On August 4, 2023, the Department of Finance (Finance) released a large package of draft legislative proposals and related explanatory notes (August 4 Proposals). The August 4 Proposals include updated legislative amendments to proposed draft legislation from the 2023 federal budget (Budget 2023), previously released draft legislation and certain other technical amendments.
This bulletin analyzes the most significant tax measures addressed in the August 4 Proposals.
The August 4 Proposals provide for further significant changes to the general anti-avoidance legislation (GAAR), including adding a new rebuttable presumption against the taxpayer in the economic substance interpretive rule proposed in Budget 2023 to the “misuse or abuse” test. Based on the August 4 Proposals, “it is presumed” that the transaction results in misuse or abuse if an avoidance transaction is significantly lacking in economic substance.
Helpfully, the August 4 Proposals include some relieving changes to the share buyback tax first proposed in Budget 2023 by expanding the definition of “substantive debt” and changes to broaden some relieving measures regarding the excessive interest and financing expenses (EIFEL) rules.
The August 4 Proposals also include some revisions to the digital services tax (DST), first released in the 2021 federal budget (Budget 2021) and that (consistent with public statements from the government) will come into force on January 1, 2024, with retroactive effect to January 1, 2022.
Notably, the August 4 Proposals do not include any further revisions to proposed amendments to modify the non-resident withholding tax rules applicable to certain payments made by partnerships with Canadian resident partners, the denial of the dividends received deduction by financial institutions proposed in Budget 2023, or the current or next iteration of the hybrid mismatch rules.
Submissions on the August 4 Proposals can be made to Finance until September 8, 2023. Submissions regarding the Global Minimum Tax (Pillar Two), however, may be made until September 29, 2023.
Table of Contents
In Budget 2023, Finance proposed certain amendments to the GAAR contained in section 245 of the Income Tax Act (Canada) (ITA). Additional information about the GAAR amendments proposed in Budget 2023 can be found here. In the August 4 Proposals, Finance proposed certain additional amendments to the GAAR. The August 4 Proposals generally reflect the approach set out in Budget 2023 but incorporate some changes that may prove to be significant.
By way of background, the GAAR applies only when three elements are present: a tax benefit, an avoidance transaction and a misuse or abuse of provisions of the ITA or other tax enactments. Where the GAAR applies, the tax consequences of an avoidance transaction may be determined as is reasonable in the circumstances to deny a “tax benefit” that would otherwise be realized.
In Budget 2023, Finance proposed to add a three-pronged preamble describing the scope of the GAAR in general terms, with the stated goal of helping to address interpretive issues and ensuring that the GAAR applies as intended.
The August 4 Proposals delete one prong that expressly provided that the GAAR could apply “regardless of whether a tax strategy is foreseen.” Finance initially included this language in response to the comment that “[t]he GAAR was enacted to catch unforeseen tax strategies” made by the majority of the Supreme Court of Canada (SCC) in Canada v. Alta Energy Luxembourg S.A.R.L. (Alta Energy). The SCC majority held that the GAAR did not apply in the particular circumstances of Alta Energy, which included that Parliament was aware of the tax strategy used by the taxpayer but that Parliament did not adopt any provisions to prevent its use (and, in fact, made a deliberate choice to leave open its availability).
After Budget 2023, the SCC released its decision in Deans Knight Income Corp. v. Canada
). In that case, the majority commented that “the GAAR is not limited to unforeseen situations
… it is designed to capture situations that undermine the integrity of the tax system by frustrating the object, spirit and purpose of the provisions relied on by the taxpayer” [emphasis added]. The explanatory notes to the August 4 Proposals (Explanatory Notes) explained that the prong of the preamble providing that the GAAR could apply “regardless of whether a tax strategy is foreseen” is no longer needed because the SCC majority in Deans Knight
“has since clarified and confirmed that the GAAR is not limited to unforeseen situations.
Misuse or Abuse: Economic Substance
Budget 2023 proposed to introduce a new economic-substance interpretive rule to the “misuse or abuse” test. If an avoidance transaction was “significantly lacking in economic substance,” Budget 2023 provided that this “tends to indicate” there is misuse or abuse. Nonetheless, Budget 2023 clarified that economic substance would not supplant the general approach under Canadian tax law that generally places primacy on a transaction’s legal, not economic, substance.
Commentators have consternated over the meaning of the “tends to indicate” language included in Budget 2023. Canadian jurisprudence has consistently held that the onus for proving misuse or abuse rests on the Crown rather than the taxpayer. If a significant lack of economic substance tends to indicate that an avoidance transaction results in misuse or abuse, this onus would appear to be shifted, at least to a certain extent, to the taxpayer in circumstances where an avoidance transaction significantly lacks economic substance. A similar critique applied to determining the existence of a significant lack of economic substance, as Budget 2023 proposed a statutory list of “factors that tend — depending on the particular circumstances — to establish that a transaction or series of transactions is significantly lacking in economic substance” [emphasis added].
The August 4 Proposals replace the “tends to indicate” language with a presumption: if an avoidance transaction is significantly lacking in economic substance, “it is presumed” that the transaction results in misuse or abuse. Similarly, the August 4 Proposals replace the “tends to establish” language by providing that the enumerated list of factors “establish” (still, “depending on the particular circumstances”) that a transaction or series of transactions is significantly lacking in economic substance. This may be more than an incremental change as the existence of a presumption of misuse or abuse for avoidance transactions that significantly lack economic substance shifts the onus for the “misuse or abuse” test to the taxpayer (i.e., to rebut the presumption of misuse or abuse) in such circumstances.
The Explanatory Notes confirm that the presumption can be rebutted in “appropriate circumstances.” For example, the Explanatory Notes contemplate that the presumption could be rebutted by showing that Parliament intended to encourage, through the enactment of a particular provision, the effect of a particular avoidance transaction that is significantly lacking in substance (such as transfers of funds into a tax-free savings account or certain transfers of losses within a related group).
