Finance Minister Paul Martin delivered his seventh budget on February 28, 2000.  A balanced budget or better is expected for 1999-2000.  The Government is committed to balanced budgets or better in 2000-01 and 2001-02.  The budget delivers much anticipated reductions in personal income tax rates as part of a Five-Year Tax Reduction Plan (the “Plan”).  The Plan also provides measures to help Canada become more competitive internationally by making the tax system more conducive to investment and innovation.  Targeted reductions in corporate tax rates are being phased in under the Plan.  In all, the Plan will reduce taxes by a cumulative amount of at least $58 billion over the next five years.

In accordance with the Government’s Debt Repayment Plan, it will continue to use the Contingency Reserve to reduce public debt in those years when it is not required.  Since the federal budget was balanced, two-thirds of all new spending has been directed towards health, access to knowledge and skills, and innovation. This budget proposes various spending initiatives aimed at making Canada’s economy more innovative and improving the quality of life of Canadians and their children.  Initiatives totalling $4.1 billion between 1999-2000 and 2002-03 are proposed: to promote leading-edge research and innovation in universities, research hospitals and the private sector; to develop new environmental technologies and improve environmental practices; and to strengthen federal, provincial and municipal infrastructure.  Canada Health and Social Transfer (“CHST”) payments will be increased by $2.5 billion to help the provinces and territories fund post-secondary education and health care.  The Government will allocate $700 million between 1999-2000 and 2002-03 to develop new environmental technologies and improved practices in co-operation with provinces, municipalities, the private sector and non-governmental organizations. The duration of employment insurance maternity and parental leave will double to 12 months. The Plan also enriches the Canada Child Tax Benefit so that by 2004 an additional $2.5 billion annually will be provided to low- and middle-income families with children.

Personal Tax Measures

Full Protection Against Inflation in the Tax System

As anticipated, the Plan immediately restores full indexation of the personal income tax system to protect taxpayers against inflation.  Full indexation will stop the tax increases resulting from tax bracket creep and benefit erosion that have occurred under Canada’s tax system since the mid-1980s.

Reduction in Personal Income Tax Rates

The Plan reduces the middle federal tax rate to 23 % from 26 %, starting with a two-point reduction to 24 % in July 2000.  For the year 2000, the middle and upper tax rate thresholds will be increased to $30,004 (from $29,590) and $60,009 (from $59,180) respectively.

5 % Deficit Reduction Surtax

Under the current rules, the 5% deficit reduction surtax applies to basic federal tax in excess of $12,500 (at an income level of about $65,000). The budget proposes to raise this amount to $18,500 (at an income level of about $85,000), effective July 1, 2000.  The budget also proposes to reduce the surtax rate from 5 % to 4 %, effective January 1, 2001.  The 5 % surtax will be eliminated within the next five years.

Top Marginal Personal Rates for 2000 for Ontario Residents

The above rates include all federal and Ontario taxes and surtaxes.

Foreign Property Rules

The foreign property rule (“FPR”) in respect of RPPs and RRSPs generally limits the amount of foreign property that such a plan can hold to 20% of the cost of the plan’s assets.   Foreign property generally consists of shares, units and debt issued by non-resident entities.  The budget proposes to raise the FPR limit to 25 % for 2000 and 30 % after 2000. 

The existing FPR contains a special "3 for 1 Bump" rule designed to encourage investment by deferred income plans in small businesses operated in Canada.  Under the rule, an extra $3 of foreign property "room" is available to a deferred income plan for every $1 invested by the plan in a qualifying small business property. However, the extra foreign property "room" generated cannot result in a plan’s foreign content exceeding a 40% limit.  The budget proposes to increase the limit with regard to small business investment to 45 % for 2000 and 50 % after 2000.

Capital Gain Rollover for Investment in Small Business

The budget proposes a mechanism to permit individuals (other than trusts) a rollover of capital gains on the disposition of a small business investment to the extent that the proceeds are reinvested in one or more other eligible small business investments.  The cost base of the new investment will be reduced by the capital gain deferred in respect of the initial investment.

