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Finance Canada
Budget 2000 - Budget Plan, Annex 7- 4
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The Income Tax Act contains rules that restrict the interest deduction that a corporation resident in Canada can claim in respect of debt owing to a specified non-resident – generally, a shareholder whose stake in the corporation represents 25 per cent or more of the votes or value in the corporation or a person who is not at arm’s-length with such a shareholder. Under these so-called "thin capitalization" rules, the Canadian corporation may deduct interest on debt to specified non-residents to the extent that such debt does not exceed three times the amount of equity contributed by such non-residents. In the event that such debt exceeds the 3:1 ratio, the interest deduction attributable to the excess is denied for Canadian tax purposes.
A number of factors support modifications to the thin capitalization rules, which were introduced in 1972. First, the permitted 3:1 debt-equity ratio is high compared to actual industry ratios in the Canadian economy, suggesting that the 3:1 ratio permits inappropriately high debt levels. On the other hand, the current rules apply to reduce the amount of interest deductible if debt to specified non-residents at any point in the year exceeds the permitted ratio relative to equity. Therefore, temporarily high debt levels can have a disproportionate impact.
The scope of debts covered by the rules is also very narrow. An anti-avoidance rule in the current law deals with so-called back-to-back arrangements. Where a specified non-resident makes a loan to a third party on condition that the third party make a loan to the Canadian corporation, the lesser amount of the two loans is deemed to be a loan to the corporation from the specified non-resident. This rule does not extend, however, to an arrangement where a Canadian corporation borrows funds from a third party with the aid of a guarantee from a specified non-resident. Such a borrowing is often economically equivalent to a direct loan from the non-resident since the guarantee supports the lender’s credit risk associated with the borrowing. This type of arrangement can result in the erosion of the tax base to the same extent as a direct loan from the specified non-resident.
In addition, as a result of a special exemption introduced in the early 1970s, the thin capitalization rules currently do not apply to a corporation whose principal business in Canada is the developing or manufacturing of aircraft or aircraft components. It is not apparent that this exemption is warranted under present conditions.
Finally, other changes to the thin capitalization rules need to be considered. The rules currently apply only to corporations and not to other business arrangements such as partnerships, trusts and branches. Taxpayers may therefore be able to use these structures in order to circumvent the rules. There is also concern that use of financing techniques that do not rely on traditional debt – such as leases from a non-resident parent – may weaken the effectiveness of the rules in protecting the Canadian tax base.
In response to these concerns, the budget proposes that the thin capitalization rules in subsections 18(4) to 18(8) of the Income Tax Act be amended in the following manner:
These four changes will come into effect for taxation years that begin after 2000.
Finally, consultations will be initiated on the extension of the thin capitalization rules to other arrangements and business structures, namely:
The Government invites public comments with respect to both the proposed changes outlined above and the extension of the thin capitalization rules to other arrangements and business structures.
Section 133 of the Income Tax Act allows a foreign-owned Canadian corporation to elect to be a "non-resident-owned investment corporation" (NRO). By so doing, income received by the corporation is taxed at the same 25-per-cent rate that would apply to income paid to a non-resident from a Canadian source that is subject to the maximum rate of Part XIII withholding tax. The tax is then refunded when the NRO pays dividends to its foreign parent, at which time withholding tax applies on the dividends. The intended effect of the provision is to place the non-resident shareholder of the NRO in a position similar to that of non-resident investors who hold investments directly.
However, NROs are increasingly being used in ways that erode the Canadian tax base. For example, an NRO may be used to lend money indirectly to an affiliated Canadian corporation. This transaction results in an interest deduction at full rates for the Canadian corporation, while the interest income is subject only to a refundable 25-per-cent tax in the NRO’s hands. In addition, this tax planning strategy can allow a double interest deduction for non-resident shareholders, if these shareholders borrow money in order to invest in the NRO.
