This blog is co-authored with Faizal Valli and Paul R. LeBreux (of Global Tax Law Corporation, Counsel to Moodys LLP)
On March 4, 2010, Federal Finance Minister Jim Flaherty released the 2010 Federal Budget (the "Budget"). The Budget contained a significant amount of tax material in comparison to recent budgets. Find below the relevant tax measures that are worthy of discussion.
PERSONAL TAX MEASURES
A. Stock Options
i. Elimination of Employer Deductions in Certain Cases
The use of stock options in employee remuneration has been common over the recent years. In some situations, the realization of a stock option benefit by an employee can result in tax preferential treatment given that the employee may be eligible for a 50% stock option deduction against the resulting stock option benefit. In some cases, the employee may actually dispose of the "rights" under the stock option agreement in exchange for cash paid by the employer. The result of such a disposition of rights for a cash settlement by the employer is that the employee may realize a preferential tax benefit (i.e. a stock option benefit less a 50% deduction) and the employer may deduct such payment in the computation of its income.
The Budget proposes to prevent both the stock option deduction for the employee and the expense deduction by the employer from being claimed from the same employment benefit. Accordingly, the stock option deduction will generally be available to the employees who dispose of stock option rights only in situations where the employer makes an election to forgo the deduction for the cash payment. These measures apply to dispositions of stock options after 4:00 p.m. EST March 4, 2010.
ii. Elimination of the Stock Option Deferral
In the early 2000s, the Federal Government introduced complex rules to enable employees of publicly traded companies to make an election to defer the recognition of their stock options benefits. The election was generally available for benefits in respect of up to $100,000 of employee qualifying stock options vesting in a particular year. The rules were tremendously complex but generally very useful in many cases.
The Budget proposes to repeal the tax deferral election legislation with respect to employee stock options exercised after 4 p.m. on March 4, 2010. Existing deferrals appear to be not affected by the Budget proposals. Also, deferrals for stock options exercised by employees of Canadian controlled private corporations are unaffected.
iii. Significant Relief for Under-Water Stock Options
The 2010 Budget introduced a relieving measure for "under-water" stock option shares. The proposed relief may apply to individuals who have disposed of stock option shares and previously deferred the stock option deduction over the last 10 years, by way of the "Fairness Provisions" in the Income Tax Act ("the Act").
Generally, this election may be beneficial if the tax otherwise payable on the stock option benefit is greater than the proceeds received on the sale of "under-water" shares.
a. Background and Example
Many individuals previously exercised their stock options when share prices were high. However, as a result of subsequent economic factors, the fair market value of such shares may be significantly lower than when the stock options were exercised. Such shares are commonly referred to as under-water stock option shares. In some cases, if the stock option benefit was deferred, individuals are faced with a future tax liability on the stock option benefit that is greater than the fair market value ("FMV") of their shares.
In order to understand the proposed relief provided in the 2010 Budget, consider the following example. Suppose Bill (an Alberta resident taxpayer) exercised a stock option in 2006 to purchase shares of Bill's employer, Pubco, a Canadian public corporation. Bill paid an aggregate exercise price of $20,000 for Pubco shares, which had an aggregate FMV at that time of $100,000. As a result, Bill realized a stock option benefit of $80,000 on the exercise.
Under current legislation, Bill could likely elect to defer the recognition of such stock option benefit until the year in which he disposed of his Pubco shares (pursuant to current subsection 7(8) of the Act, up to an annual limit of $100,000 of "strike price" on such stock options vesting in a particular year). In our example, Bill chose to make an election to defer the $80,000 stock option benefit.
Suppose further that in 2010, Bill's Pubco shares had a FMV of only $10,000, and were expected to decrease further in the future. Accordingly, Bill decided to sell his Pubco shares in 2010 for proceeds of $10,000. Under current legislation, the following would result:
1. Bill would realize the stock option benefit of $80,000 (that was previously deferred), and would receive a 1/2 deduction under paragraph 110(1)(d) of the Act, resulting in taxable income of $40,000, and taxes payable of $15,600.
