Principal tax measures from Federal Budget 2023 – Part 1: Personal and private company measures

Budget 2023 – A Made-in-Canada Plan: Strong Middle Class, Affordable Economy, Healthy Future (“Budget 2023”) was tabled by the Department of Finance (“Finance”) on March 28, 2023 (“Budget Day”). The stated focus of Budget 2023 includes targeted inflation relief, stronger public health care and significant investments towards building Canada’s clean economy. Budget 2023 introduced numerous significant income tax proposals touching on personal, business and international income taxation matters.

This post is the first of a three-part series analyzing the principal tax measures in Budget 2023. In this post, we discuss four proposals to amend the Income Tax Act (Canada) (the “Act”) that primarily affect individual and corporate taxpayers: changes to the alternative minimum tax (“AMT”), changes to the taxation of intergenerational business transfers (i.e., the Bill C-208 saga), introduction of employee ownership trusts, and proposals related to the general anti-avoidance rule (the “GAAR”).

Alternative minimum tax (AMT)

The AMT is a set of personal tax computation rules that operate in parallel to the ordinary income tax calculation rules. An individual or trust (other than certain trusts) is required to pay AMT when the result of the AMT calculation is higher than the individual’s ordinary tax computation. Additional tax paid as a result of the AMT may be carried forward seven years and credited against ordinary income tax. AMT may be non-recoverable if the individual fails to earn sufficient ordinary income in the ensuing seven years to utilize that credit.

Budget 2023 proposes to make significant changes to the AMT rules in order to “better target … high-income individuals”. While generally achieving that goal, the proposed changes lead to surprising results in several common situations (outlined below). Since draft legislation was not included alongside the budget materials, however, there remains an element of supposition.

Prior to Budget 2023, the AMT applied at the rate of 15% with a standard exemption amount of $40,000. Budget 2023 proposes to raise the AMT rate to 20.5% and increase the exemption amount to the start of the fourth federal tax bracket, which is expected to be approximately $173,000 in 2024. That threshold will be indexed for inflation.

Budget 2023 also proposes to increase the base on which AMT is computed. The main changes to the AMT base would be:

• the inclusion rate for capital gains increasing from 80% to 100%;
• the inclusion rate for employee stock option benefits always being 100%;
• capital gains realized on the donation of publicly-listed securities and the benefit associated with donating employee stock options now being included at the rate of 30%;
• disallowing 50% of numerous deductions, including non-capital loss carryovers, child care expenses, moving expenses, disability support deductions, and certain interest and carrying changes; and
• disallowing 50% of non-refundable tax credits, with limited exceptions.

Budget 2023 confirms that certain features of the AMT rules will not be impacted by these proposals. These features include the net 30% inclusion rate for capital gains sheltered by the lifetime capital gains exemption, inclusion of the cash (non-grossed-up) value of dividends, and non-relevancy of the dividend tax credit. The AMT carry-forward period will also remain seven years, notwithstanding the likely increase in AMT payable resulting from these proposals.

These proposed changes, if enacted, are likely to catch many taxpayers off guard. There is significant risk of surprising AMT implications. For example:

1. Large capital gains: The new AMT rules result in an initial effective top marginal federal rate of 20.5%, which is 4% higher than the 16.5% top federal marginal rate applicable to capital gains under the ordinary rules (i.e., one-half of 33%). Factoring in provincial tax, the combined AMT rate on such a capital gain would be about 32% for a BC resident and about 33% for an Ontario resident (vs. 26.75% and 26.76%, respectively, at top marginal rates under the ordinary tax computation). This may surprise individuals who realize large capital gains in a year, especially since any AMT could become permanent if not recovered in the ensuing seven years.

2. Capital loss carry-forwards: While capital gains are to be fully included in the proposed AMT computation, only 50% of capital loss carry-forwards will count. This may result in residual income for AMT purposes where prior year capital losses are carried forward to shelter capital gains. Individuals with unused net capital losses from prior years should consider utilizing those losses this year (i.e., before the new AMT would come into force).

3. Donations of publicly listed securities: Under the ordinary tax rules, capital gains realized on donations of publicly listed securities are reduced to nil. This encourages in-kind donations of publicly traded securities (which are easily liquidated by the donee). Under the proposed AMT computation rules, 30% of capital gains realized on such donations would be included in the AMT computation; this may produce surprising outcomes on donations of publicly listed securities – particularly since only 50% of charitable tax credits might be factored in. The changes could readily dissuade individuals from making donations.

4. Resource tax credits and flow-through shares: There are tax incentives designed to attract investment in certain sectors. Individuals will need to pay close attention to the new AMT rules in respect of such investments — particularly in relation to flow-through share and resource sector investments — as applicable non-refundable tax credits may not be fully creditable under the new AMT computation rules.

Budget 2023 confirms that trusts currently exempt from the AMT would continue to be exempt. Finance is also apparently considering whether additional types of trusts should be exempted from the AMT rules.