The August 4 Proposals also identify in proposed subsection 245(4.2) of the ITA one additional enumerated factor that may establish that a transaction or series of transactions is significantly lacking in economic substance: the use of an accommodation party that results in all or substantially all of the opportunity for gain or profit and risk of loss of the taxpayer remaining unchanged. The Explanatory Notes describe an “accommodation party” as a party that may directly or indirectly accept a fee to participate in a transaction and help the taxpayer obtain the tax benefit, without assuming any or significant economic exposure in respect of the transaction. The addition of the use of accommodation parties as a factor that may establish a significant lack of economic substance for purposes of the GAAR may have implications for how the Canada Revenue Agency (CRA) and courts will assess taxpayers’ legal, including non-arm’s-length, relationships.
Notably, proposed subsection 245(4.2) deletes the previous use of the word “includes” before the list of enumerated factors that may establish, depending on the particular circumstances, that a transaction or series of transactions is significantly lacking in economic substance. As a result, the text of the provision is not clear as to whether the enumerated factors identified in the provision form an exhaustive list. Additionally, it is not clear from the drafting of the proposed section whether each of the enumerated factors must be satisfied or whether satisfaction of only one of the enumerated factors is sufficient to establish a significant lack in economic substance. The Explanatory Notes, however, indicate that the list of enumerated factors is not exhaustive and that it is not necessary for each of the enumerated factors to be satisfied in order for subsection 245(4.2) to apply.
Budget 2023 also proposed to amend the meaning of “avoidance transaction” in subsection 245(3) of the ITA to provide, among other things, that a transaction could only be an avoidance transaction if “it may reasonably be considered that one of the main purposes for undertaking or arranging the transaction was to obtain the tax benefit.” This proposed language broadened the scope of the term “avoidance transaction,” as the previous threshold required only that it may reasonably be considered that a transaction was “undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.”
The August 4 Proposals subtly shift the Budget 2023 language by reversing the test of what “may reasonably be considered.” The Budget 2023 language provides that a transaction can only be an avoidance transaction if “it may reasonably be considered that one of the main purposes for undertaking or arranging the transaction was to obtain the tax benefit.” On the other hand, the August 4 Proposals provide that a transaction will not be an avoidance transaction if “it may reasonably be considered that obtaining the tax benefit is not one of the main purposes for undertaking or arranging” the transaction. Accordingly, the August 4 Proposals subtly raise the bar for finding an avoidance transaction (in the taxpayer’s favour). Although the Explanatory Notes are silent on the potential effects of this subtle change, and the revised language arguably better tracks the structure of existing subsection 245(3), they do remark that the revision is a “reorganization of the subsection.”
Extended Reassessment Period
Budget 2023 proposed to give the CRA three years beyond the normal reassessment period to assess or reassess on the basis of the GAAR, unless the transaction was disclosed to the Minister of National Revenue (Minister) as a reportable transaction under section 237.3 of the ITA. Budget 2023 also provided for voluntary disclosure under section 237.3. In this case, the normal reassessment period would apply to GAAR assessments or reassessments if voluntary disclosure was made within the applicable disclosure time limits under the reportable transaction rules.
The August 4 Proposals extend this approach to notifiable transactions under section 237.4 of the ITA. In addition, the August 4 Proposals change the deadline for a voluntary filing under section 237.3 of the ITA to be made in respect of a transaction or series of transactions — from the deadline required for the filing of a reportable transaction information return, to the taxpayer’s filing due date for the taxation year in which the transaction occurs. If that deadline is missed but a voluntary filing is made up to one year after the taxpayer’s filing due date for the taxation year in which the transaction occurs, the CRA will only be able to assess or reassess on the basis of the GAAR for one year beyond the normal reassessment period. Presumably, this change was included to address concerns expressed by the tax community that taxpayers may have difficulty complying with the tight timelines set out in Budget 2023.
Budget 2023 proposed to introduce a penalty to enhance the deterrent effect of the GAAR. The proposed penalty would have been equal to 25% of the amount of the tax benefit (other than a tax benefit arising from the creation of unutilized tax attributes) denied due to the application of the GAAR. It remained unclear how the penalty would apply when a tax benefit arose from a deferral, as opposed to a reduction, of tax. Budget 2023 also provided that a taxpayer would not be subject to the penalty if the transaction subject to the GAAR was disclosed (either mandatorily or voluntarily) under the reportable transaction rules in section 237.3 of the ITA.
The August 4 Proposals add an additional specified form of due diligence defence to the imposition of a GAAR penalty, though the scope of the statutory defence is in some respects quite limited. Specifically, a person will not be subject to a GAAR penalty if they can demonstrate that at the time a transaction or series was entered into, “it was reasonable for the person to have concluded that [the GAAR] would not apply to the transaction or series in reliance on the transaction or series being identical or almost identical to a transaction or series that was the subject of (1) administrative guidance or statements that were published by the Minister or another relevant government authority, or (2) one or more court decisions.” The express ability for taxpayers to rely upon “administrative guidance or statements published by the Minister or another relevant governmental authority” for purposes of the GAAR penalty due-diligence defence is notable, as Canadian jurisprudence, including the SCC’s decision in Canada (Attorney General) v. Collins Family Trust, has repeatedly indicated that CRA guidance is not authoritative and that taxpayers rely on such guidance at their own peril. One established area where such reliance may have greater significance is in defending against the discretionary assessment of penalties or interest. In this way, the August 4 Proposals constitute a codification of this principle, expressly permitting at least some reliance upon CRA guidance for the purposes of defending against the imposition of a GAAR penalty.
