Scientific Research & Experimental Development Program
Budget 2012 provides significant changes to the funding model for scientific research and experimental development. This involves an increase in the amount of direct funding for scientific research coupled with a streamlining of the current SR&ED tax credits. Key changes to the tax credit mechanism are as follows:
commencing in 2014, the general investment tax credit rate is being reduced from 20% to 15% on qualified expenditures; the CCPC rate on the first $3 million of annual qualified expenditures will remain at 35%,
capital expenditures, including lease payments for capital equipment, will not qualify for SR&ED tax deductions or investment tax credits effective January 1, 2014,
the proxy rate for overhead expenditures will be reduced from 65% of the eligible portion of salaries and wages to 60% in 2013 and to 55% in 2014 and thereafter,
only 80% of arm’s length contract payments (except those relating to capital expenditures) will be included in the qualified expenditure base, effective January 1, 2013.
Mineral Exploration Tax Credit
Budget 2012 proposes to extend eligibility for the Mineral Exploration Tax Credit for an additional year, to flow-through share agreements entered into on or before March 31, 2013. The Mineral Exploration Tax Credit is equal to 15% of specified mineral exploration expenses incurred in Canada and renounced to flow-through share investors.
Corporate Mineral Exploration and Development Tax Credit
Budget 2012 proposes to phase out the 10% corporate tax credit for pre-production mining expenditures. “Pre-production mining expenditure” includes exploration expenses and pre-production development expenses.
For exploration expenses, the corporate tax credit will be reduced to 5% for expenses incurred in 2013 and will be eliminated thereafter. For pre-production development expenses, the corporate tax credit will be reduced to 7% for expenses incurred in 2014 and 4% for expenses incurred in 2015. The credit will be eliminated altogether after 2015.
Transitional relief will be provided where pre-production development expenses are incurred before 2016 (i) under a written agreement entered into before March 29, 2012, or (ii) as part of the development of a new mine where the construction or the engineering and design work started before March 29, 2012.
Eligible Dividends – Split-Dividend Designation and Late Designation
Budget 2012 proposes two changes to the manner in which corporations pay and designate eligible dividends. First, any portion of a dividend may now be designated as an eligible dividend. Previously, eligible dividends had to be paid as a separate dividend. The designated portion of a “split dividend” will qualify for the enhanced dividend tax credit and the remaining portion will qualify for the regular dividend tax credit. Second, Budget 2012 proposes to allow corporations to file the required designation within the three-year period following the day on which the designation was first required to be made. This change will allow corporations to retroactively determine if they had general rate income to support an eligible dividend designation. These changes eliminate some of the administrative burdens currently associated with paying and designating eligible dividends and almost certainly eliminate the prospect of a corporation inadvertently paying an excess eligible dividend.
These measures will apply to taxable dividends paid on or after March 29, 2012.
Thin Capitalization Rules
The thin capitalization rules limit the ability of Canadian corporations to deduct interest paid to certain non-residents where the debt to equity ratio exceeds 2:1. The rules generally apply where the relevant non-resident holds 25% or more of the shares of the Canadian company (including non-arms’ length holdings).
Budget 2012 replaces the existing 2:1 debt to equity ratio with a less favourable 1.5:1 ratio. This change aligns the Canadian rules with the U.S. rules, which also use a 1.5:1 ratio. Accordingly, interest on debt exceeding 1.5 times equity will not be deductible.
The changes to the thin capitalization ratio will apply to corporate tax years that begin after 2012. There does not appear to be any grandfathering for existing term debt arrangements that extend beyond the 2013 implementation date.
A second change provides that the non-deductible interest will be treated as a dividend for withholding tax purposes. This change will force the non-resident to pay Canadian withholding tax (at a maximum rate of 25%) on the non-deductible interest. Accrued interest that is not paid by the end of the relevant year will be deemed to be paid to the relevant non-resident, thereby triggering a withholding tax liability for the unwary. This rule applies to taxation years that end on or after March 29, 2012. A pro-ration formula will apply to taxation years that straddle the budget date.
The thin capitalization rules are also extended to partnerships. In this case, the Canadian partners will be required to recognize additional partnership income based on the amount of excess non-resident debt.
The new partnership rules apply to taxation years that commence on or after March 29, 2012.
Transfer Pricing Secondary Adjustments
Section 247 of the Income Tax Act (Canada) (“ITA”) contains transfer pricing rules that allow CRA to adjust amounts related to transactions carried out between non-arms’ length parties to ensure that the relevant transactions reflect arm’s length terms and conditions. This adjustment is commonly referred to as a “primary adjustment”. Once a primary adjustment has been made a secondary adjustment may be required to account for any benefit conferred on non-residents participating in the transactions. For example, if a Canadian corporation overpays for goods purchased from a related non-resident, then the amount of the overpayment could be regarded as a removal of retained earnings from Canada without payment of the appropriate Part XIII dividend withholding tax.
