Business Income Tax Measures

22 mars 2013

( Disponible en anglais seulement )

IN THIS SECTION:

Leveraged Life Insurance Arrangements

The
Federal Government has grown increasingly concerned that certain leveraged life
insurance arrangements were providing unintended tax benefits to their
participants. These arrangements included, most notably, “leveraged insured
annuities” (“LIAs”) and “10/8 plans” or arrangements.

The
Budget includes proposed measures designed to eliminate the tax benefits that
may otherwise have been available to LIA and 10/8 plan participants. The
Federal Government also intends to continue to monitor planning and strategies
involving life insurance products and to determine whether further action may
be warranted in the future.

Leveraged Insured Annuities

In
general, LIAs are marketed and sold to closely-held private corporations. They
are integrated investment products that involve a loan that is used to acquire
a lifetime annuity and a policy of life insurance, both of which are on the
life of an individual, usually the owner-manager of the corporation (the
“Insured”). The life insurance policy and the lifetime annuity are assigned to
the lender as collateral for the loan.
The life insurance policy’s death benefit, payable on the Insured’s
death, is generally equivalent to the amount invested in the lifetime annuity. Investors
in LIAs receive fixed and guaranteed income until the Insured’s death. At that time, the capital invested in the
annuity is returned as a tax-free death benefit.

Although sold as integrated products in the
marketplace, each component of a LIA is treated separately for tax purposes. This separate tax treatment leads to the
unintended tax benefits that were of concern to the Federal Government, while
making LIAs attractive to investors. In
brief, these tax benefits enable a portion of the capital invested in LIAs to
be received on a tax-free basis, given that:

  • the life insurance policy in question is an “exempt policy”
    under the Income Tax Act (Canada)(« Tax Act »), such that its holder is generally not exposed to annual
    income taxation and is not taxed on the final payout of the death benefit;
  • the interest payable on the loan used to acquire the life
    insurance policy is, in general, tax-deductible; and
  • a portion of the capital that is invested in the LIA, on
    account of the premium payable in respect of the life insurance policy,
    may also be tax-deductible.

In addition to the above:

  • LIAs also provide for an
    elimination of taxes payable on retained earnings within a corporation by avoiding
    capital gains tax liability on the Insured’s (or the owner/manager’s) death;
    and
  • as the life insurance policy
    that is part of a LIA is generally corporate-owned, the payout of the death
    benefit results in a credit to the corporation’s capital dividend account
    (“CDA”) that, in turn, enables the corporation to declare and pay tax-free
    capital dividends to its shareholders.

In an
effort to eliminate these unintended tax benefits, the Budget introduces rules
for “LIA policies.” Under these rules, a
policy of life insurance may constitute a “LIA policy” if:

  • on or after Budget Day, a
    person or partnership becomes obligated to repay a borrowed amount to a
    lender by reference to the Insured’s death; and
  • an annuity contract is
    assigned to the lender, and the annuity contract provides for continuous
    payments during the Insured’s lifetime.

“LIA
policies” will be subject to taxation on an accrual basis in respect of the
income that is earned within them during a taxation year, while deductions will
be disallowed for policy premiums. Upon
the Insured’s death, for “LIA policies,” there will be no credit to a private
corporation’s CDA and the annuity contract assigned to a lender will be deemed
to have been disposed of on the annuitant’s death for proceeds equal to its
fair market value (“FMV”). An annuity
contract’s FMV, for the purposes of the “LIA policy” rules, will be deemed to
be equal to the total of the premiums paid under the contract.

Application Date for the “LIA Policy” Rules

The “LIA
policy” rules will only apply to taxation years that end on or after Budget
Day. As such, the new measures will not apply to LIAs in respect of which all
funds were borrowed prior to Budget Day.

10/8 Arrangements

In
general, 10/8 strategies permit high-net-worth individuals and closely-held
private corporations to achieve greater tax efficiency by:

  • maximum-funding or investing
    a considerable amount of money into a policy of life insurance to
    significantly and quickly increase its cash value;
  • using the life insurance
    policy or an investment account as collateral for a loan from a
    third-party lender (which lender often works in conjunction with the
    insurer), with the borrowed amount being equal to the amount invested in
    the life insurance policy; and
  • investing the borrowed funds
    in income-producing assets or a business venture, such that the interest
    payable on the loan is deductible under the Tax Act.

