Canada’s Minister of Finance (and Deputy Prime Minister) tabled Canada’s federal budget for 2023 (“Budget 2023”) on March 28, 2023 (“Budget Day”).
While there is good news insofar as Budget 2023 does not propose any increases in tax rates or reduction in cherished benefits (e.g., the capital gains inclusion rate), the good news may be tempered for some taxpayers as Budget 2023 includes details on previously announced reforms to the alternative minimum tax regime and purports to expand the ambit of the general anti-avoidance rule.
Budget 2023 also includes further details on a number of other previously announced measures, including clean technology and energy tax credits and a tax on equity buybacks by publicly-listed entities. Additional noteworthy proposals in Budget 2023 include proposed amendments to the rules in the Income Tax Act (Canada) (the “Tax Act”) introduced by Bill C-208 to facilitate certain intergenerational business transfers and proposals respecting the creation and use of employee ownership trusts to acquire and hold shares of a business.
A brief summary of these proposals, as well as select others from Budget 2023 that may be of interest to our clients, follows.
I. Personal Tax Measures
1. Employee Ownership Trusts
Following from the Government’s announcements in Canada’s 2021 and 2022 federal budgets to explore the creation and use of employee ownership trusts (“EOTs”) as an additional succession planning option for Canadian business owners and to examine the barriers that exist to the creation of EOTs, Budget 2023 introduces draft legislation to facilitate the use of EOTs to acquire and hold shares of a business. The new rules will apply in respect of transactions that occur on or after January 1, 2024.
Currently when an owner of a private business is contemplating an exit strategy, the alternatives available to the owner include: (i) an arm’s length sale; (ii) family succession planning; or (iii) management buyout. An EOT should create another viable alternative by generally permitting the business’ employees to acquire and hold shares of the business through an EOT without requiring them to pay directly to acquire the shares. Instead, the EOT generally would obtain debt financing in order to purchase the shares and that loan would be repaid by the EOT over time using profits generated from the acquired business that are distributed to the EOT.
An “employee ownership trust” is defined as an irrevocable trust that is at all times resident in Canada (not including deemed resident trusts), all or substantially all of the fair market value of the property of which is attributable to shares of a “qualifying business” that the trust controls, directly or indirectly, and which is exclusively for the benefit of individuals who are the beneficiaries of the trust, all of whom must be employed by the qualifying business. The definition also imposes restrictions on share ownership by such beneficiaries outside of the trust, restricting individual ownership to less than 10% of any class and ownership of related persons to less than 50% of any class. Beneficiaries also cannot include any person who owned, together with related or affiliated persons, 50% or more of the shares of the qualifying business prior to the qualifying transfer.
The interests of the beneficiaries in an EOT must be based on (i) hours of employment; (ii) salary, wages and other remuneration; and (iii) total period of employment. An EOT will also be prohibited from distributing the shares to any beneficiary of the trust, and cannot act in the interests of one beneficiary to the prejudice of another beneficiary. The definition of EOT will require the trustees to have an equal vote in the conduct of the trust’s affairs, and must be either a licenced trust corporation or an individual that is elected by the beneficiaries for a period not exceeding 5 years. It should be considered if prohibiting the distribution of shares to beneficiaries of the EOT will engage the perpetuities rules in the province in which the EOT is formed.
Generally, a “qualifying business” is a corporation controlled by the EOT that is a Canadian-controlled private corporation (“CCPC”) all or substantially all of the fair market value of the assets of which at that time are attributable to assets that are used principally in an active business carried on primarily in Canada by the corporation. Not more than 40% of the directors of the corporation may consist of individuals who, together with related and affiliated persons, owned 50% or more of the shares of the corporation before its acquisition by the EOT. The qualifying business must also deal at arm’s length and not be affiliated with any person who owned 50% or more of the fair market value of the shares of the corporation before the acquisition by the EOT.
A disposition generally will be a “qualifying business transfer” by a taxpayer if it is a disposition of shares of a corporation to a EOT, or to a CCPC that is controlled by an EOT, provided that (i) immediately before the disposition all or substantially all of the assets of the corporation are used in an active business carried in primarily in Canada, (ii) at the time of the disposition the taxpayer deals at arm’s length with the EOT or the CCPC that acquires control of the corporation, and (iii) at all times after the disposition the taxpayer deals at arm’s length with the corporation, the EOT and the CCPC, and the taxpayer does not retain de facto control of the corporation.