The narrow phrase “identical or almost identical” used in the due diligence defence, as opposed to a broader phrase such as “similar or substantially similar” (which would be akin to the language used in the notifiable transactions regime, as discussed in our 2022 whitepaper) limits the scope of this statutory defence considerably. The Explanatory Notes assert that the “identical or almost identical” threshold is “quite high” and that relying on a “merely similar” transaction is insufficient to qualify. Many transactions considered by governmental authorities or the courts include unique, fact-specific elements that may limit the prospect for reliance on them. While the August 4 Proposals and the corresponding Explanatory Notes do not explain precisely which aspects of a transaction or series must be “identical or almost identical,” the better view may be to focus only on aspects that are material to the determination of whether GAAR will apply, and not on aspects immaterial to that determination. Helpfully, the Explanatory Notes state that the due diligence defence could be relied upon even where there are subsequent changes to administrative positions or jurisprudence. Future cases will also need to determine whether there remains room for the application of the common law due diligence defence in the face of the enactment of this new statutory defence.
The August 4 Proposals provide that the amount of a GAAR penalty will be reduced by the amount of any related gross negligence penalty payable by the person under subsection 163(2) of the ITA. In addition, the August 4 Proposals helpfully clarify that a person will not be subject to a GAAR penalty if they disclose the transaction or series under either the reportable transaction rules in section 237.3 of the ITA, including where a taxpayer makes a late voluntary filing (as described above), or the notifiable transaction rules in section 237.4 of the ITA.
The amendments to the GAAR, including the penalty but excluding the preamble and the extended assessments provisions, are proposed to apply to transactions that occur on or after January 1, 2024. It is presently unclear whether the August 4 Proposals would apply to a series of transactions that include transactions both before and after January 1, 2024.
The Explanatory Notes provide that the preamble will come into force on royal assent. It is unclear when the extended assessments provision comes into force, assuming it is enacted in its proposed form.
The August 4 Proposals include some welcome changes from Budget 2023, though they may not go far enough to alleviate concerns regarding certain common transactions involving repurchases of equity.
As discussed in Blakes Bulletin: 2023 Federal Budget: Selected Tax Measures, the share buyback tax is a proposed 2% tax on the net value of equity repurchases by public corporations and other “covered entities,” as described below. The net value of equity repurchases is generally calculated as the total fair market value of equity (other than equity that meets the definition of “substantive debt,” as described below) of the covered entity that is redeemed, acquired or cancelled in the applicable taxation year, less the total fair market value of equity (other than substantive debt) of the covered entity that is issued in that year.
In addition to public corporations, the definition of a covered entity also includes a publicly traded trust or partnership that (1) is a real estate investment trust (REIT), (2) is a specified investment flow-through trust (SIFT) or SIFT partnership, or (3) would be a SIFT trust or SIFT partnership if, generally, the references to Canada in the definition of “non-portfolio property” were excluded. This broadens the scope of the share buyback rules to entities that may have no investments in Canada and, in the case of partnerships, may have no connection to Canada other than being established under the laws of Canada or any of its provinces. For example, covered entities could include a Canadian exchange traded fund (ETF) that derives more than 50% of its equity value from shares of corporations (other than taxable Canadian corporations) and units of trusts or partnerships (other than Canadian trusts that qualify as REITs) that derive more than 50% of their value from real property located anywhere in the world.
As noted above, equity that meets the definition of “substantive debt” is excluded from the share buyback tax. According to Budget 2023, this is meant to exclude preferred shares and units that are debt-like in nature. However, the proposed definition in Budget 2023 was very narrow and would not have applied to preferred equity with certain common features, such as an early redemption premium. The August 4 Proposals expand the definition of substantive debt in certain helpful ways but may not go far enough to capture many forms of typical preferred shares issued by public corporations. In order to qualify as substantive debt, a share must meet each of the following four tests:
(a) it is not convertible or exchangeable other than for
(i) equity that if issued would be substantive debt of the same covered entity,
(ii) a bond, debenture or note of the covered entity, the fair market value of which does not exceed the total of the amounts referred to in subparagraphs (d)(i) to (iii), or
(iii) equity that would be issued only after the occurrence of a trigger event pursuant to a non-viability contingent capital provision included in the terms of the equity to satisfy regulatory capital requirements applicable to the covered entity;
(b) it is non-voting;
(c) it has a periodic rate of dividend or other distribution payable, if any, expressed as a percentage of an amount equal to the fair market value of the consideration for which the equity was issued if the percentage is
(i) fixed, or
(ii) determined by reference to a market interest rate (including a Government of Canada Treasury Bill) plus a fixed amount, if any; and
(d) it entitles any holder of the equity to receive, on the redemption, cancellation or acquisition of the equity an amount that does not exceed the total of the following amounts:
(i) the fair market value of the consideration for which the equity was issued,
(ii) any unpaid distributions or dividends on the equity that are payable to the holder, and
(iii) any premium that is payable to the holder solely due to the early redemption, cancellation or acquisition of the equity.
Certain aspects of the tests, particularly the non-voting requirement and the requirement that a coupon must be expressed as a percentage, may still be too narrow to include certain types of publicly-traded preferred shares that would appear to fit within the policy objective of excluding debt-like equity securities. It is hoped that Finance will clarify these points before the rules are enacted.
There were also certain changes to the definition of “reorganization or acquisition transaction”, which are transactions that are excluded from the calculation of the share buyback tax. Previously, issuances of equity by a covered entity were all “reorganization or acquisition transactions” (i.e., not taken into account in the calculation of the share buyback tax) unless cash was the only consideration paid to the covered entity in exchange for the issuance or the issuance was made to an employee in the course of employment. The August 4 Proposals expand this rule to also include an issuance on the conversion of a convertible debt that was issued solely for cash consideration.
While helpful, this is a narrow expansion of the definition. As a result, many issuances will continue to be excluded for purposes of calculating the share buyback tax. For example, in the context of ETFs, in-kind subscriptions by a designated broker will be included in the definition of “reorganization or acquisition transaction”, and thus will not count as issuances for the share buyback tax for any ETF that is a covered entity.
