Carrying on business in Canada

In the past 15 years, direct investment in Canada has more than tripled in value; more than 65% of that investment has come from the U.S. It is anticipated that this figure will continue to grow as U.S. corporations seek to expand their markets. This item discusses the basic Canadian tax issues facing U.S. corporations seeking to expand their businesses into Canada and the use of limited liability companies (LLCs) and unlimited liability companies (ULCs).

Taxation of Nonresident Corporations

Under Canadian law, nonresident corporations are subject to income taxes in Canada when they carry on a business there or dispose of taxable Canadian property (generally real estate, property used in a Canadian business and private company shares). These corporations will be subject to tax at ordinary rates, which range from 31% to 39% depending on the province to which the income is allocated.

In addition to income taxes, nonresident corporations are subject to a branch tax of 25% of the profits deemed to have been repatriated to the U.S. The amount is determined by formula and is designed to replicate the withholding tax that would have been imposed had those corporations carried on their Canadian business indirectly through a Canadian corporation that distributed its after-tax business earnings via dividends

Defining “Carrying on Business”

A question often asked is, “what level of Canadian business activity can a nonresident corporation engage in before being deemed to be carrying on business in Canada?” The term “carrying on business” is not specifically defined in the Canadian Income Tax Act (Act); rather, a common-law definition has evolved from the U.K. and Canadian courts. In addition, Act Section 253 provides an extended meaning of the term that deems a nonresident to be carrying on business in Canada if it:

1. Produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs anything in Canada;

2. Solicits orders or offers anything for sale there through an agent or servant, whether the contract or transaction is completed inside or outside of Canada; or

3. Disposes of certain resource properties or Canadian real estate.

Accordingly, the level of Canadian activity required to be deemed to be carrying on business there is very low. U.S. resident corporations can usually find relief in the Convention between the United States of America and Canada with respect to Taxes on Income and on Capital, signed September 26, 1980 (Treaty).

Treaty Provisions

The Treaty generally provides relief for U.S. residents via Article VII, Business Profits. This Article states that a U.S. resident will not be taxable in Canada on business profits unless it carries on a business there via a permanent establishment (PE) situated in Canada. When there is a Canadian PE, all business profits allocable to it may be taxed there.

Article V, Permanent Establishment, defines a PE to include:

1. Place of management, a branch, an office, a factory, a workshop and a mine or oil and gas well;

2. Building site or construction or installation project that lasts more than 12 months;

3. Person acting in Canada on behalf of a U.S. resident if that person has, and habitually exercises in Canada, the authority to conclude contracts.

A PE is deemed not to include a fixed place of business used solely for storage, display or delivery of goods or for the purchase of goods. In addition, the fact that a U.S. corporation has a Canadian subsidiary that carries on business there via a PE will not result in the U.S. parent having a PE in Canada.

Accordingly, when treaty protection is available, it is possible to carry on business in Canada, within these limits, without being subject to Canadian income taxes. Note: Canada requires a nonresident carrying on business in Canada, but exempt from Canadian tax because of Treaty provisions, to file an annual information return; see Act Section 150(1)(a).

Article 10, Dividends, also reduces (and in some case eliminates) various withholding taxes and exempts the first C$500,000 of branch profits from Canadian branch tax.

The LLC Trap

The popularity of U.S. LLCs in the last few years has led these entities to establish Canadian branches or subsidiaries. While an LLC may be disregarded or treated as a partnership for U.S. tax purposes, it will be treated as a corporation for Canadian tax purposes. This differing treatment generally does not cause any problems in inbound-to-Canada planning, and can provide some significant opportunities in the area of cross-border financing structures.

The LLC trap is caused by the fact that Canada does not consider a disregarded LLC, or an LLC treated as a partnership, to be a U.S. resident for Treaty purposes; thus, it does not afford treaty benefits to such an LLC. This is became Article IV, Residence, defines a resident of a contracting state as a person that is subject to tax in that state. Because a disregarded LLC or an LLC treated as a partnership is not subject to tax in the U.S., it is not deemed to be a U.S. resident. Thus, an LLC carrying on business in Canada:

* Will be taxable in Canada, whether or not it is operating through a PE;

* Will be subject to 25% withholding tax, if it receives interest, dividends and royalties from a Canadian resident;

* Will not be eligible for the C$500,000 branch tax exemption; further, the branch tax will be imposed at 25%, rather than the 5% Treaty rate.

There are also negative consequences for an LLC that forms a Canadian subsidiary. While the subsidiary will still be taxed at regular Canadian rates, the withholding tax on dividend distributions will be 25%.

It is widely anticipated that the next protocol to the Treaty will resolve the LLC trap; however, it is not known when it will be completed. Accordingly, if an LLC is considering expansion into the Canadian market, it is vital that a Canadian tax adviser be consulted before commencing operations there.

ULCs

A special type of Canadian corporation, the ULC, has become very popular with cross-border planners over the last few years, due to the opportunities presented by its hybrid classification. It is treated as a corporation for Canadian tax purposes and may be treated as a disregarded or flowthrough entity for U.S. tax purposes. In the past, this type of corporation could only be formed in the province of Nova Scotia; very recently, the province of Alberta passed legislation allowing ULC formation there, too; compare the Nova Scotia Companies Act to the Alberta Business Corporations Amendment Act (Bill 16, 5/17/05). Some of the advantages “of using a Canadian ULC include:

1. When an S corporation carries on business in Canada through a PE, the use of a ULC can reduce the effective tax rate, by allowing the S shareholders access to foreign tax credits that would not be available if the S corporation had used a regular Canadian corporation. A qualified subchapter S subsidiary is often used to shield the parent S corporation from liabilities arising from the Canadian operations, as a ULC does not provide liability protection.

2. The use of a ULC allows losses to flow through to the U.S. parent.

3. When a ULC is disregarded for U.S. purposes, transfer pricing issues are simplified; only the Canadian authorities must be satisfied, as the transfer price does not affect U.S. taxation.

4. A ULC instead of a Canadian branch also simplifies Canadian transfer pricing issues, as there is more guidance available on establishing transfer prices between two corporations than on determining the profits that should be allocated to a PE under the Treaty.

5. The use of a ULC instead of a regular Canadian corporation avoids the complexities of the U.S. controlled foreign corporation and passive foreign investment company rules.

6. The ULC can be very useful in developing cross-border financing structures that can significantly reduce the effective cost of capital.

7. In an acquisition, it may be possible to step up the basis of the assets of a Canadian target corporation by “converting” it to a ULC.

The cost of incorporating and maintaining a ULC has risen over the past several years, due to increased fees being charged by Nova Scotia; however, with the competition provided by Alberta’s ULC legislation, it is anticipated that these costs will now decrease.

Conclusion

While this item has discussed some of the basics of Canadian taxation of nonresidents and some issues surrounding the use of LLCs and ULCs, there are many more considerations for a U.S. corporation seeking to expand into the Canadian marketplace; it will be vital for U.S. and Canadian tax planners to work together to find the most effective structure for both sides of the border

GST/HST Dentists

A dentist whose professional practice is comprised one-third of crown, bridge and denture work, with office rent, administration and other taxable costs of $200,000 per year, may be eligible to recover an estimated $5,000 per year ongoing and a four-year “catch-up” for a total of $20,000 of immediate ITC entitlement as a result of this court decision.

