Budget 2016, entitled “Growing the Middle Class”, was released today by the Department of Finance. Here is our summary of the primary tax measures in Budget 2016 and some preliminary thoughts on their impact; statutory references are to the Income Tax Act (Canada) (the “Act”).
Tax System Review. Budget 2016 proposes to begin a review over the next year of the tax system to “eliminate poorly targeted and inefficient tax measures”. Presumably, this leaves the door open for further measures targeting one of the government key stated goals: “to prevent unintended tax advantages that businesses and high-net-worth individuals may be able to obtain through sophisticated tax planning techniques involving private corporations and other mechanisms.”
Small Business Deduction. Budget 2016 cancels the gradual reductions in the small business tax rate scheduled for 2017, 2018 and 2019. The federal small business rate will remain at 10.5 % for 2016 and subsequent taxation years.
The current $500,000 annual federal small business deduction rate will not change or be reduced in the future. The current gross-up factors and dividend tax credit rates applicable to non-eligible dividends will similarly remain unchanged.
As announced in Budget 2015, the Department of Finance reviewed whether income from property (rent and royalties) earned by corporations employing more than five full time employees should continue to qualify as active business income eligible for the small business deduction. This review is complete and Budget 2016 announced there will be no changes to the current rules.
Reduced Access to Multiple Small Business Deductions. Budget 2016 takes aim at some partnership and corporate structures that multiply access to the small business deduction. These new provisions are a direct hit on business structures commonly used by groups of professionals, such as doctors, accountants and lawyers. These measures also extend to other multiple-owner business structures.
Currently corporate members of a partnership are limited in the amount of small business deduction to a pro-rata share of $500,000. This eligible pro-rata share is known as “specified partnership income”. For example, a Canadian-controlled private corporation (CCPC) that has a 10% interest in a partnership has specified partnership income of, and can claim the small business deduction, on $50,000. There are ways to enhance access to the small business deduction. For instance, a second CCPC can provide services to the partnership. The amount paid to this second CCPC would normally be deductible to the partnership and taxable to the second CCPC at the small business rate up to the remaining small business limit for that CCPC – $450,000 in the above example.
For CCPC taxation years that begin on or after Budget Day, the specified partnership income rules that limit access to the small business deduction will be extended to where: (i) the CCPC provides (directly or indirectly, in any manner whatever) services or property to a partnership during a taxation year of the CCPC; and (ii) where, at any time in the year, the CCPC or one of its shareholders is either a member of the partnership or does not deal at arm’s length with a member of the partnership. In such circumstances, the CCPC is a “designated member” of the partnership (this is a new concept) and its specified partnership income is initially deemed to be nil. This means that none of the income from services or property provided to the partnership will be eligible for the small business deduction in the hands of the CCPC.
The new rules will permit an actual partner of the partnership who does not deal at arm’s length with the CCPC to notionally assign to the CCPC a portion of their specified partnership income.
There is a relieving provision for CCPCs that earn 90% or more of their active business income from providing services or property to arm’s length persons other than the partnership.
In essence, this proposal eliminates structures which extend the small business deduction to what would otherwise be partnership income by the use of service corporations.
A new concept of “specified corporate income” is also introduced for taxation years beginning on or after Budget Day, to address similar planning using a corporation.
A CCPC’s active business income from providing services or property (directly or indirectly in any manner whatever) in its taxation year to a private corporation will be treated as “specified corporate income” and ineligible for the small business deduction where the CCPC, one of its shareholders or a person who does not deal at arm’s length with such shareholder has a direct or indirect interest in the private corporation.
As with specified partnership income, a private corporation will be entitled to assign all or a portion of its unused business limit to CCPCs that are ineligible for the small business deduction where services are provided to the private corporation and the amount allocated is determined by the Minister of National Revenue to be reasonable in the circumstances. There is also a relieving provision for CCPCs that earn 90% or more of their active business income from providing services or property to arm’s length persons other than the private corporation.
Investment Income between Associated Corporations. Budget 2016 also fixes the Department of Finance’s concern with planning used to convert what would otherwise be investment income (such as interest or rental income) into active business income eligible for the small business deduction.
Associated corporations share the $500,000 federal small business limit on active business income. Where the aggregate taxable capital limit of the associated corporations exceeds $10M, the small business limit is reduced on a straight line basis until eliminated at $15M of aggregate taxable capital limit. Normally investment income is not eligible for the small business deduction; however, investment income realized by a CCPC from the active business of an associated corporation is eligible for the small business deduction.
Where there are two corporations (otherwise not associated) that are each associated with a third corporation, the first two are also associated with each other. If, however, the third corporation elects not to be associated with the first two, this breaks the association between the first two corporations. With the filing of this election, the third corporation is denied the small business deduction but each of the first two corporations remain associated with this third corporation for the purposes of conversion of investment income into active business income.
