On February 4, 2022, the Department of Finance (Finance) released draft legislation to amend the Income Tax Act (ITA) and the Excise Tax Act (ETA). Much of the draft legislation implements some of the significant business tax measures first announced in the 2021 Canadian federal budget (Budget 2021) (see our Blakes Bulletin: 2021 Federal Budget – Selected Tax Measures | Blakes). As Budget 2021 unusually did not include proposed legislation to implement several measures, this is the first opportunity to review such measures in detail.
Not all previously announced measures were addressed in the draft legislation. The remaining unaddressed proposals include those in respect of hybrid mismatch arrangements, tax incentives for carbon capture, utilization and storage technologies, a luxury tax on cars, aircraft and boats purchased for personal use, and consultations on the Canadian transfer pricing regime and modernization of the general anti-avoidance rule (GAAR).
This bulletin addresses the most significant business tax measures addressed in the draft legislation.
These proposals have been released for consultation, and submissions may be made by the deadlines noted below.
The draft legislation implements the 30 per cent-of-EBITDA interest deductibility limitation promised in Budget 2021, with a new regime known as the “excessive interest and financing expenses limitation” (EIFEL) rules. However, as currently proposed, the EIFEL rules are in several ways more restrictive than the initial proposals in Budget 2021, including tighter limitations on highly-leveraged corporate groups and certain financial institutions. The EIFEL rules are quite complicated and will have a broad impact on taxpayers — including on existing structures implemented before the rules were proposed — so taxpayers will need to give careful consideration to the impact of these rules going forward.
As promised in Budget 2021, the draft legislation includes the following three mandatory disclosure measures intended to provide the Canada Revenue Agency (CRA) with more timely information in order to curtail tax evasion and aggressive tax avoidance:
A broadening of the existing rule for disclosure of “reportable transactions”. A reportable transaction is a transaction that features one or more general “hallmarks” of aggressive tax planning.
A new similar rule for disclosure of “notifiable transactions”. A notifiable transaction is a transaction that is the same or substantially similar to specific transaction types which have been identified by the CRA as potentially abusive, as may be designated by the Minister from time to time.
A new rule requiring disclosure with respect to uncertain tax positions reported by corporations in their audited financial statements.
Notwithstanding the later-than-expected release, the draft legislation retains the January 1, 2022 effective date originally announced in Budget 2021 for these measures, though penalties under the new rules will not apply until the legislation receives Royal Assent.
The draft legislation refines and/or expands on previously announced proposals and includes three proposed changes that may be relevant to investment fund managers. First, the draft legislation proposes rules relating to the deduction by exchange-traded funds (ETFs) that are structured as trusts of capital gains allocated to redeeming unitholders. Second, the draft legislation proposes a change intended to make the capital gains refund mechanism work more efficiently where a mutual fund trust realizes a capital gain on the distribution of property to its beneficiaries. Third, the draft legislation proposes a new exception to the enhanced reporting of beneficiary information for trusts all of the units of which are listed on a designated stock exchange.
Avoidance of Tax Debts
Section 160 of the ITA contains an anti-avoidance rule aimed at preventing taxpayers from avoiding the collection of tax debts by transferring property to non-arm’s length parties for insufficient consideration. Where applicable, the rule causes the transferee to be jointly and severally liable with the transferor for tax debts of the transferor, to the extent that the fair market value of the property transferred exceeds the consideration paid by the transferee for the property at the time of transfer. In response to certain tax planning strategies, the draft legislation introduces specific rules to broaden the circumstances in which a person can be jointly and severally liable for another taxpayer’s tax debts under the ITA. The draft legislation also introduces a new and potentially significant penalty aimed at taxpayers, their professional advisors and other parties involved in section 160 avoidance transactions.
Further developing proposals announced in Budget 2021, the draft legislation reveals additional proposed expansions to the CRA’s audit powers. The statutory amendments would permit the CRA to compel a wider range of information from taxpayers and other persons, in a number of new ways. Those include compelling persons to respond to the CRA’s questions orally or in writing, and requiring persons to attend for questioning at physical locations or virtually.
Clean Technology and Clean Energy Measures
The draft legislation introduces certain measures in respect of clean technology and clean energy equipment including a reduction of corporate income tax rates on zero-emission technology manufacturing profits and expanding Classes 43.1 and 43.2, which provide accelerated capital cost allowance rates.
The draft legislation includes new GST/HST rules for “cryptoasset” mining activities, which should provide greater certainty for businesses in that industry regarding their obligations to charge and remit GST/HST on mining remuneration and their eligibility for input tax credits on related expenses.
As promised in Budget 2021, Canada is pursuing the introduction of new EIFEL rules that would restrict the deductibility of “interest and financing expenses” (IFEs) for Canadian income tax purposes, though the proposed rules are in several respects less favourable for taxpayers than the initial budget proposals. These rules generally provide for a maximum ratio of deductible IFEs to “adjusted taxable income” (a modified measure of EBITDA (earnings before interest, taxes, depreciation and amortization)) for Canadian taxpayers and follow the broad outlines of proposals in the OECD BEPS Action 4 report. The EIFEL rules are intended to apply after all of the existing interest deductibility rules in the ITA, including the transfer pricing and thin capitalization rules. Finance released these proposals for consultation, with submissions due by May 5, 2022.
The EIFEL rules will apply to resident and non-resident corporations and to trusts but will not apply to natural persons. The rules will apply to partnerships indirectly, by requiring a partner to add back to income a portion of partnership-level IFEs if the partner has excessive IFEs (including IFEs allocated from the partnership) for purposes of these rules. Certain smaller Canadian-controlled private corporations (CCPCs) will also be excluded from the rules.