Redemptions that are “reorganization or acquisition transactions” have also been expanded in certain ways. For example, the previous rules included exchanges of equity if no consideration other than equity of the covered entity was received by the holder. This has been expanded to permit the new equity to be issued by a related entity or an entity that controls the covered entity, provided that the issuing entity is itself also a covered entity. According to the Explanatory Notes, these changes accommodate, for example, a triangular amalgamation whereby holders of a target receive equity of the parent of the acquiror, or a section 86 spin-off whereby shareholders of a public corporation receive shares of the public corporation and shares of a spinco. The August 4 Proposals also expand the definition to include redemptions as part a “qualifying exchange, which is, generally, a tax-deferred merger of investment funds or REITs.
The August 4 Proposals include revised proposals for the EIFEL rules (“revised EIFEL proposals”) that were first announced in the Budget 2021. This is the third iteration of the EIFEL proposals, following previous releases of draft legislation on February 4, 2022 and November 3, 2022 (“previous EIFEL proposals”).
At a high level, the revised EIFEL proposals do not fundamentally change the mechanics of the EIFEL regime, which will generally limit a taxpayer’s (or group’s) deductions for “interest and financing expenses” (IFEs) to 30% of “adjusted taxable income” (ATI) for taxation years beginning on or after January 1, 2024. However, the revised EIFEL proposals contain several noteworthy changes.
Taxpayers must now file a prescribed form with their income tax returns regarding the deductibility of IFEs. The revised EIFEL proposals do not specify the information that will be required on this form and no draft form is yet available; one would expect that the form will provide a common format for the calculation of the many quantitative amounts and thresholds relevant for the EIFEL regime. The normal reassessment period will be extended for any taxpayers who fail to file the prescribed form or who file the form with incomplete information.
An “excluded entity” is not subject to the EIFEL rules. Under the previous EIFEL proposals, excluded entities generally included: (a) certain Canadian-controlled private corporations, (b) corporations and trusts (or groups of corporations and trusts) and trusts whose aggregate net IFEs are below a de minimis threshold, and (c) corporations and trusts (or groups of corporations and trusts) all or substantially all of whose business, undertakings and activities are carried on in Canada, whose foreign affiliate holdings are below a de minimis threshold, who do not have any significant non-resident shareholders or beneficiaries, and all or substantially all of whose IFEs are not paid or payable to non-arm’s length tax-indifferent investors.
The revised EIFEL proposals clarify that the exclusion in (c) can apply even if the relevant taxpayer or group does not have a business, provided that all or substantially all of its undertakings and activities are carried on in Canada. This change should provide clarity to various entities that, for reasons of qualifying as a unit trust, REIT, mutual fund trust (MFT) or mutual fund corporation, cannot carry on a business. Absent this change, it was unclear whether an entity claiming status as an excluded entity may have been in conflict with the prohibitions against carrying on a business. The Explanatory Notes clarify that the mere holding of indebtedness or shares of a foreign affiliate does not constitute an undertaking or activity for this purpose.
An entity is generally prevented from being an excluded entity if any material portion of its (or any group member’s) IFEs is payable to a tax-indifferent person not dealing at arm’s length with the particular entity (or a group member). The prior EIFEL proposals used the existing definition of “tax-indifferent investor” in the ITA, which refers to a person exempt from tax under section 149, a non-resident, a discretionary trust, and a partnership or trust more than 10% of the value of whose interests are held (directly or indirectly through any partnerships or trusts) by any combination of such persons. The revised EIFEL proposals include a bespoke definition of “tax-indifferent” for this purpose, which is generally the same but does not include discretionary trusts and increases the permissible “tax-indifferent” interest in a partnership or trust from 10% to 50%.
Finally, certain aspects of the excluded entity concept are applied with reference to the particular taxpayer and any other “eligible group entity” in respect of the particular taxpayer. The definition of “eligible group entity” includes, among other things, a corporation that is related to the taxpayer. The revised EIFEL proposals provide that a right referred to in paragraph 251(5)(b) (such as a right to acquire shares under a contract) will not cause an entity to be “related” for this purpose. This change is welcome, since a paragraph 251(5)(b) right would otherwise have made it difficult for a corporate group to determine the impact of such right on the “excluded entity” status of its members. The revised definition of “eligible group entity” also includes trusts in which the taxpayer holds an interest, other than a “fixed interest” (as defined in the non-resident trust rules), and beneficiaries of the taxpayer that do not hold a fixed interest in the taxpayer. The reference to the definition of “fixed interest” in the non-resident trust rules, as opposed to the prior reference to, generally, non-discretionary trusts, suggests that certain discretionary powers of commercial trusts, such as discretion with respect to the timing of distributions, should not disqualify a trust for these purposes.
Financial Institutions and Capacity Transfer
The EIFEL regime contains rules generally permitting the transfer of capacity to deduct IFEs between members of a group. However, financial institution group entities are generally not permitted to transfer capacity to other group members other than another financial institution group entity. The previous EIFEL proposals from November 2022 introduced a relieving provision allowing financial institution group entities to transfer capacity to “insurance holding corporations” and “special purpose loss corporations.” The purpose of this relief was to allow for the sharing of capacity and implementation of loss consolidation structures within insurance company groups where the existence of certain non-financial institution entities and their participation in financing transactions can be the product of the regulatory environment and not tax planning.
The revised EIFEL proposals extend these relieving provisions to a broader category of “financial holding corporation,” which includes an entity whose value is primarily attributable to the shares and debt of certain other financial institution group entities it controls. This is a welcome change for many corporate groups that include non-insurance financial institutions similarly under strict regulatory constraints. Neither the text of the new provisions nor the Explanatory Notes make it clear whether the “primarily attributable” test is determined by looking only at directly owned properties or on a more direct or indirect basis. The usage of “attributable” elsewhere in the ITA may suggest that the direct or indirect approach is intended.