These
arrangements are known as 10/8 strategies or arrangements because participants
pay 10% interest on the borrowed amount, while earning an 8% return on the
amount that they invest in the life insurance policy, for a spread of 2%. As with LIAs, because the policy of life
insurance in question is an “exempt policy” under the Tax Act, the 8% annual
interest earned in respect of the policy is not included in a taxpayer’s annual
income. On the other hand, the taxpayer
may be able to claim a deduction from income for the 10% interest paid on the borrowed
amount, provided that the loaned funds are invested in income-producing assets
or ventures. For corporate-owned
policies of life insurance, on the taxpayer’s death, assuming that he or she is
the person insured under the policy, the death benefit generally results in a
credit to the corporation’s CDA, which may be paid to shareholders by way of a
tax-free capital dividend.

The
Federal Government’s concern with 10/8 arrangements was the subject of recent
litigation in the Federal Court and on appeal to the Federal Court of Appeal
(see MNR v. RBC Life Insurance Company et
al., 2013 FCA 50). During the course
of the litigation, it was revealed, inter
alia
, that the CRA’s “GAAR Committee” had determined that 10/8 arrangements
were not subject to the application of the general anti-avoidance rule in
section 245 of the Tax Act, although the arrangements could have still been the
subject of challenge under other provisions.
Notwithstanding this fact, the effect of the new measures introduced in
the Budget is to ensure that 10/8 arrangements are no longer used.

The New 10/8 Arrangement Rules

For
taxation years ending on or after Budget Day, if a policy of life insurance or
an investment account under a policy of life insurance is assigned to a lender
as collateral for a loan and either:

  • the
    interest rate payable on the investment account is determined by reference to
    the interest rate payable on the loan; or
  • the
    investment account’s maximum value is determined by reference to the interest
    rate payable on the loan,

then a
taxpayer participating in such an arrangement will be denied:

  • a
    deduction for the interest paid or payable on the loan;
  • a
    deduction for the premium that is paid or payable under the life insurance
    policy; and
  • for
    corporate-owned life insurance policies, the credit to the corporation’s capital
    dividend account as a result of the death benefit payable under the life
    insurance policy.

To help
terminate the 10/8 arrangements presently in place, the Budget proposes to
alleviate the tax consequences to taxpayers on a withdrawal from a policy of
life insurance that is subject to a 10/8 plan or arrangement, and the repayment
of the borrowed amount, provided that such steps are taken prior to January 1,
2014.

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Corporate Loss Trading

The
Federal Government introduced certain provisions in the Tax Act over the years to
prevent the trading of corporate tax attributes (referred to as “loss pools”)
among arm’s length persons. Notwithstanding these provisions, taxpayers continue
to enter into certain loss trading transactions which the Federal Government
considers inappropriate.

The
Federal Government introduces a new measure in the Budget to prevent a profitable
corporation (“Profitco”) from
transferring, directly or indirectly, income producing property to an unrelated
corporation with loss pools (“Lossco”)
in return for shares of Lossco.

Consider
a typical transaction targeted by this new measure, wherein Profitco avoids
acquiring control of Lossco in order to access loss pools of Lossco by acquiring
shares of Lossco that represent more than 75% (and often greater than 90%) of
the fair market value of all Lossco’s shares, but that do not give Profitco
voting control of Lossco. Lossco then uses its loss pools to shelter from tax
all or part of the income derived from the property transferred by Profitco and
pays tax-free inter-corporate dividends to Profitco.

The
Federal Government considers that these loss-trading transactions constitute
aggressive tax avoidance and undermine the integrity of the income tax
provisions that are meant to prevent the trading of corporate loss pools among
arm’s length persons.

The Budget
proposes to introduce an anti-avoidance rule (referred to as an “attribute
trading restriction”) to support the existing loss restriction rules that apply
to the acquisition of control of a corporation. The proposed amendments will
deem there to have been an acquisition of control of a corporation that has
loss pools (Lossco in the above example) at a particular time when a person (or
group of persons) acquires shares of the corporation that represent more than
75% of the fair market value of all the shares of the corporation without
otherwise acquiring control of the corporation, if immediately prior to that
particular time the person or group of persons held shares, if any, of the
corporation with a fair market value that was 75% or less of all the shares of
the corporation, and it is reasonable to conclude that one of the main reasons
that control was not acquired is to avoid the restrictions that would have been
imposed on the use of loss pools.

This
attribute trading restriction will restrict the use of a tax attribute arising
on the application of certain provisions of the Tax Act

The Budget
also proposed related rules to ensure that this anti-avoidance rule is not
circumvented. The Federal Government indicated that it will continue to monitor
the effectiveness of the constraints on the trading of loss pools and determine
whether further action is warranted.