This Tax Court of Canada decision reflects the first judicial review of CRA’s GST policy for dentists and indiscriminately rejects CRA’s narrow interpretation of the matter.

This decision establishes a legal precedence that, at the moment, is the highest authority with respect to this issue.  In plain terms, this Tax Court decision overrules CRA’s policy on the matter of dentists’ services with respect to crown, bridge and denture work.

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SALE OF ALL THE ASSETS OF A DENTAL PRACTICE

SAMPLE RULING

Statement of facts

A, who is a non-registrant dentist, has agreed to sell all the assets of his dental practice to dentist B who is also not registered for GST purposes. The closing of the sale will take place on March 15, 1995. The assets sold by A are as follows:

– dental supplies including various articles like crowns and caps;

– equipment and furniture;

– goodwill; and

– leasehold improvements

A previously acquired the above assets for use exclusively in the provision of exempt dental services, and in fact did not make any taxable supplies.

Ruling Requested

A is not required to collect and account for GST on the sale of the above business assets.

Ruling Given

Provided that the preceding statement constitutes a complete and accurate disclosure of all the facts, proposed transaction, and provided that the proposed transaction is completed as described above, our ruling is as follows:

The sale of dental supplies as well as equipment and furniture will not be subject to GST pursuant to paragraph 141.1(1)(b) of the Excise Tax Act. Furthermore, under section 167.1 of the Excise Tax Act, the consideration allocated to goodwill will not be included in calculating GST payable. However, A must collect and remit GST on the sale of the leasehold improvements since it is a taxable supply of real property. On the other hand, A will be eligible for a rebate under section 257 of the Excise Tax Act for the GST paid on the acquisition of, and improvements to the real property.

This ruling is given subject to the limitations and qualifications set out in GST Memoranda Series (1.4) issued by Revenue Canada and is binding provided that this proposed transaction (i.e., sale closing on March 15, 1995) is completed prior to June 15, 1995.

This ruling is based on the Excise Tax Act in its present form and do not take into account any proposed amendments to the Act which, if enacted, could have an effect on the ruling provided herein.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

GST/HST to Independent Medical Evaluations

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 Supplies of health care services

DRAFT FOR DISCUSSION PURPOSES ONLY

 Introduction

 In a Tax Court of Canada decision concerning

 The Court concluded that the individuals were “patients” of the Riverfront facility because they attended the facility to be examined by a physician. The Court concluded that because Riverfront provided the examination rooms and other equipment necessary for the examinations and remunerated the physicians for the examinations and reports, Riverfront’s supplies of IMEs and reports fell within the exemption provided in section 2 of Part II of Schedule V to the ETA. This provision exempts a supply made by the operator of a health care facility of an institutional health care service rendered to a patient of the facility. Thus, for an IME to be an exempt supply, the activities that comprise the IME must fall in one of the exemptions in the ETA.

In view of the Court’s comments regarding the physicians’ examinations, we reviewed our position on the tax status of supplies made directly by physicians of IME reports, as well as evaluations supplied by other health care professionals. Our position is noted below.

Riverfront Medical Evaluations Ltd. v. Canada (“Riverfront”), the issue was whether a corporation’s supplies of independent medical evaluation (“IME”) reports to insurance companies and lawyers were “institutional health care services” supplied by the operator of a health care facility and rendered to patients of the facility. Essentially, the Court found that an IME consisted of medical care because it consisted of a physical examination of an individual by a physician. In addition, the Court found that Riverfront was a “health care facility” for purposes of the Excise Tax Act (the “ETA”) because the physical examinations were provided at Riverfront’s facility.

  Under the Excise Tax Act (the Act), exemptions from the GST/HST for supplies of medical and certain other health care services are generally limited to those made by suppliers who are engaged in the practice of a particular profession and who are licensed or certified under the laws of a province to practice the particular profession. These suppliers are defined in the Act.

 For instance, a supply of a consultative, treatment, diagnostic or other health care service rendered to an individual is exempt for GST/HST purposes when a medical practitioner makes the supply. A medical practitioner is defined as a person who is licensed under the laws of a province to practice the profession of medicine or dentistry

 In addition, a supply of an optometric, chiropractic, physiotherapy, podiatric, osteopathic, audiological, speech-language pathology, occupational therapy, or psychological service rendered to an individual is exempt when a practitioner supplies the service. A practitioner is defined in the Act as a person who practices the profession relevant to one of these services and who is licensed or otherwise certified to practice that profession (if required in the province where the service is supplied) or has the qualifications equivalent to those necessary to be so licensed or certified in another province (if not required in the province where the service is supplied). Please note that it is possible for a corporation to qualify as a medical practitioner or practitioner.

