Canada: The Stikeman Elliott Federal Budget Commentary 2023

The GAAR has been in existence with some modifications for thirty five years.The government has had reasonable success with it.Nonetheless the Department of Finance recently conducted consultations on the GAAR and Budget 2023 proposes certain amendments.

First, a preamble will be added to set out the principles underlying the rule.Interestingly, the preamble provides that the rule can apply regardless of whether a tax strategy is foreseen.This change is intended to preclude the argument that the GAAR should not apply if the government knew or reasonably ought to have known that taxpayers were commonly employing a particular avoidance strategy.

Second, the purpose test threshold for an avoidance transaction is lowered so that an avoidance transaction requires only that one of the main purposes be to obtain a tax benefit, consistent with other anti-avoidance rules in theIncome Tax Act(Canada)(the Tax Act) as well as the principal purpose test contained in the OECD's Multi-Lateral Instrument (MLI).

Third, a specific rule dealing with economic substance is added that provides that a significant lack of economic substance will "tend" to indicate that a transaction is a misuse of a particular provision of the Tax Act or an abuse having regard to the Tax Act read as a whole.Factors that tend to establish that a transaction is significantly lacking in economic substance include: (i) the opportunity for profit or gain and risk of loss of the taxpayer is unchanged, (ii) at the time the transaction was entered into, it was reasonable to conclude that the expected value of the tax benefit exceeded the expected non-tax economic return and (iii) it is reasonable to conclude that the entire or almost entire purpose for undertaking the transaction was to obtain the tax benefit.

Finally, the proposals will add the long-awaited GAAR penalty equal to 25% of the tax benefit.The penalty can be avoided if the transaction is disclosed either voluntarily or pursuant to the proposed mandatory disclosure rules.

The Supreme Court has said that the requirements for the application of the GAAR are: (i) a tax benefit resulting from a transaction, (ii) an avoidance transaction (namely one not undertaken primarily for purposes other than to obtain the tax benefit) and (iii) abusive tax avoidance.As noted, the proposals lower the threshold for avoidance transaction to a "one of the purposes" test and allow the lack of economic substance to indicate misuse or abuse.If the goal as stated in the preamble is to have the rule strike a balance between a taxpayer's need for certainty and the government's responsibility to protect the tax base and the fairness of tax system, it is difficult to see how vague language like "tend to establish" and "reasonable to conclude" furthers that goal.The reality is that the GAAR requires a court to determine if particular tax planning is abusive.It is not evident that adding imprecise language and nebulous concepts to the GAAR will better assist a court in making this determination.Only another thirty-five years will tell.

As announced in the 2022 Fall Economic Statement, Budget 2023 introduces a 2% tax on the net value of all types of equity repurchases by the following entities whose equity is listed on a designated stock exchange: Canadian-resident corporations (other than mutual fund corporations), real estate investment trusts, specified investment flow-through (SIFT) trusts, SIFT partnerships (each as defined in the Tax Act), and entities that would be SIFT trusts and SIFT partnerships if their assets were located in Canada.

The tax would apply in respect of repurchases and issuances of equity that occur on or after January 1, 2024.

This measure, which is intended to ensure large corporations pay their fair share of tax, is estimated to increase federal revenues by $2.5 billion over five years.

Calculation of the Tax

The tax is equal to 2% of the net value of an entity's repurchase of equity, which is equal to the fair market value of the equity repurchased by the entity in the taxation year less the fair market value of the equity issued from treasury in the taxation year. The issuance and cancellation of debt-like preferred shares and units, and the issuance and cancellation of shares or units in certain corporate reorganizations and acquisitions, should not be considered an issuance or repurchase of equity.

Since the tax is intended to apply to large corporations, the tax would not apply to an entity in a taxation year if it repurchased less than $1 million (determined on a gross basis) of equity during that taxation year (prorated for short taxation years).

Similar Transactions

The acquisition by certain affiliates of an entity would be deemed to have been a repurchase of equity by the entity itself, subject to exceptions to facilitate certain equity-based compensation arrangements and acquisitions made by registered securities dealers in the ordinary course of business. If it is reasonable to consider that one of the main purposes of a transaction or series of transactions is to cause a person or partnership to acquire equity of an entity to which these rules apply to avoid the 2% tax, the person or partnership shall be deemed to be a specified affiliate of such entity from the commencement of the transaction or series until immediately after the transaction or series ends.

Bill C-208 was a private member's bill introduced in the previous Parliament designed to eliminate what were viewed as inappropriate tax results on the sale of a private corporation from an individual to his or her children.Generally, on the sale of shares of a private corporation to an arm's length party, the individual seller realizes a capital gain equal to the difference between the sale price and the cost of the shares.One-half of the gain is included in income and if certain conditions are met, a portion of the gain may be totally exempt from tax under the lifetime capital gains exemption.Under the rules in the Tax Act before Bill C-208 was enacted, these tax consequences did not apply on a sale of the shares of a private corporation by an individual to a corporation controlled by his or her child or other non-arm's length parties.In those circumstances, the transferor was deemed to have received a dividend equal to the amount by which the sale proceeds exceeded the "paid-up capital" of the shares transferred.While a dividend received from a Canadian corporation is taxed more favourably than ordinary income (such as salaries), the taxation of a dividend is less favourable than the taxation of a capital gain.As a result, prior to Bill C-208, there was a tax incentive to sell the shares of a private corporation to a neighbour rather than to children.

