Details to come during consultation process that firms should keep tabs on
The first federal budget in more than two years will see several significant income tax changes affecting Canadian businesses. These suggestions include new rules for interest deductibility, anti-hybrid structure rules, a new digital services tax, new CRA auditing powers and a new reporting regime.
However, Peter Macdonald, partner with Osler, Hoskin & Harcourt LLP in Ottawa, notes that many of the proposals aren’t accompanied by specific legislation. The government is allowing for a consultation process in the coming months before settling on rules. “Clients may be well served to keep tabs on, as they may want to provide submissions to ensure their voices are heard and increase the probability that their concerns are addressed.”
Businesses may choose to prepare a submission on these proposals independently, but Macdonald says law firms and accountants can also help in writing a response. Many firms might prefer to join together as an industry voice rather than through individual submissions.
A blog post by Blake, Cassels & Graydon LLP also notes that “unlike many prior budgets, the details of most of Budget 2021’s ambitious tax proposals were not included in the Budget papers.” The government will release details over the coming weeks and months in the form of draft legislative proposals. “For the time being, only general descriptions of these proposed measures are available.”
Stikeman Elliott LLP’s summary of the budget says “while some may breathe a sigh of relief, Budget 2021 does contain several measures aimed at curtailing tax avoidance.”
Macdonald says that while full details may not be out yet, “it’s clear that the government has every intention to implement several revenue-raising measures eventually,” he says. “And they are focused primarily on corporations and multinational corporations.
He adds that in addition to changing tax rules to raise more money, the proposals give Canada Revenue Agency more audit powers and require more disclosure.
But Macdonald says most of the proposed changes aren’t surprising and follow through on a number of international tax items, including efforts being undertaken by the Organisation for Economic Co-operation and Development.
New rules for interest deductibility
Among the more significant changes for business is the budget’s proposal to introduce a limit on the amount of interest certain taxpayers can deduct when computing taxable income. The premise is that an entity should be able to deduct interest expense up to a specified proportion of tax EBITDA (earnings before interest expense, interest income, income tax, and deductions for depreciation and amortization) or “fixed ratio,” to ensure that a portion of an entity’s profit remains subject to tax.
In Osler’s summary of the budget proposals, the fixed ratio is set at 30 per cent of “tax EBIDTA.” After hitting this ceiling, interest expenses “would be deductible above the 30 per cent threshold if the taxpayer is part of a consolidated group whose ratio of net third party interest to book EBITDA implies that a higher deduction limit would be appropriate.”
The rule would be phased in with an initial fixed ratio of 40% for taxation years beginning on or after January 1, 2023, but before January 1, 2024, after which the 30% fixed ratio would apply. Osler says the 30 per cent fixed ratio is at the high end of the 10 per cent to 30 per cent range that the OECD “suggests is intended to allow the majority of groups to deduct an amount equivalent to their net third party interest expense.
Anti-hybrid structure rules
Budget 2021 also proposes that government will make amendments to the Income Tax Act to eliminate the tax benefits of so-called “hybrid mismatch arrangements.” The government defines these mismatch arrangements as cross-border tax avoidance structures that exploit differences in the income tax treatment of business entities or financial instruments under the laws of two or more countries to produce mismatches in tax results.
These mismatches include:
- “deduction/non-inclusion mismatches” where a cross-border payment results in a deduction in one country but not included in income in the other country;
- “double deduction mismatches” where a tax deduction is available in two or more countries in respect of one economic expense;
- “imported mismatches” where a payment is deductible by an entity in one country and included in the ordinary income of a recipient entity resident in a second country, but that inclusion is offset by a deduction flowing from with an entity resident in a third country; and
- “branch mismatches” where the residence country of a taxpayer takes a different view from that of the country where the taxpayer’s branch is located as to the allocation of income and expenditures between the two countries.
Osler says the government intends to release proposals for stakeholder comment later in 2021 that primarily address the “deduction/non-inclusion mismatches” and “double deduction mismatches” that would apply effective July 1, 2022.
In general terms, under the proposed rules, payments made by Canadian residents under hybrid mismatch arrangements would not be deductible to the extent that they give rise to a further deduction in another country or are not included in the ordinary income of a non-resident recipient.
The note from Blakes sys that one crucial take-away is that the new earnings-stripping rule will impose a considerable compliance burden on corporate taxpayers. “New calculations of tax EBITDA will be required, as will computations of group-wide leverage ratios compliant with these new rules.”
However, Blakes also notes that the federal government recognizes this burden, suggesting that “measures to reduce the compliance burden for stand-alone Canadian corporations and exclusively Canadian corporate groups might be explored.”
New digital services tax
The federal budget also proposes a three per cent digital services tax (DST) on revenue over $20 million from digital services that rely on the engagement, data and content contributions of Canadian users. The DST will apply as of January 1, 2022, until an acceptable multilateral approach comes into effect for the relevant businesses.
The DST will apply to groups with global revenue from all sources in the previous calendar year of at least €750 million and more than $20 million of in-scope revenue from Canadian users in a calendar year. The proposed three percent tax rate and revenue thresholds are modelled after DSTs in other jurisdictions, including France.
For several years, Canada has been working with the OECD, the G20 and other countries to reach a consensus on a new taxing right. The budget notes that Canada has a strong preference for a multilateral approach but adds “whether or not a deal is reached, Canada intends to take action.” The United States had been most opposed to such unilateral taxes being imposed and threatened to impose tariffs on nations that did, but Osler says, “the new US administration has dropped the safe harbor requirement, which has revitalized the negotiations.”
