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Federal Budget 2007
Canadian Minister of Finance Jim Flaherty delivered his 2007 Budget yesterday, March 19.
As has been typical for Mr. Flaherty during his tenure as Minister of Finance, he did not fail to surprise most observers and, whether one agrees with his tax policies or not, he cannot be criticized for being reluctant to make significant tax policy proposals. Indeed, considering that he is a Minister in a minority government that is expected to go to the polls later this year, most commentators expected a pre-election budget full of "goodies" for the general electorate, and no real tax policy proposals. However, yet again, Minister Flaherty proved the commentators wrong.
Following is a brief overview, with comments, on the most significant tax policy proposals from the Budget. For more detail, please contact any of the members of Gowlings National Tax Practice Group.
Withholding Tax Measures
What may be one of the two most significant items in the Budget is the set of proposals dealing with non-resident withholding tax for interest. Currently Canada imposes a 25% withholding tax on interest paid by a resident of Canada to a non-resident, subject to reduction under any of Canada's bilateral tax treaties, and subject to a significant exemption for mid and long-term corporate debt (so-called "5/25 Debt").
There have been suggestions recently that Canada may be willing to reduce the rate of withholding tax on interest under our treaties, or expand the exemption from withholding tax. This has apparently been a topic of negotiation between Canada and the U.S. in the context of a new protocol to the Canada-U.S. Tax Treaty.
The Budget announces that an agreement in principle has been reached by the two countries' representatives on the major elements of an updated Canada-U.S. Tax Treaty and that formal negotiations are expected to conclude in the very near future. The principal features include:
o elimination of withholding tax on arm's length cross-border interest payments, to be effective for the first calendar year following the entry into force of the treaty provisions;
o elimination of withholding tax on non-arm's length cross-border interest payments in three stages:
o Reduction of withholding to 7% for interest paid in the first year following the entry into force of the revised treaty;
o Reduction of withholding to 4% for interest paid in the second year following the entry into force of the revised treaty;
o Reduction of withholding to 0% for interest paid in the third year following the entry into force of the revised treaty.
Once both the arm's length and non-arm's length exemptions from withholding tax under the Canada-U.S. Tax Treaty are implemented, the Budget proposes to amend Canadian legislation to eliminate withholding tax on interest paid to all arm's length non-residents, regardless of their country of residence. This legislated exemption will apply to interest paid on or after the date on which the withholding tax exemptions in the Canada-U.S. tax treaty come into effect.
Foreign Affiliates - Interest Deductibility
What is probably the other of the two most significant proposals in the Budget is the set of proposals relating to interest deductibility and investments by Canadian corporations in foreign subsidiaries (so-called "foreign affiliates"). Currently tax rules contain what is, in many respects, a form of "participation exemption" for investments in foreign affiliates. These rules favour Canadian corporations that receive dividends from a foreign affiliate where such dividends are deemed to be paid from that affiliate's "exempt surplus" (being, in general terms, income from an active business of the foreign affiliate carried on in a country with which Canada has a tax treaty). A Canadian corporation may receive dividends from the "exempt surplus" of a foreign affiliate free of Canadian tax. In addition, while such dividends are not taxed in Canada, a Canadian corporation is entitled to deduct an amount in respect of interest incurred on borrowed money used to finance the foreign affiliate. This treatment has been criticized in some quarters (including by Canada's Auditor General) as being overly generous.
The Budget proposes to eliminate this interest deduction. Disallowed interest expense may be carried forward and deducted in future years if and to the extent that the shares of the foreign affiliate generate non-exempt income for the corporation.
These changes will apply to interest payable after 2007 on new debt incurred on or after March 19, 2007. Interest payable on existing non-arm's length debt will be subject to the new rules after 2008 or after the expiry of its current term, whichever is sooner. Interest payable on existing arm's length debt will be subject to the new rules after 2009 or after the expiry of its current term, whichever is sooner.
AIM and Other Stock Exchanges
There was some good news for Canadian technology companies in yesterday's Budget.
Listing on the Alternative Investment Market (AIM) of the London Stock Exchange has become an attractive financing opportunity for Canadian technology and resource companies at a certain stage of development. Unfortunately, Canadian tax rules were not conducive to such AIM listings because trades on AIM were considered to be subject to tax clearance requirements. In order to avoid this unduly burdensome compliance requirement for each and every trade on the AIM by a non-resident investor, certain companies incurred great cost and inconvenience to convert themselves into mutual fund corporations before proceeding to AIM.
Under the Budget proposals, shares listed on AIM will no longer be subject to tax clearance requirements. Specifically, the Budget proposes to introduce a new category of "recognized stock exchange" which will include any stock exchange located in any OECD country with which Canada has a tax treaty. This will include AIM and many other exchanges that were not previously listed. Shares listed on such recognized stock exchanges will be excluded from the ambit of the requirement to obtain a tax clearance certificate.
The proposed change will be effective on Royal Assent.
Gowlings was a key player in the lobby effort to achieve this important change.
Further International Tax Changes
In addition to the introduction of new rules in restricting the deductibility of interest paid on indebtedness used to invest in foreign affiliates, the Budget in its "International Tax Fairness Initiative" includes the following new measures affecting the existing rules on active business income.
As mentioned above, in general, under the current rules, active business income earned in a treaty country (country with which Canada has a tax treaty) by a foreign affiliate of a Canadian corporate taxpayer may be repatriated in Canada by way of dividends without Canadian taxation.