Eligible Small Business Investment

An eligible small business investment will have the following characteristics:

·       the investment is in ordinary common shares issued from treasury to the investor;

·       the corporation is, at the time the shares are issued, an eligible small business corporation (which will generally be defined as a Canadian-controlled private corporation, all or substantially all of the assets of which are used in an active business carried on primarily in Canada, or are shares of other related eligible small business corporations);

·       the total carrying value of the assets of the corporation and related corporations does not exceed $2.5 million immediately before the investment is made, and does not exceed $10 million immediately after the investment. There will be look-through rules to account for assets held by the corporation through partnerships and trusts; and

·       while the investor holds the shares, the issuing corporation must be an eligible active business corporation (which will generally be defined as a taxable Canadian corporation, all or substantially all of the assets of which are used in an active business carried on primarily in Canada, or are shares of other related eligible active business corporations).

The eligible small business investment must be held for more than six months from the time of acquisition before a gain can be deferred.  The replacement eligible investment must be purchased after the beginning of the year of disposition of the original small business investment, and before the earlier of the 120th day following the disposition and the 60th day after the end of the year.

Eligible Gains

The deferral will be available in respect of capital gains realized after February 27, 2000, on up to $500,000 of eligible small business investments (by reference to adjusted cost base) in any particular corporation (or related group) made by an eligible investor or by a qualifying pooling arrangement on behalf of the investor.

Investment Limit

A capital gain from the disposition of an eligible investment can be deferred to the extent that the proceeds are reinvested in one or more other eligible small business investments.  There are no limits on the total amount of proceeds that can be reinvested, but no amount reinvested in excess of $500,000 in shares of a particular corporation or related group will qualify for additional capital gain deferral.

Personal-Use Property

Personal-use property is generally property that is used primarily for the personal use or enjoyment of an individual and includes jewellery, works of art, furniture and clothing.  Currently, the adjusted cost base and proceeds of disposition of personal-use property are deemed to be at least $1,000 for capital gains purposes.

Certain charitable donation arrangements have been designed to exploit the $1,000 deemed adjusted cost base for personal-use property and to create a scheme under which taxpayers attempt to achieve an after-tax profit from such gifts.  The budget proposes to amend the Income Tax Act so that the $1,000 deemed adjusted cost base and deemed proceeds of disposition for personal-use property will not apply if the property is acquired after February 27, 2000, as part of an arrangement in which the property is donated as a charitable gift.

Employee Stock Options

The current tax treatment of employee stock options is as follows:

·       A taxable employment benefit equal to the difference between the fair market value of the share at the time the option is exercised and the amount paid by the employee to acquire the share is generally included in income in the year the option is exercised.

·       In the case of CCPCs, the taxable employment benefit is generally not included in income until the year of disposition of the share acquired under the option.

·       Where certain conditions are met, a deduction in respect of the employee stock option benefit is provided that essentially results in the benefit being taxed at the same rate as capital gains.

The budget proposes to allow employees to defer the income inclusion from exercising employee stock options for publicly listed shares until the disposition of the shares, subject to an annual $100,000 limit.  Employees disposing of such shares will be eligible to claim the stock option deduction in the year the benefit is included in income.  The new rules will also apply to employee options to acquire units of a mutual fund trust.

Employee stock options granted by CCPCs are not affected by the proposed measure.

Eligible Employees

Eligible employees are those who, at the time the option is granted:

·       deal at arm’s-length with the employer and any related corporation; and

·       are not specified shareholders (specified shareholders are generally those who own 10 % or more of a company’s shares).

Eligible Options

An eligible option is one under which:

·       the share to be acquired is an ordinary common share;

·       the share is of a class of shares traded on a prescribed Canadian or foreign stock exchange; and

·       the total of all amounts payable to acquire the share, including the exercise price and any amount payable to acquire the option, is not less than the fair market value of the share at the time the option is granted.

The proposal applies to eligible options exercised after February 27, 2000, irrespective of when the option was granted or became vested.

Deferral Period

The income inclusion for a share acquired under an employee stock option will be deferred until the time the employee disposes of the share or, if earlier, the time the employee dies or becomes a non-resident.

The measure applies to options exercised after February 27, 2000.

Charitable Donations of Shares Acquired with Employee Stock Options

The 1997 budget halved the inclusion rate on capital gains arising from charitable donations made before 2002 of listed securities, such as shares, bonds, bills, warrants and futures.  Where an employee exercises a stock option in order to donate the share to a charity, the budget proposes to introduce a provision to reduce the tax burden on the employment benefit to parallel the reduced capital gains inclusion rate for donations of publicly-traded securities.  To be eligible for this measure, the share must be donated in the year and within 30 days of the option being exercised. Also, the share will have to meet the existing criteria for the reduced capital gains inclusion rate for donations of publicly-traded securities.  The measure will apply to securities acquired after February 27, 2000, and donated before 2002.

