Business Income Tax Measures

March 29, 2012

IN THIS SECTION:

Scientific Research and Experimental Development Program

The Scientific Research and Experimental Development (“SR&ED”) program is a tax incentive program that is meant to encourage the private sector to engage in research and development (“R&D”) in Canada. Allowable SR&ED expenditures are 100% deductible from income, and generate an investment tax credit of 20%, or 35% for certain small to medium Canadian-controlled private corporations (“CCPCs”).

The Budget proposes to make several fairly significant changes to the SR&ED program. The income tax changes mostly involve cuts to the program. In conjunction with the changes to the SR&ED tax deductions and credits, the Government will fund and support R&D initiatives to promote innovation. This includes: (i) doubling the contribution to the Industrial Research Assistance Program; and (ii) redirecting the research of the National Research Council to industry-relevant applied research.

SR&ED Investment Tax Credit Rate Reduction

Qualified SR&ED expenditures incurred in Canada and certain transferred amounts are included in a taxpayer’s SR&ED qualified expenditure pool (“SR&ED Pool”). The balance in the SR&ED Pool at the end of the year is multiplied by 20%, or 35% for qualified CCPC expenditures, to determine the SR&ED investment tax credit.  The enhanced 35% rate applies on up to $3 million of qualified SR&ED expenditures incurred by a CCPC in a year. The general 20% rate applies to a CCPC’s SR&ED expenditures that are not eligible for the 35% rate.

The Budget proposes:

  • to reduce the general rate from 20% to 15% for tax years that end after 2013, with the reduction in the general rate pro-rated for tax years that include January 1, 2014; and
  • no changes to the enhanced 35% rate or the $3 million maximum.

Capital Expenditures Exclusion

Under the existing SR&ED program, current and capital expenditures on qualified R&D are fully deductible. This is in addition to the tax credits noted above. The Budget proposes to exclude capital expenditures from eligibility for SR&ED deductions and investment tax credits. This measure will also apply to payments made in order to use property that would be capital property if it was bought by the taxpayer. This measure will apply to both property acquired after 2013 and the right to use property after 2013.

SR&ED Overhead Expenditures Proxy Reduction

Currently, itemized overhead expenditures that are directly attributable to the conduct of R&D are eligible for the SR&ED tax incentives. Taxpayers can elect to use a proxy method instead of calculating overhead expenditures. The proxy method allows the taxpayer to claim as eligible SR&ED expenditures 65% of the total of the eligible portion of salaries and wages of the taxpayer’s employees directly engaged in the conduct of R&D in Canada.

The Budget proposes to reduce the proxy rate from 65% to 60% for 2013, and 55% for years after 2013. The proxy rate that will apply for taxation years that include days in 2012, 2013, and 2014 will be pro-rated based on the number of days in the taxation year that are in each of those years.

Contract Payments – 80% Proxy and Exclusion of Capital Expenditures

Currently, when a taxpayer hires an arm’s length party to perform R&D, the taxpayer is entitled to claim qualified SR&ED expenditures equal to the entire amount of the contract payment, less the amount of qualified SR&ED expenditures claimed by the arm’s length party in respect of the contract.

The Budget proposes to:

  • limit the qualified SR&ED expenditures to 80% of the amount the taxpayer paid on the arm’s length R&D contract, applicable to expenditures incurred in or after 2014; and
  • exclude any amount paid in respect of a capital expenditure incurred by an arm’s length provider in fulfillment of the R&D contract, starting in 2014.

In addition, the amount that the arm’s length R&D provider is required to net against its qualifying SR&ED expenditures because of the contract payment will be reduced by the amount received by the provider that is in respect of its capital expenditures.

Administrative Measures

The Government announced that it will invest $6 million to implement changes to the SR&ED program, including:

  • enhancements to the online self-assessment eligibility tool and more effective use of tax alerts in this area; and
  • improvements to the notice of objection procedure to allow a second review of the scientific eligibility determination.

The Government also announced that it will conduct a study on contingency-fee based  consultants used by businesses to determine eligibility and the amount of SR&ED claims. Future action may be taken on such arrangements.

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Tax Avoidance Through Use of Partnerships

Denial of Section 88 Bump Where Income Producing Assets Held Through Partnerships

Section 88 of the Tax Act provides that a taxable Canadian corporation (“Parent”) that has acquired control of another taxable Canadian corporation (“Subsidiary”) may increase the cost of certain capital assets acquired by the Parent on a vertical amalgamation with or winding-up of the Subsidiary if certain conditions are met (“Bump Rules”).

