C anada’s Finance Minister delivered the 2010 Budget on 4 March 2010. Highlights of its income tax measures are reviewed below.

Complex proposals regarding foreign investment entities and non-resident trusts were first introduced in the 1999 Budget and have been re-introduced and revised several times over the last decade. In response to concerns regarding the complexity of these provisions and their numerous technical problems, the 2009 Budget announced that the proposals would be reviewed before the government proceeded with legislative amendments. The 2010 Budget contains revised proposals, which will be subject to a consultation process.

The Budget abandons previously proposed changes in favour of modest changes to the current foreign investment entity provisions. These provisions require an income inclusion at a prescribed rate with respect to shares, interests in, or debts of, a non-resident entity. Such shares derive their value primarily from portfolio investments, where it is reasonable to regard deferral or avoidance of Canadian tax as one of the main reasons for acquiring the interests. The Budget increases the rate used in computing this income inclusion from the three month average Canadian Treasury Bill rate to that rate plus two percentage points. It also extends the existing rules to interests in certain trusts not subject to the non-resident trust rules discussed below, and extends the normal reassessment period by three years for these purposes.

The Budget changes to the non-resident trusts proposals generally are relieving in nature. The former proposals imposed Canadian tax on the worldwide income of a non-resident trust where there was a resident beneficiary or a resident contributor to the trust, for which such beneficiaries and contributors could be jointly and severally liable. The revised proposals contain a carve-out for investments in non-resident trusts by tax-exempt entities, expand the carve-outs from the application of the proposed rules for commercial trusts, and provide that a Canadian financial institution will not be considered a resident contributor where it makes a loan to a non-resident trust in the ordinary course of its business.

These proposals are subject to consultation, and it may be some time before legislative amendments are seen

The revised non-resident trust proposals generally limit taxation to income arising from property contributed to the trust by residents of Canada and certain former residents (or property substituted for such property), other than income otherwise subject to Canadian tax. In addition, the trust’s income, subject to tax is attributed to its resident contributors in proportion to their relative contributions to the trust. The trust is entitled to a deduction for the amount of its income payable to its beneficiaries in the year and for amounts attributed to resident contributors. These measures are generally proposed to apply in respect of the 2007 and subsequent taxation years, with the attribution of trust income to resident contributors applicable in respect of taxation years ending after 4 March 2010.

Countering arguments that Canada’s income tax treaties override the non-resident trust rules, the Income Tax Conventions Interpretation Act will be amended so that a trust that is deemed to be resident in Canada under these rules will be considered a resident of Canada for tax treaty purposes.

Because these proposals remain subject to a consultation process, it may be some time before concrete proposed legislative amendments are seen.

The Budget proposes significant reforms to the disbursement quota for Canadian charities. The disbursement quota rules generally require charities to spend at least 80 per cent of their previous year’s donation receipts (the ‘charitable expenditure rule’), plus 3.5 per cent of all assets that are not used in charitable programmes or administration (the ‘capital accumulation rule’), where the value of these assets exceeds CAD25,000. The disbursement quota was originally enacted to ensure that a significant portion of a charity’s assets were used for charitable purposes, but it has been criticised for disproportionately affecting small charities.

The Budget proposes to raise the threshold for the capital accumulations rule for charitable organisations (a category of registered charities that generally carry on charitable activities directly) to CAD100,000 for fiscal years ending after 4 March 2010 and to eliminate the charitable expenditures rule. The Budget also proposes specific anti-avoidance rules to counter transactions intended to delay or avoid the disbursement quota and to ensure that amounts transferred between non-arm’s length charities will be used to satisfy the disbursement quota of only one of the charities.

Non-residents of Canada are taxed on gains from the disposition of ‘taxable Canadian property’ (TCP), subject to relief under an applicable tax treaty. Historically, TCP included all unlisted shares of Canadian corporations.

The definition of TCP will be amended to exclude shares of corporations and certain other interests that do not derive their value principally from real property situated in Canada, Canadian resource property, or timber resource property at any time during the previous 60 months. While corresponding amendments are proposed to continuity rules that deem property to be TCP in certain circumstances, such as a share issued in exchange for a share that was TCP on an amalgamation, reorganisation or tax deferred transfer, where the continuity rules have applied to transactions prior to the Budget date, shares may as a result continue to be deemed to be TCP in circumstances where they would not otherwise be TCP under the new rules.