Federal

Federal

  • The new tax rates and income brackets as shown on Schedule 1 are as follows:
    Tax Brackets Rates
    $0 $40,970 15%
    $40,971 $81,941 22%
    $81,942 $127,021 26%
    more than $127,021 29%
  • The personal basic amount has increased to $10,382.
  • The maximum age amount has increased to $6,446. If the taxpayer’s net income exceeds $32,506, this credit is gradually reduced and reaches NIL at a net income of $75,480
  • The spousal amount and the amount for an eligible dependant have increased to $10,382.
  • The maximum amount for an infirm dependant age 18 or older has increased to $4,223 per dependant.
  • The maximum eligible earnings for CPP/QPP purposes is $47,200. The rate respecting CPP/QPP contributions is 4.95%.
  • For Canadian employees (except Quebec) the maximum amount of eligible earnings for employment insurance purposes is $43,200. The employment insurance premium rate remains unchanged at 1.73%
  • The maximum amount of eligible earnings for employment insurance purposes for a Quebec resident is $43,200. The employment insurance premium rate is at 1.36% (maximum premiums of $587.52).
  • The maximum amount of eligible adoption expenses has increased to $10,975.
  • The pension income amount remains unchanged at $2,000.
  • The maximum amount eligible for the calculation of the caregiver amount is $4,223 per dependant.
  • The disability amount has increased to $7,239, and may be increased by a maximum supplement of $4,223 (workchart 316).
  • The maximum medical expense threshold (3% of net income) required to reduce total medical expenses has increased to $2,024.
  • The maximum amount for the Canada employment non-refundable tax credit has increased up to a maximum of $1,051.
  • The non-refundable tax credit for children under 18 has increased to an amount of $2,101 per child.
  • The 2010 budget proposes that separated parents that have shared custody of their children will be able to equally split the monthly payments of the Child Tax Benefit (“CTB”), Universal Child Care Benefit (“UCCB”), and the quarterly GST/HST credit.
  • The 2010 budget proposes to allow single parent families the option of declaring the UCCB on either the parent’s return or to tax the sum on the return for the individual for which the eligible dependant amount was claimed.
  • Starting in 2010, the Canada Revenue Agency will no longer allow as medical expenses cosmetic procedures that are done solely for cosmetic purposes. However, the same procedures will qualify if the patient required the treatment for medical reconstructive purposes such as surgery to ameliorate a deformity arising from, or directly related to a congenital abnormality, a personal injury resulting from accidental trauma or a disfiguring disease.
  • The 2010 budget also proposes to extend the existing RRSP rollover rules to allow a rollover of a deceased individual’s RRSP proceeds into a registered disability savings plan (“RDSP”) of a financially dependent infirm child or grandchild.
  • The 2010 budget proposes to clarify that a post-secondary program that consists principally of research otherwise eligible for the Education Tax Credit and the scholarship exemption will be taxable for post-doctoral fellowships.
  • According to the 2010 budget an amount will be eligible for the scholarship exemption only to the extent it can reasonably be considered to be received in connection with enrolment in an eligible educational program for the duration of the period of study related to the scholarship.
  • Effective March 4, 2010, 4:00pm EST (the “Effective Time”), in order to allow employees stock option deductions on their personal income tax returns, employers with “cash-out” stock option plans may have to provide written proof that their company has not taken any deduction in consideration of such plans.
  • The 2010 budget also proposes special relief for tax deferral elections on stock options for taxpayers who elected under the current rules to defer taxation of their stock option benefits until the disposition of the optioned securities.
  • For U.S. social security benefits received on or after January 1, 2010 the 2010 federal budget proposes to reinstate the 50% inclusion rate for Canadian residents in receipt of U.S. social security benefits since January 1, 1996 and for their spouses and common-law partners who are eligible to receive survivor benefits.
  • The 2010 budget proposes that the Mineral Exploration Tax Credit be extended for one year for flow-through share agreements entered into on or before March 31, 2011. Funds raised with this credit during the first three months of 2011 can support eligible exploration until the end of 2012.
  • The maximum amount tax credit for sport and recreation per child remains unchanged at $500, plus a $500 supplement for children under 18 with disabilities.
  • The education amount for part-time studies and the textbook amount remain unchanged at $120 and $20 per month respectively.
  • The education amount for full-time studies and the textbook amount remain unchanged at $400 and $65 per month respectively.
  • The maximum amount for the refundable medical expenses supplement (line 452) has increased to up to a maximum of $1,074.
  • The Home Renovation Tax Credit has not been renewed for 2010.
  • For 2009 and subsequent years, a taxpayer may claim the new non-refundable Home Buyers’ Tax Credit, based on an amount of $5,000, for a qualifying home acquired after January 27, 2009.
  • The maximum Home Buyers’ Plan (“HBP”) amount that can be withdrawn from an RRSP under the HBP has increased to $25,000.
  • With respect to the Investment Tax Credit, the deadline to claim the mineral exploration tax credit on qualifying expenses renounced under the flow-through share agreements was extended to March 31, 2010.
  • Eligible dividends are taxable at 144% with a federal dividend tax credit of 17.9739%. Dividends other than eligible dividends are taxable at 125% with a federal dividend tax credit of 13.3333%.

GST HST basics

HST basics: five things you must know

 Here are five fundamentals that businesses in Ontario and B.C. need to know about the new tax:

  1. HST combines the federal Goods and Services Tax (GST) with the provincial sales tax (PST) into a single tax.
  2. Ontario businesses will charge 13 per cent.
  3. B.C. businesses will charge 12 per cent (the lowest HST rate in Canada).
  4. HST applies to both goods and services, adding the provincial sales tax to services that would previously only have had GST applied.
  5. As of May 1, 2010 businesses that sell goods or services to be delivered, installed or performed on or after July 1, 2010 are required charge HST.

Which businesses will need to charge HST?

HST will apply to goods, services, real property and intangible property, such as contractual rights and patents. (We’ve included two charts below to show how the tax status of many goods and services will change.)

You will need to charge HST if:

  • you have sales over $30,000 in the calendar year or any four consecutive quarters;
  • your business is registered for the GST already.

Current GST registrants won’t need to apply for a new number. The business number (BN) you use for your GST account number will be the same number you will use for your HST account and your filing frequency stays the same.

Why harmonize?

In both Ontario and British Columbia, the HST is being introduced to help businesses cut red tape and save money. The purpose of harmonization is to make businesses more competitive and to stimulate the economy.

Here’s how this works.

Under the current tax system, you can claim back the GST you’ve paid on all of your business expenses, but you can’t do the same for PST. As a result, goods have a “tax history” that has PST added at every step of the supply chain. These hidden PST costs are included in the final price, with consumers paying tax on the embedded tax.

As a value-added tax, GST is different. There is no hidden tax, because businesses can use the GST they pay out as an input tax credit. The business only remits the difference between the GST it has collected and the GST it has paid.

Harmonization brings the same system and advantages to the collection of the retail sales tax portion. Every business expense that includes HST, from phone services to office supplies, will help reduce the total amount of tax remitted to the government.

Claiming input tax credits

Not all businesses will be able to claim input tax credits on the PST portion of the HST right away.

Small and medium-sized companies with annual taxable sales under $10 million will be able to claim input tax credits for the sales tax paid out after July 1, 2010. However, financial institutions and large businesses with annual taxable sales of more than $10 million will have to wait five years to claim input tax credits paid on the provincial portion of the HST for certain expenses. Then, full input tax credits will be phased in over a three-year period.

Once the HST is fully phased in, the estimated savings for business are substantial.

In B.C., it’s estimated that businesses will save $1.9 billion in input costs. In Ontario, the HST will slash about $4.5 billion annually in hidden sales taxes once it’s fully phased in.

Lessons learned from other provinces

The HST is not new to Canada. Already, Quebec and the Atlantic provinces have tax harmonization. And around the world, more than 130 countries have adopted value-added taxes.

Interestingly, prices actually dropped slightly in the eastern provinces after the HST was introduced. According to the C.D. Howe Institute, lessons from the implementation of HST in the eastern provinces suggest that harmonization in Ontario and B.C. will not lead to higher consumer prices.

In Ontario, businesses can expect to save more than $500 million annually in compliance costs while B.C. businesses can expect to save $150 million a year.

“Sales tax harmonization will simplify tax compliance for businesses since they will only have to manage one sales tax system,” says Ted Wigdor, vice-president, government and corporate affairs, with Certified General Accountants of Ontario. That means one harmonized tax base, one set of sales tax returns and one consistent reporting period, all of which will benefit small- and medium-sized enterprises.

HST implementation checklist

The following checklist will help you identify the systems you will need to change to be ready for the introduction of the HST on July 1, 2010.

  • Do you need to modify your cash registers or point-of-sale systems?
  • Do you need to update automatic payments to include HST?
  • Do you need to update your e-commerce website to add the HST? (Remember, your business might be closed for the July 1 holiday, but your website is not!)
  • Do you need to update your accounting software to accommodate the new tax?
  • Do you need to update your accounts receivable / accounts payable / invoicing software?
  • Do you need to make adjustments to the way you do your input tax/taxable benefits calculations?
  • Are there any other aspects of your business that will be affected by the new tax?

Sample HST remittance calculation

To better understand how value-added tax works, let’s take a British Columbia accounting firm as an example.

Scenario: The firm hires an independent contractor to work on an accounting project. The contractor bills the accounting firm $1,000 and the accounting firm, after reviewing the work and managing the project, bills its client $2,000.

As of July 1, 2010: calculating the “value-added”

Contractor’s fee to accounting firm $ 1,000
+ 12% HST $ 120
Total invoice $ 1,120
Accounting firm’s fee to client $ 2,000
+ 12% HST $ 240
Total invoice $ 2,240

 

Total HST remitted to government: $240.