The draft legislation includes several broad anti-avoidance rules aimed at preventing taxpayers from artificially changing the timing or character of payments or taxation years in order to avoid a denial of deductions under the EIFEL rules.
These rules generally will apply to taxation years beginning on or after January 1, 2023.
The EIFEL rules are very complicated and represent a fundamental change in Canada’s approach to the deductibility of interest. We expect that further refinements will be required before enactment in order to avoid anomalies in the interaction between these new rules and the existing provisions of the ITA.
The core of the new EIFEL rules is a restriction on the amount of IFEs that a taxpayer can deduct. The formulae for determining the restriction are complex, but conceptually these rules allow a taxpayer “capacity” to deduct an amount of IFEs equal to the total of (i) any interest and financing revenues of the taxpayer, plus (ii) a fixed percentage of “adjusted taxable income” (ATI), which is generally a measure of EBITDA excluding interest revenue, as discussed below.
The fixed percentage of ATI is generally 30 per cent, with a transitional rate of 40 per cent applying to taxation years beginning on or after January 1, 2023, but before January 1, 2024, and subject to the group ratio rule discussed below.
The concept of IFEs goes beyond amounts that legally constitute interest. IFEs also include other related financing costs that generally get capitalized for tax purposes and deducted under the capital cost allowance or resource expenditure regimes, imputed interest charges in respect of “financing leases”, expenses under borrowing-related swaps and other derivatives, and other costs of funding.
At a high level, ATI can be seen as an approximation of EBITDA calculated according to certain specific rules. The starting point of the calculation is the existing concept of taxable income, and therefore is generally reduced by the amount of losses deducted by a taxpayer in computing taxable income, and excludes domestic and foreign dividends that are deductible for Canadian tax purposes. This has the effect of potentially limiting the deductibility of interest on borrowed money used by corporations to acquire shares, which has long been considered a very “safe” use of funds under the existing interest deductibility rules. Starting from taxable income, ATI adds back all interest and financing expenses, all amounts deducted as capital cost allowance, and certain other specific deductions, and excludes all interest and financing revenue.
Budget 2021 suggested that excess (i.e., undeductible) IFEs could be carried back three years or carried forward 20 years to be deducted in years where the taxpayer has excess capacity. However, the proposals only provide for a carryforward of 20 years without any carryback. Instead, the proposals allow the carryforward for three years of unused deduction capacity, which a taxpayer must utilize before electing to transfer any available unused capacity to other Canadian group companies, as discussed below. The three-year carryforward of unused deduction capacity is applied automatically if the taxpayer has excess IFEs.
Default Treatment of Groups
As expected from Budget 2021, the proposed EIFEL rules include mechanisms to effectively spread the impact of the rules over a group of entities. Groups for this purpose will generally be defined by common control, subject to certain expansions.
In particular, where a taxable Canadian corporation has excess capacity, it will be permitted to transfer some or all of the excess to other group members that are taxable Canadian corporations. However, contrary to what was suggested in Budget 2021, transfers will not be allowed to or from other types of taxpayers, and no transfers would be permitted by “relevant financial institutions”, defined to include banks, insurance companies, licensed trustees, registered securities traders, mutual fund corporations and mutual fund trusts, among others.
In addition, where interest is paid between taxable Canadian corporations in a group, the entities may make annual elections to exclude such interest from the operation of the EIFEL rules. Explanatory notes accompanying the draft legislation suggest that such election is intended to accommodate common loss consolidation structures.
Alternative Group Treatment – Group Ratio Rule
The EIFEL rules also contain an alternative, elective regime for groups, which may allow IFEs to be deducted above the normal (30 per cent) limit where the group has a higher “group ratio”. Conceptually, this is an acknowledgment that if a group as a whole has a higher ratio of third-party interest expense to earnings, then having proportional deductions in Canada should not be seen as inappropriate base eroding payments but rather a function of the economic circumstances of the group.
The group ratio is calculated based on the “group net interest expense” and “group adjusted net book income” of the consolidated group. Group net interest expense and group adjusted net book income for these purposes generally are determined based on the amounts reported in audited entity or consolidated group financial statements prepared under IFRS or certain other country-specific generally accepted accounting principles.
However, contrary to how other jurisdictions have implemented this concept, the group ratio would not necessarily reflect the actual ratio of group net interest expense and group adjusted net book income, but instead would be reduced by a formula in situations where the actual ratio exceeds 40 per cent. For example, actual ratios of group net interest expense to group adjusted net book income of 50 per cent or 80 per cent would result in “group ratios” of only 45 per cent or 55 per cent, respectively, for purposes of these rules.
The stated intention for the reduction of the group ratio from the true consolidated financial ratio is to address situations where negative book EBITDA of group members or the group as a whole could otherwise unduly distort the ratio. However, certain structural features of the rules suggest that the reduction may also have been intended to limit base eroding payments of interest to non-taxable lenders. We can expect that the appropriateness and effectiveness of this approach to address these concerns may be one of the subjects of submissions to Finance as part of the consultation process.
Where applicable, a group may opt into this alternative regime on an annual basis by making a joint election. The election would also specify how the group’s aggregate capacity (generally reflecting the group ratio multiplied by the aggregate ATI of the group) is allocated among the group members. If such an election is made for a taxation year, then other transfers of capacity among group members, or carry forward of excess capacity, would not be available for the year. Taxpayers making allocations under such an election will need to exercise caution, as all of the allocations are deemed to be nil if the total amount allocated exceeds what is permitted.
