryback and carryforward rules.

Finance “expects” that Canadian corporate groups without a non-resident member would not be subject to these rules. This seems justifiable given the lack of Canadian base erosion in such a structure. Notably, however, Budget 2021 does not expressly outline a safe harbour for purely Canadian corporate groups with no foreign affiliates or other related non-resident entities.

The proposed measures would apply to taxation years beginning on or after January 1, 2023. Draft legislative proposals are expected to be released for comment this summer. Since these measures are expected to generate over $5.3 billion by 2027 – nearly $2 billion more than the digital services tax –the government will presumably be motivated to quickly move forward with these proposals.

Hybrid Mismatch Arrangements

A second anti-BEPS measure proposed in Budget 2021 relates to so-called “hybrid mismatch” arrangements – described as cross-border tax avoidance structures that exploit the differing tax treatment of an entity or financial instrument under the laws of two or more countries. The budget extensively cites the OECD’s Action 2 Report in that regard.

Two main rules are proposed under this heading:

• First, outbound payments made by a Canadian resident would not be deductible if they: (i) are not included in the non-resident recipient’s income; or (ii) give rise to a further deduction in another country. These are described as “deduction / non-inclusion mismatches”.
• Second, inbound payments that are deductible to the non-resident payor would: (i) be included in the Canadian-resident recipient’s income; and (ii) not be deductible (including, if the payment is a dividend, not eligible for the dividend deduction under section 113 of the Income Tax Act (Canada) (the “ITA”)). These are described as “double deduction mismatches”.

Budget 2021 suggests that further rules implementing other OECD recommendations may also be introduced if “relevant and appropriate”. In addition, these rules would be “mechanical in nature” in that no purpose test would need to be met. Since a tax avoidance purpose is not required, many taxpayers invested in “hybrid” entities for bona fide commercial reasons (e.g., U.S. LLCs) may unwittingly face undue hardship.

Draft legislation will be released in two tranches – the first set of rules will be released later in 2021 (and would apply as of July 1, 2022) and the second set will be forthcoming after 2021 (and would be effective no earlier than 2023).

COVID-19 Support and Recovery Programs

Budget 2021 proposes to extend the expiry of the Canada Emergency Wage Subsidy (“CEWS”) and Canada Emergency Rent Subsidy (“CERS”), including the related Lockdown Support, until at least September 25, 2021. These programs are currently set to expire on June 5, 2021.

The rules governing the CEWS and CERS are highly complex and detailed. For an overview and in-depth analysis of the applicable rules and definitions, readers can refer to our earlier posts regarding the CEWS here and here and the CERS here.

Although the CEWS and CERS are being extended, starting July 4, 2021 the subsidy amounts will begin to decline and employers must suffer a qualifying revenue decline of at least 10% to be eligible. The following table summarizes the relevant CEWS amounts and maximum weekly benefits per employee starting June 6, 2021:

For the CERS, the subsidy amounts will be calculated as follows:

The “Lockdown Support” component of the CERS – providing an additional subsidy of up to 25% of qualifying rent expenses incurred by businesses subject to a public health restriction – will continue to be available through to September 25, 2021.

Unrelated to the foregoing extensions, Budget 2021 proposes to restrict CEWS claims by public companies if the aggregate compensation paid by such companies to their “Named Executive Officers” (e.g., CEOs and CFOs) in 2021 exceeds the equivalent compensation paid in 2019. In that scenario, the corporation must repay an equivalent amount of the CEWS received after June 5, 2021. This measure is presumably in response to concerns raised by the public and media regarding the allegedly inappropriate use of CEWS receipts. However, there is no suggestion that these rules will restrict dividends paid by public companies to their shareholders (which was also an area of public concern).

Finally, Budget 2021 announced a new “hiring subsidy” through the Canada Recovery Hiring Program (“CRHP”). The program appears aimed at encouraging employers to hire additional employees, or pay their existing employees more, as they recover from COVID-19. The CRHP would adopt many of the concepts and eligibility criteria applicable to the CEWS.

Under the CRHP, beginning June 6, 2021 a portion of the net increase in eligible remuneration paid to employees during a qualifying period as compared to the aggregate remuneration paid between March 14 and April 10, 2021 would be subsidized. The subsidy amount starts at 50% of the net increase, declining in increments to 20% for the final period of October 24 to November 20, 2021. Eligible employers will be able to claim either the hiring subsidy or the CEWS, but not both.