Budget 2016 provides that investment income derived from an associated third corporation’s active business will no longer be deemed to be active business income where the third corporation so elects not to be associated. Additionally, the third corporation will continue to be associated with the other two corporations for the purpose of applying the taxable capital limit. This measure is effective for taxation years that begin on or after Budget Day.
Eligible Capital Property. Budget 2016 repeals the current eligible capital property regime and introduces a new regime with a new Class 14.1 pool for capital cost allowance (CCA). Expenditures that had been included in the CEC pool will be included in Class 14.1 at a 100% inclusion rate and will be subject to a 5% rate of depreciation. Current CEC balances will be transferred to Class 14.1 as of January 1, 2017. The CCA depreciation rate for property included in the Class 14.1 pool related to expenditures incurred before January 1, 2017 will be 7% until 2027. To facilitate the elimination of small balances, taxpayers will be allowed until 2027 to deduct the greater of $500 and the amount otherwise deductible in respect of Class 14.1 asset. A current business deduction will be allowed for incorporation costs up to $3,000.
Special rules apply for expenditures and receipts that do not relate to a specific property of a business. Expenditures that do not relate to a specific property will increase the capital cost of the goodwill of the business, and consequently the balance of the Class 14.1 pool. In contrast, a receipt that does not relate to a specific property will reduce the capital cost of the goodwill of the business, and the balance of the Class 14.1 pool, by the lesser of the goodwill or the amount of the receipt. If the goodwill balance is nil, then the amount will be treated as a capital gain.
Repeal of 2015 Charitable Donation Proposal. Budget 2016 will repeal the 2015 proposal to exempt capital gains realized on dispositions of private corporation shares or real estate if the proceeds are donated to registered charity within 30 days.
Section 55 Measures Confirmed. Budget 2016 confirms the most recent proposed amendments to section 55 of the Act. These amendments have the effect of converting otherwise tax free inter-corporate dividends into proceeds of disposition or capital gains. Inter-corporate transactions now require careful tax analysis. To learn more about the proposed amendments to section 55 of the Act, read McInnes Cooper’s Legal Update: It Gets Worse – 5 Key Proposed Changes to Section 55 of the Income Tax Act.
Life Insurance Policies. Budget 2016 proposes amendments intended to ensure that only the portion of the policy benefit received by a corporation (or a partnership) that exceeds the policyholder’s adjusted cost basis of the policy is added to the corporation’s capital dividend account (or the adjusted cost base of a partner’s interest in the partnership). Corporations and partnerships that are not policyholders but are entitled to receive benefits under a life insurance policy will be subject to new information reporting requirements.
Budget 2016 also changes the rules relating to the non-arm’s length disposition of an interest in a life insurance policy. The fair market value of any consideration given for an interest in a life insurance policy (rather than the interest surrender value) will now be included in the proceeds of disposition and purchaser’s cost. Where the disposition of an interest in a life insurance policy arises on a contribution of capital to a corporation or partnership, any resulting increase in the paid-up capital of its shares and the adjusted cost base of the shares or of an interest in the partnership will be limited to the amount of the proceeds of disposition.
A retroactive rule is introduced for transfers of an interest in a life insurance policy before Budget Day for consideration in excess of the proceeds of disposition under the existing policy transfer rule. The amount permitted to be added to a corporation’s capital dividend account or the adjusted cost base of a partnership interest will be reduced by the amount of the excess. Similar rules will be put in place for transfers prior to Budget Day made as a contribution of capital to a corporation or partnership.
PERSONAL TAX MEASURES
Budget 2016 includes the following proposals affecting individuals:
Introduction of the Canada Child Benefit. The current child benefit system will be replaced with the new Canada Child Benefit. Qualifying families will receive a single payment each month on a tax-free basis beginning in July 2016. The new Canada Child Benefit will replace the Canada Child Tax Benefit and the Universal Child Care Benefit. An additional amount of up to $2,730 per child eligible for the disability tax credit will continue to be available in certain circumstances.
Elimination of Income-Splitting Measures. Budget 2016 proposes to eliminate income- splitting for couples with children under the age of 18 for the 2016 and subsequent taxation years. Pension income splitting will not be affected by this change.
Elimination of Children’s Fitness and Arts Tax Credits. Budget 2016 proposes to reduce the maximum eligible expenses for the Children’s Fitness and Arts Tax Credits by half for 2016. Both credits will be eliminated as of 2017.
Consequential Amendments (December 2015 Rate Changes). In December 2015, the Government announced the introduction of a top personal income tax rate of 33% on individual taxable income in excess of $200,000 and a reduction of the second personal income tax rate to 20.5% from 22%. At that time, consequential amendments were made relating to certain rules in the Act that use the top personal income tax rate or use rates or formulas that reflect the top personal income tax rate. Budget 2016 proposes further consequential amendments, including:
Labour-Sponsored Venture Capital Corporations Tax Credit. Budget 2016 restores the 15% labour-sponsored venture capital corporation (LSVCC) tax credit for provincially registered LSVCCs prescribed under the Act.