The group ratio rule will not be available to any group member if there are any tax exempt Canadian corporate members of the consolidated group, if there are Canadian entities with different taxation years or functional currencies for tax purposes, or if any Canadian group member is a “relevant financial institution”.
In an attempt to limit the burden on taxpayers of compliance with the EIFEL rules in circumstances where the underlying policy concerns are not as strong, the draft legislation includes a very narrowly-defined category of excluded entities that will not be subject to the EIFEL rules.
CCPCs that, together with any associated corporations, have taxable capital employed in Canada of less than C$15-million;
Groups of corporations and trusts whose aggregate net interest expense among their Canadian members is C$250,000 or less; and
Groups comprised of only Canadian entities whose business is carried on all or substantially all in Canada and that have substantially no IFEs payable to “tax indifferent investors” (defined to include tax exempt entities and non-residents), provided that such entities have neither any foreign affiliates nor any non-resident that that is a specified shareholder or specified beneficiary, as applicable, for purposes of the thin-capitalization rules.
As described in Budget 2021, the draft legislation includes an expansion of the existing mandatory disclosure rules applicable to “reportable transactions” and also introduces a new set of disclosure rules applicable to “notifiable transactions”. The backgrounder released with the draft legislation sets out a sample initial list of notifiable transactions to which the new rules would apply. As originally announced in Budget 2021, and notwithstanding the delay in the release of draft implementing legislation, these proposals will apply to transactions entered into on or after January 1, 2022. However, the new penalty provisions included in the proposals will not apply to transactions entered into before the draft legislation receives Royal Assent.
The draft legislation also includes the rules announced in Budget 2021 for the mandatory disclosure of uncertain tax positions by certain large corporations.
Finance released these proposals for consultation, with submissions due by April 5, 2022.
Each of these measures is described in more detail below.
The reportable transaction rules in the ITA were first announced as part of the 2010 Canadian federal budget. Under this regime (found in section 237.3 of the ITA), taxpayers that realize a “tax benefit” (as defined for purposes of the GAAR) from a reportable transaction, as well as “promoters” and “advisors” involved in the transaction, have a collective obligation to file an information return in prescribed form providing details of the transaction to the CRA. In order to be caught by the existing rules, a transaction must (a) be an “avoidance transaction” (as defined for purposes of the GAAR) and (b) have at least two out of the following three generic “hallmarks” of aggressive tax avoidance:
An advisor or promoter has an entitlement to a “contingent fee” based on the amount of the tax benefit, success in obtaining the tax benefit, or the number of persons who participate in the transaction;
An advisor or promoter obtains “confidential protection” in respect of the transaction; and
The taxpayer or an advisor or promoter has or had “contractual protection” (generally defined as any insurance, protection or undertaking against the failure of a transaction to achieve any tax benefit).
Budget 2021 indicated that the existing reportable transaction rules have, to date, only resulted in limited reporting by taxpayers and are no longer in line with international norms. In order to address these concerns, Budget 2021 proposed to significantly broaden the application of the rules to increase disclosure and discourage participation in tax avoidance schemes.
The draft legislation proposes that the definition of a reportable transaction will be amended to require only one hallmark. The proposals also add an important carve-out from the contractual protection hallmark for “insurance, protection or undertakings offered to a broad class of persons and in a normal commercial or investment context in which parties deal with each other at arm’s length and act prudently, knowledgeably and willingly”. The explanatory notes indicate that this carve-out is intended to exclude contractual protection offered in the context of normal commercial transactions to a wide market.
While this is a welcome change in light of the very broad definition of “contractual protection” under the existing rules, further guidance from Finance or the CRA as to its intended scope and application would be helpful. For example, it is unclear whether the new carve-out is intended to apply to typical share purchase transactions where a buyer is either indemnified (by the seller) or insured (under an R&W insurance or tax insurance policy) against historic tax liabilities of the target.
The draft legislation also broadens the definition of an avoidance transaction for purposes of section 237.3. Under the existing definition, at least one step in the series of transactions must not have a primary bona fide non-tax purpose. Under the draft legislation, the definition of an avoidance transaction is broadened to include a transaction or series if one of the main purposes of any step in the series is to obtain a tax benefit. Given the recognition in the jurisprudence that a particular transaction may have a number of “main purposes” depending on the facts and circumstances, it will likely be very difficult to conclude that the “avoidance transaction” requirement for a reportable transaction is not satisfied in many cases.
It is worthy of note that by broadening the definition of an avoidance transaction for reporting purposes, the proposals intentionally include transactions that by definition could not be subject to the GAAR.
Reportable transactions are currently required to be reported on or before June 30 of the calendar year following the calendar year in which a transaction first becomes a reportable transaction. The proposals accelerate the timing for reporting transactions to 45 days from the earlier of the date on which the taxpayer becomes contractually obliged to enter into the transaction and the date on which the taxpayer enters into the transaction.
Notably, the revised reporting deadline does not retain the reference in the existing rules to the time when a transaction first becomes a reportable transaction. It is unclear whether this is intended to signal that under the new rules the determination of whether a particular transaction is reportable must be made at the time of the transaction.
Given that the new rules are proposed to apply to transactions entered into on or after January 1, 2022, the proposed 45-day reporting deadline for some transactions captured by the new rules could be as early as mid-February, 2022 — or even earlier in the event of transactions signed but not closed before the end of 2021. While the new enhanced penalties described below will not apply to such transactions, it is likely that the application of the draft legislation more generally (including the possible application of the existing penalty provisions to failures to report under the new rules) in respect of transactions entered into before the draft legislation was released will be a subject of submissions to Finance as part of the consultation process.