The Bump Rules are designed to recognize that the amount paid by the Parent for the shares of the Subsidiary represents the cost to the Parent of the underlying assets of the Subsidiary and that the Parent should be able to take advantage of this amount and “bump” the cost of certain capital assets owned by the Subsidiary acquired on the amalgamation or winding-up to an amount not to exceed the adjusted cost base of the shares of the Subsidiary to the Parent.  In most cases, the adjusted cost base of the shares of the Subsidiary to the Parent equals the fair market value of the shares of the Subsidiary at the time such shares were acquired.

Generally, the Bump Rules provide that only capital assets, such as land, shares of a corporation or an interest in a partnership are eligible for the bump. Assets that are not eligible for the bump include eligible capital property, depreciable property, inventory and resource property.

Certain bump transactions were designed to hold a Subsidiary’s income assets (i.e., assets that do not qualify for the bump) in a corporate partnership structure. In these structures, the income generating assets are held indirectly through a partnership rather than directly by the Subsidiary. After the acquisition of control of the Subsidiary, the Parent amalgamates with or winds up the Subsidiary and then bumps up the cost of the partnership interest in circumstances where all of the fair market value of the partnership interest is derived from income producing assets. The Bump Rules are exceptionally complex and contain a number of anti-avoidance provisions.

The Budget proposes to introduce a measure that will generally deny the bump in respect of a partnership interest to the extent that the accrued gain in that partnership interest is reasonably attributable to the amount by which the fair market value of income producing assets exceed their cost amount. This has the effect of looking through the partnership for the purpose of this proposed provision. This proposed measure will apply where the income assets are held directly by the partnership or indirectly through another partnership.  The proposed rule will not apply to income assets that are held by a corporation whose shares are held by a partnership.

This proposal will apply to amalgamations that occur, and windings-up that begin, on or after Budget Day. An exception will be provided where a taxable Canadian corporation amalgamates with its subsidiary before 2013, or begins to wind up its subsidiary before 2013. This exception will apply only if, before Budget Day, the corporation had acquired control, or was obligated, as evidenced in writing, to acquire control, of the subsidiary and the corporation had the intention, as evidenced in writing, to amalgamate with or wind up the subsidiary.

A corporation will not be considered to be obligated to acquire control where the corporation may be excused from the obligation if an amendment is made to the Tax Act.

Disposition of Partnership Interests to Non-Residents and Indirect Dispositions of Partnership Interests to Tax-Exempts

Section 100 of the Tax Act deals with the calculation of  the capital gain that arises on the disposition of a partnership interest  to a tax-exempt person.  Generally, the section is designed to ensure that income assets held by a partnership are fully taxable on the disposition of an interest in a partnership by a taxpayer to a tax-exempt person since a tax-exempt person could wind-up a partnership without paying any income tax.

First, the Government indicated that it is concerned with indirect sales of partnership interests by a taxpayer to a tax-exempt person which is not expressly referred to in section 100.  Second, the Government is concerned that this rule does not currently apply to a sale of an interest in a partnership to a non-resident even though the income from a disposition of an income asset owned by the partnership may be exempt from Canadian income tax under either Canadian domestic law or one of Canada’s tax treaties.

The Budget proposes to extend the application of section 100 of the Tax Act to the sale of a partnership interest by a taxpayer to a non-resident person, unless the partnership is using all of its assets in a business carried on in Canada through a permanent establishment. This exception is being made because the disposition of such income assets should generally be subject to Canadian taxation and not exempt under a tax treaty.

This proposed measure will also clarify that section 100 applies to dispositions made directly, or indirectly as part of a series of transactions, to a tax-exempt or non-resident person.

This proposed measure will apply to dispositions of interests in partnerships that occur on or after Budget Day. An exception will be provided for an arm’s length disposition made by a taxpayer before 2013 that the taxpayer is obligated to make pursuant to a written agreement entered into by the taxpayer before Budget Day. A taxpayer will not be considered to be obligated to make the disposition where the taxpayer may be excused from the obligation if an amendment is made to the Tax Act.

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Partnership Waivers

The Tax Act provides that the CRA may for a fiscal period of a partnership make a determination or redetermination under subsection 152(1.4) of the Tax Act of any income, loss, deduction or other amount in respect of the partnership. The CRA is precluded from determining an amount if more than 3 years have elapsed since the later of the deadline for filing the relevant partnership information return and the day the return is actually filed.

However, if the CRA obtains a waiver from each partner, the time period for making a determination is extended. If one or more of the partners does not provide a waiver, the period cannot be extended and the CRA will have to make a determination using only the information that is available to it at that time.

Under the current rules, the members of a partnership may designate a partner with authority to file an objection on behalf of all of the partners, to a determination under the Tax Act.

The Budget proposes that a single designated partner of a partnership may also be empowered to waive, on behalf of all of the partners, the 3-year time limit for making a determination.

This proposed measure will apply on Royal Assent to the enacting legislation.