A shareholder loan made by a qualifying business to a EOT in respect of a qualifying business transfer will not be included in the trust’s income pursuant to subsection 15(2) of the Tax Act provided that the sole purpose of the loan is to facilitate the qualifying business transfer and provided that bona fide arrangements are made for its repayment within 15 years of the transfer. This measure would appear to permit the use of “corporate cash” of the target to fund the acquisition.
In addition, the capital gains reserve that may be claimed by a taxpayer on the sale of the shares of a qualifying business in a qualifying business transfer to an EOT will be extended from 5 years to 10 years.
An EOT will be exempt from the 21 year deemed disposition rule generally applicable to inter vivos trusts. Without this measure, practically, an EOT would only last approximately 21 years.
Undistributed income of an EOT will be taxed at the highest personal marginal tax rate. However, EOT income distributed to its beneficiaries will be taxed at the beneficiary’s tax rate and dividends received by the EOT from a qualifying business and distributed to employee beneficiaries will maintain their dividend character for the beneficiaries, making them eligible for the dividend tax credit. This is an important measure for ensuring the employee beneficiaries also receive appropriate tax treatment from an EOT plan.
2. Alternative Minimum Tax for High-Income Individuals
Budget 2023 proposes several changes to the alternative minimum tax (“AMT“) regime that would target high-income individuals. These changes include broadening the AMT base, raising the AMT exemption and increasing the AMT rate.
The measures to increase the AMT base include raising the AMT capital gains inclusion rate from 80% to 100%, including 100% of the benefit associated with employee stock options and including 30% of the capital gains on donations of publicly listed securities. The AMT base would also be increased by disallowing 50% of a number of deductions, including employment expenses (other than those to earn commission income), deductions for Canada Pension Plan, Quebec Pension Plan and Provincial Parental Insurance Plan contributions, moving expenses, child care expenses and others. Furthermore, only 50% of non-refundable tax credits would be allowed in order to reduce the AMT, subject to certain exceptions.
Budget 2023 proposes to increase the AMT exemption amount from $40,000 to the amount at the start of the fourth federal tax bracket. This is anticipated to be $173,000 for 2024 based upon expected inflation and would be indexed to inflation annually. It is also proposed that the AMT rate be increased from 15% to 20.5%.
The proposed changes would come into force for taxation years beginning after 2023.
3. Strengthening the Intergenerational Business Transfer Framework
Budget 2023 proposes to amend certain provisions of the Tax Act, most notably section 84.1 of the Tax Act, with the stated purpose of ensuring that the rules introduced into the Tax Act in 2021 by Bill C-208 are refined to facilitate true intergenerational business transfers and to ensure that sufficient safeguards are in place to avoid inappropriate tax avoidance.
Section 84.1 of the Tax Act is an anti-avoidance rule designed to prevent corporate surplus that would normally be taxed at dividend tax rates from being converted into a capital gain taxed at capital gains tax rates. Section 84.1 applies where a taxpayer (other than a corporation) disposes of shares of a Canadian corporation (the “Subject Corporation“) to another corporation (the “Purchaser Corporation“) with which the taxpayer does not deal at arm’s length and, immediately after the disposition, the Subject Corporation would be connected with the Purchaser Corporation.
Bill C-208 amended section 84.1 to deem a non-arm’s length transaction to be an arm’s length transaction for transactions where a taxpayer sells shares of a qualified small business corporation (“QSBC“) or shares in the capital stock of a family farming and fishing corporation (“QFFC“) to a purchaser that is a corporation owned by a child or grandchild of the taxpayer, if certain conditions are met. These changes were intended to permit a taxpayer to receive capital gains tax treatment on such a sale as they would upon a sale to an arm’s length purchaser.
The proposed amendments retain the condition that the preferential tax treatment can only be accessed upon a sale of QSBC or QFFC shares. However, other conditions are significantly amended to ensure that such treatment will only be available for “genuine intergenerational share transfers”. These new and revised conditions are proposed to be added to the Tax Act to reflect the “hallmarks” of a genuine intergenerational business transfer as enunciated in a July 19, 2021, press release from the Department of Finance:
- the vendor ceasing on the transfer to have factual and legal control of the transferred business;
- the intent of the new owner to continue the business as a going concern long after its purchase;
- the vendor not having any financial interest in the transferred business; and
- the vendor not participating in the management and operations of the business.
