2019 Federal Budget Insights for Private Corporations
As was expected, the 2019 Federal Budget (the "Budget") is one for an election year. Meaning, while the Government provided a few handouts and various credits, there is little to offend anyone – at least from a tax perspective. A few legislative changes are targeted towards somewhat esoteric tax avoidance strategies (i.e., carrying on business through a TFSA and redeemer strategies for mutual fund trusts). The good news is there is little that will have negative implications for most businesses. This is a welcome change from past years.
Many commentaries have been written that review the Budget in detail, and we do not propose to do so. Instead, this article will focus on select topics that are relevant primarily to private corporations, their shareholders and their advisors.
Employee Stock Options for "Large, Mature Companies"
Employee stock options are a tax-effective way for a company to remunerate its employees without a cash outlay. There are no immediate tax consequences to the employee when the option to purchase corporate shares is granted. Instead, the employee realizes a taxable benefit when the option is exercised, equal to the value of the shares at the time the option was granted over the exercise price paid for the shares. If certain conditions are met, the amount of the taxable benefit is effectively taxed as a capital gain (effectively, only 50% of the benefit is taxable).
Employee stock options can be even more favourable if the corporation qualifies as a Canadian-controlled private corporation ("CCPC") because the taxable benefit can be deferred until the share is sold.
The Budget indicates the Government's intention to curtail use of employee stock options for "employees of large, long-established, mature firms" and "executives of large, mature companies" by imposing a cap of $200,000 per employee on stock option grants that are eligible for preferential tax treatment on exercise. The Government states the rules would not change for "start-ups and emerging Canadian businesses". However, no clear details were provided on who would and would not be subject to the $200,000 cap.
Stock option grants made prior to the release of draft legislation in the summer of 2019 should be unaffected. Following summer 2019, other equity-based incentive plans could be considered as an alternative to options for those impacted by the changes.
Proposed legislation was introduced in July 2017 that would have had a negative impact on the succession of family businesses, in addition to certain post-mortem tax plans that eliminate the double tax problem that occurs when a person dies owning shares of a private corporation. Such strategies generally involve converting dividend income to capital gains, which alleviates the double tax problem arising on death or the intergenerational transfers of a family business.
The 2017 measures did not move forward, likely due to a backlash from farmers and other business owners. The Budget indicates that the Government will "continue its outreach to farmers, fishers, and other business owners", though any proposed rules would likely affect businesses in almost all sectors of the economy.
Given this uncertainty, one approach would be to wait and see what rules the Government may come up with in connection with business succession. However, depending on the age and life cycle of the business, prudent business owners and their advisors may put a succession strategy into place under the current rules, rather than wait and see what allowances the Government might make in the future (and what may be taken away). Generally speaking, tax law is not retroactive to the extent of capturing and unwinding previously-implemented transactions. Succession strategies may be implemented sooner to mitigate the risk of adverse legislative changes.
Change in Use Rules for Multi-Unit Residential Properties
The "change in use" rules cause a taxpayer to be deemed to have disposed of a property when its use is converted from personal to income-earning or vice versa. For example, a taxpayer that converts their principal residence to an income-earning use (i.e., a rental property) will be deemed to have disposed of the principal residence for its fair market value at that time. Recognition of any gain can be deferred for up to four taxation years by filing an election.
However, this election is only available to defer gains from a change in use of the entire property. The current rules do not accommodate partial changes in use. Instead, taxpayers have had to rely on inconsistent CRA policies regarding application of the change in use rules where a property is only partially converted (i.e., a taxpayer owns a multi-unit residential property and moves into one of the units).
The Budget proposes to change the election to allow taxpayers to defer gains when a property undergoes a partial change in use. This measure is set to apply to changes in use that occur on or after March 19, 2019.
Transfer pricing involves potentially complex economic analysis of cross-border transactions. At a high level, a cross-border transaction between non-arm’s parties (such as a Canadian parent corporation with a foreign subsidiary, or vice versa) must occur at an arm’s length price. Otherwise, the tax authorities may make adjustments to the price resulting in tax reassessments and potential penalties.
Ambiguities result from the fact that other rules in the Income Tax Act, apart from the transfer pricing provisions, also affect computation of income and penalties. It has been advantageous for taxpayers facing adjustments to have such adjustments occur under the specific provisions of the Income Tax Act rather than the transfer pricing provision (because only adjustments under the transfer pricing provision are used to calculate the transfer pricing penalty).
The Budget proposes to clarify the legislation, giving the transfer pricing rules paramountcy over other tax rules. This measure may be of concern for growth companies with little revenue, as even a small transfer pricing adjustment could trigger penalties (even if the company does not have any taxable income).
No draft legislation is available at this point, so details of this measure are largely unknown. However, companies are best advised to take proactive steps to use arm's length prices and prepare the proper documentation to avoid potential penalties going forward.
Foreign Affiliate Dumping Rules
The foreign affiliate dumping rules are aimed at corporate structures that effectively use Canada as a tax haven. The typical scenario is where a foreign corporation uses a Canadian subsidiary as an intermediary to invest in another corporation (i.e., a foreign affiliate) in a different jurisdiction. Absent the foreign affiliate dumping rules, this type of "sandwich" structure could be used to take advantage of Canada’s exempt surplus dividend system. The structure can further be leveraged by having the Canadian corporation borrow money from the foreign parent, accessing interest deductions in Canada, thereby eroding the Canadian tax base.
In simple terms, if the foreign affiliate dumping rules apply, the Canadian corporation may be deemed to pay a dividend to the parent in an amount representing its investment the foreign affiliate, subject to certain exceptions and adjustments. The consequence is that Canada can then exact a withholding tax on the deemed dividend.
The foreign affiliate debt dumping rules are generally relevant to foreign multinational corporations. Arguably, the original rules were broader than what was required to address the tax avoidance they were intended to curtail. Surprisingly, the Budget proposes to broaden the existing rules even further. While the existing rules are only triggered where the foreign parent is a corporation, the new rules would apply where the "parent" is a person other than a corporation, such as a trust or individual. The amendments place these rules well outside the domain of foreign multinationals and causes the tremendously complex foreign affiliate dumping rules to apply to private clients.
In any case where there is a cross-border "sandwich" structure – that is, any foreign entity with an interest in a Canadian corporation that in turn holds more than 10% of the shares of a foreign corporation – the foreign affiliate debt dumping rules should be analyzed. Otherwise, surprising tax consequences may arise.
Scientific Research and Experiential Development ("SR&ED") Program
The SR&ED program encourages the growth of Canadian businesses and creation of skilled jobs by providing certain taxpayers making qualifying expenditures with two valuable benefits. First, qualifying SR&ED expenditures can be fully deducted in the year incurred. Second, such expenditures are also eligible for an investment tax credit ("ITC") on a maximum of $3 million in annual qualifying expenditures (the "Limit").
The ITC can result in a cash refund, a reduction of tax payable, or both. Any unused ITCs can be carried back or carried forward. The ITC benefit is further enhanced if the taxpayer qualifies as a CCPC, which generally receive an enhanced tax credit at a rate of 35% (compared to 15% for a non-CCPC).
Under the current rules, the Limit is reduced based on the CCPC’s annual income (the "Income Requirement") and size. The Income Requirement begins to reduce the Limit when the CCPCs taxable income exceeds $500,000 (and the Limit is eliminated entirely when income exceeds $800,000).
The Budget proposes to eliminate the Income Requirement for taxation years that end after March 18, 2019. Therefore, as long as a CCPC meets the size requirement (generally, less than $10 million of taxable capital employed in Canada), the CCPC can access the maximum ITC regardless of its income.