Partial Exemption for Scholarships, Fellowships and Bursaries

The budget proposes to increase the annual exemption for scholarship, fellowship or bursary income received in a year from $500 to $3,000, beginning with the 2000 taxation year. The $2,500 increase in the exemption will apply only to amounts received by a student where that student enrolls in a program which entitles the student to claim the education tax credit. Generally, this includes programs at a post-secondary level and programs at educational institutions certified by the Minister of Human Resources Development that furnish or improve skills in an occupation.

Offsetting of Interest on Personal Tax Overpayments and Underpayments

Refund interest on an overpayment of tax is included in income for tax purposes.  However, arrears interest is not deductible in computing a taxpayer’s income for tax purposes.  The taxation of refund interest and non-deductibility of arrears interest can produce inappropriate results in situations where an individual who owes interest on unpaid tax from one taxation year is concurrently owed interest on a tax overpayment from a different taxation year.  This budget proposes a relieving mechanism for individuals whereby refund interest accruing over a period will be taxable only to the extent that it exceeds any arrears interest that accrued over the same period to which the refund interest relates. Canada Customs and Revenue Agency (“CCRA”) will issue an information slip indicating the amount, if any, of the refund interest that must be included in the individual’s income for tax purposes.  This measure will apply to individuals other than trusts in respect of arrears and refund interest amounts that accrue concurrently after 1999, regardless of the taxation year to which the amounts relate.

Enhanced Tax Assistance for Persons with Disabilities

Enhancing the Disability Tax Credit (“DTC”)

The DTC recognizes the effect of a severe and prolonged disability on an individual’s ability to pay tax.  The budget proposes to extend the eligibility for the DTC to individuals who must undergo therapy several times each week totalling at least 14 hours per week in order to sustain their vital functions.  The budget also proposes to expand the list of relatives to whom the DTC can be transferred to include individuals supporting a brother, sister, aunt, uncle, niece or nephew, as well as to individuals supporting a spouse, child, grandchild, parent or grandparent.

The Child Care Expense Deduction for Persons Eligible for the DTC

The budget proposes to increase the annual child care expense deduction currently available in respect of persons eligible for the DTC from $7,000 to $10,000.

The Medical Expense Tax Credit and New Homes

The budget proposes to extend tax assistance to disabled individuals who incur reasonable expenses relating to the construction of a principal place of residence where the expenses can reasonably be considered to be incremental costs incurred to enable the individual to gain access to or to be mobile or functional within the home.

The Deduction for Attendant Care and Students

The budget proposes expanding the deduction for attendant care to include the cost of an attendant required in order to attend school. The deduction will be subject to certain income limitations.

Charitable Donations: Designations in Favour of Charity

An individual who is an annuitant under a RRSP or registered retirement income fund (“RRIF”) or the owner of a life insurance policy may wish to have the proceeds in respect thereof donated to a charity on the individual’s death by:

·       having the individual’s will provide for a cash bequest of the proceeds to the charity; or

·       designating that the proceeds be paid directly to the charity under the terms of the RRSP, RRIF or insurance policy.

Under current income tax rules, donations that are made by way of a donor’s will qualify for the charitable donations tax credit on death. However, donations made as a consequence of a direct designation do not qualify for the credit.  In respect of an individual’s death that occurs after 1998, the budget proposes to extend the charitable donations tax credit to donations of RRSP, RRIF and insurance proceeds that are made as a consequence of direct beneficiary designations.

Reduction in Federal Surtax for Non-Residents

Nonresident individuals who have income which is considered to have been earned in Canada, but which is not considered to be earned in a province, pay a special federal surtax in addition to their regular federal tax.  The budget proposes to reduce the federal surtax on income not earned in a province from 52 % of basic federal tax to 48 %. This measure will apply for the 2000 and subsequent taxation years.