Bill C-208 made amendments to the anti-surplus stripping rule in section 84.1 of the Tax Act to address this apparent inequity, and while the Department of Finance agreed with the policy direction of the amendments, it was concerned that the amendments went too far.Budget 2023 proposes to further amend section 84.1 to address these concerns.

The amendments introduce additional conditions to be met to avoid the application of section 84.1.The shares sold must be shares that qualify for the lifetime capital gains exemption (as under the current rules) and the purchaser corporation must be controlled by one or more persons each of whom is an adult child of the transferor (which, for these purposes, would include grandchildren, step-children, nieces and nephews and grandnieces and grandnephews).The additional conditions will depend on whether the transfer is an immediate intergenerational business transfer or a gradual intergenerational business transfer.

In an immediate transfer, both legal and factual control is transferred immediately to the children and all shares (other than certain non-voting preferred shares) must be transferred to the children within 36 months (up to 50% of the shares may be retained up until that time).In addition, management of the business must be transferred to the children within 36 months or a reasonable time thereafter, the children must legally control the corporation during that 36-month period and at least one child must be actively engaged in the business on a regular, continuous and substantial basis throughout that period.

In a gradual transfer, legal (but not factual) control is transferred immediately to the children and all shares (other than certain non-voting preferred shares) must be transferred to the children within the 36 month period described above. Parents can retain freeze-like preferred shares or debt of the corporation for up to 10 years after the initial sale and such shares or debt having a value of 50% or less (in the case of a farm or fishing corporation) or 30% or less (in the case of a small business corporation) of the initial value after that time.Management of the business must be transferred to the children within 60 months or a reasonable time thereafter, the children must legally control the corporation during that 60-month period (or up to 10 years after the sale) and at least one child must be actively engaged in the business on a regular, continuous and substantial basis throughout that period.

There are still a number of questions with the proposed rules.Both the immediate and gradual transfers require the transferor, either alone or together with a spouse or common law partner, to control the subject corporation immediately before the sale.This seems to preclude joint owners of a corporation from taking advantage of the section 84.1 exception.For example, two siblings that each own 50% of the shares of a corporation would not be able to take advantage of the exception to transfer the shares to a corporation owned 50/50 by their respective children.

Notably, Budget 2023 does not address the Bill C-208 changes that were made to section 55 of the Tax Act.The proposed changes to section 84.1 are effective January 1, 2024.

Budget 2023 introduces new rules to facilitate the use of an employee ownership trust (an EOT) as a mechanism for business owners to transfer their businesses to their employees.The federal government initially expressed its interest in exploring EOTs in the 2021 Federal Budget.

Under the proposed rules, an EOT would be a personal trust and, like other trusts, the EOT would be taxable at the highest marginal rate applicable to individuals, but would be entitled to deduct distributions to its beneficiaries (such distributions would be taxable to the beneficiaries).The trust would be entitled to designate dividends that are distributed to beneficiaries so that they retain their character and are eligible for the dividend tax credit in the hands of the beneficiaries.

As described in more detail below, in order to implement EOTs in Canada, changes are being proposed to the rules in the Tax Act related to (i) the capital gains reserve, (ii) shareholder loans, and (iii) the 21-year deemed disposition rule for trusts.

Qualifying Conditions

In order to qualify as an EOT, several conditions must be met.In general terms:

• The trust must be a Canadian resident trust (excluding deemed resident trusts);
• The trust must be established exclusively for the benefit of employees of one or more "qualifying businesses" controlled by the trust and who do not hold a significant economic interest in the qualifying business;
• The interest of each beneficiary is determined based on hours worked, length of employment, and salary paid to the beneficiary by the qualifying business;
• The trust is prohibited from acting in the interest of one beneficiary to the prejudice of another beneficiary;
• The trust is prohibited from distributing shares of a qualifying business to any beneficiary of the trust;
• Trustees of the trust must be elected by the beneficiaries for a period not exceeding five years;
• Individuals and their related persons who held a significant economic interest in the business prior to the trust acquiring control are not entitled to make up more than 40% of (i) the trustees of the EOT, (ii) directors of the board of a corporation serving as trustee of the EOT, or (iii) directors of any qualifying business held by the EOT;
• The trust must hold a controlling interest in the shares of one or more qualifying businesses; and
• All or substantially all of the trust's assets must be shares of qualifying businesses that the trust controls and by which all of the beneficiaries of the trust are employed;

A "qualifying business" is generally a Canadian-controlled private corporation (i) all or substantially all of the fair market value of the assets of which are used in an active business carried on in Canada, (ii) of which not more than 40% of the directors consist of individuals who owned 50% or more of the corporation, and (iii) that deals at arm's length and is not affiliated with anyone who owned 50% or more of the corporation immediately before the time the trust acquired control of the corporation.

