2017 Canadian Federal Budget Commentary – Tax Initiatives

INTRODUCTION

On March 22, 2017 (Budget Day), Finance Minister Bill Morneau tabled in the House of Commons the Liberal Government's second budget, Building a Strong Middle Class (Budget 2017).

Contrary to pre-budget rumours, Budget 2017 did not include measures increasing the capital gains inclusion rate, further restricting the principal residence deduction, taxing health and dental benefits under private health care plans or curtailing the favourable taxation of employee stock options.

Our commentary on the tax initiatives in Budget 2017 follows. Unless otherwise stated, all statutory references are to the Income Tax Act (Canada) (Tax Act).

BUSINESS TAX MEASURES

Tax Planning Using Private Corporations

Budget 2016 announced significant changes to the taxation of small businesses and a wide-ranging review of the federal tax expenditures contained in the Tax Act. The Government announced in Budget 2017 that it will be further reviewing the use of tax planning strategies involving private corporations that, in the view of the Government, inappropriately reduce personal taxes of high-income earners. Strategies specifically identified by the Government include:

using private corporations to "sprinkle" income (via both dividends and capital gains) to family members who are subject to lower personal tax rates (or who may not be taxable at all); taking advantage of the fact that corporate income tax rates (on business income) are generally lower than personal tax rates to facilitate the accumulation of earnings that can be invested in a passive investment portfolio inside a private corporation; and "converting a private corporation's regular income into capital gains" by, for example, accumulating funds in a private corporation and subsequently realizing a capital gain on the disposition of shares, rather than extracting funds on a current basis by way of salary or dividends. The Government also announced that it will consider whether there are features of the current income tax system that have an "inappropriate, adverse impact on genuine business transactions" involving family members.

The Government will be releasing a paper in the next few months setting out the nature of the issues in more detail and proposed policy responses. It is unclear whether the paper will also address some of the issues arising from the small business taxation measures introduced as part of Budget 2016; however, the Government has committed to ensuring that "corporations that contribute to job creation and economic growth by actively investing in their business continue to benefit from a highly competitive tax regime."

Meaning of Factual Control

Two forms of control exist for purposes of the Tax Act: de jure control (i.e., legal control) and de facto control (i.e., factual control). De facto control is broader than de jure control, and is relevant for purposes of various rules, including the Canadian-controlled private corporation definition, the affiliated person rules and the associated corporation provisions. Where the Tax Act intends to refer to de facto control, it does so through the use of the phrase "controlled, directly or indirectly in any manner whatever." The meaning of this phrase, defined in subsection 256(5.1), has been the subject of considerable judicial consideration. In 2002, the Federal Court of Appeal held in Silicon Graphics (2002 FCA 260) that for a person or group of persons to have de facto control they "must have the clear right and ability to effect a significant change in the board of directors or the powers of the board [...] or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board." Other cases such as Mimetix Pharmaceuticals (2003 FCA 106) considered a broad array of so-called operational control factors in evaluating de facto control. The Silicon Graphics test was recently reaffirmed in McGillivray Restaurant (2016 FCA 99), where the Federal Court of Appeal rejected the assertions that subsequent jurisprudence had broadened the test and that de facto control included operational control.

Budget 2017 proposes to override McGillivray Restaurant by adding new subsection 256(5.11) applicable in respect of taxation years that begin on or after Budget Day. New subsection 256(5.11) will provide that for purposes of the Tax Act "the determination of whether a taxpayer has, in respect of a corporation, any direct or indirect influence that, if exercised, would result in control in fact of the corporation (a) shall take into consideration all factors that are relevant in the circumstances; and (b) shall not be limited to, and the relevant factors to be considered in making the determination need not include, whether the taxpayer has a legally enforceable right or ability to effect a change in the board of directors of the corporation, or the board's powers, or to exercise influence over the shareholder or shareholders who have that right or ability."

Scientific Research and Experimental Development

Budget 2017 proposes a review of the scientific research and experimental development tax incentive program to ensure its continued effectiveness and efficiency.

Derivatives: Election to Use the Mark-to-Market Method

In the past, there was uncertainty as to whether taxpayers that held derivatives on income account could, in computing income under section 9, use the mark-to-market method or were required to use the realization method. Financial institutions are required to use the mark-to-market method in relation to "mark-to-market property" but most derivatives are not within that definition.

In Kruger Incorporated (2016 FCA 186), the Federal Court of Appeal held that the taxpayer, which was not a financial institution but carried on a business of dealing in options, was entitled to use the mark-to-market method on the basis that it provided an accurate picture of the taxpayer's income. However, the Court found, despite the unanimous view of the accounting experts that mark-to-market was now the only acceptable method of computing income from derivatives for accounting purposes, and in the absence of evidence relating to the accuracy of the realization method in computing income from derivatives, that the mark-to-market method was only "as accurate" a method of computing income from derivatives as the realization method. In such circumstances, a taxpayer would be free to choose either method. Presumably to deal with cases where there may be uncertainty as to whether mark-to-market accounting does produce as accurate a picture of income as the realization method, Budget 2017 contains a proposal for an elective mark-to-market regime for derivatives held on income account available for taxation years that begin on or after Budget Day. Once made, the election can be revoked only with the concurrence of the Minister and on such terms and conditions as are specified by the Minister.

The elective regime will apply in relation to "eligible derivatives." An eligible derivative of a taxpayer for a taxation year means a swap agreement, a forward purchase or sale agreement, a forward rate agreement, a futures agreement, an option agreement or a similar agreement if the following conditions are met:

the taxpayer has produced audited financial statements prepared in accordance with generally accepted accounting principles in respect of the taxation year, or the agreement has a readily ascertainable fair market value; the agreement is not a capital property, a Canadian resource property, a foreign resource property or an obligation on account of capital of the taxpayer; and in the case of a "financial institution,"as defined in subsection 142.2(1), the agreement is not a "tracking property" other than an "excluded property." Where the electing taxpayer is a financial institution, each eligible derivative held by it at any time in the taxation year will be deemed to be mark-to-market property for the purposes of the Tax Act so that the mark-to-market rules will apply to such eligible derivatives.

If the electing taxpayer is not a financial institution, each eligible derivative held at the end of a taxation year is deemed to have been disposed of by the taxpayer immediately before the end of the year and the taxpayer is deemed to have received proceeds or paid an amount, as the case may be, equal to its fair market value at the time of disposition, and to have reacquired, or reissued or renewed, the eligible derivative at the end of the year at an amount equal to such proceeds or amount.

A special rule applies if the taxpayer holds an eligible derivative at the beginning of the first taxation year in respect of which the election applies if the taxpayer did not compute its profit or loss in respect of that eligible derivative in accordance with a method of profit computation that produces a substantially similar effect to mark-to-market. In that case, the eligible derivative is deemed to have been disposed of by the taxpayer immediately before the end of the year and the taxpayer is deemed to have received proceeds or paid an amount, as the case may be, equal to its fair market value at the time of disposition and to have reacquired, or reissued or renewed, the eligible derivative at the end of the year at an amount equal to such proceeds or amount. However, the profit or loss that would arise on the deemed disposition is deemed not to arise in the taxation year immediately preceding the election year, but in the taxation year in which the taxpayer actually disposes of the eligible derivative.

If an agreement is an eligible derivative of a taxpayer but is not a property of the taxpayer (presumably because it is a liability of the taxpayer), the taxpayer is deemed to hold the eligible derivative at any time while the taxpayer is a party to the agreement and to have disposed of it when it is settled or extinguished in respect of the taxpayer.

If a taxpayer (other than a...