Currently, there is no specific provision in the transfer pricing rules dealing with secondary adjustments. Budget 2012 proposes to amend section 247 of the ITA to clarify that a Canadian corporation subject to a primary adjustment will be deemed to have paid a dividend to each non-arm’s length non-resident participant in the transaction in proportion to the benefit conferred on them regardless of whether the non-resident is a shareholder of the Canadian corporation. Budget 2012 also proposes to confirm that secondary adjustments be treated as dividends for Part XIII non-resident withholding tax purposes.
Budget 2012 proposes to confirm CRA’s existing administrative practice to allow for the repatriation of funds to Canada from the non-resident with the concurrence of CRA to avoid the deemed dividend treatment related to that amount. Budget 2012 also proposes to confirm CRA’s existing administrative practice to provide that a secondary adjustment related to a controlled foreign affiliate will be more akin to a capital contribution than a dividend.
Foreign Affiliate Dumping
Budget 2012 expressed concern that an erosion in the Canadian income tax base is arising where, in certain cases, the Canadian resident subsidiary (“CRIC”) of a non-resident parent acquires shares of a corporation that is not resident in Canada (“subject corporation”).
The ITA is to be amended
where CRIC makes an investment (defined to include an acquisition of shares, contribution of capital, or making of a loan) in a subject corporation that becomes a foreign affiliate of the CRIC through a series of transactions that includes the investment,
the Canadian corporation making the investment is controlled by a non-resident, and
the investment was not made primarily for bona fide purposes (referred to as the “business test”). The ITA will be amended to include a number factors that are to be given primary consideration in determining whether or not there was a bona fide purpose to the investment.
If the above conditions are met, then
all non-share consideration transferred by, or obligations assumed or incurred by, the CRIC in respect of the investment will be deemed to be a dividend paid by the CRIC subject to Part XIII withholding tax, and
no amount will be added to the paid-up capital of any shares issued by the CRIC in respect of the investment.
Transitional rules will apply to arm’s length transaction entered into pursuant to a written agreement made prior to the budget date and that is completed prior to 2013.
Budget 2012 contains two rules aimed at eliminating the tax benefits which arise from certain transactions involving partnerships.
The first rule applies where a Canadian corporation amalgamates with, or winds up into, a Canadian parent corporation. Under existing rules, the amalgamation or windup can, in certain circumstances, result in an increase in the tax basis of certain non-depreciable capital property, including partnership interests, that were held by the subsidiary. Budget 2012 proposes to restrict the tax basis increase for partnership interests where, at the time of the amalgamation or windup, the partnership owns non-depreciable capital property with accrued gains. While the new rule is effective immediately, there is limited grandfathering where, prior to Budget day, (i) the parent acquired control or was obligated (as evidenced in writing) to acquire control of the subsidiary and (ii) there was written evidence of an intention to carry out the amalgamation or windup.
The second rule applies to the sale of a partnership interest. Currently, where the purchaser of the partnership interest is a tax-exempt entity, the seller must include the full amount of the capital gain on the sale of the partnership interest in income and not just 50%. Budget 2012 proposes to extend this rule to the sale of a partnership interest to a non-resident unless the partnership carries on business in Canada through a permanent establishment in which all of the assets are used. The rule extends to any dispositions made directly or indirectly through a series of transactions to a non-resident or tax-exempt entity. There is grandfathering for arm’s length dispositions made prior to 2013 under a written agreement entered into before Budget day.
Employee Profit Sharing Plans
Employer contributions to Employee Profit Sharing Plans (“EPSP”) are fully deductible. Employees are taxable on EPSP contributions when they are allocated to the employee even if the funds are not withdrawn. It appears that some employers were using EPSP trusts to stream income to non-arms’ length employees (such as children working in a family business), thereby obtaining access to lower marginal tax rates and personal exemptions.
Commencing on March 29, 2012, new restrictions apply to EPSPs that have “specified employees”, meaning employees who are non-arms arm length to the employer or who have significant shareholdings in the employer (generally 10% or more).
The new rules are designed to discourage employers from contributing excess amounts to EPSPs for specified employees. This is accomplished by imposing a special penalty tax on EPSP amounts allocated to a specified employee if the EPSP allocation exceeds 20% of that person’s non-EPSP employment income from the relevant employer. The penalty tax applies to the employee in lieu of regular tax and is based on the top marginal tax rate in the employee’s province of residence (other than Quebec).
The new EPSP rules apply to contributions made after March 29, 2012, with limited grandfathering.
Retirement Compensation Arrangements
Retirement Compensation Arrangements (“RCA”) plans are generally implemented to allow executives to accrue retirement benefits over and above the limits permitted in registered plans. The RCA rules require that the RCA pay a 50% tax on all contributions. When the RCA pays amounts to the plan member it recovers the tax. The recipient then pays tax on the RCA benefits at his or her own marginal tax rate.