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Clean Energy Generation Equipment – Accelerated Capital Cost Allowance

Under the capital cost allowance (“CCA”) regime in the income tax system, Class 43.2 of Schedule II to the Income Tax Regulations provides an accelerated CCA rate (50% per year on a declining balance basis) for investment in specified clean energy generation and conservation equipment. The class incorporates by reference to Class 43.1 a detailed list of eligible equipment that generates or conserves energy by:

  • using a renewable energy source (e.g., wind, solar, small hydro);
  • using fuels from waste (e.g., landfill gas, wood waste, manure); or
  • making efficient use of fossil fuels (e.g., high efficiency cogeneration systems, which simultaneously produce electricity and useful heat).

Providing accelerated CCA in this context is an exception to the general practice of setting CCA rates based on the useful life of assets. Accelerated CCA provides a financial benefit by deferring taxation. This incentive for investment is premised on the environmental benefits of low-emission or no-emission energy generation equipment.

In addition, if the majority of the tangible property in a project is eligible for inclusion in Class 43.2, certain intangible project start-up expenses (e.g., engineering and design work and feasibility studies) are treated as Canadian Renewable and Conservation Expenses. These expenses may be deducted in full in the year incurred, carried forward indefinitely for use in future years, or transferred to investors using flow-through shares.

Budget 2010 expanded Class 43.2 to broaden the eligible range of applications for which heat recovery equipment and equipment of a district energy system can be used. Equipment that generates electricity using waste heat was added to Class 43.2 in Budget 2011. The Budget proposes to further expand Class 43.2 to include:

  • waste-fuelled thermal energy equipment used for space and water heating applications;
  • equipment that is part of a district energy system that distributes thermal energy primarily generated by waste-fuelled thermal energy equipment; and
  • equipment that uses residue of plants (e.g., straw) to generate electricity and heat.

These measures will encourage investment in technologies that can contribute to a reduction in emissions of greenhouse gases and air pollutants, in support of Canada’s targets set out in the Federal Sustainable Development Strategy. These measures could also contribute to the diversification of Canada’s energy supply.

Waste-Fuelled Thermal Energy Equipment

Waste-fuelled thermal energy equipment produces heat using wastes (e.g., wood waste) and fuels from waste (e.g., biogas and bio-oil). Currently, Class 43.2 includes waste-fuelled thermal energy equipment, subject to the requirement that the heat energy generated from the equipment is used in an industrial process or a greenhouse.

The Budget proposes to expand Class 43.2 by removing this requirement. This change will allow waste-fuelled thermal energy equipment to be used in a broad range of applications, including space and water heating. For example, wood waste could be used as an alternative to heating oil for space and water heating in a shopping centre.

This measure will apply to assets acquired on or after Budget Day that have not been used or acquired for use before that date.

Equipment of a District Energy System

District energy systems transfer thermal energy between a central generation plant and a group or district of buildings by circulating steam, hot water or cold water through a system of underground pipes. Thermal energy distributed by a district energy system can be used for heating, cooling or in an industrial process. Certain equipment that is part of a district energy system is currently included in Class 43.1 or Class 43.2, if the system distributes thermal energy primarily generated by one or more of an eligible cogeneration system, a ground source heat pump, active solar heating equipment and heat recovery equipment.

Building on the proposed expansion of Class 43.2 to include waste-fuelled thermal energy equipment used for a broader range of applications, the Budget also proposes to expand Class 43.2 by adding equipment that is part of a district energy system that distributes thermal energy primarily generated by waste-fuelled thermal energy equipment (that is itself eligible for inclusion in Class 43.2). For example, in a remote community a district energy system that uses heat generated by waste-fuelled thermal energy equipment could provide an alternative to equipment that uses only fossil fuels.

This measure will apply to assets acquired on or after Budget Day that have not been used or acquired for use before that date.

Energy Generation from Residue of Plants

The residue of plants (e.g., straw, corn cobs, leaves and similar organic waste produced by the agricultural sector) can be used in a number of ways, including the production of heat, electricity, bio-fuels and other bio-products. Subject to certain requirements, equipment that uses these residues to produce biogas or bio-oil is currently eligible for inclusion in Class 43.2.

The Budget proposes to add the residue of plants to the list of eligible waste fuels (e.g., biogas, bio-oil, digester gas, landfill gas, municipal waste, pulp and paper waste, and wood waste) that can be used in waste-fuelled thermal energy equipment included in Class 43.2 or a cogeneration system included in Class 43.1 or Class 43.2. For example, a greenhouse could produce heat for its operations using a heating system fuelled by the residue of plants.

This measure will apply to assets acquired on or after Budget Day that have not been used or acquired for use before that date.