These changes will greatly reduce the number of transactions to which the pre-clearance and withholding requirements applicable to a purchase of TCP from a non-resident will apply.

RDSPs were introduced as part of the 2007 Budget to provide parents with a tax-efficient vehicle to save for a child with a severe disability. A tax-free rollover of funds from a deceased individual’s registered retirement savings plan to an RDSP will be allowed for deaths occurring on or after 4 March 2010, subject to the RDSP beneficiary’s contribution limit of CAD200,000. The Budget also proposes a 10 year carryforward for unused entitlements to federal government support for RDSP contributions, in the form of Canada Disability Savings Grants and Canada Disability Savings Bonds, starting in 2011.

The Budget announces public consultations on proposals to require the reporting of certain tax avoidance transactions entered into after 2010, or as part of a series of transactions completed after 2010, which exhibit at least two of the following three characteristics:

• A promoter or tax advisor is entitled to fees contingent upon the obtaining of the tax benefit or its amount, or the number of taxpayers involved.
• The promoter or tax advisor requires confidentiality regarding the transaction.
• The taxpayer obtains contractual protection in respect of the transaction.

If a reportable transaction is not reported on a timely basis, the Canada Revenue Agency will be entitled to deny the tax benefit, unless the taxpayer files the required information and pays a penalty.

If a reportable transaction is not reported on a timely basis, the Canada Revenue Agency will be entitled to deny the tax benefit

Several changes are proposed to the current rules regarding employee stock options.

An employee who exercises or disposes of a stock option is generally required to include the ‘in-the-money’ amount of the stock option in employment income. Where certain conditions are satisfied, the employee is entitled to a deduction equal to one half of this employment benefit (the 50 per cent deduction). Although an employer is not entitled to claim a deduction on the exercise of stock options by its employees, it is generally entitled to a deduction where it makes a cash out payment upon the surrender to it of the option by the employee.

Employees will no longer be entitled to claim the 50 per cent deduction where their stock options are cashed out, unless the employer makes an election to not claim a deduction in respect of the cash out payment.

A limited, but significant, ability to defer the taxation of the employment benefit in respect of stock options for publicly listed shares until the shares are sold, will be eliminated for stock options issued after 4 pm (EST) on 4 March 2010 (and many existing stock options) to avoid employees who made the deferral election being unable to meet their tax obligations if there is a subsequent decrease in the value of the shares.

Additionally, the Budget clarifies that payroll withholding and remittance obligations apply to the employment benefit from the exercise of stock options (other than certain stock options issued by Canadian controlled private corporations).

Income trust conversions

Canadian income tax changes first announced in 2006 will subject most income trusts (other than real estate investment trusts) to entity-level taxation on 1 January 2011, eliminating the tax benefits of the income trust structure. Consequently, many income trusts have, or will convert into, corporations before the end of 2010. Some of these income trust conversions have been structured to include a takeover of the income trust by an unrelated loss company in an effort to allow the successor corporation to continue to distribute cash flows without the incurrence of entity-level taxation for a period of time.

The ability to use a corporation’s losses following an acquisition of control is restricted, and control of a corporation is deemed to have been acquired in certain circumstances, including on a ‘reverse takeover’ of a public corporation by another corporation. This rule will be extended to apply to most conversions of income trusts into corporations occurring after 4 pm EST on 4 March 2010, preventing this sort of tax advantaged conversion transaction.

The Budget proposes to eliminate the benefits from so-called ‘foreign tax credit generators’, which are transactions that allow tax credits or other tax relief to both Canadian and foreign participants for the same foreign tax.

Taxation of corporate groups

In 1985, the Canadian Department of Finance released a discussion paper recommending the use of losses within a group, which was never adopted. As a result, Canada has no comprehensive loss consolidation regime and taxpayers often undertake complicated transactions to synthesise such results. The Budget announces public consultations on a formal system of loss transfers or consolidated reporting for corporate groups.