Also, the previous EIFEL proposals restricted an insurance holding corporation to entities deriving value primarily from certain “subsidiary wholly-owned corporations.” The relaxing of this standard to controlled is another welcome change that will allow many groups having non-wholly owned structures (e.g., to address regulatory issues and otherwise) to benefit from these rules.
Recommendations made to Finance to expand the capacity transfer rules to allow transfers to and from branches of authorized foreign banks were not adopted.
The previous EIFEL proposals permitted IFEs to be deducted above the fixed ratio of 30% where a “consolidated group” of entities has a “group ratio” of group net third-party interest expense to group book EBITDA that exceeds the fixed ratio. Under the revised EIFEL proposals, the group ratio that is applicable for this purpose is now multiplied by 1.1. The Explanatory Notes indicate that the 10% up-lift is intended to account for book-tax timing differences, consistent with recommendations made in the BEPS process that serve as the template for the EIFEL regime (and similar regimes in other jurisdictions).
Where a proportion of a taxpayer’s IFEs are denied deductibility under the EIFEL rules, that proportion of the taxpayer’s controlled foreign affiliate’s IFEs (that would have been determined if the affiliate were resident in Canada) is also denied in computing the affiliate’s foreign accrual property income (FAPI). Conversely, a taxpayer’s proportionate share of a controlled foreign affiliate’s IFEs is generally included in the taxpayer’s IFEs. The revised EIFEL proposals clarify that only a controlled foreign affiliate’s IFEs relevant for the FAPI computation are considered for this purpose.
The revised EIFEL proposals include detailed rules for the computation of a controlled foreign affiliate’s IFEs with respect to interest paid by the affiliate to another controlled foreign affiliate of the taxpayer (or group). In certain cases, a part or all of such inter-affiliate interest will be excluded from the computation of IFEs.
The revised EIFEL proposals also introduce an election for a foreign affiliate to forgo deductions of its IFEs, up to the amount of the foreign accrual property loss that the affiliate would otherwise have had for the year. This election allows the taxpayer to preserve its own interest deduction capacity if an affiliate’s IFEs would generate more losses than the affiliate can use in computing its FAPI.
Adjusted Taxable Income
Several changes have been proposed to the computation of ATI, being one of the primary quantities (when multiplied by the specified percentage, generally 30%) defining a taxpayer’s capacity to deduct IFEs.
Prior years’ non-capital losses carried forward and deducted in the current year are generally added back in computing ATI to the extent such losses are attributable to the deduction of IFEs or certain other amounts. If the non-capital loss is for a year ending before February 4, 2022, a taxpayer can elect to treat such loss as a “specified pre-regime loss,” 25% of which is added back in computing ATI. This election is intended to ease the compliance burden that would otherwise result from needing to “source” prior years’ losses to particular kinds of deductions.
Modifications to the computation of ATI have been introduced to ensure that income or losses funded by borrowing on which the interest is an “exempt interest and financing expense” (the deduction of which is not restricted by the EIFEL rules) are excluded from ATI.
Further changes have been made to ensure that the receipt of governmental assistance and the deduction of certain tax credits do not erode the capacity to deduct interest. This is done by adding back to ATI such amounts that would not otherwise have been included because they are not included in income under paragraphs 12(1)(t) or 12(1)(x) by reason of these amounts reducing the cost or capital cost of property.
Section 216 of the ITA allows non-residents deriving rental income from Canadian property to elect to pay tax on a net income basis under Part I of the ITA as though they were a resident in Canada, instead of paying the 25% gross receipts tax under Part XIII. The revised EIFEL proposals clarify the application of the EIFEL rules to section 216 filers.
While confirming the application of the EIFEL rules to section 216 filers, the revised EIFEL proposals prevent such non-residents from being excluded entities or eligible group entities, which means that such non-residents will be ineligible for the election to transfer unused excess capacity between group members and will also be ineligible for the group ratio rule. The Explanatory Notes also confirm that the general rule in paragraph 216(1)(c) denying a section 216 filer any deduction in computing taxable income is intended to apply to the EIFEL regime, thereby denying section 216 filers the ability to carry forward restricted IFEs for deduction in later years under paragraph 111(1)(a.1).
The debt forgiveness rules generally apply where a “commercial debt obligation” is settled for less than its principal amount. A commercial debt obligation includes a debt obligation pursuant to which interest was paid or payable by the debtor, where an amount in respect of the interest was deductible or would have been deductible if not for the application of certain sections of the ITA. The revised EIFEL proposals clarify that the application of the EIFEL rules will not, in and of itself, prevent a debt obligation from constituting a commercial debt obligation. Therefore, the debt forgiveness rules may still apply to a debt even if interest deductions on such debt are, or would be, denied under the EIFEL rules.
Unfortunately, “restricted interest and financing expenses” being IFEs, the deduction of which was previously denied, and which can be carried forward pursuant to paragraph 111(1)(a.1) much like losses, have not been included in the waterfall of attributes in section 80 that are reduced by a forgiven amount.
Following the announcement of several tax incentives to grow Canada's clean economy, the August 4 Proposals included draft legislation regarding the below previously announced tax incentives. A history of the various proposals going back to Budget 2021 can be found here.
Clean Technology Investment Tax Credit (Clean Technology Credit)
The Clean Technology Credit is a 30% refundable investment tax credit available in respect of the capital cost of "clean technology property" acquired and available for use on or after March 28, 2023. Such property generally includes zero-emission power generation technologies, stationary electricity storage equipment for zero-emission energy, active solar heating equipment and certain heat pumps, non-road zero-emission vehicles and associated charging or refuelling equipment, geothermal energy systems (unless used for projects that will co-produce oil, gas or other fossil fuels), concentrated solar energy equipment, and small modular nuclear reactors.