2. Bill would realize a capital loss of $90,000 (Bill's ACB being $100,000 of FMV at time of exercise, less proceeds of $10,000).
As you can see, Bill would receive proceeds of $10,000 on the sale of shares, but would be faced with a $15,600 tax liability. In addition, Bill would have a capital loss of $90,000 which may be carried back three years or carried forward indefinitely against capital gains realized. To be further clear, the $90,000 capital loss would not be deductible against the $80,000 employment benefit.
b. Proposed Relief
To mend the above situation, the 2010 Budget has proposed that in the year in which a taxpayer is required to include the stock option benefit (as a result of disposing their under-water shares), such taxpayer may elect to pay a "special tax" equal to the taxpayer's proceeds of disposition from the sale of such under-water shares. Where such an election is made, the Budget proposes that:
1. The taxpayer will be able to fully offset the stock option benefit, and
2. The taxpayer must include a capital gain equal to the lesser of:
a. the stock option benefit, and
b. the capital loss realized on the disposition of the under-water shares.
In the example above, the proposed relief would apply as follows: Bill could elect to pay a special tax equal to the proceeds of disposition on his Pubco shares, or $10,000. If Bill made such election, the following would apply:
1. Bill would be able to claim a deduction to fully offset his stock option benefit of $80,000, and
2. Bill would have to report a capital gain equal to the lesser of:
a. Bill's stock option benefit of $80,000, and
b. the capital loss of $90,000.
Therefore, Bill would have to report a capital gain of $80,000. This would reduce his capital loss to $10,000 from $90,000.
c. A Twist
The economic impact would be slightly different if Bill realized capital gains in 2010 of $20,000 in the rest of his investment portfolio. Based on the above example, if Bill elected to pay the special tax of $10,000, the following would apply:
1. Bill could still claim a deduction to fully offset his $80,000 stock option benefit,
2. Bill would have to report a capital gain of $80,000 based on the above example.
As a result, Bill's total 2010 capital gain would be $100,000, and his capital loss on the under-water shares would be $90,000, resulting in a capital gain of $10,000 (or taxable capital gain of $5,000).
d. Application of Proposed Relief
As mentioned earlier, the proposed relief may apply to individuals who disposed of their under-water shares (and had previously deferred their stock option benefit) in the last 10 years, based on the "Fairness Provisions" in subsection 152(4.2) of the Act. This might provide HUGE relief to taxpayers who were affected by the inability to offset the capital loss against the stock option benefit within the last 10 years if they had previously deferred the stock option benefit. Individuals who have not yet disposed of their under-water shares and wish to have the proposed relief apply must do so before 2015.
e. Summary
As alluded to above, the special election will only be economically beneficial if the tax liability on the stock option benefit is greater than the proceeds received on the under-water shares.
iv. Changes to Withholding Remittance Requirements
Current law provides rules that require employers to remit source withholdings to the Government in respect of employment benefits. The Budget intends to clarify the existing law to ensure that an amount in respect of tax on the value of the stock option benefit is required to be remitted to the Government by the employer. As stated in the Budget, this proposal is intended to prevent situations in which an employee is unable to meet their tax obligation as a result of a decrease in the value of their shares.
B. US Social Security Benefits
US social security benefits received by Canadian residents are currently taxed at an 85% inclusion rate. However, prior to 1996, the Canada-US tax treaty only required a 50% income inclusion as opposed to 85%. The Budget proposes to reinstate the 50% income inclusion for Canadian residents who have been in receipt of US social security benefits since before January 1, 1996 and for their spouses and common-law partners who are eligible to receive survivor benefits. This measure will apply to US social security benefits received on or after January 1, 2010.