Expanded Mandatory Disclosure Rules

Under section 237.3 of the ITA, taxpayers (and their advisors) undertaking “reportable transactions” are required to disclose prescribed information to the Canada Revenue Agency (“CRA”). A reportable transaction generally means an “avoidance transaction” which meets two out of three so-called “hallmarks” – namely, a variable or contingent promoter fee, “confidential protection” for the promoter / advisor, and the existence of “contractual protection”. Failing to report as required results in the tax benefit being denied, and significant penalties potentially being imposed. These rules are intended to enhance timely information flow regarding targeted transactions to the CRA.

Budget 2021 proposes to greatly expand these rules. The budget also outlines a new “notifiable transaction” regime, and further mandates the disclosure of “uncertain tax treatments” by public companies. Each proposal would generally apply starting January 1, 2022, and feedback on each measure is requested by September 3, 2021.

Expansion of Reportable Transaction Rules

The first set of proposals would expand the existing reportable transaction rules as follows:

• reporting will be required if any of the above three hallmarks are met;
• an “avoidance transaction” will include any transaction with only one of the main purposes being to obtain a tax benefit, not merely those with the primary purpose of doing so; and
• reporting would be required within 45 days of entering into the transaction or being contractually obligated to enter into the transaction.

These proposals could result in many commonplace and uncontroversial tax planning measures becoming reportable transactions. Given the serious consequences associated with failing to report, advisors will need to pay careful attention to these amendments (if enacted).

New “Notifiable Transaction” Regime

Budget 2021 separately proposes to introduce a new “notifiable transaction” regime. Under those proposals, any transaction which the CRA either determines to be abusive or identifies as a “transaction of interest” would be subject to enhanced, timely reporting. Budget 2021 states those proposals are similar to existing rules in the U.S. and Australia.

Under the proposed regime, the CRA would publicly set out fact patterns or outcomes that constitute a notifiable transaction. Examples of specific transactions or series of transactions might also be provided. It would then be incumbent on taxpayers to determine whether any proposed transaction is sufficiently similar to constitute a notifiable transaction. If so, the relevant transaction or series of transactions would need to be reported to CRA within 45 days of entering into, or being contractually obligated to enter into, the transaction(s).

New Requirement to Report “Uncertain Tax Treatments”

Budget 2021 further proposes to require certain taxpayers to disclose “uncertain tax treatments” in their tax returns. The proposed measures seem to be in response to the decision in BP Canada (2017 FCA 61), which held that the CRA did not have authority to compel disclosure of the specific “tax accrual working papers” in question.

The reporting obligation will generally apply where:

• the corporation is required to a file a Canadian tax return;
• the corporation, on a standalone basis, has assets listed on its balance sheet with an aggregate carrying value of at least $50 million;
• the corporation, or a related corporation, has audited financial statements prepared in accordance with International Financial Reporting Standards (IFRS) – which is typically required for Canadian public companies – or other country-specific generally accepted accounting principles (e.g., U.S. GAAP); and
• the audited financial statements reflect an uncertain tax treatment – that is, the entity concludes it is “not probable” that the CRA will accept a particular uncertain tax treatment.

Corporations reporting uncertain tax treatments would also be required to provide prescribed information, such as the quantum of taxes at issue, a description of the relevant facts, the tax treatment taken (including the relevant sections of the ITA), and whether the uncertainty results in a temporary or permanent difference in tax. Although the budget states that only “limited” administrative burdens are expected for reporting corporations, the extent of information to be disclosed is clearly quite extensive and would highlight specific transactions.

Extended Reassessment Period and Penalties

To backstop each of those three proposed amendments, Budget 2021 provides that the “normal reassessment period” in respect of a reportable transaction would not commence until the associated reporting requirement is satisfied. Thus, a reassessment in respect of an issue may never become statute-barred if an applicable reporting obligation is not satisfied – whether the taxpayer was initially aware of such an obligation or not.

Failure to comply with a reporting obligation may also bring significant penalties. Taxpayers may be subject to penalties of $500 per week up to the greater of $100,000 and 25% of the relevant tax benefit. Advisors and promoters of reportable or notifiable transactions may also face severe penalties.

Immediate CCA Expensing on Qualifying Properties

Budget 2021 proposes to provide temporary, immediate expensing for certain “eligible properties” acquired by CCPCs on or after April 19, 2021. The new measures are intended to encourage capital investments across all economic sectors, and is stated as being a general economic revitalization tool.

