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Budget 2004 - Budget Plan
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Chapter 4 - Moving Forward on the Priorities of Canadians -
The Importance of Knowledge and Commercialization

Highlights

• Annual increase of $90 million to Canada’s three federal granting councils.

• Increase of $20 million annually to help offset the indirect costs of research by universities and research hospitals.

• An additional $60 million for Genome Canada to strengthen its research.

• A total of $100 million over five years to improve the capacity for commercialization at universities, hospitals and other research facilities.

• New funding of $270 million set aside to enhance access to venture capital financing for companies turning promising research into new products and services.

• Acceleration by one year, from 2006 to 2005, of the increase in the small business deduction limit to $300,000.

• Increase in the capital cost allowance rate for computer equipment to 45 per cent from 30 per cent, and in the rate for broadband, Internet and other data network infrastructure equipment to 30 per cent from 20 per cent.

Introduction

Nations that wish to compete and prosper in the 21st century global economy must build a sustained advantage in the discovery and application of new knowledge. This new knowledge enables us to understand the world around us better, while leading to the new products and services that improve our quality of life and generate economic opportunities. An investment in knowledge is therefore an investment in a better future for Canadians.

Creating a knowledge advantage begins with a commitment to research excellence. Not only is leading-edge research a key source of new knowledge and ideas, but it also helps develop the highly qualified personnel that Canada needs. A skilled workforce capable of rapidly absorbing, applying and diffusing new ideas and technologies is critical for success in the 21st century economy.

Making knowledge central to how Canadians learn and work is a pivotal challenge for all sectors. A knowledge advantage can make Canada a world leader in emerging technology-based industries, but it is equally important for more traditional sectors such as agriculture, fisheries, mining, and oil and gas development, because new knowledge can help us derive better and more sustainable value from our natural resources.

The Government’s investments in recent years have significantly strengthened Canada’s capacity for conducting world-leading research. However, if Canada is to capitalize on the momentum generated by these investments, we must improve our commercialization performance by increasingly transforming research outcomes into economic benefits for Canadians. Commercialization is the process through which research discoveries are brought to the marketplace and new ideas or discoveries are developed into new products, services or technologies that are sold around the world.

Beyond supporting ideas and the emergence of new ventures, the Government must establish an environment that allows Canadian businesses to develop, grow, prosper and take on the world. It must encourage the supply of early financing such as angel and venture capital, support small businesses that turn ideas into jobs, and encourage businesses to expand their reach and ambitions. This requires a fair, efficient and competitive tax system as well as a sound regulatory and governance framework.

In this budget the Government is introducing a number of complementary measures to further strengthen research, help accelerate commercialization, and enhance the availability of early-stage capital. It proposes new measures to support small businesses, strengthen investment, and improve the fairness and effectiveness of the tax system. It also proposes initiatives to enhance regulatory efficiency and corporate governance.

Building Research Foundations

Scientific inquiry, both basic and applied, is the foundation upon which future social and economic advancement will be based. Since the budget was balanced in 1997–98, the Government has pursued a long-term strategy for strengthening research, with federal support for research increasing each year since 1997. The Government has targeted much of this new support to strengthening research capacity at universities, colleges and research hospitals. Indeed, by 2005–06 annual federal support for research in the higher education sector will be almost $2.0 billion higher than in 1997–98 (see Table 4.5), representing a cumulative investment of nearly $9.0 billion over that period.

Through these complementary investments, the Government has helped Canada’s higher education sector double the amount of research it performs, compared to 1997–98. Canada now ranks among the top five in the Organisation for Economic Co-operation and Development (OECD) and is first in the Group of Seven (G-7) in terms of publicly performed research (at universities, research hospitals and government laboratories) as a proportion of gross domestic product (GDP).

Table 4.5
Increased Funding for University-Based Research Provided in Previous Budgets

To sustain the momentum generated through previous investments, the Government will provide an additional $280 million over the next two years to further strengthen Canada’s research advantage.

The Federal Granting Councils

The three federal granting councils—the Canadian Institutes of Health Research (CIHR), the Natural Sciences and Engineering Research Council of Canada (NSERC) and the Social Sciences and Humanities Research Council of Canada (SSHRC)—fund basic research across all disciplines to promote research excellence and ensure that Canada can compete successfully with the best the world has to offer. The councils also have an important role in promoting the commercialization of the research they sponsor.

The Government has substantially increased its support for the granting councils in every budget since 1998. Annual funding for the councils now stands at approximately $615 million for the CIHR, $615 million for NSERC and $180 million for SSHRC. This brings their combined annual budgets to over $1.4 billion in 2003–04, 90 per cent higher than funding provided in 1997–98.