C. Roll-over of RRSP Proceeds to a Registered Reitrement Disability Plan ("RDSP")
RDSPs were introduced in the 2007 Federal Budget to assist parents and caregivers for the long term financial security of a child with a severe disability. The Budget proposes to extend the existing RRSP roll-over rules (which apply upon the death of a person where such RRSP proceeds are transferrable to a surviving spouse, financially dependant child and/or a mentally infirm child) to RDSPs. The roll-over rules to RDSPs will apply for deaths that occur on or after March 4, 2010 but will be subject to the beneficiaries' existing RDSP room. However, there are certain transitional rules that were announced in the Budget where the death of an RRSP annuitant occurs after 2007 and before 2011.
D. Medical Expense Tax Credit
The Budget proposes to disallow as a medical expense tax credit any expenses that were incurred for purely cosmetic procedures aimed at enhancing ones appearance (such a lipo-suction, hair replacement procedures, Botox injections, and teeth whitening). Cosmetic procedures that are required for medical or reconstruction purposes such as surgery to correct a deformity arising from, or directly related to a congenital abnormality, a personal injury resulting from an accident or trauma, or a disfiguring disease will continue to qualify for medical tax expense credits. Such measure will apply for expenses incurred after March 4, 2010.
BUSINESS INCOME TAX MEASURES
A. Loss Trading
Recent media articles have highlighted the Department of Finance's interest in publicly traded income trusts or publicly traded partnerships ("SIFTs") that use certain tax strategies to acquire "Losscos" as a result of the looming requirement for SIFTs to convert to a corporation. The Budget intends to amend the acquisition of control rules in the Act to ensure that such rules will impose restrictions on the use of losses of "Losscos" in situations where units of a SIFT are exchanged for shares of a corporation. Proposed legislative amendments were not included with the Budget documents and therefore the "devil is in the details" but, in reviewing the Budget Documents, it would appear that most "Lossco" type deals involving SIFTs are essentially dead.
B. Section 116 Amendments
Section 116 of the Act requires purchasers of "Taxable Canadian Property" ("TCP") acquired from non-residents of Canada to withhold a portion of the purchase price and remit it to the Government unless the non-resident obtains a "clearance certificate" from the Canada Revenue Agency ("CRA"). However, in order to obtain a clearance certificate the non-resident vendor must remit an amount or post security, or satisfy the CRA that no tax will be owing. The Budget is proposing new rules to amend the definition of TCP so as to exclude certain shares of private corporations and other interests that do not derive their value principally from real property situated in Canada, Canadian resource property, or timber resource property. This measure will eliminate section 116 compliance obligations for these types of properties. The measure is HUGE and somewhat surprising. If a non-resident disposes of, say, shares of a Canadian private corporation (whose value is not principally derived from real property in Canada, Canadian resource property or timber resource property) then such non-resident will not be subject to the section 116 requirements to apply for a clearance certificate (or remit funds, post security etc...) or file a Canadian income tax return.
This is certainly welcome news for the investment community which may be encouraged to invest in Canada as a result of the reduced administrative burden. On the other hand, one could query the tax policy behind this measure since the CRA will now have no advance notice of dispositions where it could disagree with the non-resident's assertion that the property was not TCP. Interesting.
C. NRT and FIE Proposals (this section written by Paul R. LeBreux of Global Tax Law Corporation, a well-recognized international tax expert)
It is hard to believe that it has been 11 years since the proposed changes to overhaul the taxation of non-resident trusts (NRTs) and foreign investment entities (FIEs) were first introduced in the 1999 Federal Budget. Since the first draft of the legislation was released June 22, 2000, the implementation date of the legislation and its retroactive effective date have been delayed and amended numerous times. The last 11 years have seen new drafts of the proposals released, each time with substantial amendments, no less than six times. Most recently, proposals for amendments were tabled during the second session of the 39th Parliament, however these proposals were not enacted before Parliament was dissolved in September 2008. Budget 2009 stated that the Government would review the outstanding proposals before proceeding with measures in this area and today, the Budget reintroduces this controversial initiative, with some not so minor amendments designed to "simplify" these complex provisions.