Even though $360 of HST is collected between the two companies, only $240 is remitted to the government. That’s because while the accounting firm collected $240 in HST, it keeps $120 of the funds collected to cover the money paid out to the contractor and only remits the remaining $120 to the government.

In reality, each business will likely have other qualifying HST deductions as well from the tax paid on other business expenses, so the amount paid to the government would likely be reduced even further.

Special rules for transactions that staddle the implementation date

Service businesses that have not charged provincial sales tax may need to charge both taxes on work that overlaps the July 1 implementation date.

If over 90 per cent of the work is done before July 1, the business will charge GST only. However: If more than 10 per cent of the work is done after July 1, the business will need to charge GST on the pre-transition portion of their work and charge HST on the remaining portion. These rules apply to the taxable supplies of personal property and services made in Ontario or B.C.

Consider a design firm that creates a brochure a client. Work begins in May and the brochure is completed at the end of July. Seventy per cent of the work is performed in May and June, while the remaining 30 per cent is performed in the month of July.

Since more than 10 per cent of the work overlaps the HST implentation date, the firm must charge both GST and HST. Here is an example of how the company would invoice both taxes:

Invoice for services rendered

Brochure design (pre-July1) $ 7000
GST (5% of $7000) $ 350
Brochure design (post-July1) $ 3000
HST (12% of $3000 using the BC rate) $ 360
Total amount owing $ 10,710

 

How goods & services will be taxed as of July 1, 2010

Wondering which products and services will see a change in their tax status as of July 1? Here’s a run-down of some of the key ones:

Goods & services that will have the HST added in both provinces

 

Affected goods & services Up to June 30 After July 1
Advertising services GST only HST
Cleaning services GST only HST
Commissions GST only HST
Custom software* GST only HST
Electricity GST only HST
Gasoline GST only HST
Goods for resale and raw materials GST only HST
Heating fuels GST only HST
Magazines* GST only HST
Manufacturing equipment* GST only HST
Membership fees (fitness, golf) GST only HST
Office rent GST only HST
Personal services (manicures, hair cutting, etc.) GST only HST
Professional services (accounting, legal, graphic design, etc.) GST only HST
Real property contracts (home improvements, office renovations) GST only HST
Safety clothing* GST only HST
Taxi and limousine fares GST only HST
Trade show admissions and conferences GST only HST
Training seminars GST only HST
* These items may be subject to certain conditions or, as in the case of safety clothing, be defined by the province.

 

Goods and services with variable PST/HST status in Ontario and B.C.

 

Goods/services Current PST tax status Current PST tax status Tax status with HST
  Ontario British Columbia  
Legal services Non-taxable Taxable Taxable
Admissions under $4 Exempt Non-taxable Taxable
Footwear under $30 Exempt Taxable Taxable
Basic groceries Exempt Exempt Zero-rated
Restaurant and catered meals Taxable (under $4, exempt) Exempt Taxable in B.C.; In ON over $4 is taxable, under $4 has a point-of-sale rebate on the provincial portion*.
Snack foods and soft drinks Taxable Exempt Taxable
Internet access fees Non-taxable Taxable Taxable
Newspapers Exempt Exempt Taxable in B.C.; in Ontario, there is a point-of-sale rebate on the provincial portion of HST
Software services (subject to certain conditions) Taxable Exempt Taxable
Adult-sized clothing for children under 15 Taxable Exempt Taxable

 

* While the Ontario tax rate for prepared foods and beverages under $4 is often said to be tax exempt, that is not correct. According to a GST/HST bulletin GI-064, businesses will get an instant point-of-sale rebate on the 8 per cent provincial portion of the HST. There are strict guidelines for qualifying products as well as how the HST must be shown on the sales receipt.

Consumers will normally receive the rebate by being paid by the retailer at the point of sale. The consumer can file a rebate claim with CRA using Form GST189 within four years of the purchase if the vendor does not pay or credit the rebate amount at the point of sale. Be sure to visit the link in the further reading section below to learn more about which products qualify for this instant rebate.

Further reading

For more on how transitional rules for the HST may affect your business, go to http://www.cra-arc.gc.ca/tx/pstr/trnstnl/menu-eng.html.

For more information on the HST and how to get registered, go to “Demystifying the GST / HST” at http://www.canadaone.com/ezine/oct03/gst.html.

For more information on qualifying products for Ontario’s Point-of-Sale rebate on Prepared Foods and Beverages http://www.crfa.ca/pdf/cra_pos_rebates.pdf.

For more information on point-of-sale rebates for Ontario newspapers visit http://www.cra-arc.gc.ca/E/pub/gi/gi-060/gi-060-e.pdf.

For more information on transition rules for services and personal property, visit http://www.cra-arc.gc.ca/E/pub/gi/notice247/notice247-e.html#P1.2

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Health care professionals

 

 

On July 1, 2010, the provincial sales tax (PST) will be harmonized with the federal goods and service tax (GST), resulting in a federally administered single sales tax imposed at 12%. The proposed harmonization will impose significant additional costs on the health care industry.

Now is the time for medical and health care professionals to consider the implications of harmonization on their costs, compliance systems and customers. Medical and health care professionals are persons licensed or otherwise certified to provide such services and include doctors, dentists, nurses, and other health care providers (e.g., chiropractors, orthopedists, optometrists, physiotherapists, podiatrists, chiropodists, osteopaths, audiologists, pathologists, occupational therapists, psychologists and midwives).

Most services provided by medical and health care professionals are not currently subject to either the GST or the PST. Under B.C.’s proposed harmonization with the GST, these services should remain exempt from B.C. HST with no direct impact to the consumer. However, where supplies made by a medical or health care professional are taxable (e.g., therapeutic massages, cosmetic surgery, sales of certain goods such as toothbrushes, etc.) these supplies will be subject to the B.C. HST. This represents a significant increase to the price of these supplies to consumers, and it is recommended that the tax status of these items be reviewed in detail prior to the introduction of the B.C. HST.

Impact on purchases made by medical and health care professionals

Currently, the PST applies to a relatively narrow base of goods and services used by medical and health care professionals in their practices. The B.C. HST will apply to a much broader base of goods and services. As a result, medical and health care professionals will be required to pay additional non-recoverable tax on the purchase of goods and services that are not currently subject to the PST. Consequently, their overhead costs will likely increase, and these professionals may be forced to pass on the additional costs to their customers.

The following table highlights a number of typical expenses that are currently subject to the GST but not the PST. Acquiring these items under the B.C. HST will become more expensive than under the current regime.

Other issues to consider

With the implementation of the B.C. HST fast approaching, medical and health care professionals should  consider a number of strategic planning activities:

  • Timing of purchases – stocking up on purchases of goods that do not currently attract the PST but that will attract the B.C. HST on July 1, 2010, will assist in reducing overall costs.
  • Real estate issues – consider purchasing real property prior to the implementation of the B.C. HST to minimize the taxes due on the purchase (i.e., 5% GST instead of 12% B.C. HST on the purchase of real property).
  • Corporate structure – consider reviewing the structure to determine the optimal treatment for income tax and B.C. HST purposes.
  • Current contracts – discussing the impact of the B.C. HST on suppliers will assist in determining whether a supplier’s costs will be positively affected by the implementation the B.C. HST and, as such, allow the medical or health care professional to purchase these products at a lower price.