To sustain the strong research base built over the past five years, Budget 2004 will increase the annual budgets of the granting councils by an additional $90 million per annum, beginning in 2004–05. This means an increase of $39 million per year for the CIHR, $39 million per year for NSERC and $12 million per year for SSHRC. This will support additional opportunities for new and talented researchers, and help promote the translation of knowledge into commercial and social benefits for Canadians.

The Government and the councils are committed to ensuring that federal funding supports true research excellence. To this end, the granting councils will develop a more comprehensive system to track, evaluate and report on the outputs of the research they fund. This will improve accountability for federal support for university research and contribute to the high standards of excellence researchers strive for.

Indirect Costs of Research

The rise in direct federal support for research has led to an increase in the indirect costs associated with world-class research facilities (for example, maintenance of facilities, administration and intellectual property management). Recognizing this, the Government provided a payment of $200 million in 2001–02 to help universities and research hospitals meet these costs. Budget 2003 established a permanent program, providing $225 million per year to enable institutions to address these pressures on a stable and predictable basis.

This budget will increase the annual amount provided for indirect costs by an additional $20 million, to $245 million per year beginning in 2004–05. This funding will help universities and research hospitals further strengthen their capacity for research. It is also expected that institutions will use the additional funding to enhance the commercialization of research discoveries.

Genome Canada

Genomics is one of the breakthrough disciplines that are poised to transform the landscape of the 21st century. Genome researchers study the genetic codes in people, animals, plants and other living things, and apply this knowledge to improve our approach to health, nutrition and sustainable development. Canadians stand to benefit directly from these improvements, and from the economic returns of bringing these discoveries to the market. The benefits of genomics research were demonstrated last year, when a Canadian research team based in Vancouver was able to map the genetic code of the severe acute respiratory syndrome (SARS) virus, leading the way to quicker diagnosis and more effective treatment.

The Government has invested $375 million to date in Genome Canada to strengthen genomics research in Canada and position Canadian researchers for global leadership. Through its regional genome centres in Atlantic Canada, Quebec, Ontario, the Prairies and British Columbia, Genome Canada has launched three research competitions to date, and has also established five major science and technology platforms. Genome Canada’s investments are matched by its partners from the public, non-profit and private sector, levering further support beyond the Government’s original investment.

To build on these efforts, this budget provides Genome Canada with an additional investment of $60 million in 2004–05.

Genome Canada’s original five-year mandate will conclude in 2005. Over the next year the Government will review the foundations for world-leading genomics research enabled by Genome Canada’s investments, and develop a long-term strategy for excellence in this important field.

Commercialization of Research

Commercialization is important to realizing the benefits of our investment in research because it opens new markets, helps create new jobs and improves the well-being of Canadians through better products and services. Moreover, by stimulating wealth creation and economic growth, commercialization helps provide additional resources that can be used to finance other important priorities. However, there is evidence that Canada is not doing as well as other nations in bringing new research discoveries to the market, preventing us from capitalizing fully on our research investment. Improving our commercialization performance must therefore become a priority.

The commercialization challenge is a complex one, as the process requires contributions from individual researchers, institutions, entrepreneurs and capital providers, among others. While the private sector must be the driver in bringing research results to the market, the Government can also make important contributions by improving the commercialization environment and bringing together the business and research communities to identify and remove barriers to commercialization. The Prime Minister has tasked the Minister of Industry and Minister responsible for the Economic Development Agency of Canada for the Regions of Quebec, the Parliamentary Secretary to the Prime Minister with special emphasis on Science and Small Business, and the new National Science Advisor with studying how the commercialization environment could be improved, and how in the long term Canada can be at the leading edge of commercializing its intellectual property assets.

Commercializing Federally Sponsored Research at Universities

Government-sponsored research, primarily through the granting councils, now accounts for one-quarter of all research performed in Canada’s higher education sector. More can be done to encourage the commercialization of this research.

The granting councils currently provide direct support for commercialization through a number of initiatives, including the tri-council Intellectual Property Management Program, and funding for pre-commercial development. Combined council spending on these programs currently amounts to about $10 million per annum. To help accelerate the commercialization of university-based research, the granting councils are expected to triple their annual investments in programs directly supporting commercialization over the next three years.

To further strengthen the commercialization of university research, this budget sets aside $50 million over the next five years for a pilot competitive fund to be managed by Industry Canada. The granting councils, as well as consortia of universities and research hospitals, will be eligible to submit proposals designed to improve the capacity for commercialization in Canada’s higher education sector, with the best initiatives receiving funding. The Government recognizes that the success of these initiatives will depend on their responsiveness to the needs of the private sector. To ensure a role for private sector perspectives and expertise, an advisory committee will be established by Industry Canada to provide guidance in designing and implementing this competitive process, including setting objectives and the criteria for evaluating proposals.