In addition to accelerating the time period for reporting, the draft legislation significantly increases the potential penalties applicable to failures to report. Under the proposals, taxpayers who fail to disclose reportable transactions will be subject to a maximum penalty equal to the greater of 25 per cent of the amount of the tax benefit in issue and a prescribed amount (either C$100,000 or C$25,000, depending on whether the carrying value of the taxpayer’s assets is greater than or equal to C$50-million). For promoters and advisors, the maximum penalty is equal to the total amount of fees charged in respect of the transaction, plus C$110,000.
The draft legislation also carries out the Budget 2021 proposal to eliminate the existing relieving rule whereby reporting by one person in respect of a transaction satisfies the reporting requirement for that transaction in respect of all relevant taxpayers, advisors and promoters. This will generally mean that reporting will be required by multiple parties in respect of the same transaction, and that certain adverse rules applicable to a taxpayer for non-reporting (such as the extension of the normal reassessment period in respect of the transaction) may apply even if it was an advisor or promoter that failed to report.
Unlike the reportable transaction regime, which aims to identify transactions of all sorts that bear the general hallmarks of aggressive tax avoidance, the notifiable transaction proposals impose reporting requirements in respect of specific types of transactions that have been identified by the Minister as transactions that the CRA considers to be abusive and other “transactions of interest”.
Under the draft legislation, the Minister of National Revenue will be empowered to designate, with the concurrence of the Minister of Finance, specific types of transactions and series of transactions that will require reporting. Reporting will be required in respect of a transaction that is the same as or substantially similar to a series of transactions that has been so designated.
The draft legislation defines “substantially similar” transactions for this purpose to include transactions that are expected to obtain the same tax consequences (as defined for purposes of the GAAR), and that are either factually similar or based on the same or similar tax strategy. The explanatory notes indicate that this concept is intended to be interpreted broadly in favour of disclosure, and the draft legislation takes the unusual step of codifying a general rule of broad interpretation into the text of the provision itself.
The proposals include a backgrounder with a list of six sample notifiable transactions. Presumably the transactions listed in the backgrounder are intended to be designated as notifiable transactions once the draft legislation receives Royal Assent. The transactions listed in the backgrounder are:
Transactions involving the manipulation of CCPC status designed to avoid anti-deferral rules applicable to investment income earned by Canadian private corporations. While the listed transactions in the backgrounder involve taking positive steps to change the status of a CCPC to a non-CCPC (for example by continuing a CCPC to a foreign jurisdiction), the explanatory notes indicate that forming a corporation in a foreign jurisdiction in the first instance would be a substantially similar transaction for purposes of the rules.
Derivative transactions involving partnerships designed to avoid the application of the “straddle transaction” rules introduced in the 2017 Canadian federal budget.
Certain transactions involving tax-free distributions by Canadian resident trusts under subsection 107(2) to Canadian holding corporations that have the effect of avoiding or deferring the 21-year deemed disposition rule generally applicable to trusts under subsection 104(4).
Transactions involving the temporary bankruptcy of a taxpayer in order to avoid the application of the debt forgiveness rules in the ITA.
Transactions that rely on subjective purpose tests to avoid the application of the corporate attribute trading limitations in section 256.1.
Certain transactions involving “back-to-back” arrangements between two non-residents and a resident of Canada that may escape or limit the application of the thin capitalization and/or interest withholding tax rules in the ITA. (While the backgrounder is not clear on this point, presumably this category is intended to capture situations where the taxpayer takes the position that the existing back-to-back rules in the ITA do not apply.)
As is the case for the revised reportable transaction proposals described above, the notifiable transaction proposals require reporting both by taxpayers who benefit from notifiable transactions and by advisors or promoters in respect of those transactions.
The time limits for disclosure under the notifiable transaction proposals and the penalties for failure to report are generally the same as under the amended reportable transaction proposals described above. In addition, as is the case for reportable transactions, failure to properly report a notifiable transaction will result in an extension of the normal reassessment period applicable to the transaction.
These rules are proposed to apply for all transactions entered into on or after January 1, 2022. However, penalties for failure to report will not apply to transactions entered into before the proposals receive Royal Assent. As is the case with the reportable transaction amendments, it is expected that the proposed retroactive effect of these rules will be the subject of submissions in the consultation.
It is worthy of note that Quebec’s mandatory disclosure rules were also recently amended to include a requirement to disclose “specified transactions” as designated by the Minister of Revenue of Quebec and published in the Gazette Officielle du Québec from time to time. To date, Revenu Québec has published four specified transactions subject to these reporting requirements under the Quebec Taxation Act. The transactions currently designated under the Quebec regime are:
Transactions involving the avoidance of deemed dispositions of trust property (similar to item 3 above in the backgrounder);
Certain transactions involving payments to a non-treaty country of over C$1-million;
Transactions resulting in multiplication of the capital gains deduction for dispositions of shares of a qualified small business corporation; and
Certain transactions involving tax attribute trading either between unaffiliated taxpayers or in the context of an injection of capital by a third-party investor to a corporation or trust.
Uncertain Tax Treatment
As noted in the backgrounder, the purpose of the draft legislation on mandatory disclosure is to allow the CRA to “respond quickly to tax risks through informed risk assessments, audits and changes to legislation”. In furtherance of this objective, the draft legislation regarding reportable uncertain tax treatments imposes a reporting obligation on certain large corporate taxpayers regarding their tax positions in respect of which uncertainty is reflected in the audited financial statements.