Although draft legislation has not yet been released, and implications of the DST will be discussed with provinces and territories, the budget provides these details:
- revenue calculations will not include applicable value-added tax or sales tax amounts;
- in-scope revenue will consist of revenue from online marketplaces, social media, online advertising and user data;
- the DST will apply to businesses organized as corporations, trusts or partnerships;
- groups will generally be defined in the same manner used for country-by-country reporting (and will use a similar €750 million threshold);
- revenue is to be sourced to in-scope activities on a reasonable basis, with tracing required where income may be traced to relevant users in Canada – and a specified formulaic allocation used otherwise (which may vary depending on the nature of the income);
- a user’s location will generally be based on the ordinary location of the individual and the regular place of business of a business user (using generally available information); and
- the deductibility of DST would not be eligible for a credit against Canadian income tax payable;
- a designated entity in a group will be required to file an annual return following the calendar year reporting period – with a single yearly payment required (with entities in a group being jointly and severally liable for payment);
Other budget proposals impacting businesses
The budget, at more than 700 pages, also outlines other measures that will affect Canadian businesses.
These measures include:
Transfer pricing consultation. On February 18, 2021, the Supreme Court of Canada declined to hear the Crown’s appeal of unanimous decisions of the Tax Court of Canada and the Federal Court of Appeal siding with the taxpayer in the Cameco transfer pricing case. The CRA had challenged Cameco’s decision two decades ago to set up a Swiss subsidiary to acquire uranium from Cameco and from 3rd parties and sell that uranium around the world. Budget 2021 says that, in light of the Federal Court of Appeal’s reasoning in Cameco, the current transfer pricing rules may result in “the inappropriate shifting of corporate income out of Canada, artificially reducing corporations’ taxes owed in Canada.” The federal government proposes to will release a consultation paper for comment on possible measures and what “next steps” will be taken to strengthen and modernize the general anti-avoidance rule
Mandatory Disclosure Rules. Budget 2021 proposes that, in support of these rules, where a taxpayer has a reporting requirement in respect of a transaction relevant to the taxpayer’s income tax return for a taxation year, the standard reassessment period (which generally determines how long a particular transaction may be subject to reassessment by the CRA) would not commence in respect of the transaction until the taxpayer has complied with the reporting requirement.
This could result in an indefinite extension of the standard reassessment period if the taxpayer does not comply with a mandatory disclosure reporting requirement.
Reporting of uncertain tax positions. The budget proposes that specified corporate taxpayers report particular uncertain tax treatments to the CRA in order to allow the CRA to more efficiently identify issues. Under accounting rules, Canadian public corporations and those Canadian private corporations that use International Financial Reporting Standards to prepare their financial statements have an existing requirement to identify uncertain tax treatments for financial statement purposes, proposes the reporting of uncertain tax treatments be required for corporations with at least $50 million in assets.
For each reportable uncertain tax treatment of a corporation, the corporation would be required to provide information such as the amount of taxes at issue, a description of the relevant facts, the tax treatment taken and whether the uncertainty relates to a permanent or temporary difference in tax.
The reporting of uncertain transactions would be due at the same time as the corporation’s Canadian income tax return is due. The penalty for failure by a corporation to report each particular uncertain tax treatment is $2,000 per week, up to a maximum of $100,000.
Broadening audit power to compel oral responses. The Federal Court of Appeal’s decision in the Cameco audit case found the federal government did not have a right to compel oral interviews as part of an audit.
The budget proposes to amend the general audit power in section 231.1 to include the ability to require an owner, manager or persons on the premises of a business to give “all reasonable assistance” and respond to all pertinent questions orally or in writing as required.
Reportable Transactions. Currently, for a transaction to be reportable, it must be an “avoidance transaction” as defined in the tax act, and the transaction must bear at least two of three generic hallmarks.
These are: (1) a promoter or tax advisor is entitled to contingent fees in respect of the transaction based on tax benefits obtained under the transaction or the number of taxpayers who participate, (2) a promoter or tax advisor requires “confidential protection” with respect to the transaction, and (3) the taxpayer or certain other persons obtain “contractual protection” in respect of the transaction including certain forms of insurance against a failure to achieve the intended tax benefit.
The budget proposes to amend these rules so that only one generic hallmark needs to be present for a transaction to be reportable. In addition, it is suggested that the definition of “avoidance transaction” for these purposes be amended so that a transaction is considered an avoidance transaction if it can reasonably be concluded that one of the primary purposes of entering into the transaction is to obtain a tax benefit.
Taxpayers who enter into reportable transactions and fail to satisfy the mandatory disclosure requirement face penalties of up to the greater of $25,000 (or up to $100,000 for corporations with assets of a total carrying value of $50 million or more) or 25% of the tax benefit.
Promoters or advisors of reportable transactions would also be subject to penalties equal to the total of (1) 100% of the fees charged to a person for whom a tax benefit results, (2) $10,000, and (3) $1,000 for each day during which the failure to report continues, up to a maximum of $100,000.
Macdonald notes that regardless of whether these proposals are all passed, he would advise clients that it is always a good practice to make sure that any proper documentation is available to show government auditors, especially at a time when the federal government has indicated that it is putting more money into the auditing functions of CRA.