Federal Budget Highlights
Overall, we believe that some of the announced changes to the Income Tax Act are fair and reasonable. We have never been supportive of some of the tax structures available and as a consequence have steered our clients away from them. For example, we are pleased to see that the Liberal government has tightened the rules on the taxation of both split fund shares and the transfer of life permanent insurance policies to a corporate entity. We have seen these structures as an abuse of the tax system and therefore are satisfied that the rules governing these structures are being tightened up.
On the other side of the coin, we have a number of corporate clients that have benefited greatly from flow-through share financings, therefore we are pleased to see mineral exploration flow-through program extended for another year. We however will be happier if this program becomes permanent as the Canadian mineral exploration industry has benefited greatly from it.
Overview of the Federal Government’s Spending Plan
Our Federal government made good on its election promise to return to deficit financing for the purpose of laying a foundation for economic growth. During the last Federal election the Liberals committed to incur a deficit of $10.0 billion per year. However, as expected, the Federal government achieved their pre-budget information leaks by committing to incur a $30.0 billion deficit for fiscal 2016-17, being a tripling of their election promise.
In part, the Federal Government hopes to build its way to economic growth by spending $12 billion over five years on a range of infrastructure projects including public transit, affordable housing, water management for First Nations communities, climate change mitigation, early learning and childcare. The government predicts these investments will increase Canada’s GDP by 0.2% this year and 0.4% in 2017.
According to Statistics Canada, our nation’s GDP for 2014 was $1.7 trillion (2014 is the most recent year for which GDP information is available from its website). This means that the Federal government’s 2016-17 planned deficit of $30.0 billion represents a minuscule 0.02% of GDP. It is therefore difficult to understand how this budget is to achieve the economic growth projected by our Liberal government.
Income Tax Measures Introduced in the Budget
During the election campaign Justin Trudeau commented on many occasions that, if he was elected to form a new Liberal government, one of his main priorities is to lay a foundation upon which the middle class will be able to improve their personal financial situation and to accumulate savings. It is difficult to understand how this overall objective will be achieved when you consider the new income tax measures that were introduced in this budget. In preparing the following budget highlights summary we included only those proposed changes that we expect to be most relevant to our clients.
Personal Tax Measures
- As noted in the government’s December 2015 update, the second marginal income tax rate has decreased from 22% to 20.5%. This lower rate will apply to taxable income from $44,700 to $89,400. This will result in a tax savings of $1,340 per year for an individual earning the high end of the range. This savings, of just under $26 per week, will be more than offset by some of the other Budget changes that will increase taxes on the middle class.
- The budget also confirmed the December 2015 update announcement that the new top Federal marginal tax rate is now 33% on income above $200,000. This means that, for those of us living in Ontario, our new combined Federal and provincial top marginal tax rate is a whopping 53.53% on ordinary income!
- As promised during the election campaign, our new government dramatically reduced the annual TFSA contribution limit from $10,000 to $5,500. The one “bright spot” in this aspect of the budget is that the Liberals promised to continue with the previous Conservative government’s commitment to index the annual limit to inflation. Considering that Canada’s annual inflation rate is running less than 2% per year, this indexing commitment does little to assist the middle class with the accumulation of savings.
- Beginning July 2016, the new income tested Canada Child Benefit (“CCB”) will provide up to $6,400 per year for each child under the age six and up to $5,400 per year for children aged 6 to 17. Only families with incomes below $30,000 per year will receive the full benefit. These CCB payments begin to phase out where the adjusted family net income is between $30,000 and $65,000.The CCB will replace the taxable Canada Child Tax Benefit and Universal Child Care Benefit.
According to Statistics Canada’s website, median total income by family for 2013 was $76,550 (2013 is the most recent year for which this information is available). Therefore, it will be interesting to see how many middle class families will truly benefit from this change to the CCB.
- For the 2016 taxation year and beyond, the Budget proposes to eliminate the Family Tax Cut Credit that currently permits limited income splitting for couples with at least one child under the age of 18. This credit allows a higher-income earning spouse or common-law partner to notionally transfer up to $50,000 of taxable income to their spouse or common-law partner in order to reduce the couple’s combined tax liability by a maximum of $2,000.