The budget proposes to repeal the NRO provisions for elections made after February 27, 2000. To allow for an orderly restructuring of their operations, existing NROs will be entitled to retain their status until the end of their last taxation year that begins before 2003. However, existing NROs will not be allowed to issue new shares, other than by way of reorganization, or increase debt levels to finance new investments, subject to grandfathering of arrangements in writing entered into before February 28, 2000.
"Weak currency borrowings" are transactions that take advantage of the fact that, where a currency is expected to decline in value relative to some reference currency, the interest rate on a loan in the "weak" currency will be higher than on a loan on similar terms in the reference currency. The higher rate reflects the market’s expectation that the borrowed amount will be worth less in terms of the reference currency when the loan is repaid. Lenders demand a higher interest rate to compensate for this expected depreciation.
A taxpayer pursuing tax advantages may borrow in a weak currency, even though that currency is not required in its business. The proceeds of the weak currency loan are converted into a currency that is needed for business purposes, but the interest obligation remains in the weak currency at the higher rate. The higher interest payments form the basis for a claimed interest deduction that is higher than would be available if the taxpayer had borrowed directly in the final currency. If, as expected, the currency of the borrowing depreciates, the taxpayer will realize a foreign exchange gain on maturity when the principal of the loan is repaid in the depreciated foreign currency. While this gain compensates for the higher interest payments, the taxpayer may treat it as a capital gain, which would be taxed at a preferential rate. The full deduction of additional interest, coupled with capital gains treatment of the offsetting appreciation, produces an inappropriate result which has been challenged by the Canada Customs and Revenue Agency.
The Supreme Court of Canada has recently ruled that specific rules in the Income Tax Act do not deny the tax benefits sought by proponents of these weak currency structures. However, the disputed transaction preceded the introduction of the Act’s General Anti-Avoidance Rule (GAAR). The Government’s position that the GAAR applies to weak currency borrowings is currently being adjudicated by the courts.
While the Government is pursuing its challenge of these transactions under the current law, prudent risk management supports the introduction, for greater certainty, of specific legislative rules defining particular weak currency arrangements and setting out their appropriate tax treatment. Essentially, a weak currency borrowing will be treated for tax purposes as equivalent to a direct borrowing in the currency that is used by the taxpayer to earn income.
The proposed rules will apply when a taxpayer incurs foreign currency indebtedness that meets the following conditions:
Where these conditions are met, the following rules will apply:
The measure will not apply to corporations whose principal business is the lending of money.
It is proposed that this measure apply as of July 1, 2000, in respect of indebtedness incurred after February 27, 2000. This will allow interested parties an opportunity to comment on the proposal.
Example
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| Payment | F$ value | Exchange rate | C$ value |
|---|---|---|---|
| (all amounts in 000s) | |||
| Interest – 2002 | F$260 | 0.4779 | C$124 |
| Interest – 2003 | F$260 | 0.4567 | C$119 |
| Principal – 2003 | F$2,000 | 0.4567 | C$913 |
|
| Value of principal on borrowing: | C$1,000 |
| Value of principal on repayment: | C$913 |
| Foreign exchange gain: | C$87 |
Proposed Tax Treatment
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| Year | Interest paid | Deductible | Not deductible in year |
|---|---|---|---|
| (all amounts in 000s) | |||
| 2002 | C$124 | C$80 | C$44 |
| 2003 | C$119 | C$80 | C$39 |
| Total | C$243 | C$160 | C$83 |
|
| Foreign exchange gain: | C$87 |
| Undeducted interest: | C$83 |
| Adjusted foreign exchange gain (loss): | C$4 |
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Various levels of government provide both tax and non-tax assistance to taxpayers in order to achieve a variety of policy objectives. Tax assistance includes investment tax credits (ITCs) and super-deductions (i.e., deductions over 100 per cent of cost). Non-tax assistance includes grants and conditionally repayable contributions. The combined level of assistance can be overly generous with a resultant misallocation of resources.
One of the ways that this misallocation is avoided is to base the cost of the expenditure for federal ITC purposes on the cost of the eligible investment net of any other government assistance or reimbursement that the taxpayer has received or is entitled to receive. This ensures that the ITC is based on the taxpayer’s actual costs.
