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                                                 THE 2002 ONTARIO BUDGET

 

 

 

 

The Ontario Finance Minister, Janet Ecker, delivered the 2002 Ontario budget (the “Budget”) on June 17, 2002.  Due to the economic slowdown in late 2001, the Budget proposes to delay by one year the implementation of the government’s 1999 and 2001 promises to cut certain corporate and personal income tax rates.  Nevertheless, the previously announced reductions to the Ontario small business tax rate will not be delayed.  To discourage smoking and to raise revenue, increases in Ontario tobacco taxes, together with increases in federal tobacco taxes announced today, will result in combined tobacco tax increases of $8.50 per carton of 200 cigarettes.   On the spending side, outlays on health care, education and clean water will be increased.

 

The significant proposed tax changes are discussed below.

 

 

Personal Income Tax Measures

 

Personal Income Tax Rates

 

The Budget proposes to delay by one year previously announced cuts to the Ontario low and middle personal income tax rates originally slated for 2003.  While the top Ontario personal income tax rates will remain unchanged, as shown below, all Ontario taxpayers are affected by the delay in the modest reduction in the personal income tax rates on the low and middle income brackets.  The impact of the rate cuts to the low and middle income tax brackets is shown on page 2.

 

The maximum combined federal and Ontario tax rates for 2002 and future years are unchanged as follows:

 

 

Combined Federal and Ontario Personal Tax Rates

 

The following combined federal and Ontario personal income tax rates will apply from 2002 to 2004:

 

 

 

 

(1)   The income brackets shown above reflect all applicable taxes and surtaxes, and do not include any personal tax credits.  This chart shows the 2002 tax brackets, which will be indexed for inflation after 2002.

 

Equity in Education Tax Credit

 

The Budget proposes to delay by one year the phase in of the refundable education tax credit, which is provided in respect of kindergarten, elementary and secondary tuition fees at independent schools in Ontario.  This annual credit applies to the first $7,000 per child of tuition fees (not including expenses for books, sports, uniforms, computers, travel, boarding etc.).

 

This tax credit is now proposed to be phased in over a six-year period as follows:

 

 

 

 

Corporate Income Tax Measures

 

General Income Tax Rate

 

The Budget proposes to reschedule the Ontario general corporate income tax rate reductions as follows:

 

-          effective January 1, 2002, the tax rate will be 12.5%;

-          effective January 1, 2004, the tax rate will be 11%;

-          effective January 1, 2005, the tax rate will be 9.5%;

-          effective January 1, 2006, the tax rate will be 8%.

 

Manufacturing and Processing (M&P) Income Tax Rate

 

The Budget also proposes to reschedule the Ontario M&P corporate income tax rate as follows:

 

-          effective January 1, 2002, the tax rate will be 11%;

-          effective January 1, 2004, the tax rate will be 10%;

-          effective January 1, 2005, the tax rate will be 9%;

-          effective January 1, 2006, the tax rate will be 8%.

 

Small Business Tax Rate

 

No changes were proposed to the phase in of the previously announced Ontario small business tax rate reductions.  In addition, no changes were proposed to the timetable for the phase in of the increase in the amount of income eligible for the small business tax rate to $400,000, or to the increase in the clawback income levels.

 

The scheduled Ontario small business tax rates remain unchanged as follows:

 

 

(1) The benefit of the small business tax rates is phased out for income of the corporation, together with other associated corporations, in excess of the amount eligible for the small business tax rate for the applicable year.  The phase out is effected by imposing an additional tax equal to the lesser of (a) the clawback rate multiplied by the excess income and (b) the small business deduction claimed.  In 2002, the benefit of the small business tax rate is fully phased out at $ 700,000 of the aggregate taxable income (increasing to $ 1,000,000 by 2005).

 

Combined Federal and Ontario Corporate Tax Rates

 

The following combined federal and Ontario rates⁽¹⁾ will apply to corporations subject to Ontario tax:

 

 

(1)     The rates shown reflect the tax rates on the band of income specified.  The rates do not include the impact of the claw back of the Ontario small business deduction, where applicable.

 

All Ontario corporate tax rate reductions will be prorated for taxation years straddling the effective dates.