“Eligible property” would include capital property that is subject to the CCA rules, other than property in certain CCA classes comprising “long lived” assets (e.g., classes 1 and 14.1). Further, the subject property must be purchased from an arm’s length party on a non-rollover basis and be available for use before January 1, 2024. Taxpayers may also only immediately expense up to $1.5 million (shared amongst associated companies) of qualifying capital expenditures incurred per year. Certain overarching “integrity” measures (e.g., the specified leasing property rules) would continue to apply.

These proposals are similar to the “accelerated investment incentive property” regime announced in 2018. However, given the number of qualifying properties, high annual monetary threshold, and immediate write-off, businessowners may find this regime significantly more beneficial.

Tax Rate Reduction for Zero-Emission Technology Manufacturers

Budget 2021 proposes to temporarily reduce the corporate income tax rate for qualifying zero-emission technology manufacturers. That is, for the next several years eligible corporations would pay federal tax at the rate of only 4.5% instead of 9.0% (at the small business rate) or 7.5% instead of 15.0% (at the general corporate rate) on qualifying income. The stated intent is to incentive taxpayers to transition, even in part, to zero-emission technology manufacturing.

To qualify, at least 10% of a company’s gross revenue must be derived from “eligible activities”. Generally, eligible activities are zero-emission technology manufacturing or processing (“M&P”) activities – for example, manufacturing solar, wind or water energy conversion equipment or zero-emission vehicles, batteries or fuel cells. Eligible activities would not include activities that do not qualify as M&P for the purposes of the CCA rules.

The reduced tax rates would apply to a corporation’s “adjusted business income” multiplied by the proportion of labour and capital costs used in eligible activities. Both concepts would be substantially based on the existing rules for calculating M&P profits. In essence, eligible income would be prorated according to the proportion of a corporation’s resources that are devoted to zero-emission technology M&P. No adjustments would be made to the dividend gross-up and tax credit rules, notwithstanding the lower corporate tax rate payable by eligible companies.

These measures would apply to taxation years beginning after 2021, but gradually phase out starting 2029. The reduction would be fully eliminated as of 2032.

National Vacancy Tax

Budget 2021 describes a new proposed “tax on unproductive use” of Canadian residential real estate by foreign non-resident owners. Although no draft legislation was released, the proposals provide for an annual tax of 1% on the value of “non-resident, non-Canadian owned residential real estate” that is “vacant or underused”. Certain exemptions from the tax are suggested (e.g., qualifying tenancy arrangements), but all owners of residential real estate in Canada, except potentially Canadian citizens and permanent residents, will be required to file an annual declaration stating the current use of residential property they own.

Limited details were provided in the budget, though the federal government plans to release a consultation paper in the coming months. As proposed, the tax would apply as of January 1, 2022.

Tax Debt Avoidance Transactions

Budget 2021 raises concerns that certain taxpayers are engaging in transactions designed to avoid section 160 of the ITA. That section generally deems a transferee of property received from a non-arm’s length party to be jointly and severally liable to pay the transferor’s tax debt, to the extent (if any) that the fair market value of the transferred property exceeds the value of the consideration given by the transferee. Certain recent cases – namely, 594710 B.C. Ltd. (2018 FCA 166), Eyeball Networks (2021 FCA 17), and Damis Properties (2021 TCC 24) – analyze transactions which were challenged by the CRA as either being subject to, or inappropriately circumventing, section 160.

Budget 2021 proposes three specific anti-avoidance rules to counter such transactions, albeit without accompanying draft legislation:

• The first rule targets inappropriate “deferrals of tax debts”. It would deem a tax debt to arise before the end of a transferor’s taxation year in which a property transfer occurs if it is reasonable to conclude that the transferor (or a non-arm’s length person) knew, or ought to have known, that the transferor would owe a tax amount – or would owe a tax amount if not for “additional tax planning” done as part of the series of transactions – arising in a subsequent taxation year and one of the purposes for the property transfer was to avoid the payment of that future tax debt. This appears in specific response to 594710 B.C. Ltd., in which (per the court in Damis Properties) “section 160 was circumvented by the triggering of a year-end to place the tax liability in a different (future) year from the transfer of property in issue.” Nevertheless, the implication that this rule could deem the transferor to owe a tax debt even if “additional tax planning” by the transferee appropriately results in that tax liability being reduced or eliminated is concerning.
• The second rule targets intentional “avoidance of non-arm’s length status”. That rule would deem a transferor and transferee, who would otherwise deal with each other at arm’s length at the time of a property transfer, not to deal at arm’s length if: (i) the parties did not deal at arm’s length with each other at any time within the same series of transactions; and (ii) one of the purposes of a transaction or event was to cause the parties to deal at arm’s length at the time of transfer. This rule seems to be in direct response to the transactions analyzed in Damis Properties.
• The third rule seemingly imposes a new valuation principle. Specifically, the “overall result” of a series of transactions would be considered in determining the value of property transferred and consideration given. Eyeball Networks and the standard “butterfly” transactions analyzed therein appear to be the focus of this rule. However, the rule’s conceptual operation and the manner in which it would technically apply are not readily discernible.

Bolstering these rules is a proposed penalty on “planners and promoters of tax debt avoidance schemes”. That penalty would be equal to the lesser of: (i) 50% of the tax attempted to be avoided; and (ii) $100,000 plus the planner or promoter’s compensation. As such, one would expect that in most cases the penalty would be greater than $100,000.

Perhaps most troubling is that, notwithstanding the lack of any specific legislative provisions, the above rules are already in force; that is, they apply in respect of property transfers occurring on or after April 19, 2021. The absence of clear guidance regarding the circumstances in which those rules might apply – backstopped by extremely serious penalties – should be a matter of considerable consternation for tax advisors.

Expanded CRA Audit Powers

Section 231.1 of the ITA provides the CRA with extensive audit powers. Those powers are not unlimited, however. In the recent decision of Cameco (2019 FCA 67), for example, the Federal Court of Appeal held – in the specific circumstances under review – that the CRA did not have the authority to compel employees of the corporation under audit to attend an interview in person and answer questions orally.

In response, Budget 2021 proposes to expand the CRA’s audit powers to expressly permit auditors to compel taxpayers to answer questions orally or in writing, in any form the auditor specifies. Given the breadth and serious implications of such a power, this change – which would come into force when the proposed legislation receives Royal Assent – will be of significant concern for taxpayers and advisors alike.

Notably, the proposed rules do not include procedural safeguards such as those that apply to oral examinations for discovery in Tax Court of Canada proceedings (e.g., the presence of a court reporter transcribing every statement). In Cameco, one of the reasons the corporation refused the CRA’s request was that oral interviews, which had not been recorded, were conducted in a previous audit and the parties later had “very different recollections” of what had been said. Even more concerning, answers given by a taxpayer in an oral interview might be used to advance a criminal investigation or prosecution under the rule in Jarvis (2002 SCC 73), potentially engaging constitutional issues.

Additional Income Tax Measures

Budget 2021 contains many other income tax proposals, including:

• enhancing the Canada Workers Benefit;
• expanding the disability tax credit and northern residents’ deduction;
• permitting repaid COVID-19 benefits to be deducted in the year of initial receipt;
• prorating Part X.2 tax for “registered investments” based on the number of investors subject to the “qualified investment” rules;
• limiting the possibility of registered charities being used for terrorist financing purposes;
• creating a new investment tax credit for capital invested in “carbon capture, utilization and storage” (CCUS) projects;
• expanding the list of “clean energy” equipment eligible for enhanced CCA write-offs and removing existing entitlements for certain fossil-fuelled and low efficiency waste-fuelled electrical generation equipment;
• permitting the electronic transmission of correspondence, assessments, and tax slips, even without taxpayer authorization;
• qualifying post-doctoral fellowship income as “earned income” for RRSP purposes;
• facilitating or mandating electronic filing of tax returns and online payments; and
• extending timelines to claim certain film and video tax credits.

Budget 2021 also reaffirms the government’s commitment to various previously-announced but as-of-yet unpassed legislative proposals. Various public consultations – including regarding possible changes to the ITA’s transfer pricing rules to prevent the “inappropriate shifting of corporate income out of Canada” (citing Cameco (2020 FCA 112)) – were also announced.

Conclusion

Budget 2021 outlines several extensive proposed changes to the ITA. The absence of specific draft legislation for many of the proposals, however, gives rise to significant uncertainty for taxpayers and their advisors. We will continue to monitor the proposals and provide further details as and when specific statutory provisions or consultation papers are released.