However, not all types of government assistance are treated equally for income tax purposes. Deductions in excess of 100 per cent, commonly known as "super-deductions," are provided in certain provinces. These super-deductions are not considered to be government assistance and thus do not affect the expenditure base for federal ITC purposes, even though they are similar in many respects to provincial ITCs.
To address this issue, the budget proposes to treat provincial deductions for scientific research and experimental development (SR&ED) that exceed the actual amount of the expenditure as government assistance for taxation years ending after February 2000. If a corporation is eligible for SR&ED ITCs at the enhanced rate of 35 per cent (i.e., it is a small Canadian-controlled private corporation), the value of the assistance will be determined at the relevant provincial small business corporate income tax rate that is applicable in that province multiplied by the amount by which the deduction for provincial income tax purposes exceeds the actual amount of the expenditure. For all other corporations, the value of the assistance will be determined as the maximum provincial corporate income tax rate applicable to active business income multiplied by the amount by which the deduction for provincial income tax purposes exceeds the actual amount of the expenditure.
This change will result in SR&ED deductions and credits having comparable value, reduce stacking of benefits and make the tax system fairer.
To limit the impact of the application of Canadian and foreign taxes on the same income, Canada provides its residents with "foreign tax credits" for income or profits taxes they have paid to another country. In most cases, it is clear whether a foreign tax is sufficiently similar to Canada’s income tax to qualify for these credits. However, the characterization of a levy as an income tax is less clear with respect to certain levies imposed in some oil- and gas-producing countries.
The levies in question are imposed under "production sharing agreements" between the governments of the countries concerned (or their agents) and Canadian-resident companies. Under a typical production sharing agreement, the company undertakes to conduct exploration activities within a defined territory and, where the exploration efforts are successful, to develop the resource property and exploit it commercially. At the commercial exploitation stage, the resource production is divided between the company and the foreign government, often through a state-owned corporation, according to a sharing formula agreed to in the contract. Such formulas, which vary from contract to contract, typically grant the company enough of the resource production to cover its costs and to generate a profit. Production sharing agreements generally set out in detail how costs are to be recovered over time, what proportion of the production must be allocated to the state in any given year, and other key terms.
Most of the countries that enter into such agreements with Canadian companies also impose a corporate income tax. Rather than applying the tax separately, however, these countries integrate their income tax into the production sharing agreements themselves. In effect, part of the foreign government’s share of the production under the agreement is characterized as a payment in satisfaction of the Canadian company’s income tax liability to that government.
Because a production sharing agreement both allocates oil and gas production and incorporates the foreign country’s income tax, it can be difficult to determine which portion of the foreign government’s share is on account of an income tax. Indeed, the Income Tax Act’s current foreign tax credit rules may deny credit for any and all payments made pursuant to such agreements. The uncertainty Canadian companies face as a result can put them at a disadvantage relative to those foreign competitors whose domestic taxation rules provide foreign tax credits in similar circumstances.
The budget proposes to introduce amendments to the Income Tax Act that will clarify the eligibility for a business foreign tax credit of certain payments made by Canadian resident taxpayers to foreign governments on account of levies imposed in connection with production sharing agreements. The proposed amendments will set out those circumstances in which a levy will be considered to be, in substance, an income tax paid by a taxpayer.
More specifically, the proposed amendments will require that, for a foreign levy to qualify, it must be computed by reference to net income, after recognition of relevant expenses, and must not be, under the agreement, either a royalty or any other consideration paid for the exploitation of the resource. Because the amendments are intended to accommodate situations where the foreign income tax is calculated pursuant to a production sharing agreement, as opposed to being assessed separately, the proposed rules will apply only where the foreign country otherwise imposes what can be regarded as an income tax.
The amount eligible for a foreign tax credit cannot, under the proposal, exceed 40 per cent of the taxpayer’s income from the business for the year and will be subject to the existing rules of the Act governing the claiming of business foreign tax credits and the carry-overs of unused credits. The 40 per cent rate is an approximation of the Canadian corporate rate and is the same proxy rate currently used for other foreign tax credit purposes.