Application Date

This
measure will apply to a corporation the shares of the capital stock of which
are acquired on or after Budget Day unless the shares are acquired as part of a
transaction that the parties are obligated to complete pursuant to the terms of
an agreement in writing between the parties entered into before Budget Day.
Parties will be considered to not be obligated to complete a transaction if one
or more of those parties may be excused from completing the transaction as a
result of changes to the Tax Act.

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Taxation of Corporate Groups

Canada
does not have a formal system of corporate group taxation like the United
States and other jurisdictions. Although Canadian corporate groups may be able
to undertake loss consolidation transactions through financing arrangements,
reorganizations, and transfers of property on a tax-deferred basis, such
consolidation is generally more cumbersome and often requires obtaining tax
rulings.

In its
2010 and 2012 Budgets, the Federal Government expressed interest in exploring
the issue of whether new rules for the taxation of Canadian corporate groups,
such as the introduction of a formal system of loss transfers or consolidated
reporting, could improve the functioning of the corporate tax system in Canada.

The
Federal Government conducted extensive public consultations on this issue,
including with provincial and territorial officials. Generally, businesses indicated that they
were primarily interested in a system of group taxation that would allow them
to easily transfer losses, tax credits and other tax attributes between members
of a corporate group. Provinces and territories expressed their concerns about
the possibility that a new system of corporate group taxation could reduce
their revenues, and could result in significant upfront costs for governments
associated with introducing a new approach to the taxation of corporate groups.

The
Federal Government confirmed that it completed its examination of the taxation
of corporate groups and determined that moving to a formal system of corporate
group taxation is not a priority at this time. The Federal Government indicated
that it will continue to work with provinces and territories regarding their
concerns about the uncertainty of the cost associated with the current approach
to loss utilization.

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Mining Expenses

The Budget
proposes changes to align the deductions available for expenses in the mining
sector with those available in the oil and gas sector. The alignment of
deductions will affect the mining sector generally, including coal producers. This
measure is intended to phase out inefficient fossil fuel subsidies.

Pre-Production
Mine Development Expenses

Pre-production
mine development expenses (“PMDE”) refer to certain expenses (e.g., expenses
for removing overburden, stripping, sinking a mine shaft, or constructing an
adit or other underground entry) incurred for the purpose of bringing a new
mine for a mineral resource located in Canada into production in reasonable
commercial quantities, excluding expenses resulting in revenue before production,
except for those expenses that exceed such revenue earned. PMDE qualify as Canadian exploration expenses
(“CEE”) which may generally be 100% deducted in the year incurred or carried
forward indefinitely for use in future years. PMDE incurred after a mine comes into
production qualify as Canadian development expenses (“CDE”) and are generally deductible
at a rate of 30% per year on a declining-balance basis.

Phasing-In
Period

The Budget
proposes that specified PMDE be treated as CDE. The transition from CEE to CDE treatment will
be phased-in, with PMDE being allocated proportionally to CEE and CDE based on
the calendar year in which the expense is incurred. Starting in 2015, 20% of PMDE will be
allocated to CDE. The CDE allocation
will increase to 40% in 2016, 70% in 2017, and 100% after 2017.

Application
Date

This
measure will generally apply to PDME incurred on or after Budget Day. The existing CEE treatment for PMDE will still
apply to expenses incurred before Budget Day and expenses incurred before 2017
either under a written agreement entered into by the taxpayer before Budget Day
or as part of the development of a new mine, generally where either the
construction was started before Budget Day, or the engineering and design work
for the construction (evidenced in writing) was started before Budget Day, by
or on behalf of the taxpayer. Obtaining
permits or regulatory approvals, conducting environmental assessments,
community consultations or impact benefit studies, and similar activities will
not be considered construction or engineering and design work.

Accelerated
CCA for Mining

Most
machinery, equipment and structures used to produce income from a mine or an
oil or gas project are currently eligible for CCA at a rate of 25% on a
declining-balance basis. The 25% rate is also applicable to assets that are
used in the initial processing of oil or gas, or ore from a mineral resource.

Accelerated
CCA is also provided for certain assets acquired for use in new mines or
eligible mine expansions, by way of an additional allowance. The additional
allowance allows the taxpayer to deduct in computing income for a taxation year
up to 100% of the remaining cost of eligible assets acquired for use in a new
mine or an eligible mine expansion, not exceeding the taxpayer’s income for the
year from the mining project (calculated after deducting regular CCA).