Farmers in BC

Currently, farmers are exempt from paying PST on the cost of many items purchased for use in the farming business.  If a farmer is registered to collect GST/HST, any HST paid on costs for the farming business are recoverable as input tax credits. As most agricultural products are zero-rated (they are considered taxable, but the HST rate is zero), very little or no HST would be collected.  Many farmers are small suppliers, so registering to collect GST/HST is not mandatory, but would probably be to their advantage.  See Who has to register to collect GST/HST?

 Proposed General Transitional Rules for BC HST

Transitional rules are required to determine which tax – the existing PST (Social Services Tax) or the BC component of the HST – would apply to transactions that straddle the July 1, 2010 implementation date.

November 18, 2009 – New home sales – Grandparenting

Where written agreements of purchase and sale are entered into on or before November 18, 2009, and both ownership and possession of the homes are transferred under the agreement after June 2010, the sales will be subject to the federal component of the HST, but not the provincial component.  This would apply to sales of newly constructed or substantially renovated single-unit homes to individuals, and to sales of residential condominiums to all persons including individuals.

Sales of these grandparented homes would not be eligible for the new housing rebate or new rental housing rebate.

October 14, 2009

Certain purchasers that are non-consumers may have to self-assess the BC component of the HST on consideration that becomes due, or is paid, after October 14, 2009 and before May 1, 2010 for goods and services provided on or after July 1, 2010.  This would not apply if the non-consumer is a GST registrant and would therefore be entitled to an input tax credit.

Note:  Consumer means an individual who acquires goods or services for the individual’s personal consumption or use or for the personal consumption or use of another individual.  See the detailed information in Canada Revenue Agency’s Notice 247 regarding this topic.

A GST registrant in BC or Ontario should not be collecting the provincial portion of the HST prior to May 1, 2010, for goods or services provided in BC or Ontario, even if the goods or services are to be provided on or after July 1, 2010.  Prior to May 1, only the 5% GST should be collected for these goods or services.

May 1, 2010

The HST would generally apply to consideration that becomes due or is paid on or after this date, for property and services provided on or after July 1, 2010.

Some items addressed in the proposed HST transitional rules:
 
 
 
 
 
 

 

  

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Funeral services – HST will not apply to funeral services where the contract is entered into before July 1, 2010.    
 
 

 

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Transitional PST inventory rebate for residential real property contracts – A rebate will be available for PST embedded in construction materials purchased before July 1, 2010, but used in residential property contracts on or after July 1, 2010.    
 
 

 

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Subscriptions to newspapers, magazines and other periodical publications – HST will not apply to subscriptions paid before July 1, 2010.    
 
 

 

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Passenger transportation services – HST will generally not apply to the cost of continuous journeys that commence before July 1, 2010.    
 
 

 

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Freight transportation services – HST will generally not apply to the cost of a freight transportation service performed on or after July 1, 2010 if the service is part of a continuous freight movement of goods that begins before July 2010.     
 
 

 

 

For further information on the BC HST and the proposed transitional rules, see the following on the BC Ministry of Finance website

  

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News Release    
 
 

 

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Canada Revenue Agency information:
 
 
 
 
 
 

 

  

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Notice247 Harmonized Sales Tax for Ontario and BC – Questions and Answers on General Transitional Rules for Personal Property and Services    
 
 

 

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Notice246  Harmonized Sales Tax for BC – Questions and Answers on Housing Rebates and Transitional Rules for Housing and Other Real Property Situated in BC.    
 
 

 

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GST/HST Information SheetsTransition to the Harmonized Sales Tax
 

 

  

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GI-070 Goods    
 
 

 

 

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GST/HST Information Sheets:  Harmonized Sales Tax:
 
  

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  Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice. 

Chinese Tax

Chinese Tax Developments Re-draw the Map for

Canadian Investors

Canadians doing business in China may have a hard time keeping up with the country’s rapid pace of tax reform. Over the past year, China has introduced a host of changes to its tax laws and administration that aim to increase compliance and eliminate tax avoidance by non-resident investors. A new protocol to the China-Barbados tax treaty could also affect companies investing into China through Barbados by eliminating relief that was previously available to dividends and capital gains. On a brighter note, China has also announced a series of Business Tax exemptions for certain foreign business activities.

Companies with business investments or operations in China may need to review their activities and business structures in light of these reforms. The following recent Chinese tax developments of interest to Canadian investors:

  • Changes to the China-Barbados tax treaty
  • New anti-avoidance rules for non-residents
  • Enterprise Income Tax on representative offices in China
  • New exemptions from China’s Business Tax.

Protocol to the China-Barbados tax treaty

Access to reduced dividend withholding tax rate restricted

Under the protocol to amend the China-Barbados tax treaty signed on February 10, 2010, access to the reduced five-percent withholding tax rate on dividend payments between China and Barbados is only available if a beneficial owner company directly holds at least 25 percent of the dividend payer’s capital. If not, the withholding tax rate under the treaty is 10 percent.

The five-percent withholding tax rate on dividends is still competitive compared with other China treaties. Among popular holding company jurisdictions, only China’s treaties with Luxembourg, Ireland, Singapore and Hong Kong currently provide a five-percent withholding rate on dividends. Each of these treaties also includes a 25-percent ownership test as a condition for the reduced withholding tax rate.

Capital gains exemption narrowed

The China-Barbados protocol restricts the current exemption for capital gains on the disposition of shares in Chinese companies, eliminating one of the advantages of the China-Barbados treaty and bringing it in line with other Chinese treaties. Once the protocol takes effect, China’s capital gains tax will apply to gains realized on the disposition of shares deriving more than 50 percent of their value from immovable property in China. Further, if a Barbados company holds at least 25 percent of a Chinese corporation, any gains realized on the disposition of shares are also taxable in China.

The changes to the China-Barbados treaty eliminate opportunities for foreign shareholders to avoid the Chinese capital gains tax on shares in land-rich Chinese companies and significant interests in Chinese investees.

New anti-avoidance rules for non-residents

The Chinese tax authority recently issued three circulars with guidance that aims to prevent cross-border tax planning that the government perceives as abusive.

Pre-approval of treaty benefits

Starting October 1, 2009, non-residents must request pre-approval to obtain benefits under one of China’s tax treaties on Chinese-source dividends, interest, royalties and capital gains. In a circular dated August 24, 2009, China’s tax authority clarified existing procedures and documentation requirements for non-residents to apply for pre-approval. The process requires extensive disclosure of the non-resident’s operations and group structure.

Intermediate holding companies

In a circular issued on December 10, 2009, China’s tax authority announced plans to eliminate traditional tax planning approaches involving intermediate holding companies. Specifically, the circular targets the “indirect” transfer of an interest in a Chinese company through the transfer of shares in a foreign-incorporated holding company. If the transfer of the intermediate holding company has no commercial purpose, avoids tax liabilities, and is undertaken in an “abusive” manner, the tax authorities can use the substance over form principle to recharacterize the transaction as a sale of the Chinese company and levy capital gains tax accordingly. These changes are retroactive to January 1, 2008.