If the RCA incurs a loss so that it is not able to pay the full amount of the initial contribution to the member, then the existing rules allow the plan to claim a refund for the appropriate portion of the 50% tax that was paid on that contribution.
It appears that CRA has identified a number of situations whereby RCA plans have been manipulated to realize inappropriate losses, thereby triggering a refund claim. In other cases, expenses (such as life insurance premiums) have been used to erode RCA assets.
Budget 2012 contains several rules and penalty taxes that are designed to combat these RCA “strips”. In general terms the new RCA restrictions and penalty taxes will mirror the existing restrictions that apply to registered plans such as RRSPs and TFSAs. A “prohibited investment” rule will apply to a RCA that has a member who has a significant equity interest in the employer. Holding a prohibited investment will trigger a 50% penalty tax for the RCA. The existing concept of an “advantage” will also be imported into the RCA rules. If a decline in RCA value was due to prohibited investments or advantages, then a refund of the initial 50% tax will generally be denied.
The new RCA rules apply after March 29, 2012, with limited grandfathering.
Group Sickness or Accident Insurance Plans
Budget 2012 proposes to include the amount of an employer’s contributions to a group sickness or accident insurance plan in an employee’s income for the year in which the contributions are made, to the extent the contributions are not in respect of a wage-loss replacement benefit payable on a periodic basis. This measure will apply to such employer contributions made on or after March 29, 2012, to the extent they relate to coverage after 2012.
Overseas Employment Tax Credit
Budget 2012 proposes to phase out the Overseas Employment Tax Credit (“OETC”) over a period of four taxation years beginning with the 2013 taxation year. The OETC is a program offered to employees who are employed outside of Canada for a period of more than six consecutive months by a person resident in Canada where the employee’s employment is in connection with certain defined activities.
A foreign charitable organization that has received a donation from the Government will no longer be automatically eligible to register as a qualified donee, so as to be entitled to issue tax donation receipts to Canadian donors. At the discretion of the Minister of National Revenue, the charity will have to demonstrate that its activities are associated with disaster relief or urgent humanitarian aid or be in Canada’s national interest. The status will be granted for a 24 month period and will be made public.
Registered charities carrying on political activities will face increased compliance and disclosure requirements and CRA will be provided with greater enforcement tools. Canadian amateur athletic associations will be subject to the same measures.
To encourage proper registration and reporting of charitable tax shelters, promoters will face increased and new penalties in certain situations including the failure to file an information return upon the request of CRA. Tax shelter penalties for gifting arrangements will be based on the asserted value of the property by the promoter rather than on the cost of the property to the donee.
Tax shelter numbers will now have expiration dates. Commencing March 29, 2012, numbers are valid for the calendar year indicated in the application. Numbers issued for applications submitted prior to March 29, 2012 will be valid until the end of next year.
Accelerated Capital Cost Allowance for Clean Energy Generation Equipment
Budget 2012 proposes to expand the type of equipment that qualifies for Class 43.2 accelerated capital cost allowance by: (i) removing the requirement that the heat energy generated from waste-fuelled thermal energy equipment be used in an industrial process or a greenhouse; (ii) adding equipment that is part of a district energy system that distributes thermal energy primarily generated by eligible waste-fuelled thermal energy equipment; and (iii) including equipment that uses the residue of plants, generally produced by the agricultural sector, to generate electricity and heat.
Where equipment using eligible waste fuels does not comply with the applicable environmental laws and regulations at the time the equipment first becomes available for use, the equipment will not be eligible under Class 43.1 or 43.2. This measure will apply to assets acquired on or after March 29, 2012.
Notable Non-Tax Related Measures
First, Budget 2012 proposes the elimination of the penny. As of fall 2012, the Government will no longer distribute pennies; however, the penny will retain its value indefinitely and can continue to be used in payments. The Government will not require, but will allow, businesses to round cash transactions to the nearest nickel.
Second, Budget 2012 proposes that effective June 1, 2012, the value of goods that may be imported duty- and tax-free by Canadian residents returning from abroad be increased. For trips lasting longer than 24 hours, the limit will be raised from $50 to $200 and for trips lasting longer than 48 hours, the limit will be raised from $400 to $800. This new $800 limit will also replace the $750 limit that used to apply for trips lasting longer than 7 days.
Finally, the age of eligibility for Old Age Security (“OAS”) and the Guaranteed Income Supplement (“GIS”) will be gradually increased from 65 to 67, starting in April 2023, with full implementation by January 2029. This proposed legislative change to the age of OAS/GIS eligibility will not affect anyone who was born on March 31, 1958 or earlier. Individuals born on or after February 1, 1962 will have an age of eligibility of 67. Individuals born between April 1, 1958 and January 31, 1962 will have an age of eligibility between 65 and 67.
For further details on pension-related changes in Budget 2012, please refer to our Pension Pulse “Pensions: The Penny Dropped”.
Please contact any member of our Tax Group to discuss the impact of the federal budget.