Highlights Of The 2018 Federal Budget

Canada's Department of Finance ("Finance") released Canada's federal budget for 2018 ("Budget 2018") on February 27, 2018 ("Budget Day").

Finance has made good on its promise made on October 18, 2017 to introduce proposals regarding the taxation of passive income earned in private corporations but in a form that differs substantially from the rules initially proposed. Finance is combating its perceived problem by limiting the small business deduction available in a corporate group that earns significant passive investment income and by limiting a private corporation's ability to fully clear out its refundable dividend tax on hand if it only pays "dividends" that match the nature of the income giving rise to the refund.

Among other domestic measures included in Budget 2018 are those aimed at further closing perceived tax loopholes, such as preventing taxpayers (primarily targeted at Canadian financial institutions and banks) from creating artificial tax losses through the use of sophisticated financial instruments and structured share repurchase transactions, and clarifying the application of the at-risk and limited partnership loss rules in the context of multi-tier partnerships.

Internationally, Budget 2018 focuses primarily on tightening existing rules dealing with cross-border surplus stripping, narrowing some of the various exceptions to the "investment business" definition contained in the foreign affiliate property income rules and deeming certain foreign affiliates to be a controlled foreign affiliate of a taxpayer where the taxpayer benefits from what Finance calls a "tracking arrangement" in respect of the foreign affiliate. Other proposed measures deal with reductions in a taxpayer's deadline to file information returns of foreign affiliates and extensions of the time within which the Canada Revenue Agency ("CRA") may assess such returns.

Notably absent from Budget 2018 is any response to recent tax reform in the United States. This could be expected given that the far-reaching effects of such reform cannot be known with any certainty and related legislation was enacted quite speedily only at the end of 2017. Further, Finance may be waiting to obtain clarity on Canada's overall trade position with the United States before considering any response.

The following summary provides an overview of business, international, and personal income tax measures included or proposed in Budget 2018. It also provides a brief overview of some administrative changes that have been proposed including some changes to certain reassessment periods.

BUSINESS TAX MEASURES

Passive Investment Income Rules - Reduction of Small Business Deduction: Budget 2018 contains the long-awaited release of the proposed rules governing the taxation of passive investment income earned by private corporations (the "PII Rules"). In July of 2017, Finance announced that it was exploring ways to eliminate the perceived investment advantage shareholders enjoyed over employed individuals due to the greater amount of after tax capital within a corporation versus the lesser amount of after tax income individual taxpayers generated on the same income. Budget 2018 introduced a simplified approach to address the perceived advantage. The PII Rules contained in Budget 2018 work to achieve Finance's stated objectives of leveling the playing field between incorporated business persons and employed individuals in two ways.

The first of these methods is to progressively reduce the amount of "small business deduction" ("SBD") on active business income earned by a "Canadian-controlled private corporation" ("CCPC") to the extent by which the CCPC's "adjusted aggregate investment income" ("AAII") exceeds $50,000. The second of these methods is to restrict a corporation's ability to trigger a refund of its "refundable dividend tax on hand" ("RDTOH") through the payment of preferentially taxed eligible dividends. Proposed subsection 125(5.1) of the Income Tax Act (Canada) ("Tax Act") provides that a CCPC's SBD will be reduced on a straight line basis to the extent that the corporation, or any other corporation with which the first corporation is associated, earns AAII in excess of $50,000. If a CCPC has AAII of $150,000 or more in a given taxation year, the CCPC's SBD limit will be ground to nil. The term AAII is defined in the proposed revision to subsection 125(1) of the Tax Act as the "aggregate investment income" of a corporation if that definition:

excluded capital gains and losses on "active assets;" excluded losses carried forward under paragraph 111(1)(b) of the Tax Act; included dividends from non-connected corporations; included proceeds from a life insurance policy included in its income and not otherwise included in its "aggregate investment income;" and were read as though no adjustment were made to the corporation's income under subsection 91(4) of the Tax Act. The term "active assets" is also defined in the proposed revision to subsection 125(1) of the Tax Act. "Active assets" are defined as property which are:

used by the corporation or a related CCPC primarily in an active business carried on in Canada; shares of a connected corporation which would be QSBC shares if the references to individual shareholders were replaced with references to the particular corporation; or an interest in a partnership at a particular time, where the partnership interest represents not less than 10% of the value of all interests in the partnership; 50% of the partnership's assets consisted of assets described in paragraphs (a) and (b) throughout the 24-month period immediately preceding the particular time; and all or substantially of the partnership's assets (i.e. 90%) consist of the assets described in paragraphs (a) and (b) at the particular time. The rules will operate in tandem with the reduction in the business limit with respect to corporations that have taxable capital employed in Canada in excess of $10,000,000. These rules are set to take effect for taxation years which begin after 2018. However, proposed subsection 125(5.2) contains an anti-avoidance rule which deems related corporations which are otherwise unassociated to be associated for the purposes of subsection 125(5.1) where one corporation transfers or lends property to the other for the purpose of reducing its AAII as calculated in the second formula in proposed subsection 125(5.1).

Reform of RDTOH Regime

The second mechanism in the PII Rules to deter the accumulation of passive investments in business corporations consists of a new distinction between "eligible refundable dividend tax on hand" ("Eligible RDTOH") and "non-eligible refundable dividend tax on hand" ("Non-Eligible RDTOH"). Both terms are defined in the proposed revision to subsection 129(4) of the Tax Act.

The Eligible RDTOH of a private corporation is the amount by which the total of the

Part IV tax paid by it in the year on eligible dividends paid to it by non-connected corporations; Part IV tax paid by it in the year on taxable dividends paid to it from connected corporations where the payment of such dividends resulted in a dividend refund of the payer corporation from its Eligible RDTOH account; and Its Eligible RDTOH balance at the end of the preceding taxation year (if it were a private corporation in that year) exceeds the dividend refund received from its Eligible RDTOH for the preceding taxation year.

The Non-Eligible RDTOH of a private corporation is calculated in the same way as RDTOH is currently calculated in subsection 129(3) of the Tax Act, except that any amount included in Eligible RDTOH is excluded from Non-Eligible RDTOH.

The proposed revision to subsection 129(1) of the Tax Act provides that payment of an eligible dividend can only trigger a refund of Eligible RDTOH. In other words, if the only RDTOH account in which a corporation has a positive balance is its Non-Eligible RDTOH, that corporation's payment of an eligible dividend will not trigger any dividend refund. Relatedly, payment by the private corporation of a non-eligible dividend will first trigger a refund of Non-Eligible RDTOH and will only trigger a refund of Eligible RDTOH to extent that 38.33% of non-eligible dividends paid by the private corporation exceeds its Non-Eligible RDTOH balance.

Budget 2018 provides a transition rule for the division of RDTOH into Eligible RDTOH and Non-Eligible RDTOH in the first year in which the new regime applies to a private corporation. Proposed subparagraph 129(5)(a)(i) of the Tax Act sets out that, in the first taxation year in which the definition of Eligible RDTOH applies to a particular private corporation, that private corporation's Eligible RDTOH for the...