Environmental Compliance

If equipment using fuels from waste does not comply with environmental regulations, there could, in some instances, be an increased risk of the release of pollutants. To ensure that taxpayers who benefit from Class 43.1 or 43.2 do so in an environmentally responsible manner, the Budget proposes that equipment using eligible waste fuels not be eligible under Class 43.1 or Class 43.2 if the applicable environmental laws and regulations of Canada or of a province, territory, municipality, or a public or regulatory body are not complied with at the time the equipment first becomes available for use.

This measure will apply to assets acquired on or after Budget Day that have not been used or acquired for use before that date.

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Corporate Mineral Exploration and Development Tax Credit

A corporate tax credit is available at the rate of 10% for pre-production mining expenditures incurred in respect of certain mineral resources in Canada. Qualifying minerals for purposes of the credit are diamonds, base or precious metals and industrial minerals that become base or precious metals through refining.

The Budget proposes to phase out this corporate tax credit.  The credit will apply at a rate of 10% for exploration expenses incurred in 2012, and at a rate of 5% for such expenses incurred in 2013. The credit will not be available for exploration expenses incurred after 2013.

The corporate tax credit will apply at a rate of 10% for pre-production development expenses incurred before 2014, at a rate of 7% for such expenses incurred in 2014, and at a rate of 4% for such expenses incurred in 2015. The credit will not be available for pre-production development expenses incurred after 2015.

Additional transitional relief will be provided in recognition of the long timelines involved in developing mines. The corporate tax credit will apply at a rate of 10% for pre-production development expenses incurred by a taxpayer before 2016 either:

  • under a written agreement entered into by the taxpayer before Budget Day; or
  • as part of the development of a new mine where
    • the construction of the new mine was started by, or on behalf of, the taxpayer before Budget Day, or
    • the engineering and design work for the construction of the new mine, as evidenced in writing, was started by, or on behalf of, the taxpayer before Budget Day.

Exploration and pre-production development expenses will continue to qualify as Canadian exploration expenses, and as such will continue to be fully deductible in the year incurred.

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Atlantic Investment Tax Credit

The Atlantic Investment Tax Credit (“AITC”) is a 10% credit currently available for qualifying acquisitions of new buildings, machinery and equipment, used primarily in farming, fishing, logging, mining, oil and gas, and manufacturing and processing in the Atlantic provinces, the Gaspé Peninsula and their associated offshore regions.

Oil and Gas and Mining Activities

The Budget proposes to phase out the AITC for oil and gas and mining activities over a four-year period. In particular, this proposal will apply to assets acquired on or after Budget Day for use in any of the following activities:

  • operating an oil or gas well;
  • extracting petroleum or natural gas from a natural accumulation of petroleum or natural gas;
  • extracting minerals from a mineral resource;
  • processing ore from a mineral resource to any stage that is not beyond the prime metal stage or its equivalent;
  • processing iron ore from a mineral resource to any stage that is not beyond the pellet stage or its equivalent;
  • processing tar sands ore from a mineral resource to any stage that is not beyond the crude oil stage or its equivalent;
  • producing industrial minerals;
  • processing heavy crude oil recovered from a natural reservoir to a stage that is not beyond the crude oil stage or its equivalent;
  • Canadian field processing;
  • exploring or drilling for petroleum or natural gas; and
  • prospecting or exploring for or developing a mineral resource.

The availability of the AITC for assets acquired for use in other activities will not be affected.

The AITC will apply at a rate of 10% for assets acquired before 2014 for use in any of the activities listed above and at a rate of 5% for such assets acquired in 2014 and 2015. The AITC will not be available for such assets acquired after 2015.

Transitional relief will be provided in recognition of the long timelines involved in some oil and gas and mining projects. The AITC will apply at a rate of 10% for assets acquired by a taxpayer before 2017 either:

  • under a written agreement entered into by the taxpayer before Budget Day; or
  • as part of a project phase where
    • the construction of the project phase was started by, or on behalf of, the taxpayer before Budget Day, or
    • the engineering and design work for the construction of the project phase, as evidenced in writing, was started by, or on behalf of, the taxpayer before Budget Day.

Electricity Generation Equipment

Equipment is generally eligible for the AITC if the equipment is a qualified property. Electricity generation equipment described in Class 1, 8, 29 or 41, paragraph (c) of Class 43.1 or paragraph (a) of Class 43.2 of Schedule II to the Income Tax Regulations used in the Atlantic region primarily in an eligible activity is a qualified property.

The Budget proposes to improve the neutrality of the AITC by amending the Tax Act so that qualified property will include certain electricity generation equipment and clean energy generation equipment used primarily in an eligible activity (i.e., farming, fishing, logging, and manufacturing and processing).

This change will apply to assets acquired on or after Budget Day that have not been used or acquired for use before that date, other than such assets that are used primarily in oil and gas or mining activities.

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