Department Of Finance (Canada) Releases Significant Draft Tax Legislation

• Published date: 14 February 2022
• Subject Matter: Finance and Banking, Tax, Financial Services, Commodities/Derivatives/Stock Exchanges, Income Tax, Capital Gains Tax, Sales Taxes: VAT, GST
• Law Firm: Blake, Cassels & Graydon LLP
• Author: Blakes Tax Group

On February 4, 2022, the Department of Finance (Finance) released draft legislation to amend the Income Tax Act (ITA) and the Excise Tax Act (ETA). Much of the draft legislation implements some of the significant business tax measures first announced in the 2021 Canadian federal budget (Budget 2021) (see our Blakes Bulletin: 2021 Federal Budget - Selected Tax Measures | Blakes). As Budget 2021 unusually did not include proposed legislation to implement several measures, this is the first opportunity to review such measures in detail.

Not all previously announced measures were addressed in the draft legislation. The remaining unaddressed proposals include those in respect of hybrid mismatch arrangements, tax incentives for carbon capture, utilization and storage technologies, a luxury tax on cars, aircraft and boats purchased for personal use, and consultations on the Canadian transfer pricing regime and modernization of the general anti-avoidance rule (GAAR).

This bulletin addresses the most significant business tax measures addressed in the draft legislation.

These proposals have been released for consultation, and submissions may be made by the deadlines noted below.

EXECUTIVE SUMMARY

Interest Deductibility

The draft legislation implements the 30 per cent-of-EBITDA interest deductibility limitation promised in Budget 2021, with a new regime known as the "excessive interest and financing expenses limitation" (EIFEL) rules. However, as currently proposed, the EIFEL rules are in several ways more restrictive than the initial proposals in Budget 2021, including tighter limitations on highly-leveraged corporate groups and certain financial institutions. The EIFEL rules are quite complicated and will have a broad impact on taxpayers - including on existing structures implemented before the rules were proposed - so taxpayers will need to give careful consideration to the impact of these rules going forward.

Mandatory Disclosure Rules

As promised in Budget 2021, the draft legislation includes the following three mandatory disclosure measures intended to provide the Canada Revenue Agency (CRA) with more timely information in order to curtail tax evasion 'and aggressive tax avoidance:

1. A broadening of the existing rule for disclosure of "reportable transactions". A reportable transaction is a transaction that features one or more general "hallmarks" of aggressive tax planning.
2. A new similar rule for disclosure of "notifiable transactions". A notifiable transaction is a transaction that is the same or substantially similar to specific transaction types which have been identified by the CRA as potentially abusive, as may be designated by the Minister from time to time.
3. A new rule requiring disclosure with respect to uncertain tax positions reported by corporations in their audited financial statements.

Notwithstanding the later-than-expected release, the draft legislation retains the January 1, 2022 effective date originally announced in Budget 2021 for these measures, though penalties under the new rules will not apply until the legislation receives Royal Assent.

Trust Measures

The draft legislation refines and/or expands on previously announced proposals and includes three proposed changes that may be relevant to investment fund managers. First, the draft legislation proposes rules relating to the deduction by exchange-traded funds (ETFs) that are structured as trusts of capital gains allocated to redeeming unitholders. Second, the draft legislation proposes a change intended to make the capital gains refund mechanism work more efficiently where a mutual fund trust realizes a capital gain on the distribution of property to its beneficiaries. Third, the draft legislation proposes a new exception to the enhanced reporting of beneficiary information for trusts all of the units of which are listed on a designated stock exchange.

Other Income Tax Measures

Avoidance of Tax Debts

Section 160 of the ITA contains an anti-avoidance rule aimed at preventing taxpayers from avoiding the collection of tax debts by transferring property to non-arm's length parties for insufficient consideration. Where applicable, the rule causes the transferee to be jointly and severally liable with the transferor for tax debts of the transferor, to the extent that the fair market value of the property transferred exceeds the consideration paid by the transferee for the property at the time of transfer. In response to certain tax planning strategies, the draft legislation introduces specific rules to broaden the circumstances in which a person can be jointly and severally liable for another taxpayer's tax debts under the ITA. The draft legislation also introduces a new and potentially significant penalty aimed at taxpayers, their professional advisors and other parties involved in section 160 avoidance transactions.