Phasing-Out
Period

The Budget
proposes to phase out the additional allowance available for mining (excluding bituminous
sands and oil shale, already scheduled for phase-out by 2015). The additional
allowance will be phased-out over the 2017 to 2020 calendar years. Starting in
2017, a taxpayer will be allowed to claim 90% of the amount of the additional
allowance otherwise permitted. The percentage reduces to 80% in 2018, 60% in
2019, 30% in 2020 and nil for later calendar years. Where a taxpayer’s taxation
year includes more than one calendar year the additional allowance will be
prorated, based on the number of days in each calendar year.

Application
Date

This proposed
measure will generally apply to expenses incurred on or after Budget Day. The existing additional allowance will be
maintained for eligible assets acquired before Budget Day, and will also apply
for such assets acquired before 2018 for a new mine or a mine expansion either under
a written agreement entered into by the taxpayer before Budget Day, as part of
the development of a new mine or as part of a mine expansion where the
construction was started before Budget Day, or the engineering and design work
for the construction (evidenced in writing) was started before Budget Day, by
or on behalf of the taxpayer. Obtaining
permits or regulatory approvals, conducting environmental assessments,
community consultations or impact benefit studies, and similar activities will
not be considered construction or engineering and design work.

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Restricted Farm Losses

The restricted farm loss (“RFL”) rules apply to taxpayers who have
incurred a loss from farming, unless their chief source of income for a
taxation year is farming or a combination of farming and some other source of
income. The RFL rules limit the deduction of farm losses to a maximum of $8,750
annually ($2,500 plus ½ of the next $12,500). Farm losses incurred in a year in
excess of that limit can be carried forward for 20 years to be claimed against
farming income.

The Budget proposes to amend the RFL rules to overturn a recent Supreme
Court of Canada decision in The Queen v.
Craig
, 2012 SCC 43. In Craig, it
was held that a taxpayer could meet the chief source of income test even though
his primary source of income was not farming provided that the taxpayer places
significant emphasis on both farming and non-farming sources of income. This
decision had the effect of overruling a previous decision of the Supreme Court
of Canada in Moldowan v. The Queen,
[1978] 1 SCR 480. In Moldowan, the Court had held that
farming that results in a loss could satisfy the chief source of income test if
farming is the taxpayer’s chief source of income in combination with a
non-farming source of income that is a subordinate source or a side-line employment
or business. The Budget restores this prior Moldowan
test requiring that a taxpayer’s other sources of income must be subordinate to
farming in order for farming losses to be fully deductible against income from
those other sources.

The Budget also proposes to increase the RFL limit to $17,500 of
deductible farm losses annually ($2,500 plus ½ of the next $30,000).

Application Date

These
measures will apply to taxation years that end on or after Budget Day.

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Reserve for Future Services

Paragraph
20(1)(m) of the Tax Act is designed to permit a taxpayer earning income from a
business to claim for a taxation year a reserve for amounts received from
customers in respect of, among other things, services that may reasonably be
expected to be rendered after the end of the taxation year. This reserve
applies only if the amounts received have been included in computing the
taxpayer’s income for the year or a previous year.

However,
the reserve under paragraph 20(1)(m) of the Tax Act is not intended to apply to
amounts received for the purpose of funding future reclamation projects (e.g. a
waste disposal facility that charges fees to its customers to cover the future
cost of reclaiming its landfill).

Taxpayers
with future reclamation obligations are generally eligible to use the
Qualifying Environmental Trust (“QET”) rules. Under these rules, a taxpayer may
claim a deduction for amounts contributed to a QET established for the purpose
of funding the future reclamation of a qualifying site.

In order
to clarify the tax treatment of amounts set aside to meet future reclamation
obligations, the Budget proposes to amend subsection 20(7) of the Tax Act to specifically
exclude a reserve in respect of a reclamation obligation from paragraph
20(1)(m).

This
measure will apply to amounts received on or after Budget Day, other than
amounts received that are directly attributable to future reclamation costs,
that were authorized by a government or regulatory authority before Budget Day
and that are received: (i) under a written agreement between the taxpayer and
another party (other than a government or regulatory authority) that was
entered into before Budget Day and not extended or renewed on or after Budget
Day, or (ii) before 2018.

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Additional Deduction for Credit Unions

The small
business deduction effectively provides a preferential corporate income tax
rate, on up to $500,000 of qualifying business income, to Canadian-controlled
private corporations (“CCPCs”) with taxable capital employed in Canada of less
than $15 million. Credit unions also have access to this preferential income
tax rate on the same basis as CCPCs.