The amendments to the business foreign tax credit provisions of the Act will also include specific rules for the recognition of a taxpayer’s foreign exploration and development expenses (FEDE), discussed in the next section. While there already exists a general requirement in the Act for taxpayers to recognize FEDE in computing the amount of foreign tax credit that can be claimed in respect of foreign source income, these rules will specify how FEDE will be allocated to a particular foreign country for purposes of claiming a foreign tax credit.
The new rules will apply for foreign income taxes paid by any given taxpayer, pursuant to production sharing agreements, in taxation years that begin after the earlier of December 31, 1999, and a date chosen by the taxpayer (which date cannot in any case be earlier than December 31, 1994).
A Canadian oil and gas or mining company that incurs foreign exploration and development expenses (FEDE) may claim a minimum 10 per cent of its FEDE balance against its income from any source. A greater claim is permitted if a taxpayer’s foreign resource income exceeds the 10-per-cent minimum.
The existing regime for FEDE raises a number of concerns.
First, there is no explicit requirement under the existing rules that FEDE be incurred by a taxpayer for the purpose of entitling the taxpayer to profits or gains in respect of any foreign resource property of the taxpayer. For example, some taxpayers have claimed FEDE even though a foreign affiliate of the taxpayer owns the foreign resource property to which the FEDE relates.
In addition, there are circumstances where FEDE expenses have been generated by virtue of a taxpayer resident in Canada acquiring resource property of little value from a debtor of the taxpayer in circumstances to which section 79.1 of the Income Tax Act applies. The general effect of section 79.1 is that a creditor acquires property seized from a debtor in default of a payment of a debt at a cost equal to the principal amount of the debt, but is not entitled to claim a capital loss or bad debt expense with regard to that debt. The application of section 79.1 in this context is a particular concern where the debtor is not resident in Canada. This is because the parallel rules in section 79, under which the debtor is generally deemed to have proceeds of disposition from the resource property equal to the principal amount of the debt, will not have any effect on the debtor’s Canadian income tax.
Second, existing FEDE rules allow taxpayers to claim a FEDE deduction of up to the full amount of foreign resource income earned. In this respect, the FEDE rules are more generous than the rules permitting the deduction of Canadian development expenses and Canadian oil and gas property expenses. The FEDE rules also result in similar treatment for foreign exploration expenses as compared to Canadian exploration expenses, even though the 100-per-cent write-off is an accelerated incentive rate designed to encourage exploration activities in Canada.
Third, existing FEDE rules do not expressly apply on a country-by-country basis. Thus, it is difficult to source FEDE deductions to a particular country in cases where a taxpayer incurs FEDE in connection with more than one country outside Canada. This issue is of particular significance with regard to the calculation of a taxpayer’s entitlement to foreign tax credits pursuant to the proposed new rules for production sharing agreements.
Also, the discretionary nature of the FEDE deduction may provide overly generous opportunities for maximizing foreign tax credit claims. This is because a FEDE deduction might be claimed in a taxation year for which little or no foreign business income taxes are paid, and not claimed in a taxation year for which large amounts of foreign business income taxes are paid. This action might be taken either to minimize the impact of the proposed 40-per-cent limit with regard to production sharing agreements, or to minimize the effect of income-based restrictions in the existing foreign tax credit rules.
The budget proposes to introduce amendments to address all of these concerns.
With regard to outlays made by a person or partnership after February 27, 2000 (other than any outlay made pursuant to an agreement in writing entered into before February 28, 2000), FEDE must
Consistent with this new measure, section 79.1 will not apply in connection with foreign resource property acquired after February 27, 2000, from a person (other than a person resident in Canada) or a partnership (other than a partnership each member of which is resident in Canada). These measures are aimed at ensuring that FEDE incurred by a taxpayer has the potential of directly generating income for the taxpayer that is subject to tax in Canada.