Canada is not alone in this quest for information. The United States and Australia have already implemented rules on uncertain tax treatments and, in January 2022, the United Kingdom published updated draft guidance on notification of uncertain tax treatments. In the Canadian context, the draft legislation regarding reportable uncertain tax treatments will effectively override the Federal Court of Appeal decision in BP Canada Energy Company v. Canada (National Revenue), 2017 FCA 61.
Under the draft legislation, a corporation is required to file an information return with the CRA for a taxation year in which the following conditions are met:
The corporation is required to file a Canadian income tax return for the year (i.e., any Canadian resident corporation or any non-resident corporation with taxable presence in Canada);
The carrying value of the corporation’s assets is at least C$50-million at the end of the year;
The corporation, or the consolidated group of which the corporation is a member, has audited financial statements that are prepared in accordance with IFRS or other country-specific GAAP relevant for public corporations listed on a non-Canadian stock exchange; and
Such audited financial statements reflected uncertain tax treatment in respect of a transaction, or series of transactions, that the corporation uses, or plans to use, in an income tax return or information return.
The requirement to reflect uncertain tax treatment in audited financial statements is generally expected to be based on a determination that it is not probable that the relevant taxation authority (in this case, Canadian courts) will accept the filing position taken, though specific requirements among different countries’ GAAP may vary.
Where these rules apply, a reporting corporation is required to provide prescribed information with respect to each such uncertain tax treatment. The backgrounder sets out the following list of information that is expected to be included in the prescribed information:
The taxation to which the uncertain tax treatment relates;
A description of the relevant facts;
A description of the provisions relied upon for determining the tax payable or the refund or other amount under the ITA;
The differences between the tax payable (or the refund or other amount) under the ITA, determined in accordance with the relevant financial statements and the tax treatment used by the corporation in preparing its tax returns;
Whether those differences represent a permanent or temporary difference, involve a determination of the value of any property, and involve a computation of basis; and
Such other information required by the CRA.
Under the draft legislation, the filing of an information return with respect to a reportable uncertain tax treatment does not constitute an admission by the reporting corporation that the tax treatment is not in accordance with the ITA, or that any transaction is part of a series of transactions.
An information return under these rules is to be filed at the same time as the reporting corporation’s Canadian income tax return is due. Failure to comply with these reporting requirements will result in an extension of the normal reassessment period up to three years after the information return is filed, and the reporting corporation will be subject to a late filing penalty of C$2,000 per week, up to a maximum of C$100,000.
The draft legislation regarding reportable uncertain tax treatments is proposed to apply for taxation years beginning on or after January 1, 2022. However, penalties for failure to report will not apply to taxation years that begin before the proposals receive Royal Assent.
The draft legislation refines and/or expands on previously announced proposals and includes three proposed changes that may be relevant to investment fund managers. First, the draft legislation proposes rules relating to the deduction by exchange-traded funds (ETFs) that are structured as trusts of capital gains allocated to redeeming unitholders. Second, the draft legislation proposes a change intended to make the capital gains refund mechanism work more efficiently where a mutual fund trust realizes a capital gain on the distribution of property to its beneficiaries. Third, the draft legislation proposes a new exception to the enhanced reporting of beneficiary information for trusts, all of the units of which are listed on a designated stock exchange. Finance released these measures for consultation, with submissions due by April 5, 2022.
Allocation to Redeemers
In the 2019 Canadian federal budget, Finance introduced rules to counter perceived abuses caused by certain investment funds structured as trusts that allocated income and capital gains to redeeming unitholders (the 2019 ATR Rules). The draft legislation proposes significant, and welcome, changes to the 2019 ATR Rules to accommodate the unique structure of ETFs, which are generally mutual funds, the units of which are listed on a designated stock exchange and that are in continuous distribution.
Generally, the 2019 ATR Rules deny a mutual fund trust a deduction to the extent of (i) income allocated to a redeeming unitholder, and (ii) a capital gain allocated to a redeeming unitholder to the extent such capital gain exceeds the capital gain that would otherwise have been realized by the unitholder on the redemption (the “original CG deduction denial rule”). For a detailed explanation of the background behind the 2019 ATR Rules, please see our Blakes Bulletin: 2019 Federal Budget – Selected Tax Measures | Blakes.
Following the announcement of the 2019 ATR Rules, the Investment Funds Institute of Canada (IFIC) and the Canadian ETF Association (CETFA) submitted to Finance that the 2019 ATR rules were inappropriate for ETFs because of the role of a designated broker (DB) or “market maker” in an ETF structure.
Typically, a DB acts as an intermediary between the ETF and its public unitholders by buying and selling units of the ETF in order to ensure that the trading price of a unit of the ETF on the applicable stock exchange does not significantly differ from the net asset value (NAV) per unit of the ETF. Generally, the terms of an ETF provide that a “prescribed number of units” (PNU) of an ETF can be redeemed by a DB at any time for an amount equal to the NAV of such units, less administrative fees, if any.
When a DB buys units of an ETF on a stock exchange, and holds more units than it needs to hold in order to facilitate stock market purchases, the DB is permitted under the applicable market making agreement to redeem one or more PNUs at NAV. However, the units redeemed by the DB may have been held by the person that sold the units to the DB for a relatively long period of time, and that person may have realized a material capital gain on the sale of the units on the stock exchange. Moreover, that capital gain of the unitholder may correspond to a capital gain realized by the ETF on the sale of underlying assets to fund the payment of the redemption price to the DB. Nonetheless, the DB would not typically realize a material capital gain on the redemption of the units, and accordingly, under the original CG deduction denial rule, the ETF could not allocate to the DB the capital gain that it realized in order to fund the redemption. Instead, the only option for the ETF to reduce double tax would be to rely on the capital gains refund mechanism (CGRM). However, many investment fund managers find the CGRM to be inefficient, especially in situations where a fund realizes a capital gain early in a taxation year, but the market declines later in the taxation year.