Commercializing Research Performed in Federal Labs

In addition to being a funder of research, the Government is also a major performer of research. In 2002–03 research performed in federal government laboratories (including the National Research Council of Canada) totalled over $2.2 billion. This research supports a broad spectrum of responsibilities, including regulation, public health, environmental stewardship, and social and economic development. More can be done to take advantage of federally performed research with commercial potential.

As a first step, the Government will initiate a pilot program to encourage the commercialization of research conducted in non-regulatory federal laboratories, similar to the approach being taken for university-based research. Through this initiative, $25 million will be made available over the next five years, on a competitive basis, to support proposals by federal science-based departments and agencies aimed at improving their research commercialization activities. An advisory committee will be established by Industry Canada, in coordination with science-based departments and agencies, to provide guidance in designing and implementing this competitive process, including setting objectives and the criteria for evaluating proposals.

Commercialization and the National Research Council of Canada

The National Research Council of Canada (NRC) is a significant funder and performer of research across Canada. Since Budget 2000 the Government has provided $360 million to the NRC to support 11 new regional innovation strategies across Canada. In partnership with universities, provinces and the private sector, these strategies are expected to generate leading-edge technologies, create jobs and fuel economic growth. This budget provides an additional $5 million per year to the Industrial Research Assistance Program to strengthen its support for the regional innovation and commercialization strategies.

Canada must enhance the flow of discoveries, inventions and new concepts from laboratories into commercial products and processes for the marketplace to accelerate the growth of innovative small and medium-sized companies. Over the coming year the Government will examine opportunities to strengthen its contribution to addressing Canada’s technology, innovation and commercialization challenges. In this context, the NRC has a strong track record of supporting technology-intensive clusters in areas such as biopharmaceuticals in Montréal and plant biotechnology in Saskatoon. The NRC’s research laboratories and regional innovation strategies have significant potential to accelerate the growth of small- and medium-sized firms by providing technology transfer support, and to improve the commercialization activities of small firms.

Venture Capital Financing

Investors in the early stages of company development—business angels and venture capital (VC) firms—play a critical role in the transformation of ideas into R&D and ultimately into products, before revenues are available to support a bank line of credit and the anticipated and sought-after issuance of debt and equity securities. Access to financing early in the life of new companies is therefore a crucial element of a successful commercialization framework.

While entrepreneurs can typically start a company using their own money and borrowing from family and friends, they need additional sources of financing before their ideas reach a commercial stage. Firms that exploit leading-edge research and new technologies are ill suited to traditional forms of financing such as bank loans because their assets consist mainly of intangibles such as ideas and employee expertise, which cannot be used as collateral. Since these companies are likely at early stages of their development and not near commercialization of their products, it may take some time before they deliver revenues or profits needed to service interest payments. Hence they need private equity investors—those willing to take an ownership stake in the company in the expectation that it will grow and prosper.

Entrepreneurial companies developing an idea usually require more than just money. They also need the business know-how that experienced venture capitalists can provide. This hands-on management advice is why VC is sometimes referred to as "smart money." To facilitate this process, VC firms tend to invest locally, which means that to develop new companies in Canada, it is critical to have a healthy and active VC industry across the country.

The Government of Canada has played an important role in the development of the Canadian VC industry. In the 1980s it created the labour-sponsored venture capital corporation program in cooperation with several of the provinces. This program provides individuals with federal and provincial tax credits for investing in eligible, union-sponsored funds mandated to make investments in smaller businesses. The Government has also been active in venture capital through the direct involvement of the Business Development Bank of Canada and, more recently, Farm Credit Canada.

Recent budgets have introduced a number of significant tax measures to facilitate VC investment, including reduced taxation of capital gains, rollovers for investments in small business shares, and tax changes that facilitate the use of partnerships by pension funds and foreign investors. In addition, reductions in the general corporate income tax rate and the phasing out of the federal capital tax have improved the competitiveness of our tax system and contributed to a better climate for VC investing. A summary of recent federal measures in support of increased venture capital investment in Canada is provided in Table 4.6.

Table 4.6
Summary of Recent Government Initiatives to Stimulate Entrepreneurship and VC Investments

In this budget the Government is taking additional steps to enhance access to venture capital for promising Canadian firms, through new venture capital investments totalling $270 million.

Investing in Innovative Start-Up and Early-Stage Companies

Budget 2004 sets aside $250 million for investment in venture capital by the Business Development Bank of Canada (BDC). BDC has been asked to submit a detailed plan for the implementation of specific seed-stage and venture capital initiatives. Funding will be provided upon approval of this plan by the Government.

The Government’s objectives for the plan are to increase the amount of early-stage and late-stage venture capital available for innovative Canadian companies:

• $100 million for pre-seed and seed investment to nurture the development of embryonic technologies, bringing them to the next level of venture capital financing. BDC will make direct investments, and create and participate in investment funds, in areas where Canada has a strong research base and successful firms, such as:

• Life sciences.
• Biotechnology.
• Medical technologies.
• Environmental technologies.
• Information and communications technologies.