Post-2000 FEDE expenses will be allocated to separate pools on a country-by-country basis. Foreign resource income will be applied first to support global FEDE claims (i.e., FEDE claims generated under existing rules) and then, subject to a new limit equal to 30 per cent of the FEDE balance in respect of a country, to support FEDE deductions in respect of the country to which the income relates. However, to the extent that the country-by-country limitation would cause a taxpayer’s overall maximum FEDE deductions for a taxation year to be less than 30 per cent of total FEDE balances, the taxpayer will be permitted to augment the portion of a FEDE balance for a taxation year that may be claimed. The augmentations to FEDE deductions for specific countries in these circumstances will be structured so that a taxpayer will be allowed in aggregate to claim FEDE deductions for a taxation year totalling not more than the lesser of
It is proposed to provide taxpayers with maximum flexibility as to which FEDE balance a deduction is claimed against. This is consistent with the approach taken with regard to the undepreciated capital cost of depreciable property. However, it is only after determining the amount of deduction against an FEDE balance generated by pre-2001 expenses that it will be possible to determine deductions against FEDE balances generated by post-2000 expenses.
The new 30-per-cent restriction for new FEDE balances necessitates consequential changes to the successor rules for foreign resource properties in section 66.7 of the Income Tax Act.
All of these measures apply to taxation years that begin after 2000.
Consistent with the proposed approach for the treatment of post-2000 FEDE, the budget proposes that the FEDE deduction that a taxpayer who ceases to reside in Canada may claim be limited to the taxpayer’s foreign resource income (including foreign resource income arising from the deemed disposition of foreign resource property on the taxpayer ceasing to reside in Canada). However, the taxpayer will be permitted to deduct annually up to 10 per cent of the taxpayer’s FEDE balance while non-resident against taxable income earned in Canada while a non-resident.
This measure will apply to taxpayers who cease to reside in Canada after February 27, 2000.
An FEDE deduction claimed for a taxation year that begins after December 31, 1999 (or after such earlier date as the taxpayer has elected to have the new production sharing agreement rules apply), will be explicitly required to be allocated to a specific country where the FEDE deduction relates to a pre-2001 FEDE balance. This rule is intended to apply primarily for the purpose of computing a taxpayer’s foreign tax credit.
A taxpayer will be permitted to make reasonable assumptions as to which country or countries a particular deduction from a pre-2001 FEDE balance relates, provided that those assumptions apply consistently from year to year. If a taxpayer fails to make reasonable assumptions in this regard, the Minister of National Revenue will make reasonable assumptions that will be binding on the taxpayer.
It will be assumed for the purpose of the foreign tax credit calculation that a taxpayer’s FEDE deduction for a taxation year in respect of a country is generally the greater of
Since 1973, the Government has provided a tax credit to reduce the rate of corporate tax applicable to Canadian manufacturing and processing profits. Before the February 16, 1999, budget, the definition of manufacturing and processing (M&P) had specifically excluded the production or processing of electrical energy or steam for sale. That budget proposed the extension of the M&P tax credit to corporations that produce, for sale, electrical energy or steam used in the generation of electricity.
This budget proposes to extend the M&P tax credit to corporations that produce, for sale, steam for uses other than the generation of electricity. This change will ensure that all producers of steam for sale will face the same income tax rate. Access to the credit will be phased in beginning January 1, 2000, with a three-percentage-point reduction. In each of the two subsequent years, there will be additional two-percentage-point reductions. The phase-in to M&P treatment will be completed in 2002. These proposed rate reductions will be prorated for taxation years that straddle calendar years.
A portion of the capital cost of depreciable property is deductible as capital cost allowance (CCA) each year. The maximum CCA rate for each type of property is set out in the Income Tax Regulations. The Government attempts to ensure that these CCA rates reflect, as closely as possible, the useful lives of the assets.
Various factors affect the useful lives of capital assets, including technological obsolescence and changing market conditions. The CCA regime is reviewed on an ongoing basis to ensure that the CCA rates are appropriate and do not impede the ability of Canadian firms to invest and compete.