As a result of the efforts of IFIC and CETFA, Finance delayed the application of the original CG deduction denial rule to ETFs multiple times, with such rule finally applying to taxation years that begin after December 15, 2021. The draft legislation includes the proposed rule for determining the amount of taxable capital gains allocated to redeeming unitholders that can be deducted by an ETF, the result of more than two years of discussions between members of IFIC, CETFA and Finance.
The proposals allow an ETF to deduct taxable capital gains allocated to redeeming unitholders up to an amount limited by a complex formula that is intended to determine the portion of the ETF’s net taxable capital gains realized in a taxation year that is associated with redeeming unitholders as compared to unitholders that remain in the ETF at the end of the year.
For a trust that offers both ETF units that are listed on a designated stock exchange and are continuously distributed and units that are not (non-ETF units), a special rule effectively splits the trust into two parts based on the relative NAV of each type of units. The ETF part will be subject to the new rule, and the non-ETF part will be subject to the original CG deduction denial rule.
The proposed rule for ETFs works in addition to the CGRM, so that an ETF could rely on both the CGRM and the allocation to redeemers (ATR) methodology in the same year. However, a capital gain allocated to a redeeming unitholder reduces the amount that can be refunded under the CGRM such that there should not be double counting between the two regimes. ETF managers will have to think carefully each year about how to best maximize the CGRM and the ATR methodology.
The ATR methodology may be particularly helpful in a taxation year where an ETF realizes capital gains in order to fund redemptions, but at the end of the taxation year does not have unrealized capital gains, perhaps due to a decline in the market after such redemptions. Because of the way that the CGRM formula works in practice, many investment fund managers find that the CGRM is not practical in such a situation because the ETF may be required to pay more tax than the CGRM formula would provide a refund for. The ATR methodology, on the other hand, does not require a fund to pay tax and receive a refund. Accordingly, the ATR methodology can provide at least some benefit to ETFs in such a situation. However, the CGRM may be better than the ATR methodology in some situations because the CGRM takes into account unrealized gains, whereas the ATR formula does not allow allocations to redeeming unitholders to be increased by an ETF’s unrealized gains.
The new ATR rule for ETFs does not apply to all mutual fund trusts that issue units that are listed on a designated stock exchange. For example, REITs and other closed-end funds that qualify as mutual fund trusts, and whose units are listed but are not in continuous distribution (i.e., are only offered to investors from time to time), cannot benefit from the new ATR rule. Accordingly, such trusts are subject to the original CG deduction denial rule. However, since their units trade on an exchange, these trusts may not be able in practice to monitor their unitholders’ cost of the units, and hence may not be able to determine the capital gain that would otherwise have been realized by the unitholder on a redemption. As a result, in practice such trusts may not be able to allocate capital gains to redeeming unitholders because they may not be able to comply with the original CG deduction denial rule.
This new ATR rule for ETFs is proposed to apply to taxation years that begin after December 15, 2021.
Capital Gains Refund Mechanism
As noted above, the CGRM provides a refund to a mutual fund trust in respect of tax on net realized capital gains based on a formula that depends, in part, on the amount paid by the trust on the redemption of units that is included in its beneficiaries’ proceeds of disposition of such units.
A separate rule in the ITA provides that where a trust realizes a capital gain on the disposition of property distributed to a beneficiary of the trust in a transaction where the beneficiary disposes of all of part of its interest in the trust, the beneficiary’s proceeds of disposition are automatically reduced by the capital gain realized by the trust (the POD reduction rule). This is generally appropriate from a policy perspective since it avoids taxing the same economic gain both at the trust and the investor level. However, it has a side effect of reducing the amount that the trust may claim under the CGRM (or, where applicable, the 2019 ATR Rules).
The draft legislation proposes that the POD reduction rule will not apply where the distributing trust is a mutual fund trust, which follows a related recommendation made by IFIC to Finance in connection with the 2019 ATR Rules. This change will positively impact the ability of a mutual fund trust to claim refunds under the CGRM, and for mutual fund trusts (including ETFs) to claim deductions for amounts allocated to redeeming unitholders. However, the usefulness of this change may be tempered by the fact that it re-introduces the potential for double tax noted above.
This measure is proposed to apply to taxation years that begin after December 15, 2021.
Enhanced Trust Reporting Rules
The 2018 Canadian federal budget (Budget 2018) proposed new rules that would require many trusts that were not previously required to submit a T3 return to begin doing so. Additionally, these new rules would increase reporting requirements for trusts that were not exempted from the rules in order to improve collection of beneficial ownership information as a means of countering aggressive tax avoidance through the misuse of certain corporate vehicles. Once in force, the new rules would require trustees of trusts that are not excepted from the new rules to gather and report significantly more information on annual T3 returns than under the rules that are currently in force. Trusts that are excepted from the new rules include mutual fund trusts, registered charities, tax-exempt non-profit organizations and trusts governed by registered plans.
For further details on the Budget 2018 proposals, see our Blakes Bulletin: 2018 Federal Budget – Selected Tax Measures | Blakes.
The draft legislation expands the list of trusts exempted from the enhanced trust reporting rules to trusts all of the units of which are listed on a “designated stock exchange”. This means that an ETF that does not meet the minimum distribution requirements for mutual fund trust status will not be subject to the new enhanced reporting requirements provided all of the units of the ETF are listed on a designated stock exchange.