Corporate Tax Measures

Corporate Tax Rate Reduction

The Government intends to reduce, within five years, the federal corporate income tax rate from 28 to 21 % on business income not currently eligible for special tax treatment.  As an initial step in achieving this tax rate reduction, the budget proposes that, effective January 1, 2001, the federal corporate income tax rate on such income be reduced by 1 percentage point from 28 to 27 %. This rate change will be prorated for taxation years that include January 1, 2001.  The tax rate reduction will not apply to income that benefits from preferential corporate tax treatment such as small business and Canadian manufacturing and processing (“M&P”) income, investment income that benefits from refundable tax provisions or income from non-renewable natural resource activities.

Faster Corporate Tax Rate Reduction for Small Business

Income earned by small businesses in excess of the $200,000 threshold is currently subject to the federal corporate tax rate of 28 % or, for M&P income, to the 21 % M&P rate.  Small businesses that are currently taxed at the 28 % tax rate on their active business income in excess of the $200,000 small business limit will benefit from the proposed 1 percentage point reduction in the general tax rate next year and from the further reductions planned for the future. However, in order to provide additional and more immediate support for this sector, the budget proposes to advance the planned 7 percentage point rate reduction for small business.  Specifically, the federal corporate tax rate on income between $200,000 and $300,000 earned by a CCPC from an active business carried on in Canada will be reduced to 21 % from 28 %, effective January 1, 2001 (prorated for taxation years that include that date).  Associated corporations will share the additional $100,000 of income eligible for the faster rate reduction in proportion to their share of the $200,000 small business limit.

Government Assistance for Scientific Research and Experimental Development (SR&ED)

The budget proposes to treat provincial super allowances (that is, deductions for SR&ED in excess of 100 % of the expenditures) as government assistance which will affect the expenditure base for federal investment tax credits (“ITC”) purposes.

Non-Resident-Owned Investment Corporations (“NRO”)

Previously, a foreign-owned Canadian corporation could elect to be an NRO.   The budget proposes to repeal the NRO provisions for elections made after February 27, 2000.  Existing NROs will be entitled to retain their status until the end of their last taxation year that begins before 2003.

Other Specific Tax Measures

Capital Gains

The budget proposes that the income inclusion rate for capital gains be reduced to two thirds from the current rate of three quarters for capital gains realized after February 27, 2000.  As a result of this change, capital gains will be taxed at about the same rate as dividends received from taxable Canadian corporations.  Because this measure becomes effective for capital gains realized after February 27, 2000, two different inclusion rates will apply for the 2000 taxation year.  Accordingly, individuals (and other taxpayers with calendar taxation years) will be required to separately report capital gains and losses realized in the period January 1 to February 27 inclusive, and capital gains and losses realized after February 27 for that year. For each period, the net capital gain or loss will have to be computed and the applicable inclusion rate applied.  An individual’s capital gains inclusion rate for the 2000 taxation year will depend on whether the individual has realized net gains or net losses in one or both periods, or a net gain in one period and a net loss in the other.  Where there is a net gain or net loss in one period and none in the other, the individual’s capital gains inclusion rate for the year will be that applicable to the period in which the net gain or net loss is incurred.  That is, if the net gain or net loss is incurred in the period January 1 to February 27, the individual’s inclusion rate for the 2000 taxation year will be three quarters; if the net gain or net loss is incurred in the period February 28 to December 31, the individual’s inclusion rate for the 2000 taxation year will be two thirds.  Where a net capital loss of a given year is used to reduce a taxable capital gain of another year for which the capital gains inclusion rate is different, the amount of the loss is adjusted to match the inclusion rate in effect for the year in which the loss is being applied. The adjustment factor is determined by dividing the inclusion rate for the year the loss is claimed by the inclusion rate for the year in which the loss arose. 

For taxpayers whose taxation years do not coincide with the calendar year (such as some corporations), the reduced two-thirds inclusion rate will also apply to capital gains realized after February 27, 2000. Similar to individuals, corporations will be required to report capital gains and losses realized on or before February 27, 2000 separately from those realized after that date.

Related Items

To reflect the reduction in the capital gains inclusion rate effective February 28, 2000, the appropriate adjustments will be made to related items, including:

·       the deductions for amounts included in income in respect of employee stock options and employer shares from a deferred profit-sharing plan;

·       allowable business investment losses;

·       the $500,000 lifetime capital gains exemption for qualified small business shares and qualified farm property; and

·       the inclusion rate applicable to the gain on the charitable donation of listed securities (i.e., one-half the otherwise applicable inclusion rate).