 

Capital Taxes

 

The Minister announced that she would be seeking advice with a view to announcing, in next year’s budget, steps towards eliminating the capital tax.  However, no changes were announced in this Budget to the capital tax regime.  The capital tax exemption announced in the 2001 budget continues to allow a deduction from taxable paid-up capital of $5 million, which must be shared by associated corporations based on their relative taxable capital.

 

Other Corporate Tax Measures

 

For taxation years ending after June 17, 2002, the Budget proposes to parallel Canada’s income tax treaties for the purpose of determining whether a non-resident corporation has a permanent establishment in Ontario.

 

Corporations must make monthly installments if their taxes payable exceed $2,000 in the current or preceding year.   The Budget does not change the 2001 Budget measure which permits corporations to pay their installments quarterly, rather than monthly, if their taxes payable are less than $10,000 in the current or preceding year, for taxation years commencing in 2002.

 

MUNICIPAL PROPERTY TAXES

 

To help support the farming community, the Ontario government intends to provide municipalities with the flexibility to lower municipal property taxes on farm properties.  Beginning in 2003, upper-tier and single-tier municipalities would be able to lower the municipal portion of the property tax rate below 25% of the residential tax rate.  The reduction would apply to both the upper-tier and lower-tier portions of the municipal property tax.

 

Currently, government-owned farms are not eligible for inclusion in the farmlands property class.  To bring equity to the tax treatment of farms and to provide farmers with a level playing field, Ontario intends to make government-owned farms, which are occupied by tenant farmers, eligible for inclusion in the farmlands property class.

 

 

RETAIL SALES TAX (“RST”)

 

Legislation will be introduced to confirm the application of the RST exemption for ready-mixed concrete, which is used on-site to make integral component parts of production machinery and equipment, under terms and conditions as prescribed by the Minister.  This measure will be effective for purchases made after June 17, 2002. 

 

The RST rebate for alternative fuel vehicles, of up to $1,000 per vehicle, will be modified to include electric-hybrid light trucks and sport utility vehicles delivered after June 17, 2002.

 

Amendments will be proposed in the fall to improve compliance by motor vehicle dealers with outstanding RST accounts.

 

The Budget proposes the next step of the government’s commitment announced in the 2001 Budget to consult with taxpayers on simpler and more effective RST definitions and rules for computer software. It is proposed that draft legislation will be posted on the Ministry's Website for industry comments that will be used to introduce amendments in the Legislature this fall.

 

 

OTHER SPECIFIC TAX MEASURES

 

Fuel Tax

 

Effective after June 17, 2002, an exemption from the 14.3 cents per litre tax under the Fuel Tax Act will be provided for biodiesel fuel, regardless of whether it is mixed with diesel fuel.

 

Tobacco Tax

 

Effective June 18, 2002, the Ontario government is proposing to increase the tobacco tax on cigarettes and cut-tobacco by 2.5 cents per cigarette or gram of cut-tobacco.  For cigarettes, this increase will amount to $5 per carton of 200 cigarettes.

 

In addition, the Ontario government is proposing to amend the structure of tobacco taxation by exempting tobacco products from RST and recovering the revenues through an equivalent increase in rates under the Tobacco Tax Act.

 

The new Ontario tax rates per cigarette, tobacco stick or gram of cut-tobacco would be 8.6 cents and 56.6% of the retail price of cigars.

 

 

FEDERAL PROPOSAL

 

Tobacco Tax

The federal government announced today that, effective June 18, 2002, the federal taxes on cigarettes will increase by $3.50 per carton of 200 cigarettes, on tobacco sticks by $2.50 per 200 tobacco sticks, and on manufactured tobacco by $2.50 per 200 grams of manufactured tobacco.  In addition, the federal taxes on cigars will increase to the greater of 6.5 cents per cigar (currently 3.947 cents per cigar) and 65% (currently 50%) of the sale price or duty-paid value.  These increases apply to tobacco products sold in Canada.

 

Similar federal tax increases have been announced on exports of Canadian produced tobacco products, domestic tobacco products delivered to duty-free shops, and duty on tobacco products imported by a returning resident under the personal exemption allowance.