A further change ensures that bare trusts are subject to the enhanced trust reporting rules.
The enhanced reporting rules were initially proposed to come into effect for taxation years ending after December 30, 2021, but still have not been enacted. The CRA and Revenu Québec each recently stated that because the proposed measures remained pending, each of them would continue to administer the existing rules for trusts, and would not administer the rules proposed in Budget 2018. The draft legislation provides that the enhanced trust reporting rules will now apply to taxation years ending after December 30, 2022.
Avoidance of Tax Debts: Section 160 Amendments and Planning Penalty
Section 160 of the ITA contains an anti-avoidance rule aimed at preventing taxpayers from avoiding the collection of tax debts by transferring property to non-arm’s length parties for insufficient consideration. Where applicable, the rule causes the transferee to be jointly and severally liable with the transferor for tax debts of the transferor, to the extent that the fair market value of the property transferred exceeds the consideration paid by the transferee for the property at the time of transfer. While the existing rule is arguably already broad, the explanatory notes to the draft legislation indicate that the CRA has encountered “abusive planning” techniques designed to circumvent the existing rule. In addition, the federal government has recently been unsuccessful in challenging complex planning intended to avoid the application of section 160 in court (see Eyeball Networks Inc. v. Canada, 2021 FCA 17 and Damis Properties Inc. v. The Queen, 2021 TCC 24 (currently under appeal)). The combination of the measures described below signals the government’s clear focus on curbing section 160 avoidance planning.
The proposed changes to section 160, which were first announced in Budget 2021, are two-fold. First, specific anti-avoidance rules have been introduced in new subsection 160(5) to broaden the circumstances in which a person can be held jointly and severally liable for a taxpayer’s liabilities under the ITA (addressing certain existing section 160 avoidance planning strategies). Second, the draft legislation introduces a new and potentially significant penalty aimed at taxpayers, their professional advisors, and other parties involved in section 160 avoidance transactions.
Under the proposed anti-avoidance rules in subsection 160(5), section 160 will be expanded to apply to:
Transfers of property that occur as part of a transaction or series of transactions to a person who does not deal at arm’s length with the transferor in the period beginning immediately prior to, and ending immediately after, the transaction or series of transactions;
Transactions designed to crystallize tax liabilities in taxation years following the year in which the non-arm’s length transfer of property occurs; and
Transactions where the fair market value of the consideration paid by the non-arm’s length transferee diminishes, or where the consideration itself is cancelled or extinguished, in the period beginning immediately prior to, and ending immediately after, the transaction or series of transactions (e.g., a promissory note that is subsequently cancelled for no consideration).
The first two anti-avoidance rules noted above only apply where it is reasonable to conclude that one of the purposes of the transaction(s) is to avoid the application of section 160. While the purpose test included in the rules helps to narrow the rules’ application to transactions designed, at least in part, to circumvent section 160, it is worth noting that the “one of the purposes” test has been interpreted as having a low threshold by Canadian courts, such that the rules could apply where the avoidance of section 160 is an ancillary consideration in the overall transaction. In addition, due to the breadth of the concept of a “series of transactions” for purposes of the ITA, there may be significant uncertainty with respect to the scope of the time period that begins “immediately before” and ends “immediately after” the transaction or series of transactions.
The new section 160 avoidance planning penalty applies to any person who engages, participates in, assents to or acquiesces in “section 160 avoidance planning”. For this purpose, “section 160 avoidance planning” means tax planning in respect of a transaction or series of transactions that the person knows, or would reasonably be expected to know but for circumstances amounting to culpable conduct, has as one of its main purposes the reduction of joint and several liability for taxes payable under the ITA by a transferor, or that would be payable but for certain tax attribute transactions undertaken to reduce the actual tax payable under the ITA.
The amount of the penalty is equal to the lesser of: (i) 50 per cent of the section 160 joint and several liability and (ii) C$100,000 plus the sum of all amounts which the person, or another person not dealing at arm’s length with the person, is entitled to receive in respect of the planning at the time the penalty is assessed. Thus, the quantum of the penalty can be significant, and the penalty can apply to virtually all parties involved in the tax planning (including professional advisors and other third parties). A limited carve-out is available for persons solely providing clerical or secretarial services with respect to the planning.
As previously indicated, once enacted, the amendments to section 160 and the new section 160 avoidance planning penalty will be retroactively effective to April 19, 2021, being the date of Budget 2021. Finance released these measures for consultation, with submissions due by April 5, 2022.
The draft legislation puts forth updated proposals concerning the CRA’s statutory audit and enforcement powers. These amendments now focus on the CRA’s ability to collect information that may be relevant to “determining the obligations or entitlements of the taxpayer or any other person” under the ITA. While the recent proposals aim at refreshing and modernizing the statutory audit power under section 231.1 of the ITA more generally, the major amendments largely reflect previously announced changes (especially those announced in Budget 2021). This includes amendments that would allow the CRA to compel persons to respond to the CRA’s questions either orally or in writing, and, where questions are to be answered in writing, they are to be answered “in any form specified” by the CRA. As we observed in our Budget 2021 commentary, such words have the potential to be interpreted very broadly, perhaps even in a manner that requires taxpayers to produce documents and information that they do not otherwise maintain (and are not required to maintain) in their books and records. The intended reach of this expansion is not yet clear.