The proposed changes to the AMT computation rules would come in force for taxation years beginning after 2023.

Intergenerational business transfers

Historically, sales of corporate shares to family members resulted in significantly worse outcomes than selling to a third party.

In 2021, Bill C-208 (a private member’s Bill) introduced changes that attempted to provide arm’s length tax treatment to certain intergenerational share transfers; i.e., in situations where an individual sells qualified small business corporation shares (“QSBCS”) or “share[s] of the capital stock of a family farm or fishing corporation” (“SFFC”) to a corporation controlled by their adult children or grandchildren. The objective of these changes was to allow parents to obtain capital gains treatment (and potentially claim their lifetime capital gains exemption) on the sale, while also allowing the purchase price to be corporately funded.

The legislative history of Bill C-208 is unusual (as described in our earlier blog post) and the enacted legislation contained several drafting ambiguities. Shortly after enactment, Finance set out its intention to overhaul the intergenerational transfer exclusion to safeguard against “unintended tax avoidance loopholes.” Budget 2023 contains the new intergenerational transfer scheme.

Finance has proposed two options for undertaking an intergenerational transfer: an “immediate” or “gradual” transfer of QSBCS or SFFC. Both proposed avenues have done away with the affidavit and valuation requirements required under the existing rules. They also introduce an array of new conditions, which can be summarized as follows:

Most of these conditions do not apply under the current Bill C-208 rules. The proposed regime is far more restrictive and arguably goes beyond addressing “unintended tax avoidance loopholes.”

The concept of a “relevant group entity” appears frequently in these conditions. A “relevant group entity” is a person or partnership who carries on, at the transfer time, an active business that is relevant to determining whether the subject shares are QSBCS or SFFC. This may effectively require the first-generation individuals to exit not only the business they intend to transfer but any inter-related family businesses within their corporate group. These rules may also pose a hardship where several family businesses will be transitioned to children at different times. Further, the concept of “relevancy” which underpins the relevant group entity definition is not defined in the proposed rules and may lead to confusion or potential disputes.

Several consequential rules have been introduced to facilitate this scheme. This includes a ten-year capital gains reserve for intergenerational transfers and relieving rules where a child dies, is incapacitated, or transfers their shares to an arm’s length party. The limitation period for reassessment of intergenerational transfers will be extended by three years for immediate transfers and ten years for gradual transfers.

These proposals are expected to come into force on January 1, 2024, meaning that the current rules will likely continue to apply for transactions carried out in 2023. Taxpayers should consider the implications under the existing versus proposed regimes in deciding whether to expedite transfers of their business to the next generation while the current rules remain in effect.

Employee ownership trusts

Budget 2023 introduced a new form of trust — the employee ownership trust (“EOT”) — as a succession planning option for business owners. In general, an EOT is Canadian-resident trust that acquires shares of a corporation for the benefit of the corporation’s employees. An EOT is intended to facilitate a business transfer to those employees.

The EOT regime contains numerous conditions and limitations. As a result, it can reasonably be expected that there will be minimal uptake of the succession route presented by these rules.

First, all employees (other than those in a maximum 12-month probationary period) must be beneficiaries of the EOT. Further, distributions to those employees must be determined by formula and may only consider their length of service, remuneration, and hours worked. Such factors must apply to all employees in the same manner. This precludes the trustees from taking into consideration other factors – such as non-pecuniary contributions to the business, responsibility level, and placement within the overall business – when making distributions. An EOT is also precluded from acting in the interests of one or more beneficiaries to the prejudice of one or more other beneficiaries (i.e., no favouring some employees over others).

An EOT is also prohibited from distributing shares of the company to the employee beneficiaries. This renders a single employee’s interest in the structure unsaleable. This may be unattractive compared to other employee share ownership structures designed to facilitate the divestiture of an employee’s interest in the company on cessation of employment (e.g., sidecar arrangements). On a sale of shares held by the EOT, employees may benefit from certain designations on the distribution of sale proceeds (e.g., to treat the resulting gains as though realized by the employee directly), though such designations must be made by the EOT and may not be available to all employees.

Additional restrictions include:

• limited influence and post-transfer ownership entitlements to vending shareholders;
• who can serve as a trustee of the EOT, how those trustees are elected, and the frequency of elections; and
• the purposes and accepted assets of an EOT.

Budget 2023 also proposed several changes that are aimed at facilitating investment in and use of EOTs, including:

• excluding EOTs from the 21-year deemed disposition rule for personal trusts;
• an extended capital gain reserve for “qualifying business transfers” to an EOT; and
• permitting EOTs to borrow funds from the target company without attracting the shareholder loan rules in s.15(2) provided that, among other things, bona fide arrangements are made when the loan is issued for repayment within 15 years of the “qualifying business transfer” (i.e., 15 years instead of the maximum two-year repayment exception under s. 15(2.6)).

The EOT amendments are proposed to apply as of January 1, 2024.