INTERNATIONAL TAX MEASURES
Budget 2016 includes the following international tax measures. To learn more about how Budget 2016 addresses international taxation issues, read Cross-Border Banter: BEPS and Liberal Government extends Anti-Conduit Rules to Royalties.
Base Erosion and Profit Shifting (BEPS) Measures. The Government is proceeding with initiatives to address base erosion and profit shifting (BEPS) subsequent to the release of the OECD’s final reports from the BEPS project in October 2015, including:
Debt-Parking Transactions. Budget 2016 proposes to introduce new specific anti-avoidance rules to address the avoidance of foreign exchange gains on foreign dollar denominated debt through a form of debt-parking transaction. Normally, a foreign exchange gain (or income) would be realized by a debtor if it repaid a foreign dollar denominated debt (e.g., USD) and the Canadian dollar had strengthened as against the foreign currency since the date of the borrowing. The gain could be avoided if the debt is instead purchased by a non-arm’s length person (a friendly purchaser) for a purchase price equal to the principal amount either in the foreign currency that the debt is denominated in or the Canadian dollar equivalent. In either scenario, the creditor is made whole, but in the latter scenario the debtor avoids the gain (or income) so long as the debt is not repaid. Under the new measures, accrued foreign exchange gains on a foreign currency debt will be realized when the debt becomes a “parked obligation”. These new measures piggy-back on the debt-parking regime currently in place to address the avoidance of the debt forgiveness rules through debt-parking transactions. The new measures will deem the debtor to have incurred the gain, if any, that it otherwise would have incurred if it had repaid the principal amount of the debt equal to (i)the amount for which the debt was acquired by the friendly acquirer (where the debt becomes a parked obligation as a result of its acquisition by the acquirer); and (ii) in other cases, the fair market of the debt.
Generally, a foreign denominated debt will become a “parked obligation” when both of the following conditions are met: (i) the debt holder does not deal at arm’s length with the debtor at the time it acquires the debt (or, where the debtor is a corporation, holds 25% or more of the votes or value in the corporation); and (ii) at any previous time, a person (i.e., the former creditor or lender) who held the debt dealt at arm’s length with the debtor (and where the debtor is a corporation did not hold 25% or more of the votes and value of the corporation).
An exception to the debt-parking rules will be provided in the context of certain bona fide commercial transactions. These measures will apply to foreign denominated debt that meets the conditions of a “parked obligation” on or after March 22, 2016 (with an exception for such parked obligations resulting from a written agreement entered into before Budget Day).
Cross Border Surplus Stripping. The Act contains an anti-surplus stripping rule that, subject to certain exceptions, applies where a non-resident transfers shares of a Canadian corporation to another Canadian corporation and the transferor does not deal at arm’s length person with the acquirer. Depending on the consideration received by the non-resident transferor, the rule will either reduce the paid-up capital of the shares received as consideration from the acquirer (a valuable tax attribute) or result in it being deemed to receive a dividend which would be subject to Canadian withholding tax.
The Government announced amendments to subsection 212.1(4) of the Act, also known as the exception to the anti-surplus stripping rule. Budget 2016 proposes to amend the exception by providing that the exception will not apply when a non-resident (i) owns, directly or indirectly, shares of the acquiring Canadian corporation, and (ii) does not deal at arm’s length with the acquiring Canadian corporation.
The Government also proposes to clarify the application of the anti-surplus stripping rule in circumstances where it may be uncertain whether consideration has been received by a non-resident from the acquiring Canadian corporation (e.g., where shares are gifted to the acquiring corporation and contributed surplus has been created). In such a case, where the non-resident transferor receives neither shares or non-share consideration, new rules deem the non-resident to receive non-share consideration from the acquiring Canadian corporation equal to the fair market value of the shares that have been transferred.
Back-to-back Rules Extended. The Government announced an extension to rules regarding back-to-back loan arrangements. Budget 2016 includes: amending the existing back-to-back loan rules in Part XIII to extend their application to rents and royalties; adding character substitution rules to the back-to-back rules in Part XIII where the arrangement consist of a mixture of royalties and interest; adding back-to-back loan rules to the existing shareholder loan rules in the Act for domestic and international purposes; and clarifying the application of the back-to-back loan rules to multiple intermediary structures.
Investment in Service and Capacity Enhancements for CRA. Budget 2016 announces significant investment in service and capacity enhancements for the CRA. It allocates $185.8M over five years to enhance the service capability of CRA, with a particular focus on improving telephone services, readability of correspondence and the turnaround time to resolve objections. At the same time, Budget 2016 makes it a priority to improve tax compliance with a specific focus on combating (indeed, “cracking down on”) tax evasion and aggressive tax avoidance. To this end, it announces $444.4M over five years as a direct investment to provide CRA with sufficient resources to enforce tax laws and “crack down” on tax evasion and aggressive tax avoidance. This measure is expected to raise $2.6B in revenue and is intended to enhance collections capability of CRA with a $351.6M dollar investment over five years. The expected revenue from this measure is $7.4B.
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