Some of the more interesting revised proposals which will address certain concerns and challenges and also provide a degree of simplification are:
- Entities exempt from tax under section 149 of the Act (for example, pension funds and registered charities) will be granted an exemption from resident-contributor and resident-beneficiary status.
- Investments in bona fide commercial trusts will not be caught by the new NRT rules.
- A commercial trust will not be caught by the deemed residence rules if it satisfies certain criteria, including that the trust not be a discretionary or personal trust and that each beneficiary be entitled to both the income and capital of the trust.
- Loans by a Canadian financial institution to a non-resident trust will not cause the financial institution to be a resident contributor to the trust provided the loan is made in the ordinary course of business.
- Resident contributors to a trust that is deemed resident under these rules will no longer be jointly and severally liable for the trust's income tax obligations, but would only be liable for their proportionate share of the trust's income.
However, the Budget will also propose substantial modifications that effectively introduce a whole new level of complexity to the NRT legislation. The Budget proposes to modify the taxation of a deemed Canadian resident trust by dividing the trust's property into "resident" and "non-resident" portions. The resident portion will consist of property acquired by the trust through contributions from residents and certain former residents (and property substituted for such property). The non-resident portion will consist of all other property contributed to the trust. It is proposed that income earned on the non-resident portion will be excluded from Canadian taxation as long as it is not from sources in Canada on which non-residents would normally be required to pay tax.
New ordering rules would be introduced for distributions to trust beneficiaries. For example, distributions to Canadian resident beneficiaries will be deemed to be made first out of the resident portion of the trust's income, while distributions to non-resident beneficiaries will be deemed made first out of the non-resident portion of the trust. Distributions to non-resident beneficiaries out of the non-resident portion of the trust will not be subject to Canadian withholding tax, whereas a distribution to a non-resident beneficiary out of the resident portion of the trust will be subject to withholding tax.
It is further proposed that, when income of the trust is not distributed to beneficiaries, the amount of the accumulated income will automatically be deemed to be a contribution by the trust's connected contributors and will form part of the resident portion for the next taxation year, unless the said accumulated income is kept separate and apart from all the property forming the resident portion.
Some other interesting proposals regarding NRTs:
- The reassessment period for income in respect of trusts subject to these rules will be extended by three years.
- The Tax Conventions Interpretation Act will be amended to clarify that a trust that is deemed to be resident in Canada under these rules is a resident of Canada and subject to Canadian tax for treaty purposes.
- The measures regarding non-resident trusts will apply retroactively to the 2007 and later taxation years, except for the attribution of trust income to resident contributors, which applies only to taxation years ending after March 4, 2010.
The proposals effecting FIEs were minor in comparison to that for NRTs. The Budget amends the FIE rules as follows:
- The prescribed interest rate applicable in computing the income inclusion for an interest in an offshore investment fund property is increased to the three-month average Treasury Bill rate plus two percentage points.
- Existing rules will be broadened to require beneficiaries of certain non-resident trusts to report income on a modified foreign accrual property income basis so that these rules apply to any resident beneficiary who, together with non-arm's-length persons, holds 10 percent or more of the fair market value of any class of interests in a non-resident trust.
- The reassessment period will be extended by three years for interests in offshore investment fund properties, and require more detailed reporting will be required in respect of "specified foreign property".
- The measures regarding FIEs will apply for taxation years that end after March 4, 2010.