Carbon Capture, Utilization and Storage Investment Tax Credit (CCUS Tax Credit)
The CCUS Tax Credit is a refundable tax credit for eligible expenses incurred on or after January 1, 2022 and before 2041. Following draft legislative proposals in August 2022 and Budget 2023, the August 4 Proposals address, among other aspects, eligibility of dual use equipment, eligibility of refurbishment costs, clarification of the interaction of the CCUS Tax Credit with other government assistance including other tax credits, validation of storage in concrete, addition of British Columbia as an eligible jurisdiction, the recovery tax mechanism, the recapture mechanism in certain circumstances of export or sale, and revisions to the knowledge sharing and climate risk disclosure requirements.
Zero-Emission Technology Manufacturers
The draft legislation includes the changes announced in Budget 2023 to expand, for taxation years beginning after 2023, the list of eligible property the manufacturing or processing of which may constitute a "qualified zero-emission technology manufacturing activity" to include nuclear energy equipment, heavy water, nuclear fuels and nuclear fuel rods. The draft legislation also extends the availability of the corporate tax rate reduction to taxation years that begin after 2021 and before 2035.
Flow-Through Shares and Critical Mineral Exploration Tax Credit — Lithium From Brines
The draft legislation includes Budget 2023's proposal to expand the eligibility of the Critical Mineral Exploration Tax Credit and the flow-through share regime by allowing principal-business corporations to renounce certain expenses related to exploration and development activities of lithium from brines.
Labour requirements are proposed to apply to the Clean Technology Credit and the CCUS Tax Credit and are expected to apply to the investment tax credit for clean hydrogen and investment tax credit for clean electricity. Claimants are able to claim the higher rate for the applicable investment tax credit by electing, in prescribed form, into the requisite labour requirements, being: (i) a prevailing wage requirement that addresses compensation provided to workers, and (ii) an apprenticeship requirement to ensure that registered apprentices perform a certain percentage of total labour hours.
Budget 2023 proposed significant changes to the AMT regime applicable to individual taxpayers, including certain trusts, but did not include any draft legislation with respect to these changes. The August 4 Proposals include draft legislation for the proposed AMT amendments, including new exemptions for certain trusts as described below.
Briefly, Budget 2023 proposed increasing the AMT rate from 15% to 20.5%, and increasing the AMT exemption threshold from C$40,000 to approximately C$173,000 based on expected indexation for the 2024 taxation year, indexed to inflation. The exemption is not relevant for trusts that are not qualified disability trusts. Budget 2023 also proposed broadening the AMT base in several ways, including (i) increasing the inclusion rate for capital gains and employee stock option benefits from 80% to 100%, (ii) disallowing 50% of certain deductions, including interest and carrying charges incurred to earn income from property, non-capital loss carryforwards and limited partnership losses of other years, and (iii) disallowing 50% of most non-refundable tax credits. These changes were proposed to be effective for taxation years beginning after December 31, 2023.
The August 4 Proposals are generally consistent with the proposals set out in Budget 2023. However, the August 4 Proposals contain some helpful departures from Budget 2023. The most significant change expanded the types of investment trusts that will be exempt from AMT. Under the existing legislation, as well as Budget 2023, MFTs and related segregated fund trusts are exempt from AMT. However, trusts that do not fall within those categories are subject to AMT. Under the August 4 Proposals, trusts that qualify as “investment funds” (as defined in subsection 251.2(1) for purposes of the “loss restriction event” rules) will also be exempted from the application of AMT, subject to an anti-avoidance rule. An “investment fund” for this purpose includes a trust that meets certain conditions, including satisfying the conditions necessary to qualify as an MFT for purposes of the ITA other than the minimum distribution requirements, not holding any property that it uses in the course of carrying on a business and complying with certain asset diversification requirements. The August 4 Proposals also exempt a trust of which all of the units are listed on a designated stock exchange. A further exemption applies to trusts of which some of the units are listed on a designated stock exchange — the exemption refers to an exemption from trust reporting requirements for the listed units of such a trust. It is unclear precisely how this exemption is intended to apply. Tax-exempt trusts and certain trusts having only tax-exempt beneficiaries will also be exempt from AMT.
Trusts that do not fit into one of the above-noted categories will continue to be subject to AMT, which may not be able to be eliminated simply by flowing more income out to beneficiaries. A common example where AMT may apply occurs where a trust realizes a capital gain, which is sheltered by deductible expenses. For ordinary tax purposes, only one-half of the capital gain is included in income. Accordingly, the trust can shelter the taxable half of the capital gain with deductible expenses equal to half of the capital gain. However, for AMT purposes, where the entire capital gain will be a taxable capital gain, the trust will not have applied sufficient deductible expenses or distributed sufficient income to reduce its AMT exposure to nil, and therefore may be subject to AMT.
Further, despite the increase in the capital gains inclusion rate to 100% for AMT purposes, capital loss carryforwards will be limited to the amount the trust actually deducts in computing its income for non-AMT purposes (generally 50% of the capital losses carried forward). However, allowable capital losses realized in the same taxation year as capital gains will be grossed-up to 100% for the purposes of calculating AMT in that taxation year. This differential treatment creates a further incentive to match the realization of capital gains and losses in the same taxation year.
The August 4 Proposals also clarify the meaning of “interest and carrying charges” for purposes of calculating the AMT base, only half of which will be allowed as a deduction for these purposes, which generally refer to deductible interest, financing expenses and discounts on certain debt obligations, and do not include management fees. The exclusion of management fees is helpful as this new provision does not prohibit trusts from fully deducting management fees for purposes of calculating AMT.
Trustees and managers of trusts that are not exempt from AMT are encouraged to review and plan for the potential exposure to AMT each year, which may include limiting discretionary deductions and ensuring that trust deeds permit discretionary deductions to be limited and for “phantom income” caused by not deducting discretionary income to be distributed for trust law purposes.