BDC Venture Capital has a nationwide network of professionals who identify the very best prospects and invest talent and money to commercialize them. They will remain alert to developments in promising new areas such as nanotechnology.

• $100 million to support the creation of specialized venture capital funds, including in the priority areas identified above, that will lever additional private equity investment in leading-edge technologies. This investment will support the development of a broader base of private VC fund managers.

• $50 million to invest directly in innovative start-up and early-stage companies to further support the commercialization of enabling technologies.

Based on past experience, the Government’s additional investments through BDC should lead to over $1 billion in new venture capital investment in Canadian companies.

To ensure that it has the benefit of the best advice possible, encompassing both science and financial issues, the Government expects that BDC Venture Capital will establish a number of external advisory committees comprising Canada’s leading scientists, engineers and financiers. These experts will bring to bear their unique knowledge and skills in analyzing complex technological and business proposals, and will serve as sounding boards for the BDC’s venture capital decision makers.

Investing in Agriculture and Agri-Food Innovation

In 2003 the Canadian cattle industry faced unprecedented challenges, following the discovery in May of a case of bovine spongiform encephalopathy (BSE) and the resulting closure of all of our major beef and cattle export markets. While some markets have since partially reopened, the detection in December of a second case of BSE in North America has added to the uncertainty currently facing the industry. Access to our export markets is a priority for Canada, and the Government will continue to press for the reopening of borders.

To date a number of research projects on BSE and other transmissible spongiform encephalopathies (TSEs) have been undertaken at universities and health facilities across Canada. For example, through research conducted at the Centre for Research in Neurodegenerative Diseases at the University of Toronto, a possible basis for diagnosing, treating and vaccinating against TSEs has been discovered. The Networks of Centres of Excellence (NCE) program supports partnerships among universities, industry, government and non-governmental organizations. Through this budget, an additional $5 million a year will be provided to support the creation of a new NCE network for research on BSE and other TSEs, to further support Canadians in their research leadership roles and position Canada as a world leader in TSE/BSE science.

In 2002 Farm Credit Canada (FCC) launched a new business line, FCC Ventures, to provide venture capital financing for the agriculture and agri-food sector. Last year the Government of Canada contributed an initial investment of $20 million over two years. The Government will continue to make investments to ensure that FCC Ventures is able to provide the ongoing financing needed to develop value-added businesses and promote diversification in this sector. Specifically, this budget provides FCC Ventures with an additional $20 million for venture capital financing.

Investing in Offshore Development

In the February 2004 Speech from the Throne, the Government committed to pursuing a new Oceans Action Plan to maximize the potential of our coastal and offshore areas. As a first step, this budget provides $70 million over 10 years for seabed mapping of Canada’s Arctic and Atlantic continental shelves. This investment will enable Canada, as a signatory to the United Nations Convention on the Law of the Sea, to achieve greater certainty with regards to its sovereignty over the Arctic and Atlantic continental shelves, and any mineral and hydrocarbon resources they hold, beyond the customary 200 nautical mile exclusive economic zone.

Small Business and Entrepreneurship

Entrepreneurs and small businesses are a key source of economic growth and job creation in Canada. Creating new businesses, growing them, and developing ideas into income-earning ventures are challenging endeavours. The Government is committed to helping entrepreneurs and small businesses succeed through supportive tax, regulatory and contracting policies.

Government Electronic Tendering System

The Government recognizes that electronic access to government procurement opportunities needs to be open and less onerous for business. This is in accordance with the Government’s mandate to provide fair and equal access for all businesses.

As a result of comments received by small business and organizations such as the Canadian Federation of Independent Business and the Canadian Construction Association, changes to the current Government Electronic Tendering Service are being implemented, and should be in place by June 2004. The new system will provide a number of significant improvements in the nature and level of service, including a 30-per-cent reduction in subscription fees. Furthermore, the Government will eliminate the monthly subscription fee for electronic access by March 2005.

Reducing the Paperwork Burden for Small Businesses

The cost of complying with government regulations can be burdensome, especially for small businesses. In fact, a recent survey of Canadian Federation of Independent Business members found that 61 per cent cite government regulations and paper burden as having a significant impact on their operations. Entrepreneurs’ time is best spent growing their businesses and creating new jobs.

Budget 2004 commits the Government to working with small business groups to make measurable reductions in the paperwork burden. A working group composed of small business representatives and officials will be created and mandated to find practical and actionable ideas for early implementation. They will also be asked to develop a measure of paper burden so that progress can be tracked regularly in the future. Results will be referred to the appropriate parliamentary committees for review to ensure that continuing progress is made.