OTHER TAX MEASURES
A. Information Reporting of Tax Avoidance Transactions
Similar to our blog on Quebec's take on tax avoidance of October 21, 2009 and also recent US proposals that we blogged about on February 10, 2010, the Budget proposes a requirement to report certain tax avoidance transactions. Legislative proposals were not released but a promise was made to release details on the proposals at an early opportunity. The Government also announced a consultation process with stakeholders will take place with the view to improving the "fairness of the Canadian tax system". The Budget did, however, announce that a "reportable transaction" would be an avoidance transaction, as currently defined in the Act, which is entered into by or for the benefit of the taxpayer that bears at least two of the following three "hallmarks":
1. A promoter or tax advisor in respect of the transaction is entitled to fees that are to any extent attributable to the amount of the tax benefit from the transaction, contingent upon the obtaining of a tax benefit from the transaction, or attributable to the number of taxpayers who participate in the transaction or who have been provided access to advice given by the promoter or advisor regarding the tax consequences from the transaction,
2. A promoter or tax advisor in respect of the transaction requires "confidential protection" about the transaction, or
3. The taxpayer or the person who entered into the transaction for the benefit of the taxpayer obtains "contractual protection" in respect of the transaction (otherwise than as a result of a fee as described in the first hallmark).
A transaction that is a tax shelter or flow-through share arrangement will not be impacted by these proposals.
Upon discovery of a reportable transaction that has not been reported when required, the CRA could deny the tax benefit resulting from the transaction. If the taxpayer still wanted to claim the tax benefit, it would be required to file with the CRA any required information and to pay a penalty (quantum unknown as at this time).
These are certainly interesting times, and these proposals are another example of the ongoing push around the world towards financial transparency. One will have to wait and see what form of penalty will be arising from such proposals and what the ultimate legislation looks like. As we mused about in our February 10, 2010 blog, we are of mixed mind with respect to such proposals. On the one hand, one can certainly see the tax policy benefits from this. However, how far will the Government go in order to seek transparency of tax transactions? Will solicitor-client privilege be of any future benefit in tax transactions? (Certainly today solicitor-client privilege is generally of great value.) Will such proposals ultimately discourage tax professionals entering into the practice of tax? The musings will continue but hopefully such issues will be discussed in the public consultation process to find an appropriate balance.
B. Taxation of Corporate Groups
The Government announced in its Budget documents that it has heard concerns from the business community and from the provinces regarding the utilization of tax losses within corporate groups. The Government announced that it will explore whether new rules for the taxation of corporate groups - such as the introduction of a formal system of loss transfers or consolidated reporting-could improve the functioning of the tax system. This is certainly welcome and may eliminate certain tax risks (such as section 67 reasonableness issues) that currently exist.
C. Previously Announced Tax Measures
The Budget documents announced that the Federal Government intends to proceed with previously announced tax measures such as amending GST legislation on Financial Services and to introduce various tax technical amendments (such as the previously announced restrictive covenant rules).
D. Repeal of Charitable Expenditure Rule
Charities are subject to a charitable expenditure rule which generally requires the charity to spend 80% of the previous year's tax receipted donations plus other amounts relating to enduring property and transfers between charities and 3.5% of all assets not currently used in charitable programs or administration if such assets exceed $25,000 ("capital accumulation rule"). The charitable expenditure rule has been the subject of much debate over the years and the Federal Government acknowledges in its Budget documents that some stakeholders have called for the elimination of the disbursement quota because it imposes an unduly complex and costly administrative burden on charities particularly small and rural charities.
Accordingly, the Budget proposes to repeal the charitable expenditure rule for fiscal years that end on or after March 4, 2010. This, to us, is a bit of a surprise but certainly welcome.
The proposal to reform the disbursement quota comes with two additions. The first is that the current exception from the capital accumulation rule for charities having $25,000 or less in assets is to be increased to $100,000 for charitable organizations. In addition, the Budget proposes to extend existing anti-avoidance rules for charities to situations where it can reasonably be considered that a purpose of a transaction was to delay unduly or avoid the application of the disbursement quota.
SUMMARY
As stated earlier, this is certainly a deep budget as compared to prior years with respect to tax measures. Moodys LLP Tax Advisors will keep you up to-date on the progress of these measures.
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