Technical Amendments to Section 7 of the ITA
Section 7 of the ITA applies to determine the timing and amount of the benefit an employee is required to include in income where a particular corporation or an MFT agrees to sell or issue its shares or trust units (as applicable) or shares or trust units of a corporation or MFT with which it does not deal at arm’s length to an employee of the particular corporation or MFT, or of a corporation or MFT with which the particular corporation does not deal at arm’s length. The August 4 Proposals propose to make some helpful technical amendments to subsections 7(1.11) and 7(1.31) of the ITA.
Subsection 7(1.11) currently deems an MFT to not deal at arm’s length with a corporation only if the MFT controls the corporation. Section 7 would therefore currently not apply to agreements entered into with employees to sell or issue shares or trust units in any other situation where an MFT and a corporation do not deal at arm’s length. The August 4 Proposals propose to extend the scope of subsection 7(1.11), such that a corporation owning securities that would give it not less than 50% of the votes that could be cast at the trust’s meeting of unitholders would also be deemed to not deal at arm’s length with the MFT. The securities to which such voting rights are attached would not be limited to units of the trust and could also include securities that are exchangeable into units of the trust. This amendment applies to rights exercised or disposed of after 2004 under agreements to sell or issue securities made after 2002.
Subsection 7(1.31) applies where a taxpayer acquires shares or units of an MFT under an agreement granted in accordance with section 7 and sells the underlying security within 30 days thereafter. In these circumstances, subject to certain conditions and the taxpayer’s designation, the cost base of such shares or units will not be averaged with the cost base of other identical securities the taxpayer owns. The ‘no cost averaging rule’ in subsection 7(1.31) allows a taxpayer to avoid a capital gain on the sale of securities underlying an option or other agreement governed by section 7 that are sold shortly after they are acquired under the agreement, if they already hold identical securities with a lower cost base. The August 4 Proposals propose to extend the scope of subsection 7(1.31) to include securities that are acquired on the surrender of a stock option or other right to acquire securities to which section 7 applies. For example, an option holder will be able to benefit from subsection 7(1.31) if they agree to surrender the option without paying any exercise price in return for shares with a value equal to the ‘in the money’ value of the surrendered option. This amendment is deemed to have come into force on January 1, 2023.
Technical Amendments to Paragraphs 6204(1)(a) and(b) of the Regulations to the ITA (ITR)
The August 4 Proposals propose to make some technical amendments to paragraphs 6204(1)(a) and (b) of the ITR.
Pursuant to paragraph 110(1)(d) of the ITA, where an employee acquires shares on the exercise of a stock option (or, subject to further conditions pursuant to subsection 110(1.1), where the employee surrenders their stock option) to which section 7 of the ITA applies, the employee will be entitled to deduct 50% of the stock option benefit which needs to be included in the employee’s taxable employment income in the year when the stock option is exercised (or settled), provided that certain conditions are met. One of these conditions is that the share underlying the stock option is a “prescribed share” for the purposes of section 6204 of the ITR at the time of exercise or surrender. Among other requirements set out in section 6204, paragraph 6204(1)(b) requires that, at the time of the sale or issue of the share, the corporation or any person or partnership which with the corporation does not deal at arm’s length or any partnership or trust of which the corporation (or any person or partnership which with the corporation does not deal at arm’s length) is a member or beneficiary cannot be reasonably be expected to, within two years after the time the share is issued or sold, redeem, acquire or cancel the share in whole or in part, or reduce the paid-up capital of the corporation in respect of the share, subject to certain exceptions.
The August 4 Proposals propose to add new subparagraph (iv) to paragraph 6204(1)(b) as a new exception to the above-described restrictions. Pursuant to this new provision, a share issuable under an option can be a prescribed share if it may be converted or exchanged into another security of the corporation or of another corporation with which it does not deal at arm’s length immediately after the conversion or exchange, provided that the share was a prescribed share prior to the conversion or exchange and the converted or exchanged share meets the prescribed share requirements under section 6204. The Explanatory Notes indicate that this amendment is intended to provide more flexibility for the exercise or settlement of stock options prior to an acquisition or reorganization wherein shareholders are maintaining their equity position in the issuer or a related entity after the exchange (such as on a share-for-share exchange).
In addition, sub-paragraph 6204(1)(a)(iii) of the ITR is also amended to add a reference to an exchange of securities. This intends to clarify that an exchange that is permissible under amended paragraph 6204(1)(b) would not cause the share to be disqualified from meeting the conditions under paragraph 6204(1)(a).
This amendment is deemed to have come into force on January 1, 2023.
Employee Ownership Trust (EOT)
As outlined in Blakes Budget 2023 bulletin, the Budget 2023 provided draft legislation for a new type of trust called an “employee ownership trust.” Subject to some minor technical changes, the August 4 Proposals largely reflect the draft legislation released with Budget 2023. Please refer to the Blakes Budget 2023 bulletin for further details on the requirements for EOTs and associated tax benefits. These new rules will apply as of January 1, 2024.
As originally set out in Budget 2021, the new gross-revenue based DST is now expected to come into force effective January 1, 2024. Following similar measures in France, the United Kingdom and other countries, the proposed tax will be imposed at a rate of 3% on revenues from digital services that rely on data and content contributions from Canadian users.
The impetus for this potentially provocative measure is the slow pace of international discussions to reform the tax treatment of the digital economy through the implementation of the “Pillar 1” regime. Mounting political pressure in recent years precipitated ongoing international discussions aimed at reaching an agreement on a new taxing right for source countries. Progress has however been slow, and various countries — and now Canada — have grown impatient. On July 11, 2023 an “Outcome Statement” was published by the Organisation for Economic Co-operation and Development (OECD) and approved today by 138 members of the Inclusive Framework, which provided inter alia for countries to refrain from imposing a new DST until the end of 2024. However, Canada refused to sign on to the statement, due to concerns that some countries have continued to collect their taxes while Canada waits.