Ecologically Sensitive Lands

Donations of ecologically sensitive land from individuals are eligible for the charitable donations tax credit, while those from corporations are eligible for a charitable donation deduction.  Ecological gifts are exempt from the rules which would otherwise limit the amount of charitable donations eligible for tax assistance in a year to 75 % of net income.  The budget proposes an enhancement of the incentives for the protection of ecologically sensitive lands.  Specifically, it is proposed that, where ecologically sensitive land (and related easements, covenants and servitudes) is capital property of the donor, the income inclusion will be reduced by one-half in respect of capital gains arising from gifts of such property to qualified donees other than private foundations.  It is also proposed that the value of all ecological gifts be determined by a special process to be established by the Minister of the Environment.  These measures will be effective for ecological gifts made after February 27, 2000.

Strengthening Thin Capitalization Rules

The Income Tax Act contains "thin capitalization" rules that restrict the interest deduction that a corporation resident in Canada can claim in respect of debt owing to a specified non-resident – generally, a shareholder who owns 25 % or more of the votes or value in the corporation or a person who is not at arm’s-length with such a shareholder.  Under these thin capitalization rules, the Canadian corporation may deduct interest on debt to specified non-residents to the extent that such debt does not exceed three times the amount of equity contributed by such non-residents.  In the event that such debt exceeds the 3:1 ratio, the interest deduction attributable to the excess is denied for Canadian tax purposes.

The rules currently apply only to corporations and not to other business arrangements such as partnerships, trusts and branches.  Taxpayers may therefore be able to use these structures in order to circumvent the rules. There is also concern that use of financing techniques that do not rely on traditional debt – such as leases from a non-resident parent – may weaken the effectiveness of the rules in protecting the Canadian tax base.

In response to these and other concerns, the budget proposes that the thin capitalization rules be amended in the following manner:

·       The threshold debt-equity ratio will be lowered from 3:1 to 2:1.

·       The debt-equity ratio will be calculated on an averaged basis.  Specifically, average debt for a fiscal year will be calculated as the average of monthly amounts, each of which is the highest amount of debt to specified non-residents outstanding at any time in the month. Of the three components of equity, retained earnings will continue to be measured at the beginning of the year, while the amount of paid-up capital and contributed surplus attributed to specified non-residents will be a monthly average amount.

·       The conditional loan rule will be broadened to include loans to a Canadian corporation from a third party that are guaranteed or secured by a specified non-resident.

These changes will come into effect for taxation years that begin after 2000.

The government intends to initiate consultations on the extension of the thin capitalization rules to other leasing arrangements and to business structures, such as partnerships that have non-resident members, trusts that have non-resident beneficiaries, and Canadian branches of non-resident companies carrying on business in Canada.

Adjustments to the Capital Cost Allowance System

Proposed changes to capital cost allowance (“CCA”) in respect of depreciable property include an extension of the separate class election to Class 43 manufacturing and processing equipment costing more than $1,000.  This measure will apply to property acquired after February 27, 2000.  The proposed election must be filed with the income tax return for the taxation year in which the property is acquired.

Weak Currency Borrowings

"Weak currency borrowings" are transactions that take advantage of the fact that, where a currency is expected to decline in value relative to some reference currency, the interest rate on a loan in the "weak" currency will be higher than on a loan on similar terms in the reference currency.  A taxpayer seeking to maximize his interest expense deduction may borrow in a weak currency, even though that currency is not required in its business.  If, as expected, the currency of the borrowing depreciates, the taxpayer will realize a foreign exchange gain on the maturity of the loan.  The full deduction of the additional interest, coupled with the preferential treatment of capital gain on the offsetting appreciation, was recently unsuccessfully challenged by CCRA in the Supreme Court of Canada decision in Shell Canada Limited v. Her Majesty the Queen. 

Under proposed rules, a weak currency borrowing will be treated for tax purposes as equivalent to a direct borrowing in the currency that is used by the taxpayer to earn income.  Where the proposed rules apply, deductible interest on the indebtedness will be limited to the interest that would have been payable if the taxpayer had incurred an equivalent debt directly in the currency of use, and the total of interest expense disallowed over the term of the indebtedness will be subtracted from the foreign exchange gain or loss realized when the debt is repaid.  The budget proposes to apply these rules as of July 1, 2000, in respect of indebtedness incurred after February 27, 2000.