As a result of this review, the budget proposes several adjustments to improve the CCA system. Proposed changes include
Most rail assets owned by common carriers, including railway cars and locomotives, are currently eligible for a 10-per-cent CCA rate.
Current CCA TreatmentClass 6 and Class 35 of Schedule II to the Income Tax Regulations include:
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The budget proposes that the CCA rates for such locomotives, railway cars and rail suspension devices acquired after February 27, 2000, be increased to 15 per cent. This rate will better reflect the estimated useful life of these assets.
In certain instances, Class 35 railway assets that are the subject of a lease are already eligible for a 13-per-cent CCA rate. The proposed 15-per-cent CCA rate will apply to these assets only if the lessor elects to have the "specified leasing property" rules apply to the asset.
In general, the CCA system groups properties into a limited number of broad classes with specified depreciation rates that apply on a diminishing balance basis. In most cases, this system works well and is simple to administer. The use of a class system provides, on average, deductions for tax purposes that reflect the useful life of the property. However, the rate at which any particular piece of equipment depreciates can vary significantly depending on how it is used and the progress of technological change. In some circumstances, the CCA system does not adequately reflect variations in depreciation experience resulting from technological change. In response to this, the 1993 budget introduced a separate class election for computer equipment and certain types of office communication and electronic equipment.
The separate class election allows taxpayers to place eligible property in a separate class for CCA purposes. Although the separate class election does not change the specified CCA rate, it ensures that, upon the disposition of all the property in the class, any remaining undepreciated balance can be fully deducted as a terminal loss.
The useful life of manufacturing equipment can vary widely. To address situations where certain types of equipment have an unusually short economic life, the budget proposes that the separate class election be extended to include manufacturing and processing property included in Class 43 of Schedule II to the Income Tax Regulations costing more than $1,000. This measure will apply to property acquired after February 27, 2000. The proposed election must be filed with the income tax return for the taxation year in which the property is acquired.
As with the 1993 provision, the undepreciated capital cost (UCC) in each separate class created pursuant to this measure, that is remaining after five years, must be transferred into the general Class 43 UCC pool.
Currently, the electrical generating equipment of a producer of electrical energy is generally eligible for a 4-per-cent CCA rate under Class 1 of Schedule II to the Income Tax Regulations. The production and distribution equipment of a distributor of heat or water are also generally eligible for this rate under Class 1.
Current CCA TreatmentClass 1 of Schedule II to the Income Tax Regulations includes:
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Industry consultations have established that this rate no longer reflects the estimated useful life of such equipment. The budget proposes that the CCA rate be increased from 4 per cent to 8 per cent for the following equipment currently included in Class 1:
The 8-per-cent rate will apply to equipment acquired after February 27, 2000, that has not been used or acquired for use prior to that date.
It is further proposed that combustion turbines that generate electricity (and any associated burners and compressors) be eligible for a separate class election. The general rule which would otherwise require the property to be transferred into the general UCC pool after five years will not apply.
The separate class election will only apply to equipment acquired after February 27, 2000, that has not been used or acquired for use prior to that date. The proposed election must be filed with the income tax return for the taxation year in which the property is acquired.
The budget proposes that the capital tax surcharge on large deposit-taking institutions, which was introduced in the 1995 budget, and extended in subsequent budgets, will be further extended to October 31, 2001. As announced by the Government in its June 25, 1999, paper Reforming Canada’s Financial Services Sector, a review of the application of this surcharge is, however, underway and the results will be announced when the financial sector review legislation is tabled.
This surcharge applies to financial institutions as defined under Part VI of the Income Tax Act except life insurance companies. The surcharge will continue to apply at a rate of 12 per cent of the capital tax imposed under Part VI, calculated before any credit for income taxes and with a capital deduction of $400 million. The surcharge is not eligible to be offset by tax payable under Part I of the Act.
The surcharge will be prorated for taxation years that straddle October 31, 2001.
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