The DST was originally held in abeyance and was not intended to ever have effect if there would be international implementation of Pillar 1 by January 1, 2024. With the announced delay in Pillar 1 implementation, the DST now appears to be a reality in Canada. If and when the DST comes into effect, it is proposed to apply to revenues earned since January 1, 2022, with the first year of the tax (referred to as the “first year of application”) applying on both a current and lookback basis. The revised DST legislation is not materially different from what was proposed in Budget 2021, and details can be found here.
Some additions and changes in the current draft and subject to the consultation are worth noting, including:
More robust rules around bankruptcy and insolvency events, where the DST is payable.
Additional details regarding when an entity becomes included in the relevant corporate group for purposes of the DST threshold.
An optional election to have digital revenues for pre-2024 years computed based on a proxy that looks to the proportion of total revenues in the first year of application constituting Canadian digital services revenues (a helpful concession to taxpayers that may not be in a position to determine digital services revenues for 2022 and 2023).
Rules providing for joint and several liability for DST obligations between partnerships (which are taxpayers for purposes of the DST) and their partners and former partners (at the relevant time).
Expanding the transferee liability rules to include anti-avoidance provisions, including penalties, paralleling those recently introduced to section 160 of the ITA to counteract any planning undertaken to avoid such liability.
Expanding CRA’s audit powers in respect of the DST to mirror the expanded audit power (e.g., including the power to compel interviews or the answering of questions in writing) granted under the ITA.
As part of Pillar Two, in December 2021, the “Inclusive Framework” of countries was developed, and the OECD released model rules, titled “Global Anti-Base Erosion” (GloBE) rules, with the stated intention of introducing a 15% global minimum corporate tax rate for Multinational Enterprises (MNEs) of a sufficient size. The GloBE rules generally apply to enterprises with annual revenue of €750-million or more in at least two of the four preceding fiscal years.
The mechanics of the proposed rules are quite complex. The GloBE rules include a primary “Income Inclusion Rule” (IIR) and a secondary “Undertaxed Profits Rule” (UTPR). The IIR imposes on an ultimate parent of a group a top-up tax to the extent that group income (determined on a jurisdiction-by-jurisdiction basis) is not taxed at the minimum rate of 15%. The UTPR is a secondary rule intended to apply when no ultimate parent or substitute parent entity applies an Income Inclusion Rule. The UTPR allows jurisdictions to apply a top-up tax on group entities in each such jurisdiction, allocated on a formulaic basis, thus providing an incentive for jurisdictions to implement Pillar Two (as non-implementation will not relieve group profits from the minimum tax, but just change the jurisdictions that collect it). The GloBE rules also contemplate that a jurisdiction may enact a “qualifying” domestic minimum top-up tax (QDMTT) on the low-taxed income of domestic entities, creditable against the top-up tax liability otherwise arising under Pillar Two.
The August 4 Proposals include a draft Global Minimum Tax Act (GMTA) to implement the GloBe rules in Canada. The GMTA is drafted to be very consistent with the GloBe rules and includes a statutory rule that the provisions of the GMTA are to be interpreted in a manner consistent with the GloBe rules, the GloBE commentary and the administrative guidance in respect of the GloBE model rules approved by the Inclusive Framework and published by the OECD from time to time. This interpretive rule forms a trend with similar approaches seen in recent amendments and proposed amendments to the ITA (e.g., in the anti-hybrid provisions and the consultation proposals to amend the transfer pricing rules). While stated as only an interpretive rule, we can expect that the extent to which this amounts to an impermissible delegation of taxing authority in Canada will be a topic of some discussion in the future.
The GMTA will enact the IIR and a QDMTT to be effective in Canada for years beginning on or after December 31, 2023. The GMTA includes only a placeholder for the UTPR, consistent with Budget 2023’s statement that at some point in the future after enactment of the IIR and QDMTT the government intends to release draft legislation to implement the UTPR with effect for fiscal years of MNEs that begin on, or after, December 31, 2024.
The proposed GMTA is subject to further consultation, with submissions to Finance being invited on or before September 29, 2023.
Budget 2023 announced a retroactive change to the GST and HST status of payments to payment card network providers, such as Visa and Mastercard, by amending the definition of “financial service” to specifically exclude certain services (other than a prescribed service) supplied by a payment card network operator in respect of a payment card network (new paragraph r.6 of the definition of “financial service” under subsection 123(1) of the Excise Tax Act).
The current consultation proposes the types of services that will be excluded from this new definition and will remain exempt, including:
(a) a service that is supplied by a payment card network operator and that enables a merchant to accept payments by payment card by providing the merchant, or a payment service provider engaged by the merchant, with access to a payment card network for the transmission or processing of the payments;
(b) a service that is rendered to a holder of a payment card and that is supplied by a payment card network operator in its capacity as the issuer of the payment card; and
(c) a service, in respect of the settlement of a transaction made by payment card, that is supplied
(i) by a payment card network operator, in its capacity as the acquirer for the transaction, to the issuer of the payment card,
(ii) by a payment card network operator, in its capacity as the issuer of the payment card, to the acquirer for the transaction, or
(iii) by a payment card network operator to the acquirer for the transaction if the amount of consideration for the supply of the service is equal to the amount of the fee that is payable, by the payment card network operator to the issuer of the payment card, in respect of the settlement of the transaction.
It is not entirely clear what services Finance intends to capture. Broadly speaking, most services supplied by payment card networks may be described under paragraph (a), and as currently drafted the regulation contemplates that these services will remain exempt. However, according to the Explanatory Notes, paragraph (a) or (b) apply only where the payment card network operator is also an issuer or an acquirer and the service is supplied or rendered in its capacity as issuer or acquirer rather than in its capacity of payment card network operator (i.e., as described in paragraph (c)). This is a very restricted set of circumstances, and perhaps following the consultation period, the language of the provisions will be further amended to restrict the broad exclusion.
For further information, please contact any member of our Tax group.