Reviewing the Efficiency of Small Business Programming

Small business programs, such as those offered by the Community Futures Development Corporations (CFDCs) and their equivalents across the country, have a significant influence on local economic development. This is especially the case in regions without a regional development agency such as eastern Ontario. Over the next year the Government will review the role played by the CFDCs in these areas and examine the possibilities for broadening and deepening their mandate.

Improving the Tax Treatment for Small Businesses

Accelerating the Increase in the Small Business Deduction Limit

To help small businesses retain more of their income for reinvestment and growth, a lower federal corporate income tax rate of 12 per cent applies on qualifying small business income. The 2003 budget increased the amount of income eligible for the 12-per-cent small business tax rate from $200,000 to $300,000 over four years. This budget proposes to accelerate this initiative, providing small businesses with access to the full $300,000 limit by 2005; this will cost $20 million in 2005–06.

Improving Access to SR&ED Tax Assistance

An important source of capital for small firms conducting scientific research and experimental development (SR&ED) is the enhanced 35-per-cent refundable SR&ED tax credit. Under current tax rules, two or more small businesses may not have full access to this credit where they are associated through common investors, such as venture capital investors, even if these investors are not acting together. This budget proposes to remove this impediment by ensuring that small businesses that conduct SR&ED and raise funding from common investors not acting as a group have full access to the enhanced SR&ED tax credit.

Loss Carry-Forward

It can sometimes take many years before new businesses begin to earn profits. A fair and efficient tax system must recognize appropriately both profits and losses in determining tax liability. The current rules allow businesses to carry non-capital losses forward seven years and backward three years. Small businesses have submitted that seven years is not a long enough carry-forward period, particularly for new businesses undertaking risky ventures. For example, a small biotechnology firm may incur losses over a number of years before successfully commercializing its technology and earning profits. To provide additional support, particularly to the small business sector, this budget proposes extending the non-capital loss carry-forward period of all taxpayers to 10 years.

Small Business Tax Measures—Charting Next Steps

The Canadian Federation of Independent Business, other small business representatives and the cooperative sector have proposed a range of other measures to support the emergence, capitalization and growth of enterprises. The suggestions from entrepreneurs and small businesses have formed an important part of the budget consultation process over the years. In order to assist the Government to identify the best options for future consideration among a range of competing proposals, the Government will seek the advice of the House of Commons Standing Committee on Finance. The committee will have the opportunity to assess the merits of proposed measures, and to advise on the relative priority that should be accorded to them, taking into account limited fiscal resources.

Strengthening the Canadian Tax Advantage

Given the mobility of investment capital globally, a competitive tax system is critical to fostering business investment in Canada. Investment supports economic growth and job creation. With more and better equipment embodying the latest technology, workers are more productive. Increased investment and higher labour productivity, in turn, lead to increased employment, higher wages and a higher standard of living. The importance of improving the competitiveness of the tax system has been underscored in recent years by reductions in corporate tax rates in many of our major trading partners.

Establishing a Canadian tax advantage for investment, jobs and growth was one element of the Five-Year Tax Reduction Plan. As of 2004 the general rate of corporate income tax was lowered to 21 per cent from its 2000 level of 28 per cent. The 2003 budget reduced the corporate income tax rate on resource income from 28 to 21 per cent over five years while making improvements to the tax structure. In addition, it phased out the federal capital tax over five years. As of 2004 the tax is eliminated for firms with less than $50 million of taxable capital.

Capital Cost Allowances for Information and Communications Technology Assets

Competitive corporate statutory tax rates are essential for creating an advantage for investment. However, other aspects of the tax structure affect competitiveness, economic efficiency and the contribution of the tax system to growth in productivity and standard of living. One area where the tax system has an important impact on new investment is the treatment of capital assets.

Businesses use capital assets over a number of years. The capital cost allowance (CCA) system determines how much of the cost of a capital asset a business may deduct in a particular year. CCA deductions are generally determined by assigning a rate to a class of assets, and then applying the rate to the undepreciated balance in the class to determine the allowable deduction for the year.

As a general principle, CCA rates should reflect the useful life of assets and thus provide adequate recognition of capital costs over time. Indeed, alignment of CCA rates with the useful life of assets can enhance productivity and standards of living through an increase in total investment and a more efficient allocation of investment across classes of assets.

In this regard, the Government recognizes the importance of information and communications technology (ICT) equipment. Improved productivity in several countries since the mid-1990s, including the U.S., has been associated with higher ICT investment. Similarly, in Canada, productivity growth is faster and has increased more rapidly since 1997 in ICT-intensive sectors, most notably in services.