Credit
unions are currently also entitled to an additional deduction from income tax.
The amount of taxable income eligible for the additional deduction is subject
to a limit based on the credit union’s cumulative taxable income that was taxed
at the preferential rate (including as a result of the additional deduction)
and the amount of their deposits and member shares. This deduction permits the credit union to
accumulate capital and increase its reserve on a preferential tax basis.

Prior to
1972, credit unions were exempt from income tax under Part I of the Tax Act. When
credit unions became subject to Part I tax, the additional deduction for credit
unions was introduced to level the playing field between credit unions and
CCPCs. However, the small business deduction has changed significantly over the
years. As a result of those changes, the additional deduction for credit unions
now provides access to a preferential corporate income tax rate not available
to CCPCs.

Phasing-Out Period

The Budget
proposes to phase-out the additional deduction for credit unions over five
calendar years, beginning in 2013. For 2013, a credit union will be permitted
to deduct only 80 per cent of the amount of the additional deduction otherwise
calculated. The percentage of the additional deduction, otherwise calculated,
that a credit union will be permitted to deduct will be 60 per cent for 2014,
40 per cent for 2015, and 20 per cent for 2016. For 2017 and subsequent years,
the additional deduction will be eliminated.

Application Date

This measure will apply to taxation years
that end on or after Budget Day. For a taxation year that includes Budget Day,
the measure will be prorated to apply only to the portion of the year that is
on or after Budget Day. The measure will also be prorated for all taxation
years during the phase-out period that do not coincide with the calendar year.

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Manufacturing and Processing Machinery and Equipment: Accelerated Capital Cost Allowance

Machinery and equipment acquired by a
taxpayer after March 18, 2007 and before 2014, primarily for use in Canada for
the manufacturing or processing of goods for sale or lease qualifies for a
temporary accelerated capital cost allowance (“CCA”) rate of 50% calculated on
a straight-line basis under Class 29, subject to the half-year rule applied in
the acquisition year. These eligible assets would otherwise be included in
Class 43 and qualify for a CCA rate of 30% calculated on a declining-balance
basis.

The Budget extends the accelerated CCA to
eligible assets acquired in 2014 or 2015.
Eligible assets acquired in 2016 and subsequent years will qualify for
the regular 30% declining-balance rate, and will be included in Class 43.

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Clean Energy Generation Equipment: Accelerated Capital Cost Allowance

Class 43.2 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 includes eligible
equipment that generates or conserves energy by using a renewable energy source,
fuel from waste, or making efficient use of fossil fuels. The accelerated CCA provides an incentive for
investment in low-emission or no-emission energy generation equipment.

Class 43.2 currently includes biogas
production equipment using organic waste that is sewage from an eligible sewage
treatment facility, food and animal waste, manure, plant residue or wood
waste. The Budget proposes to expand
Class 43.2 by making biogas production equipment that uses more types of
organic waste eligible for inclusion in Class 43.2, including pulp and paper waste
and wastewater, beverage industry waste and wastewater and separated organics
from municipal waste.

Class 43.2 also includes only certain
cleaning and upgrading equipment used to treat eligible gases from waste
(biogas, digester gas and landfill gas).
The Budget proposes to expand the range of cleaning and upgrading
equipment used to treat eligible gases from waste that is eligible for
inclusion in Class 43.2, to all such cleaning and upgrading equipment.

These measures
will apply to property acquired on or after Budget Day that has not been used
or acquired for use before Budget Day.

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Scientific Research and Experimental Development Program

The Budget proposes measures to provide the
CRA with new resources and administrative tools to address Scientific Research
and Experimental Development (“SR&ED”) claims.

One of these measures will require
additional disclosure obligations on SR&ED program claim forms with respect
to SR&ED program tax preparers and billing arrangements. The Business Number of third party preparers
and details about billing arrangements (e.g. whether a contingency fee arrangement
exists and the amount of the fee payable) will now be required. Where third parties are not involved, the
claimant will have to certify that no third party assisted in any aspect of the
preparation of the SR&ED claim.

The Budget also proposes a new penalty for
non-compliance with the new reporting requirements. A $1,000 penalty will apply
to each SR&ED program claim for which the information about SR&ED
program tax preparers and billing arrangements is missing, incomplete or
inaccurate. If a third-party SR&ED program tax preparer was involved, the
claimant and the preparer will be jointly and severally, or solidarily, liable
for the penalty.

This measure will apply to SR&ED
program claims filed on or after the later of January 1, 2014 and the day of
Royal Assent to the enacting legislation.

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