 

 

RECENT SIGNIFICANT COURT CASES

 

Reasonable Expectation of Profit

 

Brian J. Stewart v. The Queen

The Queen v. Jack Walls and Robert Buvyer

 

In the last several years, the Canada Customs and Revenue Agency (the “CCRA”) has been challenging investors who claimed rental or business losses on the basis that they did not have a reasonable expectation of profit (“REOP”).  The CCRA has been aggressive in applying this test, leaving many taxpayers frustrated with the process and with the CCRA.  To make matters worse, the courts had been arbitrary and inconsistent in their decisions concerning when the REOP test would apply to deny a taxpayer from claiming the losses realized from a commercial venture.

 

The roots for the REOP test lay in certain comments made by Justice Dixon of the Supreme Court of Canada (“SCC”) in the tax case of William Moldowan v. The Queen.  In that case, Justice Dixon stated that in order to have a “business”, the venture must be conducted with a REOP.  Justice Dixon then laid out certain criteria as relevant in determining whether a REOP exists, including the businesses’ profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, and the capability of the venture as capitalized to show a profit after claiming depreciation. 

 

Both the Stewart and Walls cases involved real estate tax shelters that generated significant losses which the taxpayers deducted against other sources of income.  In Stewart, the taxpayer acquired four Reemark condominiums, each for $1,000 down and the balance fully financed.  In Walls, the taxpayers were limited partners in a partnership that acquired a mini-warehouse.  The Partnership’s purchase price was almost double what the vendor paid for the property a few months earlier, and the price was completely financed (except for $1) with a high interest vendor take-back loan.  The losses claimed by Stewart were denied based on the REOP test and that the interest expenses incurred were non-deductible, whereas the losses claimed by Walls and Buvyer were denied on a number of grounds, including REOP.

 

 

The SCC released their decisions in both the Walls and Stewart cases on May 23, 2002, and fortunately, both taxpayers were successful in their appeals.  The SCC effectively rebuked both the CCRA and the lower courts for relying on the REOP test to second-guess bona fide commercial decisions of taxpayers, thereby running afoul of the principle that the courts should avoid judicial rule-making in tax law.  The SCC pointed out that the REOP test is problematic due to its vagueness and uncertainty of application, and therefore, results in unfair and arbitrary treatment of taxpayers.

 

In place of REOP, the SCC advocated a “Pursuit of Profit” test, asking the question “was the activity commercial in nature or was it a personal endeavour”?  If the activity is commercial in nature, then the taxpayer’s pursuit of profit is established, and therefore, there is no reason to analyze any further whether he has a source of income, except to establish whether that source of income was from a business or from a property.  Where the activity is a personal endeavour, the venture will be considered a source of income only if it is undertaken in a sufficiently commercial manner, namely that the taxpayer must have the subjective intention to profit and there must be evidence of businesslike behaviour which supports that intention.  REOP is no more than a single factor, among others, to be considered at that stage.

 

Therefore, by virtue of the SCC’s decision, it established that the REOP test does not arise for consideration where the nature of an activity is clearly commercial in nature and has no personal aspect.  In such situations, there is no need to analyze a taxpayer’s business decisions, since commercial endeavours necessarily involve the pursuit of profit.

 

Beyond this very important decision of the SCC, which effectively provided a death knell to the availability of the REOP test to the CCRA as a basis of denying business/property losses, some other noteworthy comments made by the SCC are as follows:

 

1)                  In the Walls case, the SCC agreed that the taxpayers were clearly motivated by tax considerations when they purchased their partnership interests; nevertheless, this did not detract from the commercial nature of the operations of the partnership.  In other words, subject to the potential application of the general anti-avoidance rule, a tax motivation does not affect the validity of transactions for tax purposes.

 

2)                  One of the primary reasons that Stewart incurred significant rental losses was that his investment was heavily financed.  In the past, the courts had tended to negatively view a commercial venture that was highly leveraged, invoking REOP to deny the deductibility of interest, despite the fact that a specific provision of the Income Tax Act (the “Act”) otherwise permits its deduction.

 

The SCC completely rejected this proposition.  In its view, the fact that an activity has been financed externally is an indication that the taxpayer is operating his/her activity in a businesslike manner.  As such, the existence of financing is an element which adds to the commerciality of a venture, and thus, operates in favor of characterizing the activity as a source of business/property income.  Furthermore, the SCC pointed out that the specific provision which permits interest to be deducted is not a tax avoidance mechanism, and therefore, in light of the specific anti-avoidance provisions contained in the Act, courts should not be quick to embellish provisions of the Act in response to tax avoidance concerns.