- The government proposes to eliminate the Children’s Fitness and Art Tax Credits in 2017. The first step to eliminating these credits is to halve the maximum eligible expenditures on which the 15% refundable Children’s Fitness and Art Tax Credits that can be claimed in the 2016 taxation year.
In particular, the Budget proposes to reduce the Children’s Fitness Credit maximum eligible amount from $1,000 to $500 in 2016 and to eliminate it in its entirety in 2017. The maximum eligible amount for the Children’s Arts Tax Credit will be reduced from $500 to $250 in 2016 and then eliminated in 2017 as well.
- Effective January 1, 2017, the Liberal government also proposes to eliminate the 15% non-refundable Education and Textbook Tax Credits. Unused education and text book credits carried forward from prior to 2017, will remain available to be claimed in 2017 and subsequent years.
- The Budget proposes to introduce a new Teacher and Early Childhood Educator School Supply Tax Credit, being a 15% refundable credit based on the amount of expenditures, up to a maximum of $1,000, made for eligible supplies purchased on or after January 1, 2016.
The credit is available to eligible educators who are teachers or early childhood educators that hold a valid certificate recognized by the province or territory in which they are employed. The credit cannot be claimed on expenditures claimed under any other provision of the Income Tax Act.
- The Ontario Electricity Support Program, which took effect on January 1, 2016, provides relief to low-income households for the cost of electricity via a monthly credit on a taxpayer’s electricity bill. The Budget proposes to exclude such credits from a taxpayer’s income so that other benefits subject to income threshold tests are not adversely impacted.
- Eligibility for the Mineral Exploration Tax Credit is proposed to be extended for one year under the Budget. That is, the credit will apply to flow-through share agreements entered into on or before March 31, 2017.
- The Budget proposes to increase the maximum Northern Resident Deduction from $8.25 to $11 per day for each member of a household that resides in a Northern Zone for at least six consecutive months beginning or ending in a particular taxation year. In cases where only one member of a household claims the deduction, the increase is proposed to be from $16.50 to $22 per day. Taxpayers resident in an Intermediate Zone can only deduct half of the aforementioned amounts.
- In general terms, a mutual fund corporation that is a “switch fund” allows its shareholders to exchange their shares for another class of shares in order to change their economic exposure to a different fund of the corporation. The provisions of the Income Tax Act currently deem such an exchange to not be a taxable disposition. The Liberal government proposes to change this favourable tax treatment such that an exchange after September 2016 will be treated as a disposition at fair market value.
Business Tax Measures
- The Liberal’s first budget is eliminating the previous Conservative government’s proposed stepped increases to the federal small business rate reduction. Under yesterday’s budget, this rate reduction will be frozen at 17.5% for 2016 and subsequent taxation years. The implementation of the previous Conservative government’s rate reduction results in an effective federal small business tax rate of 10.5%, which is down from 11.0% in 2015. Once the Ontario provincial rate is added to this new Federal rate, Ontario’s effective combined tax rate will become 15% on income eligible for the small business deduction.
- The current specified partnership income rules are intended to prevent the multiplication of the Small Business Deduction (“SBD”) where a corporate partnership is utilized. Under the current rules, each corporate partner is only entitled to a SBD equal to its share of the partnership’s active business income multiplied by $500,000.
Over the past few years, a number of professional partnerships have implemented structures to circumvent these rules through the utilization of a separate Canadian-controlled private corporation (“CCPC”) which is not a member of the partnership. Such a corporation, which is owned by the shareholder of one of the corporate partners or by a person who is not at arm’s-length with the shareholder, is paid by the partnership for services provided.
These structures have resulted in a significant loss of tax revenue to the Federal government. For example, a 100 partner partnership who implemented this structure was multiplying the income eligible for the $500,000 small business deduction by 100. This resulted in $50.0 million in annual income eligible for the small business rate deduction instead of the Federal government’s intended $500,000 of eligible income annually.
The Liberal government proposes to eliminate this tax loophole by deeming these separate CCPC’s to be a member of the partnership, which in effect, causes the active income earned by the CCPC from services billed to the partnership to still be subject to its prorated share of the annual SBD thus eliminating the multiplication of the SBD by these professional partnerships. These proposals generally apply to taxation years that begin on or after March 22, 2016.