The last increase in CCA rates for ICT assets occurred in 1976, when the rate applying to computer equipment was increased from 20 to 30 per cent. A review of the CCA rates for computers and certain other ICT assets indicates that higher CCA rates would better reflect the useful life of these assets. This budget therefore proposes the following changes:

• An increase in the CCA rate applying to computer equipment from 30 to 45 per cent.

• An increase in the CCA rate applying to broadband, Internet and other data network infrastructure equipment from 20 to 30 per cent.

These changes will allow firms to write off these ICT investments more quickly, thereby ensuring that the tax system provides an appropriate environment for investment.

It is estimated that the fiscal cost of these CCA changes will be $110 million in 2004–05 and $255 million in 2005–06.

The increases in the CCA rates proposed in this budget represent a significant improvement to the tax system. As stated in Budget 2003, the process of reviewing CCA rates is ongoing. As fiscal conditions permit, future budgets will identify further opportunities to better align CCA rates to the useful life of assets to support productivity growth.

Ensuring a Fair and Effective Tax System

Canada’s income tax system is based on self-assessment. It is important that Canadians have confidence that it operates in a fair and effective manner and that taxpayers in similar positions pay a similar amount of tax.

This budget proposes a number of targeted measures to enhance the fairness and effectiveness of the tax system, including:

• Eliminating the deductibility of fines and penalties.

• Addressing certain issues raised by income trusts.

• Tightening certain provisions of the tax system.

Eliminating the Deductibility of Fines and Penalties

The Income Tax Act generally permits a taxpayer to deduct, in computing income from a business or property, expenses incurred for the purpose of earning that income. Concerns have been raised about whether fines and penalties are deductible, based on current legislation, administrative practice and jurisprudence. The budget proposes to introduce measures to ensure that fines and penalties are not deductible for Canadian income tax purposes. This measure will apply to fines and penalties imposed by a government, government agency, regulator, court or other tribunal, or any other person having statutory authority to levy the fine or penalty in question. This will ensure, for example, that a business cannot deduct a fine levied under an environmental protection law.

Addressing Certain Issues Raised by Income Trusts

Income trusts have become an increasingly important investment vehicle in Canada. The income trust structure has been used for more than 10 years to manage real estate holdings (real estate investment trusts, or REITs) and to fund the ongoing operation of resource properties (resource royalty trusts). More recently businesses in other sectors of the economy have begun to use the income trust structure; these are known as business income trusts.

The income trust model has provided additional choice and flexibility for businesses to access capital markets as they determine the most advantageous structure for their particular circumstances. Businesses that put a premium on growth tend to use the corporate structure as this form improves their capacity to finance growth through retained earnings. However, when both corporate and shareholder taxation are considered, the corporate structure may result in higher taxes on distributed earnings, when compared to other business structures. Accordingly, certain mature and stable businesses that are not seeking additional capital have been attracted by the business income trust structure because it improves their ability to distribute earnings.

Assessing the impact of income trusts on government revenues requires that a broad range of factors be taken into account, including the timing of taxation and the extent to which income trust units are held by tax-exempt entities and non-residents. Net earnings retained within the trust are taxed at the top federal-provincial personal income tax rate. However, the trust can distribute (flow) its earnings to its unitholders on a before-tax basis. Such distributions are considered to be income in the hands of the unitholders. The tax treatment of that income depends on the tax status of the unitholder.

Currently it is estimated that foregone tax revenue from business income trusts is modest because reduced tax revenue at the corporate level is largely offset by increased tax revenue at the unitholder level. This occurs because, at the present time, most unitholders in income trusts are taxable.

Most of the larger pension funds have not been active investors in the business income trust market. This has been attributed to concerns about potential liability. However, pension funds may consider becoming more active in this market once the liability issue is clarified in provincial legislation. Unlimited participation of pension funds in the business income trust market could have a significant impact on the market and government revenues because of their tax-exempt status and their influence in Canadian capital markets.

In response to the issues raised above, the budget proposes to limit the size of investment and degree of participation of pension funds in business income trusts. Pension funds will be limited to holding no more than 1 per cent of fund assets in business income trusts and no more than 5 per cent of the units of any business income trust. Pension funds’ investments in resource royalty trusts and REITs would not be affected by these limits. Deferred income plans that are not registered pension plans, such as RRSPs and registered retirement income funds, similarly would not be affected.

The budget also proposes that interests held by non-residents in mutual funds, including royalty trusts, REITs and other funds whose value is attributable primarily to Canadian real and resource property, be subject to capital gains tax.

The Department of Finance will continue to evaluate the development of the income trust market as part of its ongoing monitoring and assessment of both the Canadian financial market and the Canadian tax system.

Tightening Certain Provisions of the Tax System

This budget proposes a number of tightening measures designed to improve the fairness of the tax system. Specifically the budget proposes to:

• Clarify the application of the general anti-avoidance rule in the Income Tax Act to encompass the Income Tax Regulations and Canada’s income tax treaties.