The December 2009 circular does not define “abusive reorganisation planning”. However, if the shares of the Chinese resident corporation are transferred indirectly and the capital gains tax paid by the ultimate transferor is less than 12.5 percent of the gain, detailed information on the transaction and the parties’ relationship must be submitted to China’s tax authority within 30 days of the transfer. The documentation requirements include questions relating to the substance of the intermediary holding company and its function within the group.

Based on these information requirements, it appears that the Chinese tax authorities may consider the transfer of an intermediate holding company to be abusive where the transfer occurs tax-free and the intermediary company has no assets or activities other than its investment in the Chinese company.

Beneficial ownership of interest, dividends, and royalties

Another new circular sets out guidance on determining whether a non-resident is eligible for beneficial owner status and thus able to claim treaty relief on dividends, interest, and royalties. This circular took effect on October 27, 2009.

The Chinese tax authorities will take a “substance over form” approach in making these determinations. The circular distinguishes a “beneficial owner”, who owns or controls property in substance and “generally” carries on business in substance, from a “conduit company”, which is only registered to satisfy legal requirements but does not manufacture, trade or manage any commercial activities in substance. The circular lists seven factors that constitute unfavourable evidence:

1.      The entity applying for beneficial owner status is liable to distribute all or most (e.g., more than 60 percent) of its income to a resident of a third country within a specified time period (e.g., 12 months).

2.      The entity has no commercial activities other than holding property or shares that generate dividends, interest or royalties.

3.      Where the entity does carry on a business, the assets, number of employees and scale of the business are so small that the business’s size cannot match the revenues earned by the entity.

4.      The entity has little or no control over the property or shares that generate the dividend, interest or royalty income.

5.      The entity pays little or no tax on income earned in the treaty country.

6.      Where the entity seeks treaty benefits for interest income on a loan, the entity has a third-party loan that is similar in amount, interest rate and issuance date.

7.      Where the entity seeks treaty benefits for royalty income from an underlying right regarding patent, franchise or intellectual property, there is a similar underlying right with a third party.

Factors 1 to 4 focus on whether the recipient has substantial activities in its residence country to justify the revenue received. Factor 5 focuses on the amount of tax paid on income earned in the treaty company. Factors 6 and 7 address situations where the loan, patent, franchise or intellectual property is provided via a back-to-back arrangement through an intermediate holding company in a favourable treaty jurisdiction.  

Previously, a non-resident of China generally only had to provide a certificate of tax residency from its state of residence to obtain benefits under one of China’s tax treaties. These new administrative measures require extensive disclosures on the holding company and related tax planning arrangement. The measures reflect the Chinese government’s intention to tighten its enforcement of the taxation of non-residents and strengthen the tax authority’s ability to scrutinize and challenge tax planning strategies that are perceived to be abusive.

If the measures are applied and interpreted strictly, many current investment structures into China may have difficulty sustaining treaty benefits. KPMG in China is aware of cases where non-residents have failed to have their previous treaty entitlements renewed under the new rules.

Canadian companies with Chinese interests should review their holding, financing and intellectual property structures in light of these rules. Structures that do not meet these substance requirements could be restructured to increase the level of activity in the intermediary company (such as by transferring additional functions, assets and resources to the relevant country). Companies intending to set up new structures should account for these substance requirements in their planning. For example, such structures could be set up in countries in which the corporate group has or plans to establish a substantial business operation with its own third-party revenue, employees and physical assets, or substantial head office management functions.

Enterprise Income Tax on representative offices

On February 20, 2010, China’s tax authority announced new rules for calculating China’s Enterprise Income Tax (EIT) and related filing requirements. The EIT applies to non-resident companies that carry on business in China through a “representative office” in China. The changes apply retroactively from January 1, 2010.

Before 2010, Chinese domestic law provided an EIT exemption for representative offices on their market research, marketing communication, and auxiliary activities in China in support of the manufacture and sale of their products. Under the new rules, the relevant tax treaty must be reviewed to determine whether the representative office has a permanent establishment in China. If it does, China has the authority to tax the activities of the representative office. Treaties based on the OECD model treaty typically exclude certain auxiliary activities from their “permanent establishment” definitions; however, the specific treaty should be consulted.

Further, unless a representative office can provide complete and accurate financial records, it must calculate its income tax liability based on the cost-plus method. The new rules raise the mark-up rate to not less than 15 percent (from 10 percent).

Representative offices in China that do not meet the new requirements for exemption should consider the potential benefits of converting the entity to a wholly-foreign-owned corporation.

New exemptions from China’s Business Tax

On September 27, 2009, the Chinese government announced that certain foreign business activities are exempt from China’s Business Tax.

Background

China’s Business Tax is a turnover tax that applies to individuals and entities providing services, transferring intangible assets or selling immovable property in China. The tax rate on the transaction ranges from three to 20 percent depending on the type of transaction. At the end of 2008, the scope of the Business Tax was significantly broadened. Previously, the tax only applied to services that were physically carried out in China. The current regime applies to companies or individuals that either provide or receive services that are located in China

Under the recent changes, Chinese companies and individuals that render services outside China are exempt from Business Tax with respect to construction, cultural and sporting activities. Also exempt are services provided to Chinese recipients outside of China by non-resident individuals and corporations in certain areas, including cultural and sporting services, entertainment, catering, hotels and warehousing services.

Since China’s Business Tax applies to any business services provided to or received by a Chinese resident, the tax can be a significant cost for Canadian companies investing or providing services in China. For example, the tax applies not only to transfers of intangible assets from a foreign entity to a resident of China but also to any future royalties paid by the Chinese resident with respect to the intangible assets, even though the withholding tax also applies to the royalties.

China Business Tax also represents an additional cost for interest payments made by a Chinese borrower to a foreign lender as the five-percent tax is charged in addition to the 10-percent withholding tax. Further, this additional tax is beyond the scope of China’s tax treaties and no treaty protection is available. In effect, for all jurisdictions other than Hong Kong, the effective tax burden on interest payments is now 15 percent (12 percent for Hong Kong).

Further, where a Chinese resident makes service payments to a foreign entity through an intermediate Chinese resident, the Business Tax would apply to both transactions. Foreign entities investing in China should be aware of the potential adverse application of China Business Tax and structure their transactions accordingly.

Since the active business income of foreign affiliates is exempt from Canadian tax, this change does not affect income earned through Chinese subsidiaries of Canadian companies. However, if the Canadian company carries on business in China directly, the change may jeopardize the company’s ability to offset the tax by claiming foreign tax credits for Canadian purposes since the Business Tax is not a tax on income or profit. As a result, Business Tax payments only qualify for an ordinary tax deduction for Canadian purposes, instead of a foreign tax credit or grossed-up deduction under the foreign affiliate rules.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

International Taxation

Non-residents who conduct business in Canada, earn Canadian income or own taxable Canadian property are required to report and file Canadian income tax returns. Failure to file the required withholding taxes and remittances to CRA can result in severe tax penalties, significant amounts of interest on back taxes, increased accounting and legal costs, and could even tie up proceeds from the sale of Canadian property for extended periods of time.

We have experience in preparing and filing NR4, NR6 and Section 216 tax returns with Canadian tax authorities for non-residents and obtaining Clearance Certificates from CRA.