Further, the recent amendments broaden the scope of persons who may be required to answer questions orally or in writing (now including “a taxpayer or any other person”, rather than the owner or manager of a property or business, or persons already on the premises). They also permit the CRA to require such persons to attend “at a place designated by the authorized person, or by video-conference or by another form of electronic communication” (whereas the original Budget 2021 announcement contemplated attendance only at premises associated with the business or property). While undoubtedly permitting for greater flexibility in how the CRA carries out its audits and collects information, the expanded powers could perhaps allow CRA auditors to compel any persons to attend at CRA offices (or to do so virtually) for information-gathering interviews — not unlike the threat of having witnesses “come downtown for questioning” in TV crime dramas. Of course, even such expanded audit powers will need to be interpreted and applied reasonably, taking into account both commercial practices and decades of relevant jurisprudence.
Finance released these measures for consultation, with submissions due by April 5, 2022.
Clean Technology and Clean Energy Measures
Rate Reduction for Zero-Emission Technology Manufacturers
Budget 2021 proposed a temporary reduction of the corporate income tax rates for certain technology manufacturing and processing activities related to zero-emission products.
Based on the draft legislation, taxpayers would be entitled to a rate of 7.5 per cent on zero-emission technology manufacturing profits that would otherwise be taxed at 15 per cent, and a rate of 4.5 per cent on zero-emission technology manufacturing profits that would otherwise be taxed at nine per cent (i.e., the small business tax rate for CCPCs).
These reduced rates would apply in full for taxation years beginning after 2021 and before 2029, with the amount of the rate reduction being gradually phased out for taxation years after 2028 and completely eliminated in respect of taxation years beginning after 2031.
The rate reduction is designed as a deduction from the tax otherwise payable and is determined by a formula based on “zero-emission technology manufacturing profits”. Such profits are in turn determined by a formula that includes the cost of capital and cost of labour used or engaged in “qualified zero-emission technology manufacturing activities”.
The draft legislation also includes a condition that the deduction is only available if at least 10 per cent of the corporation’s gross revenue for the year from all active businesses carried on in Canada is from qualified zero-emission technology manufacturing activities. Such activities include:
The manufacturing or processing of solar, wind, and water energy conversion equipment, geothermal energy equipment, equipment for ground source heat pump systems, electrical energy storage equipment used for storage of renewable energy or for providing grid-scale storage or other certain ancillary services, equipment used to charge, or to dispense hydrogen to, a zero-emission vehicle, and equipment used for the production of hydrogen by electrolysis of water;
Production in Canada of hydrogen by electrolysis of water, gaseous biofuels, liquid biofuels, and solid biofuels; and
Conversion of a vehicle into a zero-emission vehicle.
Capital Cost Allowance for Clean Energy Equipment
Budget 2021 proposed to expand Classes 43.1 and 43.2, which provide accelerated capital cost allowance rates of 30 per cent and 50 per cent, respectively, to support investments in clean technologies.
Based on the draft legislation, Class 43.1 is expanded to include, among others:
Pumped hydroelectric energy storage installations;
Equipment that generates electricity by diverting or impeding the natural flow of water;
Equipment used to convert specified waste material into solid biofuel;
Equipment used to convert specified waste material or carbon dioxide into liquid biofuel;
Equipment used to produce hydrogen by electrolysis of water; and
Hydrogen refuelling equipment.
In addition, under the proposals, Class 43.1 is also amended to restrict eligibility for certain cogeneration systems, specified waste-fuelled heat production equipment and producer gas generating equipment.
Proposed amendments to expand Class 43.1 eligibility apply to property acquired after April 18, 2021, that has not been used or acquired for use before April 19, 2021. Subject to certain exceptions, generally, the amendments to restrict Class 43.1 eligibility apply to property of a taxpayer that becomes available for use by the taxpayer after 2024.
Class 43.2 includes certain of the property described in Class 43.1 if acquired after February 22, 2005, and before 2025; however, in certain cases, more stringent conditions (e.g., heat rate thresholds) must be met.
Finance released both of these proposals for consultation, with submissions due by March 7, 2022.
The draft legislation includes amendments to the ETA regarding the GST/HST status of “cryptoasset” mining.
A previous amendment implemented in 2021 (in force May 18, 2019) had deemed cryptocurrencies (or “virtual payment instruments”) to be financial instruments, the purchase and sale of which is exempt from GST/HST. The draft legislation proposes deeming rules that would exclude cryptoasset mining activities from GST/HST commercial activities and therefore exclude persons engaging in such activities from claiming input tax credits. Once in force, these proposed rules would apply effective February 5, 2022.
The new defined term “cryptoasset” is broader than “virtual payment instrument”, indicating that the government intends to treat mining activities as outside the scope of GST/HST even when the subject of the mining is not necessarily itself a financial instrument. Cryptoassets are defined as “property…that is a digital representation of value and that only exists at a digital address of a publicly distributed ledger”. Notably, while the definition of “virtual payment instrument” excludes exchangeable tokens, loyalty/reward points and in-game currencies, the new term “cryptoasset” implicitly includes these kinds of assets.
The draft legislation provides certainty for cryptocurrency miners who earn rewards from their mining activities. It was previously unclear whether miners are considered to be performing a taxable “service” for GST/HST purposes (and if so, who was the recipient of such service), such that they should be remitting GST/HST on any mining rewards earned. Mining activities will be deemed not to be a supply, with limited exceptions where the mining activity is performed for another person (who is not the mining group operator of a mining group that the person is part of), and the identity of the other person is known. These rules could potentially put miners who earn taxable cryptoassets as mining remuneration in the unique situation of being unable to claim input tax credits in connection with their acquisition of those assets, but the underlying policy of treating mining as a non-event seems coherent.
Finance released these measures for consultation, with submissions due by April 5, 2022.
For further information, please contact any member of our Tax group.