• Expand the scope of the affiliated persons rules to apply to trusts.

• Restrict the ability of corporations (other than cooperative corporations and credit unions) to make deductible patronage dividends to non-arm’s-length persons.

• Limit to 10 years the period in which the Canada Revenue Agency (CRA) may make taxpayer-requested adjustments.

• Limit the ability to carry forward charitable donations after a change of control.

• Enable the CRA to serve a financial institution with a notice or order in respect of one of its customers at either the customer’s branch or at a designated office of the institution.

Further information on these and other tax measures is provided in Annex 9, "Tax Measures: Supplementary Information and Notices of Ways and Means Motions."

Remittances by Employers

Remittance by Employers of Canada Pension Plan Contributions

To reduce the burden of compliance on employers and ensure harmonization between the Canada Pension Plan (CPP) and the Quebec Pension Plan, this budget proposes to legislate amendments to the CPP that were announced on February 27, 2004.

Starting in 2004 the amendments would deem CPP contributions made or remitted by one employer in a year for a given employee to have been made or remitted by a second employer in cases where the employee becomes employed by the second employer as a result of a merger of the two employers or acquisition of all or a distinct part of the business activities of the first employer by the second employer.

The amendments would also clarify the rules governing employer contributions in respect of current and previous years by making explicit the long-standing practice that the total amount an employer is required to contribute in a year for a given employee is the amount that the employer is required to remit at source for the employee.

These changes to the CPP will have no impact on budgetary revenues or expenditures or on CPP contribution rates, and the CPP will continue to be financially sound over at least the next 50 years. As required by the CPP legislation, the Chief Actuary of the CPP will prepare an actuarial assessment on proposed changes that will be tabled in Parliament following introduction of the legislation. The changes also require the consent of two-thirds of the provinces accounting for two-thirds of Canada’s population before coming into force.

Remittance by Employers of Employment Insurance Premiums

To further reduce the burden of compliance on employers undergoing business restructuring, this budget also proposes to legislate amendments to the Employment Insurance Act to deem employment insurance premiums paid or remitted by one employer in a year for a given employee to have been paid or remitted by a second employer in cases where the employee becomes employed by the second employer as a result of a merger of the two employers or acquisition of all or a distinct part of the business activities of the first employer by the second employer. This change would apply starting in 2004.

Enhancing Regulatory Efficiency

Sound and flexible market framework policies are another important source of competitive advantage. A business environment that is stable, efficient and growth-friendly provides firms with the tools and incentives to compete and succeed. A sound regulatory system instills trust and confidence, protects the public interest, supports innovation and market performance, and encourages competition to better serve consumers and small businesses. The Government must ensure that the regulatory system is improving on an ongoing basis and that it continues to meet these policy goals.

Strengthening Securities Regulation

Securities regulation is crucial to well-functioning and efficient capital markets. There is a strong consensus among capital market participants that our current securities regulatory structure is complex and inefficient. In December 2003 the Wise Persons’ Committee, established to review Canada’s securities regulatory structure, submitted its final report.

The Wise Persons’ Committee found that Canada’s system of securities regulation is outdated and needs to change. They concluded that a single securities regulator would best meet the needs of Canada’s issuers and investors and would improve securities regulation in four key ways: the enforcement effort would be strengthened, policy development would be streamlined, compliance and other costs imposed on the markets would be reduced, and Canada’s international regulatory voice would be enhanced. The Wise Persons’ Committee also concluded that, while a passport system would provide some improvements, it would not meaningfully address these four objectives.

The Government of Canada agrees with the conclusions that the best possible securities regulatory structure for Canada is a single securities regulator, structured to be responsive to regional capital market needs and the special requirements of small and medium-sized enterprises, with an inclusive governing structure. The Government of Canada will work with provincial and territorial governments to move this forward. It is now incumbent on governments to act quickly or run the risk that our capital markets will be left behind.

Improving Financial Sector Regulation

Given the importance of the financial sector to our economy, it is the responsibility of governments to find ways to improve the regulatory framework and to deliver the benefits of regulation as efficiently and effectively as possible.

Currently two separate entities have a responsibility for prudential oversight of federally regulated deposit-taking institutions. The Office of the Superintendent of Financial Institutions (OSFI) is the primary prudential regulator of federal financial institutions. OSFI’s objectives include safeguarding the integrity of the financial system and protecting depositors from undue loss. The Canada Deposit Insurance Corporation (CDIC) protects Canadians by insuring eligible deposits up to $60,000 in the event of the failure of a CDIC member institution. CDIC is also involved in the prudential oversight of federal deposit-taking institutions through activities such as the assessment of new entrants and the application of its standards of sound business and financial practices.