We have also helped many non-residents obtain favourable results under Voluntary Disclosure rules for waiving CRA penalties.

Recent case

Are Management fees deductible?

Tax planning to use tax losses in a corporate group structure may be allowed by the Canada Revenue Agency , using management fees as a tool for that planning may not be. As the recent case, Les Entreprises Rejean Goyette Inc. v. Her Majesty the Queen (2009 CCI 351), in which the Tax Court of Canada (TCC) denied the taxpayer’s deduction of inter-corporate management fees because there was no formal management agreement and, therefore, no legal obligation to pay them.

Time to Rework

 

Companies that offer stock option plans to their employees may have to quickly re-evaluate these arrangements following significant changes to the tax treatment of stock options announced in the 2010 federal budget. Many of these changes are effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.

These measures change the tax treatment of stock option cash-outs and eliminate the opportunity to defer tax on the employment benefit resulting from exercising qualifying stock options in public companies and private companies that are non-Canadian controlled private corporations (non-CCPCs). The budget measures also require employers to withhold tax on benefits from employee stock options exercised after 2010.

For employees with underwater stock options, the budget measures may provide some welcome tax relief. This relief may be available for stock option benefits going as far back as 2001.

Background — Tax treatment of stock options

A stock option plan is an arrangement whereby a corporation gives an employee the right (an option) to purchase its shares at a given price. The price may be above or below the market price at the time the option is granted.

When the employee exercises the option to acquire the shares, the difference between the price the employee pays for the shares and their market value is treated as a taxable benefit to the employee.

If certain conditions are met, the employee can claim a deduction of one-half of the taxable benefit. The effect of this deduction is to tax the employment benefit at the same rate as a capital gain.

Generally, public company employees may qualify for the deduction if:

  • The shares are normal common shares (not preferred shares)
  • The exercise price is at least equal to the fair market value of the shares at the time the option was granted
  • The employee deals at arm’s length with the corporation.

 

Before the 2010 federal budget, public company and non-CCPC employees were allowed to postpone the taxation on the benefit on $100,000 per year of qualifying stock options to when the shares were sold instead of when the options were exercised.

Stock options in Canadian controlled private corporations (CCPCs) are treated differently. As long as the employees deal at arm’s length with the corporation, the taxable benefit is reported when the employees sell the stock option shares, rather than when they exercise their options and acquire the shares. The 2010 federal budget does not affect these rules for CCPCs and their employees.

Stock option cash-outs

Some stock option plans have a “stock appreciation right” attached to them. Such plans allow the employee to receive a cash payment equal to the value of the options instead of purchasing the shares. In other words, the employee can “cash out” the options.

Before March 4, 2010, the same tax consequences for the employee resulted from the cash payment as from the issuance of shares — the employment benefit was included in income and the related one-half deduction was available if the required conditions were met. The employer could claim a deduction for the full amount of the cash payment.

The 2010 federal budget proposes to change these rules such that employees who receive a stock option cash-out can only claim the deduction of one-half of the employment benefit if the employer elects to forgo the deduction for the cash payment. If the employer does not make this election, it will be entitled to a corporate tax deduction for the payment but the employees must pay tax on the full value of the employment benefit. This change is effective for all stock options that are cashed out after 4:00 pm (EST) on March 4, 2010, regardless of when the options were issued.

The Department of Finance has not provided any grandfathering relief for stock option cash-out arrangements that were in place before the proposed changes to the rules in the 2010 federal budget. As such, employers and employees will need to reconsider the implications of any cash-out arrangements in place prior to March 4, 2010 before completing the transactions.

Finance has confirmed that an employer’s election to forgo the deduction for the cash payment when an employee cashes out his or her stock option rights can be made separately for each employee. In other words, it does not necessarily have to apply to all the employees in the stock option plan.

Finance has also indicated that the policy reason for not allowing employers to claim a deduction for a stock option cash-out payment is to preserve symmetry in the tax treatment of stock-based compensation. (When an employee exercises stock options and acquires shares, the employer does not get a deduction because it does not pay out cash.) This policy change also achieves more consistency with the U.S. tax treatment of stock options.

Example of new tax treatment of stock option cash-out
The following analysis illustrates the effect of the change by comparing the after-tax cost of stock option cash-outs to employees and employers under the old pre-budget rules and the new post-budget rules.

As the table shows, the employee’s after-tax proceeds of a $100 cash-out payment can remain the same pre- and post-budget at $77 (columns 1 and 2). However, the pre-budget regime caused the CRA to effectively lose a total of $7 in tax revenue per $100 of benefit, rather than receiving $23 in tax revenue from the employee. The reason for this tax revenue difference is the employer’s tax savings of $30 from claiming a deduction for the $100 cash payment to the employee.

Post-budget, the elimination of the employer’s tax deduction results in the CRA receiving $23 per $100 of benefit (when the employer elects to forgo the deduction (column 2)). If the employer does not elect to forgo the deduction (column 3), the CRA receives $16 in tax (compared to $23) but the net after-tax proceeds to the employee fall to $54 because the employee cannot claim the stock option deduction.

Tax Results of Pre- and Post-Budget Employee Cash-Outs 
  Pre-Budget   Post-Budget
  Cash-Out Cash-Out
with Election1
Cash-Out
No Election
Employer Cash Paid  $100  $100  $100
Tax Savings @ 30% (C)2    30        –    30
Net After-Tax Cost to Employer  $  70  $100  $  70
       
Employee Cash Received  $100  $100  $100
Less Stock Option Deduction    50    50       –
Taxable Income    50    50   100
Tax thereon @ 46% (P)3  (23)  (23)  (46)
Net After-Tax Proceeds to Employee  $  77  $  77  $  54
CRA perspective: Net tax
revenue lost (received) (C –
P)
$    7 $(23) $(16)
1)       The employee and employer will get the same tax result as the cash-out with election if
the employee acquires the shares instead of taking the cash-out.2)       Assuming a 30% corporate tax rate, $100 deduction equals $30 in tax savings.3)       Assuming a combined federal/provincial top marginal personal tax rate of 46%.

 

The table illustrates that the cash-out without the employer election to forgo the deduction may be the least appealing, even though less tax is paid initially, because the employee is significantly worse off.

If the employer did not elect to forgo the deduction (column 3), the employee would get a better result (from a tax point of view) by acquiring the shares instead of taking the cash-out option. The employee could then sell the shares to achieve the same cash position as the cash-out option with the employer election to forgo the deduction.

Accounting implications of tax changes
In situations where employees holding options to acquire shares under an employee stock option plan are entitled or can choose to receive cash in lieu of shares and they elect to receive those cash payments, these cash-settled grants were generally classified in the financial statements as a liability. 

For Canadian GAAP purposes, transactions settled in equity instruments are generally classified as equity-settled awards and other transactions are classified as liability (cash-settled awards).

For these cash-settled awards, the company may have recorded a future tax asset on the basis that it will receive a deduction when the employee ultimately elects to receive cash payments and the cash payment is made. The proposed budget changes may require the company to review its accounting treatment of its future tax asset.