The proposed amendments create a dual-stream approach that provides flexibility in how particular taxpayers and their families can access the new rules. Taxpayers can rely on one of two transfer options:
- an immediate intergenerational business transfer (three-year test) based on arm’s length sale terms; or
- a gradual intergenerational business transfer (five-to-ten-year test) based on traditional estate freeze characteristics.
There are a number of conditions that would need to be met in order for an intergenerational share transfer to be excluded from the application of section 84.1 of the Tax Act under either stream. The immediate intergenerational business transfer would provide finality earlier in the process through more stringent conditions. The gradual business transfer would provide additional flexibility on the conditions recognizing that not all business transfers are immediate. The conditions under both streams relate to the transfer of control of the business, transfer of economic interests of the business, transfer of management of the business, retention of control of the business by the child and active involvement by the child in the business.
In addition to the foregoing conditions, the transferor and child will be required to jointly elect for the transfer to qualify as an immediate or gradual intergenerational share transfer. For the purposes of this regime, a “child” would include grandchildren, step-children, children-in-law, nieces, nephews, grandnieces and grandnephews. The child or children would be jointly and severally liable for any additional taxes imposed as a result of the requisite conditions not being satisfied and a reassessment under section 84.1. Furthermore, the normal reassessment period for these transfers would be extended by three years for an immediate business transfer and by ten years for a gradual business transfer.
All of the proposed amendments to the intergenerational business transfer rules are to apply to transactions that occur on or after January 1, 2024.
II. Business Income Tax Measures
1. Environment‑Related Measures
Budget 2023 announced several investment tax credits and other measures relating to clean energy. These include:
- Investment Tax Credit for Clean Hydrogen – First announced in the 2022 Fall Economic Statement, Budget 2023 provides details about the new Clean Hydrogen Investment Tax Credit. This refundable tax credit will apply to projects that produce all, or substantially all, hydrogen through their production process. The applicable credit rate will be based on the carbon intensity of the hydrogen that is produced and ranges from 15% – 40%. The Clean Hydrogen Investment Tax Credit will be fully phased out for property that becomes available for use after 2034.
- Clean Technology Investment Tax Credit ‑ Geothermal Energy – Budget 2023 proposes to expand eligibility of the Clean Technology Investment Tax Credit, which was first announced in the 2022 Fall Economic Statement, to include geothermal energy systems eligible for Class 43.1 of Schedule II of the Tax Regulations.
- Investment Tax Credit for Clean Technology Manufacturing – Budget 2023 proposes a 30% refundable investment tax credit for clean technology manufacturing and processing, and critical mineral extraction and processing. This investment tax credit is applicable to the capital cost of eligible property associated with eligible activities. Eligible property includes machinery and equipment, certain industrial vehicles, used in manufacturing, processing, or critical mineral extraction, and related control systems. Eligible activities include: manufacturing of solar, wind, water, geothermal or nuclear energy equipment; processing or recycling of nuclear fuels and heavy water; manufacturing of nuclear fuel rods; manufacturing of electrical energy storage equipment used to provide grid-scale storage or other ancillary services; manufacturing of equipment for air- and ground-source heat pump systems; and manufacturing of zero-emission vehicles. Only one of the credits for Clean Technology Manufacturing, Clean Technology, Clean Electricity and Clean Hydrogen may be claimed where a certain property is eligible for more than one of the foregoing credits.
- Zero‑Emission Technology Manufacturers – Budget 2021 introduced a temporary measure to reduce corporate income tax rates for qualifying zero-emission technology manufacturers by one‑half. Budget 2023 expands the eligible activities by proposing that income from manufacturing of nuclear energy equipment, processing or recycling of nuclear fuels and heavy water, and manufacturing of nuclear fuel rods, will also qualify for the reduced tax rates. Budget 2023 also proposes to extend the planned phase-out rate such that it would start in taxation years beginning in 2032 and be fully phased out for taxation years beginning after 2034.
- Investment Tax Credit for Carbon Capture, Utilization, and Storage – Budget 2023 proposes additional details with respect to the refundable investment tax credit for carbon capture, utilization, and storage that was first announced in Budget 2022. These include the dual use of equipment, addition of British Columbia as an eligible jurisdiction, validating concrete storage requirements, interactions with other federal tax credits, the treatment of refurbished costs, recovery of refurbished investment tax credits, knowledge sharing and climate risk disclosure.
- Flow-Through Shares and Critical Mineral Exploration Tax Credit – Lithium from Brines – Budget 2023 proposes to expand the flow‑through share regime to include lithium from brines as a Canadian exploration expenses (CEE) and Canadian development expenses (CDE). The 30% non‑refundable Critical Mineral Exploration Tax Credit will also be expanded to include lithium from brines. The proposed amendment will apply to share agreements entered into after Budget Day and before April 2027.