 

3)         For income tax purposes, a capital gain is not a component of determining a person’s profit from a business or property source.  Nevertheless, the SCC affirmed that a taxpayer’s motivation of realizing a capital gain from the disposition of property underlying the business/property source accords with an ordinary business person’s understanding of  “Pursuit of Profit”, and therefore, may be taken into account in determining whether the activity is commercial in nature.

 

Interest Deductibility

 

Ludco Enterprises Ltd., et al. v. The Queen

 

In this case, the SCC allowed interest deductions to the taxpayers where the interest expense on funds borrowed for investment purposes significantly exceeded the income earned on the investments. 

 

The taxpayers borrowed funds to acquire shares of certain offshore corporations. The policy of each offshore corporation was to reinvest almost all of its profits, and to retain only a relatively small portion for the purpose of dividend distribution.  In the eight years during which the taxpayers held the shares, they received $600,000 in dividends, and incurred $6 million in interest charges. Ultimately, they disposed of their shares and reported substantial gains of approximately $9.2 million. The Minister of National Revenue (the “Minister”) disallowed the deduction of interest to the taxpayers on the grounds that the funds had not been used to earn income from a business or property, and that they had no REOP in the form of dividends.

 

The SCC allowed the interest deductions to the taxpayers. In reaching its decision, the SCC indicated that, in order to deduct interest under the Act, it is only necessary for a taxpayer to show that it had a reasonable expectation of income at the time the investment was made. For this purpose, “income” refers to income subject to tax i.e. gross income, not net income.

 

The Queen v. John R. Singleton

 

The SCC allowed an interest deduction to the taxpayer where the taxpayer carried out a series of transactions designed to make his interest expense deductible.

 

Singleton, a partner in a law firm, withdrew funds as a tax-free distribution from his capital account with the law partnership, used the funds to acquire a residence, and then borrowed against the residence to make a capital contribution to the law partnership. Singleton deducted the interest on the borrowing on the basis that the funds were used for business purposes. The Minister disallowed the interest deduction on the grounds that the borrowed money had effectively been used for personal purposes i.e. to finance the purchase of a house.

 

The SCC held that there was a direct link between the borrowed money and an eligible use, and the taxpayer was not required to demonstrate a bona fide business purpose test. Furthermore, it was also irrelevant that the taxpayer had structured the transaction for tax purposes.

 

Following the Ludco and Singleton decisions, the CCRA announced that, in consultation with the Departments of Justice and Finance, it was reviewing these judgements and its own administrative positions regarding interest deductibility. However, until the review is complete, the CCRA stated that it does not intend to modify any of its existing practices with regards to interest deductibility.

 

Payment under a Non-competition Agreement (“NCA”)

 

Tod T. Manrell v. The Queen

 

Often, a purchaser requires that an individual active in the operations of his business sign a NCA, where that individual sells the shares of his corporation which owns the business.  In some cases, an amount is paid by the purchaser to the vendor as compensation for signing the NCA. 

 

In a 1997 Tax Court of Canada (“TCC”) decision, which was upheld by the Federal Court of Appeal in 2000, Giovanni Fortino, together with his spouse and other vendors, successfully argued that their NCA receipts were not income from a productive source, and as a result, they escaped the tax net.   In the recent Manrell decision, however, the taxpayer was unsuccessful in arguing that his NCA was a non-taxable receipt. 

 

Manrell received $1,000,000 under an NCA for his personal covenant not to compete with the corporation that purchased his shares of a plastic-bottle manufacturing business. The TCC held that the NCA was property and that Manrell sold this property, resulting in a capital gain. The TCC indicated that, while the “right to compete” may not be property at common law, the definition under the Act is broader and includes the right to compete.  Furthermore, the TCC indicated that the Fortino decision was not helpful to Manrell, since Fortino was successful only because the Minister had not pleaded that NCA receipts were capital gains, and therefore, was not allowed to raise the argument at trial.  However, in Manrell, the Minister had argued that the NCA was a capital gain, and consequently, was successful.

 

 

 

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To discuss the impact of the Ontario budget on your business, please contact your partner at
Goldfarb, Shulman, Patel & Co. LLP.