In order to transfer a business to an EOT, the taxpayer disposing of the shares to the trust must deal at arm's length with the trust and the corporation following the transfer.

Changes to Existing Rules to Permit EOTs

To facilitate the use of EOTs, the following changes have been proposed:

• Ten-year capital gains reserve: Budget 2023 proposes to extend the capital gains reserve for taxpayers who transfer qualifying businesses to an EOT from five years to ten years. This means that a capital gain on the transfer of shares to an EOT can be deferred until the year in which proceeds are received, up to a maximum of 10 years.A minimum of 10% of the gain would be required to be brought into income each year.
• Exception to the shareholder loan rules: Under the existing rules in the Tax Act, a taxpayer who receives a shareholder loan is generally required to include the loaned amount in income in the year the loan is received unless it is repaid within one year. Budget 2023 proposes to amend this rule so that the EOT can borrow funds from a qualifying business in order to finance the purchase of shares, and the amount of the loan would not be included in the EOT's income provided thatbona fidearrangements are in place at the time the loan is made for the repayment of the loan within 15 years of the transfer.
• Exception to the 21-year deemed disposition rule: Because an EOT is intended to allow for shares to be held indefinitely for the benefit of employees, Budget 2023 proposes to exempt EOTs from the rules in the Tax Act that would otherwise deem the trust to dispose of its assets every 21 years.

These amendments are proposed to come into force as of January 1, 2024.Certain details about EOTs still remain unclear, most notably what happens to the accrued value of the business when an employee ceases to be employed by the qualifying business or dies.

To better target the AMT to high-income individuals, Budget 2023 proposes various changes to its calculation and application. The proposed amendments will raise the AMT rate from 15% to 20.5% and limit the use of tax credits, deductions, exemptions and other tax preferences. At the same time, the AMT exemption will increase from $40,000 to $173,000 (indexed annually to inflation), thereby increasing the income level necessary to be subject to the AMT.

In terms of limiting tax preferences, Budget 2023 proposes the following key, additional changes:

• The AMT capital gains inclusion rate will be increased to 100% and capital loss carry forwards and allowable business investment losses would apply at a 50% rate. 100% of the benefit associated with stock options would also form part of the AMT base;
• 30% of capital gains on donations of publicly listed securities will now be included in the AMT base, as will the full benefit associated with stock options to the extent that a deduction is available because the underlying securities are publicly listed securities that have been donated;
• 50% of several deductions (such as employment expenses and non-capital loss carryovers) will be disallowed, thereby broadening the AMT base; and
• Certain non-refundable credits which can be credited against the AMT will be limited to 50%.

Additional details will be released later this year. The proposed changes will come into force for taxation years that begin after 2023. The revised AMT rules will generate an estimated $3 billion of revenue over five years.

The Tax Act generally permits corporations, including financial institutions, to claim a deduction in respect of dividends received on shares of other corporations resident in Canada, while the mark-to-market rules in the Tax Act treat gains on the disposition of certain property held by financial institutions in the ordinary course of business (mark-to-market property) as ordinary income. To align the treatment of dividends and gains on shares that are mark-to-market property, Budget 2023 proposes to deny financial institutions a deduction in respect of dividends received on such shares after 2023.

Generally, shares are mark-to-market property when a financial institution has less than 10% of the votes or value of the corporation that issued the shares. These proposed rules provide that a share (other than a share of a financial institution) that is a tracking property of a corporation at any time in a taxation year is deemed to be mark-to-market property of the corporation for the year.

Overview of Investment Tax Credits

Budget 2023 delivers a series of major incentives to ensure Canada's clean economy can deliver prosperity, middle class jobs, and more vibrant communities across Canada. These new incentives in form of investment tax credits are in certain cases accompanied by labour requirements, as initially announced in the 2022 Fall Economic Statement, to help ensure that Canadian workers see the benefits of a clean economy.

Over the next five years the cost of such incentives is estimated to be more than $10 billion dollars.

Taxpayers are only eligible to claim one of the Clean Hydrogen Investment Tax Credit (the CH Tax Credit), the Investment Tax Credit for Clean Technologies, the Investment Tax Credit for Clean Electricity, the Investment Tax Credit for Clean Technology Manufacturing or the Investment Tax Credit for Carbon Capture, Utilization, and Storage (the CCUS Tax Credit).Accordingly, if a property is eligible for more than one of these tax credits, taxpayers will need to carefully model out and decide which of these tax credits to claim in any given taxation year to achieve maximum tax efficiency.

The accompanying Notice of Ways and Means does not yet provide any draft provisions or specific amendments to the Tax Act. Accordingly there is still significant uncertainty as whether these credits would be available and, if so, how they would be computed in respect of projects being operated through limited or general partnership structures.