GST Rebate on New Residential Rental Accommodation

The budget proposes a GST rebate for new residential rental accommodation. The purchasers or self-suppliers of new residential rental property are not eligible for any GST rebate under the existing system. The budget proposes a New Residential Rental Property Rebate of up to 2.5 percentage points of tax, potentially reducing the GST payable by the purchaser or self-supplier to 4.5 %. This rebate will apply to newly constructed, substantially renovated or converted residential rental accommodation where construction commences after February 27, 2000. The rebate will also apply to the leasing of land that is used for residential purposes pursuant to agreements entered into after February 27, 2000.

Under this proposed Rebate, purchasers or self-suppliers of a new qualifying unit will be eligible for the rebate regardless of whether the unit is merely leased until the unit can be sold. The amount of the rebate, plus interest, must be recaptured if the unit is sold, within one year from the time it is first occupied, to a person who is not acquiring it for use as the primary place of residence of the person or a related party of the person.

OTHER RECENT DEVELOPMENTS

Numerous recent court decisions should generally please taxpayers, particularly those taxpayers in the real estate industry.  However, the Minister of Finance has responded to one favourable case, Sherway Centre Limited, by proposing legislation to prohibit the deductibility of interest payments in respect of certain, but not all, participating loans.  The court decisions (and the proposed tax amendment) are discussed below.  Your partner at Goldfarb, Shulman, Patel & Co. LLP would be pleased to assist you in determining the impact of these decisions on your situation.

Tenant Inducement Payments (“TIPs”)

Toronto College Park Limited v. The Queen, Canderel Limited v. The Queen,

and Ikea Limited v. The Queen

The Supreme Court recently released its judgments on three cases all dealing with TIPs made to tenants.  The appeals of Toronto College Park Limited and Canderel Limited (both payors of TIPS) were allowed.  The TIPs were held to qualify as running expenses and were deductible in the year incurred.  The appeal of Ikea Limited (a recipient of a TIP) was dismissed.  The TIP had to be included in income in the year received.

Toronto College Park and Canderel deal with the timing of the deduction of TIPs made by landlords in order to procure tenants to lease their premises over a long term.  In the Canderel decision, the Court held that the matching of the TIPs against the future revenues generated from the lease did not provide a more accurate picture of income as compared to upfront deductibility. Although some of the benefits yielded by the payments were realized over the terms of the leases, some benefits were realized in the year of expenditure so that amortization was not required. In Toronto College Park, the Court held that the benefits yielded by the TIPs in that case were realized entirely in the year of expenditure, so that current deductibility was the only appropriate treatment.  However, the Supreme Court did state that the matching principle may be relevant in those cases where its application portrays the more accurate picture of the taxpayer's profit. The Court indicated that matching could apply to an expense that is incurred for the specific purpose of earning a discrete and identifiable item of future revenue. The Court confirmed that matching does not apply to a running expense, which is essentially an expense that does not relate to particular revenues.

It will be essential for TIPs to be carefully structured if upfront deductibility is desired.  CCRA's view is that these cases do not mean that TIPs in all situations will be deductible up front and that the judgments in these two cases were based on the facts of those cases.  CCRA has stated that a difficult decision has to be made whether an expenditure is incurred for the specific purpose of earning an identifiable item of revenue which results in the application of the matching principle or whether there are sufficient current benefits from the expenditure to justify treatment as a running expense.  An important change resulting from these cases is that once the taxpayer shows that he or she has presented an accurate picture of income, the onus of proof shifts to CCRA to show that the taxpayer's determination of income is not an accurate picture, or at least not as accurate as the one presented by CCRA.

Where a taxpayer has previously filed tax returns amortizing TIPs over the life of the lease and the facts are the same as Canderel and Toronto College Park, CCRA will accept the write-off of the unamortized TIPs balance in the tax return filed after the Supreme Court decisions. 

For further information regarding these cases or for assistance in structuring TIPs or similar expenditures, please contact your partner at Goldfarb, Shulman, Patel & Co. LLP.

Participation Payments on Debt

The Queen v. Sherway Centre Limited

The Sherway Centre Limited case involves the deduction of interest payments made on participating debt.  Prior to the Sherway Centre decision, CCRA’s position was that participation payments made on a borrowing were generally not considered interest because they did not accrue on a day to day basis, and they were not normally calculated with reference to the principal amount of the debt.  Furthermore, CCRA maintained that participation payments were not deductible as expenses incurred in the course of a borrowing under paragraph 20(1)(e) of the Tax Act.  However, CCRA’s administrative practice had been to treat participation payments as interest if the payments were limited to a stated percentage of the principal amount of the borrowing, and the limited percentage reflected existing commercial rates of interest.