General anti-avoidance rule

Further to a consultation paper released in August 2022, Budget 2023 proposes to significantly amend the general anti-avoidance rule (the “GAAR”) found in section 245 of the Act by:

• introducing a preamble;
• lowering the “avoidance transaction” standard;
• introducing an economic substance test;
• introducing an automatic GAAR-based penalty; and
• extending the reassessment period for GAAR assessments. 

Preamble

Proposed subsection 245(0.1) of the Act introduces a preamble to the GAAR. It provides that the GAAR strikes a balance between taxpayers’ need for certainty in planning their affairs and the government’s responsibility to protect the tax base and fairness of the tax system. The preamble also clarifies that the GAAR is intended to apply regardless of whether a tax benefit was foreseen at the time of the transaction (ostensibly to rebut statements to the contrary in Canada v. Alta Energy Luxembourg S.A.R.L., 2021 SCC 49 – see our earlier blog post on that case here). Although Finance suggests the preamble will help address interpretive issues in applying the GAAR, it seems unlikely to have much practical effect in the course of a GAAR dispute.

Anti-avoidance standard

The GAAR will only apply if there is an “avoidance transaction”. Currently, a transaction will not be an avoidance transaction if it may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain a tax benefit. Under proposed 245(3), the standard would change such that a transaction would be an avoidance transaction if, among other things, it may reasonably be considered that one of the main purposes for undertaking or arranging the transaction was to obtain a tax benefit.

The proposed changes would broaden the application of subsection 245(3) of the Act and lower the standard for what is considered an avoidance transaction. In practice, however, much of the GAAR jurisprudence turns on whether the transaction results in a misuse or abuse of the provisions of the Act. As such, it remains to be seen whether the change in the avoidance transaction standard will materially affect the legal analysis in future GAAR decisions.

Economic substance test

The proposed economic substance test would be introduced via new subsection 245(4.1) of the Act. That test would be considered only in the “misuse or abuse” stage of the GAAR analysis (found in subsection 245(4) of the Act). Significantly, however, subsection 245(4) itself would remain unchanged.

In Alta Energy Luxembourg, the majority differentiated between a transaction that is primarily or solely tax-motivated and a transaction that is abusive. Under the proposed amendments to the GAAR, while a lack of economic substance will not necessarily result in the finding that the transaction is abusive, it “tends to indicate” the transaction results in misuse or abuse for the purposes of subsection 245(4) of the Act. Proposed subsection 245(4.1) also includes a list of factors that “tend — depending on the particular circumstances — to establish” a transaction or series of transaction is significantly lacking in economic substance:

(i) all or substantial all of the opportunity for gain or profit and risk of loss of the taxpayer (taken together with those of non-arm’s length taxpayers) remains unchanged, including because of a circular flow of funds; offsetting financial positions; or the timing between steps in the series;

(ii) it is reasonable to conclude that, at the time of the transaction was entered into, the expected value of the tax benefit exceeded the expected non-tax economic return (which excludes both the tax benefit and any tax advantages connected to another jurisdiction); and

(iii) it is reasonable to conclude that the entire, or almost entire, purpose for undertaking or arranging the transaction or series was to obtain the tax benefit.

The third factor essentially seeks to establish that a transaction motivated solely by tax considerations will indicate abuse, contrary to the long-held view that the presence of an avoidance transaction does not in itself establish misuse or abuse.

Budget 2023 emphasizes that even when economic substance is lacking, it will be necessary to determine the object, spirit and purpose of the provisions in the Act. Transactions with sufficient economic substance will still be subject to existing misuse or abuse jurisprudence. The introduction of the economic substance test may shift the evidentiary burden to the taxpayer to demonstrate there is sufficient economic substance in undertaking certain transactions. However, given the ambiguity of the terms “tends to indicate” and “tend to establish”, much remans unclear in how the economic substance test will be applied.

Penalty

Budget 2023 further proposed to introduce a penalty that would automatically apply in respect of transactions subject to the GAAR. The amount of that penalty would be 25% of the amount of the tax benefit sought or achieved. An exception applies for transactions disclosed to the Minister under the “reportable transaction” rules in subsection 237.3(2) of the Act or as an optional disclosure for the GAAR under proposed 237.3(12.1). In addition, unutilized tax attributes are effectively disregarded for purposes of this penalty.

Given the potential quantum of the penalties (and the potential impact of the extended reassessment period, highlighted below), it may be reasonable to expect a significant increase in disclosures being made to the Minister.

Reassessment period

The proposed changes also include a three-year extension to the normal reassessment period for GAAR assessments, unless the transaction has been disclosed (mandatorily or voluntarily) to the Minister under the reportable transaction rules. Budget 2023 states this extension is based on the apparent complexity of many GAAR transactions and the difficulties associated in identifying them.

The government has invited stakeholders to provide comments on the proposed changes to the GAAR by May 31, 2023.