Budget 2023 also confirms the government’s intention to proceed with the Investment Tax Credit for Clean Technologies, which was first announced in the 2022 Fall Economic Statement.
2. Tax on Repurchases of Equity
In its 2022 Fall Economic Statement, the Government announced its intention to introduce a 2% tax on share buybacks by public corporations (the “Buyback Tax”). Budget 2023 includes further details and draft legislation relating to the Buyback Tax, which will apply in respect of repurchases and issuances of equity occurring from January 1, 2024.
Budget 2023 proposes that the Buyback Tax will apply to every person that is a “covered entity”, which is defined to include Canadian resident corporations whose shares are listed on a designated stock exchange (other than mutual fund corporations), real estate investment trusts, SIFT trusts, SIFT partnerships and publicly-traded entities that would be SIFT trusts or SIFT partnerships if their assets were located in Canada.
Budget 2023 proposes that a covered entity’s Buyback Tax for a taxation year is calculated as 2% of the difference between:
- the total fair market value of the covered entity’s equity (with specific exceptions) that is redeemed, acquired or cancelled in the taxation year by the covered entity; and
- the total fair market value of the covered entity’s equity that is issued in the taxation year.
For this purpose, both normal course issuer bids and substantial issuer bids would constitute the repurchases of equity. In addition, the issuance or cancellation of shares or units as part of certain corporate reorganizations and acquisitions (e.g., a butterfly reorganization and certain winding-ups and amalgamations) will not be considered to be issuances or repurchases of equity for this purpose.
Budget 2023 also proposes certain anti-avoidance measures vis-à-vis the Buyback Tax. These measures include deeming certain acquisitions of equity of a covered entity by a “specified affiliate” of the covered entity (i.e., a corporation, trust or partnership that is controlled, directly or indirectly, by the covered entity or a corporation, trust or partnership, 50% of the fair market value of whose equity is directly or indirectly owned by the covered entity) to be a repurchase of the entity by the covered entity itself.
Budget 2023 includes a de minimis rule exempting entities that repurchase less than $1 million of equity during the taxation year (prorated for short taxation years) from the Buyback Tax.
3. General Anti-Avoidance Rule
Budget 2023 contains legislative proposals that address concerns raised by the Department of Finance in its August 9, 2022 consultation paper on the general anti-avoidance rule (the “GAAR”).
Budget 2023 proposes the following five amendments to the GAAR:
A preamble will be added to the GAAR to address interpretative issues. At this time, the particular wording of the proposed preamble has not yet been released. However, Budget 2023 indicates that it will provide clarity on the following three areas of concern: (i) the GAAR is intended to deny tax benefits that are obtained through avoidance transactions; (ii) the GAAR must strike a delicate balance between taxpayer certainty and the government’s mandate to protect the tax base and the fairness of the tax system; and (iii) the GAAR is intended to apply whether or not the tax planning used to obtain the tax benefit was foreseen by the taxpayer.
Lowering the Avoidance Transaction Standard
Budget 2023 seeks to reduce the threshold required for the application of the avoidance transaction test where “one of the main purposes” (as opposed to the “primary purpose”) of that transaction was to obtain a tax benefit. Under the existing regime, an avoidance transaction requires that the “primary purpose” of a transaction or series of transactions is to obtain a tax benefit.
Economic Substance Rule
An economic substance rule will be added to the GAAR in line with its initial objective of requiring economic substance to a transaction. The economic substance of a transaction is to be considered at the third stage of the analysis, which is whether there has been a misuse of, among other things, the Tax Act, Regulations, a tax treaty; or an abuse thereof, read as a whole. Budget 2023 states that “… a lack of economic substance tends to indicate abusive tax avoidance.” However, GAAR will not apply if the tax results of a transaction are consistent with the purpose of the provision being relied upon by the taxpayer and even if economic substance is lacking. The amendments will contain indicators for determining whether a transaction lacks substance.
Interestingly, this proposal will not displace the general approach and focus of Canadian tax law on the legal form of a transaction. Instead, the revised GAAR analysis considers whether there is a lack of economic substance but not what the economic substance actually is.