Audit Authorities

Further developing proposals announced in Budget 2021, the draft legislation reveals additional proposed expansions to the CRA's audit powers. The statutory amendments would permit the CRA to compel a wider range of information from taxpayers and other persons, in a number of new ways. Those include compelling persons to respond to the CRA's questions orally or in writing, and requiring persons to attend for questioning at physical locations or virtually.

Clean Technology and Clean Energy Measures

The draft legislation introduces certain measures in respect of clean technology and clean energy equipment including a reduction of corporate income tax rates on zero-emission technology manufacturing profits and expanding Classes 43.1 and 43.2, which provide accelerated capital cost allowance rates.

Sales Tax: GST/HST Treatment of Cryptoasset Mining

The draft legislation includes new GST/HST rules for "cryptoasset" mining activities, which should provide greater certainty for businesses in that industry regarding their obligations to charge and remit GST/HST on mining remuneration and their eligibility for input tax credits on related expenses.

INTEREST DEDUCTIBILITY

As promised in Budget 2021, Canada is pursuing the introduction of new EIFEL rules that would restrict the deductibility of "interest and financing expenses" (IFEs) for Canadian income tax purposes, though the proposed rules are in several respects less favourable for taxpayers than the initial budget proposals. These rules generally provide for a maximum ratio of deductible IFEs to "adjusted taxable income" (a modified measure of EBITDA (earnings before interest, taxes, depreciation and amortization)) for Canadian taxpayers and follow the broad outlines of proposals in the OECD BEPS Action 4 report. The EIFEL rules are intended to apply after all of the existing interest deductibility rules in the ITA, including the transfer pricing and thin capitalization rules. Finance released these proposals for consultation, with submissions due by May 5, 2022.

The EIFEL rules will apply to resident and non-resident corporations and to trusts but will not apply to natural persons. The rules will apply to partnerships indirectly, by requiring a partner to add back to income a portion of partnership-level IFEs if the partner has excessive IFEs (including IFEs allocated from the partnership) for purposes of these rules. Certain smaller Canadian-controlled private corporations (CCPCs) will also be excluded from the rules.

The draft legislation includes several broad anti-avoidance rules aimed at preventing taxpayers from artificially changing the timing or character of payments or taxation years in order to avoid a denial of deductions under the EIFEL rules.

These rules generally will apply to taxation years beginning on or after January 1, 2023.

The EIFEL rules are very complicated and represent a fundamental change in Canada's approach to the deductibility of interest. We expect that further refinements will be required before enactment in order to avoid anomalies in the interaction between these new rules and the existing provisions of the ITA.

Basic Rule

The core of the new EIFEL rules is a restriction on the amount of IFEs that a taxpayer can deduct. The formulae for determining the restriction are complex, but conceptually these rules allow a taxpayer "capacity" to deduct an amount of IFEs equal to the total of (i) any interest and financing revenues of the taxpayer, plus (ii) a fixed percentage of "adjusted taxable income" (ATI), which is generally a measure of EBITDA excluding interest revenue, as discussed below.

The fixed percentage of ATI is generally 30 per cent, with a transitional rate of 40 per cent applying to taxation years beginning on or after January 1, 2023, but before January 1, 2024, and subject to the group ratio rule discussed below.

The concept of IFEs goes beyond amounts that legally constitute interest. IFEs also include other related financing costs that generally get capitalized for tax purposes and deducted under the capital cost allowance or resource expenditure regimes, imputed interest charges in respect of "financing leases", expenses under borrowing-related swaps and other derivatives, and other costs of funding.

At a high level, ATI can be seen as an approximation of EBITDA calculated according to certain specific rules. The starting point of the calculation is the existing concept of taxable income, and therefore is generally reduced by the amount of losses deducted by a taxpayer in computing taxable income, and excludes domestic and foreign dividends that are deductible for Canadian tax purposes. This has the effect of potentially limiting the deductibility of interest on borrowed money used by corporations to acquire shares, which has long been considered a very "safe" use of funds under the existing interest deductibility rules. Starting from taxable income, ATI adds back all interest and financing expenses, all amounts deducted as capital cost allowance, and certain other specific deductions, and excludes all interest and financing...