In addition, as a result of the proposed budget changes, companies may choose to modify the terms of their existing stock option agreements such that their existing liability classified stock option awards are reclassified as equity-settled awards. In these cases, they need to carefully consider the accounting treatment for the change in terms and conditions.

Deferral of stock option taxable benefit

Before the 2010 federal budget, public company employees who exercised stock options could generally defer tax on the related taxable benefit on up to $100,000 of annual qualifying employee stock options until the shares were actually sold. The budget proposes to eliminate this deferral, effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.

As such, employees who exercise stock options after 4:00 pm (EST) on March 4, 2010 will not be able to defer tax on any of their employment benefit.

Employer withholding tax requirements

The budget states that, for benefits arising on the issuance of securities after 2010, employers must withhold tax on a stock option employment benefit from the employee’s pay. The amount of the withholding can be reduced for the 50 percent stock option deduction if the employee qualifies for the deduction. 

As a result, employees who exercise stock options after 2010 will effectively have to pay the tax right away, rather than when they file their tax return for the year.

This tax withholding measure does not apply to options granted before 2011 under a written agreement entered before 4:00 pm (EST) on March 4, 2010, if the agreement includes restrictions on the optioned shares’ disposition.

Background

Before the budget, employers were technically required to withhold tax on the employment benefit at the time of exercise. However, if the employee was not paid any cash, the CRA administratively waived the tax withholding requirement on the benefit for Canadian resident employees.

The budget does not provide details on how the employer will, as a practical matter, withhold the appropriate tax on the employment benefit when the employee does not receive any cash compensation on the exercise of the stock option.

Presumably, the employee will have to provide cash to the employer so that the employer can remit the required employee withholding tax to the CRA. Non-CCPC private companies will unfortunately place their employees in a difficult position where no market in which to sell the shares is available to the employee. Amendments to such plans will likely be necessary.

Employees who exercise stock options will need to keep in mind when considering whether to sell any of the shares that they will effectively need to have funds to pay a tax liability as soon as they exercise their options. 

Underwater stock options

Shares purchased through a stock option plan are usually expected to increase in value. However, some employees who exercised stock options and did not sell the shares right away may have seen the shares’ value fall since the day they exercised their options.

Depending on how much the shares’ value has fallen, employees with these “underwater” stock option shares who deferred the taxable benefit when they exercised their options (as described above) could end up with a deferred tax liability greater than the value of the shares. The budget proposes a special election that the employee can make to ensure that any tax liability on the deferred stock option benefit, when realized, does not exceed the proceeds from the shares’ disposition.

Effectively, the election mechanism converts the taxable employment benefit from the employee’s income into a deemed taxable capital gain. In exchange, the employee pays a special tax equal to the actual proceeds received on the sale of the shares. By making the election, the employee applies the capital loss realized on the disposition of the shares to the deemed taxable capital gain, thereby using allowable capital losses that otherwise must be applied to taxable capital gains.

As such, employees who deferred the taxable benefit on a stock option exercise and who dispose of the shares for proceeds less than the taxable benefit can elect to pay tax equal to the proceeds of disposition instead of paying tax on the taxable benefit. To take advantage of the election, the employee must make the disposition before 2015.

In assessing whether they should take advantage of the special relief, employees should keep in mind that the election reduces the potential for tax relief from using the capital losses otherwise available on the underwater shares against capital gains realized from disposing of other property.

Relief available as far back as 2001
The budget proposes to allow these elections for the previous 10 years (which goes beyond the normal three-year assessment period). Thus, it may be possible for employees to go back as far as 2001 to obtain relief for a deferred employment benefit that was realized on shares that were sold before the March 4, 2010 budget announcement.

To take advantage of this tax relief, employees must make the special election on or before their tax return filing due date for 2010 (generally April 30, 2011). For dispositions after 2010 but before 2015, the deadline for making the election will be the tax filing due date for the year the disposition occurs.

Example of underwater stock option election
The following example illustrates the tax consequences of making the underwater stock option election.

Assume that Mr. X is granted a stock option by his public company employer (Pubco) in 2008, when the fair market value of the Pubco shares equals the exercise price of $1,000. Mr. X exercises the option in 2009, when the fair market value of the shares has increased to $10,000. Thus, Mr. X has a taxable employment benefit of $9,000 in 2009 ($10,000 fair market value minus $1,000 exercise price). Mr. X chooses to defer the $9,000 employment benefit until he disposes of the shares. However, by 2010, the fair market value of the shares has declined to $1,000. Mr. X chooses to dispose of the shares in July 2010.

The following table illustrates the results of Mr. X making the underwater stock option election. This analysis assumes that Mr. X is subject to a combined federal/provincial top marginal tax rate of 46%.

Tax Consequences of Underwater Stock Option Election
   No Election Election
Employment Benefit 2010 $9,000 $9,000
Stock Option Deduction   (4,500)   (9,000)
Deemed Taxable Capital Gain1   4,500
Allowable Capital Loss2   (4,500)
Taxable Income $4,500 $ –
Tax @ 46%   2,070   –
Special Tax (Proceeds of Disposition)      N/A $1,000
Total Tax $2,070    $1,000
     
1)       Deemed capital gain equals ½ of the lesser of the employment benefit
and the capital loss (both $9,000 in this example).2)       Allowable capital loss realized offsets deemed capital gain.

As the table shows, by making the election, Mr. X will reduce his normal $2,070 tax liability to $1,000. With the election, he claims a $9,000 deduction to remove the entire employment benefit from his income but instead he has to include in his income a deemed taxable capital gain of $4,500 ($9,000 benefit × 50% capital gain inclusion rate). He is then able to use his allowable capital loss of $4,500 ($10,000 cost base of the shares – $1,000 proceeds = $9,000 × 50%) to offset the deemed capital gain of $4,500. Thus, no capital loss remains for carryover.

Making this election completely eliminates Mr. X’s regular tax liability for the employment benefit/capital gain and uses up his capital loss. He is then left with paying the special tax equal to his proceeds of disposition of $1,000. This results in a current tax savings of $1,070 ($2,070 – $1,000).

However, if Mr. X expects to realize capital gains that he could use his allowable capital loss of $4,500 to offset, he may be better off not making the special relief election. In this situation, he would carry over the $4,500 capital loss and apply it against $4,500 in taxable capital gains to realize tax savings of $2,070 ($4,500 × 50%). Doing this would completely offset the $2,070 tax cost of the employment benefit while allowing him to keep the $1,000 proceeds from disposing of his underwater shares.

Generally, to make the special relief election worthwhile, an employee would have to see a significant drop in the value of the stock option shares (e.g., a loss of at least 80 percent of the stock’s value in our example) and not be able to use the related capital losses to reduce tax on other gains.

Also, depending on the exercise price, even if the shares significantly decline in value, an election may not be beneficial if the proceeds of disposition of the stock option shares are high in relation to the taxable employment benefit.

If the shares’ sale proceeds exceed the tax on the deferred taxable benefit, the election is not helpful. 

Non-arm’s length employees’ stock options

The 2010 federal budget proposes to amend the income tax rules to clarify that the disposition of rights under a stock option agreement to a non-arm’s length person results in an employment benefit at the time of disposition (including cash out). Although the government considered that these benefits were taxable in these circumstances under existing tax rules, it also believed that clarification of these rules was warranted.