Budget 2023 also indicates the Government’s intention to impose a penalty on transactions subject to the GAAR. Such transactions will be subject to a penalty of 25% of the amount of the tax benefit conferred upon the taxpayer. Where the tax benefit involves a tax attribute which has not yet been applied to reduce tax, the purported tax benefit will be deemed to be nil.
Taxpayers seeking to avoid the application of the GAAR may disclose the transaction to the CRA either as part of the proposed mandatory disclosure rules or on a voluntary basis.
Extending Reassessment Period
The normal reassessment period will be extended by 3 years for GAAR assessments unless the relevant transaction is disclosed by the taxpayer.
The legislative proposals (if enacted) will be some of the most significant changes to-date in the context of the GAAR. The renewed focus on the lack of economic substance may lead to a new line of jurisprudence in this context and perhaps, further scrutiny from the Supreme Court of Canada. Additionally, the prospect of a significant penalty may prove to be an additional deterrent to tax planning. Canada remains a jurisdiction with significant barriers to tax planning and an increasingly vigilant administrative body in the Canada Revenue Agency. These additions to GAAR (if enacted) are expected to add to the barriers and the punitive arsenal available to the tax administrators.
The proposals noted above are subject to a further consultation period, extending to May 31, 2023.
III. International Tax Measures
Budget 2023 provides further details on Canada’s progress and plans with respect to the OECD-led “Inclusive Framework on Base Erosion and Profit Shifting” (“BEPS”). The BEPS initiative is governed by a two-pillar plan for international tax reform, which reallocates profits of a multinational enterprise (“MNE”) across countries where the users and customers of the MNE are located (“Pillar One”) and ensures the application of a minimum effective tax rate of 15% on the profits of large MNEs (“Pillar Two”).
Budget 2023 announced that in the absence of the multilateral convention to implement Pillar One entering into force by January 1, 2024, Canada will impose a Digital Services Tax (“DST”), applicable as of that date and in respect of revenues earned as of January 1, 2022. Draft legislative proposals for the DST were released in 2021 and will be revised as part of a public consultation process.
Pillar Two applies a global minimum tax regime to MNEs with annual revenues of at least 750 million Euros. Budget 2023 announced the implementation of the following with respect to Pillar Two:
- an Income Inclusion Rule (IRR), which will grant Canada the primary right to impose a top-up tax on an ultimate parent entity located in Canada with income from MNE operations in jurisdictions where it is taxed at an effective rate below 15% (effective for fiscal years of MNEs beginning on or after December 31, 2023).
- an Undertaxed Profits Rule (UTPR) that allows a jurisdiction to impose the top-up tax on MNE group entities located in that jurisdiction if the parent jurisdiction of an MNE has not implemented the IRR (effective for fiscal years of MNEs beginning on or after December 31, 2024).
Draft legislation for each of the above is expected in the coming months.
IV. Sales Tax Measures
Payment Card Clearing Services Subject to GST/HST
Budget 2023 proposes to amend the definition of “financial service” in the Part IX of the Excise Tax Act (Canada) to include payment card clearing services in the list of services that are excluded from the definition, and thus subject to GST/HST. This proposed amendment is in response to a recent court case.
Specifically, Budget 2023 proposes to expand the list of exclusions in the definition of “financial service” to add a service that is supplied by a “payment card network operator” in respect of a “payment card network” and that is (i) a service in respect of the authorization of a transaction in respect of money, an account, a credit card voucher, a charge card voucher or a financial instrument, (ii) a clearing or settlement service in respect of money, an account, a credit card voucher, a charge card voucher or a financial instrument; or (iii) a service provided in conjunction with a service referred above.
The term “payment card network operator” is defined in the Payment Card Networks Act (Canada) to mean an entity that operates or manages a payment card network. A payment card network is in turn defined as a credit or debit card — or any other prescribed device — used to access a credit or debit account on terms specified by the issuer. These operators generally render card clearing services (e.g., payment processing) to system participants like banks.
Generally, this amendment is intended to be effective as of Budget Day.
Please reach out to a member of our team if you have any questions about how the 2023 Budget may impact you. Ron Choudhury, Bryant Frydberg, Neil Gurmukh, Brendon Ho, Carolyn Inglis, Anish Kamboj, Emmanuelle Laliberté, Colleen Ma, Justin Ng, Regan O’Neil, Pierce Quaghebeur, Victoria Rodrigues, Stephen Sweeney and Articling Student Andrew Rodrigues contributed to this year’s Federal Budget Review.
Read about the proposals affecting the Charities and NPO sector in the 2023 Federal Budget Edition of our Social Impact Newsletter.