- The Budget proposes measures to ensure that the addition to the capital dividend account (“CDA”) for private corporations and the adjusted cost base for partnership interests, on the death of an individual insured under a life insurance policy, is reduced by the adjusted cost basis of the policy. This will be the case whether or not the corporation or partnership that receives the policy benefit is the policyholder and therefore the premium payer. In addition, information reporting requirements will apply where a corporation or partnership is not a policyholder, but is entitled to receive a policy benefit. This measure will apply to policy benefits received as a result of a death that occurs on or after March 22, 2016.
- Currently, where a policyholder disposes of their interest in a life insurance policy to a non-arm’s-length person; e.g. to a corporation; the policyholder’s proceeds are deemed to be equal to the cash surrender value (“CSV”) of the policy at the time notwithstanding the fact that the fair market value (“FMV”) of the policy, and therefore the consideration received by the transferor, is usually much higher. The policyholder would be taxable only to the extent that the CSV exceeds the adjusted cost basis of the policy at the time of transfer. Any excess of the FMV of the policy over the CSV is not currently taxable. In addition, this excess of FMV over the adjusted cost basis can later be effectively extracted free of income taxes through the corporation’s Capital Dividend Account (“CDA”). Similar concerns arise in the partnership context and where a policy is contributed to a corporation as capital.
The government proposes that the policyholder’s proceeds in the above scenario will become the FMV of the policy rather than its CSV. Consequently, any excess of the FMV over the adjusted cost basis will become taxable. This measure will apply to dispositions on or after March 22, 2016.
The Budget also proposes to amend the CDA rules for private corporations and the adjusted cost basis computation for partnership interests where the interest in the policy was disposed of before March 22, 2016 for consideration in excess of the CSV of the policy. This amendment, which in essence amounts to retroactive taxation, will reduce the addition to the corporation’s CDA or adjusted cost base of an interest in a partnership by the amount of such excess, which will result in tax when the funds are withdrawn from the company. Consequently, additional funds will be required to pay these taxes, a cost not anticipated when the policy was transferred to the company. This measure will apply in respect of policies under which policy benefits are received as a result of deaths occurring on or after March 22, 2016.
- The 2014 Federal budget announced that the existing rules that relates to both the acquisition and disposition of eligible capital property (“ECP”), such as goodwill, will be reviewed.
At the present time, 75% of the cost of ECP is added to the cumulative eligible capital (“CEC”) pool which is amortized at the rate of 7% per annum of the declining balance. The proceeds of disposition of ECP are first credited to the CEC pool, if any, and previous deductions are recaptured. 50% of the balance is treated as active business income with the remaining 50% being added to the CDA. The effective tax rate is therefore half of the small business rate and/or half of the general rate applicable to active business income.
Each of the provinces imposes its own provincial rate. Therefore, for example, in Ontario, the rate applicable to the small business income portion would be 7.50% (50% of 15.0%) and 13.25% (50% of 26.5%) on the non-small business portion.
Ignoring the lack of a reserve for deferred proceeds on the sale of goodwill, this treatment has, initially, been more attractive than the result of treating the gain as a capital gain which is taxed at 50% of the high corporate rate applicable to investment income resulting in an effective rate of approximately 25%.
The Budget introduces a new regime that will be effective on January 1, 2017. The new rules will add 100% of the cost of what has heretofore been classified as ECP to a new capital cost allowance (“CCA”) class, Class 14.1, which will be depreciated at the rate of 5% of the declining balance per annum. On disposition, 100% of the proceeds of disposition of this type of property will be credited to the pool in accordance with the existing rules applicable to dispositions of depreciable property.
Transitional rules will transfer December 31, 2016 CEC pool balances to Class 14.1. For ten years, pre-2017 balances will be depreciated at the rate of 7% of the declining balance per annum.
Small businesses will benefit from more generous write-offs for minor expenditures. For example, the first $3,000 of the cost of incorporation will be deductible as a current expense instead of being added to the CEC pool, which is the current case.