The new international initiative included in the Budget proposes to:
o narrow the current recharacterization rules that permit certain passive income earned by a foreign affiliate to be treated as active business income. The current rules allow certain passive income (such as interest and royalties) paid between related foreign affiliates to be deemed to be active business income. For tax purposes, a corporation may be related to another without one owning shares in the other. The new measure will require that the Canadian taxpayer own, directly or indirectly, at least a 10% economic interest in the foreign entity paying the passive income. One could wonder why such a new rule is being introduced as the notion of related corporations implies that the foreign affiliates are ultimately controlled by the same person or group of persons.
o expand the exemption from Canadian tax on active business income earned, not only in a treaty country, but also earned in a non-treaty jurisdiction which has signed a tax information exchange agreement (TIEA) with Canada. This new rule will also apply in relation to countries with which Canada entertains TIEA negotiations, except where those negotiations do not result in an agreement within five years.
o as a counterpart of this enhancement in respect of TIEA countries, active income earned by a foreign affiliate in a non-treaty, non-TIEA country will be taxed in Canada as it is earned in the foreign country (in other words, it will be treated as so-called "FAPI").
In the context of the Canada-US Tax Treaty, the Budget also announced that the protocol to the treaty is expected to address the following items:
o the harmonization of pension contribution rules in Canada and the U.S.; and
o clarification of the treatment of cross-border stock options.
The treatment of U.S. "limited liability corporations" under the Canada-U.S. Tax Treaty has been a controversial topic for many years. The Canada Revenue Agency has taken the position that LLCs that are fiscally transparent for U.S. tax purposes are not entitled to the benefits of the Canada-US Tax Treaty. The Budget announced the extension of treaty benefits to U.S. LLCs. This will await announcement and ratification of the forthcoming protocol to the treaty.
Lifetime Capital Gains Exemption
The Income Tax Act (Canada) currently provides for a lifetime capital gains exemption of up to $500,000 on capital gains realized on the disposition of qualified small business corporation shares as well as qualified farm and fishing property.
The Budget proposes to increase the lifetime capital gains exemption to $750,000 in respect of dispositions that occur on or after March 19, 2007. In order to give effect to the measure for the 2007 taxation year, the capital gains exemption will be capped at $625,000 for dispositions occurring on or after March 19, 2007 through to December 31, 2007.
Donation of Securities to Private Foundations
To encourage further charitable donations to private foundations, the Budget proposes to eliminate the taxation of capital gains arising from the donation of publicly-listed securities to private foundations. The changes apply to donations made on or after March 19, 2007.
Capital Cost Allowance Rates
The Budget includes a proposal to temporarily increase the capital cost allowance ("CCA") rate for manufacturing and processing ("M&P") machinery and equipment currently included in Class 43 to a 50% straight-line rate, up from the current 30% rate. The new rate will apply to eligible assets acquired on or after March 19, 2007 and before 2009.
The Budget also contains proposed increases in the CCA rates for the following assets acquired on or after March 19, 2007:
o Buildings used for manufacturing or processing - from 4% to 10%
o Other non-residential buildings - from 4% to 6%
o Computer equipment - from 45% to 55%
o Natural gas distribution lines - from 4% to 6%
o Liquified natural gas facilities - from 4% to 8%
To access the enhanced CCA rates for buildings used in M&P and for other non-residential buildings, the asset will be required to be placed in a separate class or the current treatment will apply. Further, at least 90% of the building (measured by square footage) must be used for the designated purpose by the end of the taxation year. Buildings used for M&P that do not meet the 90% M&P usage threshold at the end of the taxation year will at least be eligible for the new 6% proposed rate for other non-residential buildings if 90% of the building is used for non-residential purposes.
Phase-out of accelerated CCA for oil sands
The Budget proposes to eliminate the additional CCA allowance that allows taxpayers to deduct up to 100% of the remaining cost of eligible assets used for oil sands projects for a taxation year (up to the taxpayer's income for the year from the project after deducting regular CCA). Oil sands projects (both mining and in situ) will continue to be eligible for the regular 25% CCA rate for such projects.
Accelerated CCA will continue to be available for assets acquired before March 19, 2007 and for assets acquired before 2012 that are part of a project phase on which major construction began before March 19, 2007. For other assets, the additional accelerated CCA will be phased out over a period from 2011 to 2015.
Accelerated CCA for clean energy generation
The budget proposes to extend eligibility for accelerated CCA under Class 43.1 (30%) or 43.2 (50%) to include the following assets acquired on or after March 19, 2007 and used to produce clean energy through the following emerging technologies:
o Wind and tidal energy equipment
o Active solar equipment
o Small photovoltaic and fixed-location fuel cell systems
o Biogas production equipment
o Pulp and paper waste fuel cogeneration systems
o Biomass drying and other fuel upgrading equipment
o Waste-fuelled thermal energy systems
In recognition of the significant tax issues raised by the influx of Olympic athletes, officials and support personnel, the Budget announced a number of changes to Canadian tax laws to address these issues. These include the following:
o The International Olympic Committee and International Paralympic Committee will be exempted from tax under Part XIII of the Act on payments made to them after 2005 and before 2011 in respect of the 2010 Olympic and Paralympic Winter Games;
o The following non-residents of Canada be exempted from income tax under Part I of the Act on income derived from the non-resident's activities, after 2009 and before April 2010, in connection with the 2010 Olympic and Paralympic Winter Games:
o employees, officers and members of the International Olympic Committee and the International Paralympic Committee, and individuals (other than trusts) providing services under contract with those organizations;
o athletes representing countries other than Canada;
o officially registered support staff associated with teams from countries other than Canada;
o persons serving as games officials; and
o accredited foreign media organizations and their employees and individuals (other than trusts) providing services under contract with those organizations;
o Every person who makes a payment to a non-resident of Canada described above in respect of the income described in that paragraph be exempted from the usual tax withholding obligations for payments to non-residents.