In the Sherway Centre decision, the Federal Court of Appeal held that the participation payments made in that case, which did not meet CCRA’s strict guidelines, nonetheless constituted interest and were deductible under paragraph 20(1)(c) of the Tax Act.  The Court found that an amount paid as compensation for the use of money for a set period of time, including a participation payment, could be considered interest and could be said to accrue from day to day.  Furthermore, because the participation payments in that case were payable only so long as there was a principal sum outstanding on the loan, they were considered referable to the principal sum.  In its decision, the Court placed some significance on the fact that the sum of the stated interest rate and the participation payments approximated a commercial rate of interest.  Finally, the Court held that even if the participation payments were not deductible as interest expense, they were deductible as expenses incurred in the course of a borrowing under paragraph 20(1)(e) of the Tax Act.  That part of the decision will be overridden by the proposed amendment discussed below.

CCRA views the decision as upholding that participation payments that are intended to increase the interest rate of the underlying loan to the prevailing market rate may be considered interest. However, CCRA believes that other participation payments that are structured to be a distribution of profit (or demonstrate any other indication of an equity investment) would not qualify as interest and would not normally be deductible.

The proposed amendment provides that, effective with respect to expenses incurred by a taxpayer after November 30, 1999 (except where the expenses were incurred pursuant to a written agreement made by the taxpayer on or before that date), participation payments and similar “excluded amounts” will not be deductible under paragraph 20(1)(e) of the Tax Act.  An excluded amount is broadly defined to include any payment that is contingent or dependent upon the use of or production from property, or any amount that is computed by reference to revenue, profit, cash flow or similar criterion (such as the borrower's profitability).  As a result of the proposed amendment, profit participation and similar payments will generally only be deductible if the payments qualify as interest expense under paragraph 20(1)(c) of the Tax Act.

Deductibility of Regional Development Charge ("RDC")

Urbandale Realty Corporation Limited v. The Queen

In a very recent decision, the Federal Court of Appeal allowed the taxpayer’s appeal regarding the deductibility of RDCs.  The corporate taxpayer was a land developer who paid $2.9 million during its 1986 taxation year to a regional municipality as an RDC.  None of the lands with respect to which the RDCs were paid had been sold by the taxpayer during 1986.  CCRA argued that the deduction of the RDC was not in conformity with GAAP and that the RDC was a cost of earning revenue from selling land in later taxation years and was not a running expense.  In allowing the taxpayer's appeal, the Court concluded that CCRA’s position that the deduction of the RDC was not in conformity with GAAP was indeterminate, and that CCRA would therefore have been required to show that the fair market value of the land at the close of 1986 was greater than the amount shown in its financial statements by the amount of the RDC.  Furthermore, to obtain an accurate picture of the taxpayer's profit for the year of payment (applying the Canderel test), the RDC was required to be deducted in computing taxpayer's income for 1986.  Finally, the Court concluded that the prepaid expense rule in the Tax Act did not apply since the RDC payment was not taxes, interest, rent, or royalty.  It is not yet known whether CCRA will request a leave to appeal the case to the Supreme Court.

Reasonable Expectation of Profit

Stremler et al v. The Queen

In a recent Tax Court of Canada (“TCC”) decision, the taxpayers were allowed a deduction for rental losses and losses on dispositions of certain residential condominium units acquired for the sole purpose of resale at a profit.  CCRA disallowed the deduction of the rental losses on the basis that the taxpayers had no reasonable expectation of profit.  In addition, CCRA denied the losses on the disposition of the properties on the basis that the properties were capital assets, and that taxpayers could not characterize them as inventory, since they had previously reported them as capital assets.  The TCC allowed the taxpayers' appeals concluding that the question of whether or not the properties in issue were capital or income was a question of fact and that based on the evidence, the properties were purchased by taxpayers as an adventure in the nature of trade.  The TCC concluded that, since the properties were inventory, the taxpayers should be allowed to annually deduct their carrying costs and any loss related to the decline in the fair market value of the units.  It appears that CCRA will not appeal this decision.  However, CCRA has verbally indicated that the decision will only be applied to a narrow group of situations having a virtually identical fact pattern.