The Government is committed to maintaining the present level of deposit insurance protection. However, there may be opportunities to improve the efficiency and effectiveness of the delivery of federal financial services regulation. To that end, the Government will seek views on how best to address any overlap in prudential, administrative and corporate services functions between OSFI and CDIC. The Government is undertaking this initiative with a view to introducing any changes before the end of this year.

Strengthening Corporate Governance

More broadly, the actions of corporate management, the role and responsibility of boards of directors and auditors, and the integrity and reliability of financial reporting are fundamental to investor confidence in capital markets. Canada must adopt the highest standards of practice to ensure continued investor confidence in Canadian public companies.

Over the last year governments, regulators and industry have undertaken initiatives to strengthen the framework for corporate governance and financial reporting for public companies. Securities regulators have developed new financial integrity rules and corporate governance guidelines for public companies, and the accounting profession has adopted new auditor independence rules. The Canadian Public Accountability Board, a new independent public oversight body, has recently proposed rules dealing with professional standards, inspections, investigations and sanctions for accountants and accounting firms that audit reporting issuers. The Government will work closely with the Canadian Public Accountability Board, as well as with the industry, regulators and provincial governments, as appropriate, to ensure that the new independent public oversight body is able to achieve its mandate, within a sound governance structure and a strong legal framework.

The Government of Canada has increased its enforcement efforts. It has established Integrated Market Enforcement Teams in Toronto and Vancouver and will be creating new teams in other financial centres this coming year. In addition, it has reintroduced proposed amendments to the Criminal Code that would, among other measures, create new offences, permit targeted evidence gathering and increase penalties for white collar crime.

In addition, the Government is currently preparing proposals for amendments to the Canada Business Corporations Act, which it expects to release in the near future, that will enhance the transparency and accountability of corporations towards investors and shareholders. These proposals will touch on the role and composition of boards, auditor oversight and independence, financial reporting and enforcement.

The Canada Corporations Act, Part II (CCA) now governs voluntary and non-profit organizations. The Government is committed to creating a new Not-for-Profit Corporations Act that will deliver on the Government’s commitment under the Voluntary Sector Initiative, and help build a solid foundation upon which Canada’s social economy can continue to develop.

Strengthening Productivity to Enhance the Well-Being of Canadians

A key objective of government policy is to improve the well-being of all Canadians so that they can achieve their economic and social goals in a secure and sustainable environment. One way to improve well-being is to raise living standards. Increased living standards contribute directly to Canadians’ well-being and also allow increased resources to be devoted to important social objectives.

There are two ways to increase living standards: greater employment and higher productivity. Greater employment increases living standards because more of the population is producing and earning income. Higher productivity increases living standards because each employed person produces and earns more.

Productivity can be improved directly by investing in more education and better skills, and in more and better production equipment. An equally powerful approach is to invest in innovation. Innovation—new ideas—can improve how existing goods and services are produced and allow new goods and services to be introduced. The key ingredients for innovation are research and development, which also require highly skilled individuals and the latest equipment.

Canada recorded the fastest rate of growth in living standards of any G-7 country over 1997–2003, more than doubling the rate from 1980–96. This achievement was gained through both strong employment and productivity growth. Strong employment growth since 1997 has brought the unemployment rate down and encouraged a growing number of Canadians to enter the labour force. As a result, the share of working-age Canadians with jobs rose to a record high of 63 per cent in 2003. For the first time in more than 20 years, Canada’s employment ratio has now exceeded the corresponding ratio in the United States, for two years in a row.

While most of the activities that lead to productivity gains take place in the private market, the Government, for its part, can contribute to productivity growth by maintaining and strengthening a policy framework that provides the right environment for more investment in the drivers of productivity growth. The Government has been putting this kind of framework in place over the past decade.

Sound macroeconomic policy is a key part of this framework. Low and stable inflation, prudent fiscal planning, balanced budgets and falling government debt help to keep interest rates low, reduce uncertainty and boost confidence. This in turn encourages investment in human and physical capital and innovation, and therefore encourages productivity growth.

This sound macroeconomic policy is complemented with an effective microeconomic policy framework. Personal income tax changes have increased incentives for Canadians to learn, work, save and invest. Entrepreneurship and small business have benefited from a number of tax measures and programs. Reductions in corporate taxes have increased our international competitiveness by creating a Canadian tax advantage for investment and levelled the playing field for firms in all sectors. Government investments in education and research directly have supported Canada’s productivity performance. Freer trade has provided not only better access to large foreign markets, but also the necessary competitive environment and incentives for firms to adopt the latest advances in technology.

The recent improvement in standard of living growth in Canada shows the value of this policy framework. Because of the increasing importance of productivity growth, this policy framework needs to be maintained, and where necessary enhanced, to ensure that we can meet the challenge of an aging population.

Table 4.7
The Importance of Knowledge and Commercialization

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