TMT TAX UPDATE. Several changes aim to restrict research expenditures that qualify for a credit. Smaller

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1 ISSUE TECHNOLOGY, MEDIA AND TELECOMMUNICATIONS TMT TAX UPDATE Following provincial and federal budgets tabled in March 2012, there were several changes made to certain tax rules applicable to technology, media and telecommunications (TMT) businesses that should be considered, such as federal Scientific Research and Experimental Development (SR&ED) credits, international taxation changes and new provincial incentive programs. FEDERAL GOVERNMENT CHANGES RELATING TO SR&ED AND INVESTMENTS TO SUPPORT BUSINESS INNOVATION News and information for our clients in the technology, media and telecommunications industries CONTENTS Federal government changes relating to SR&ED and investments to support business innovation Changes in international taxation Thin capitalization rules Provincial changes Several changes aim to restrict research expenditures that qualify for a credit. Smaller Canadian-controlled private corporations (CCPCs) will be less affected by these changes than large corporations or those under foreign control. Small businesses can still claim a refundable credit equal to 35% of eligible SR&ED expenses 1. The non-refundable credit for larger corporations (or foreign-controlled corporations) will be reduced from 20% to 15% for taxation years ending on or after January 1, For taxation years that straddle this date, the rate reduction will be prorated. Eligible SR&ED expenses include overhead costs incurred by a business that are directly related to SR&ED work. Two methods are generally considered acceptable to compute the credit on overhead costs: the first (traditional method) requires the calculation of all overhead costs in detail, while the second allows an approximation to determine overhead expenditures without the requirement of a detailed accounting. This second method, also known as the proxy method, currently allows for an estimate of overhead expenses that is

2 2 SR&ED salaries will become the larger component of expenditures allowing for a credit equal to 65% of direct costs. This proxy rate will decrease to 60% for 2013 and 55% for the following years (proportionally to the number of days in the taxation year within each calendar year). While 100% of contractual payments for SR&ED are currently eligible expenditures for calculation of SR&ED credits, starting after December 31, 2012, only 80% of these payments will be eligible as SR&ED expenses. The Government justifies the new rule due to the need to eliminate the contract profit portion from the eligible expenditure base, even though these contracts may be at arm s length. The budget also proposes to exclude capital expenditures (including payments for use of an asset that would be a capital asset acquired by the taxpayer) entirely from eligible expenditures for both deduction and tax credit purposes when the expenditures are incurred after December 31, Based on our experience with claims filed by CCPCs in the TMT industry, these changes are not material. However strategies should be developed to preserve the expenditure base for future years. Obviously SR&ED salaries will become the larger component of expenditures allowing for a credit, in particular when the taxpayer also benefits from provincial tax credits for research that emphasizes wage costs (as in Quebec for example). However, the management of contractual payments and incurred overheat costs will need more rigorous planning and monitoring. It may be that the proxy method (especially when it will be reduced to 55% of direct expenses) will simply cease to be beneficial for some taxpayers. In some cases, the traditional method could be used by smaller CCPCs in their pre-commercialization phase for which many activities are SR&ED related. Comparisons between the traditional and proxy method results will therefore be more important than ever. It goes without saying that capital expenditures are no longer encouraged and proactive entrepreneurs will accelerate their acquisitions before the deadline of January 1, Companies seeking to maximize available credits will need to focus specifically on the changes made to the program s administration, which is documented in the Claim Review Manual [for SR&ED] for technical and scientific reviewers published on June 1, Although the Manual is not necessarily an easy read, it does provide many suggestions to taxpayers for presenting and documenting SR&ED claims, as well as insight to the claims review process followed by the CRA. As a result, our SR&ED team has observed that using detailed contemporary documentation will enhance success as opposed to documentation prepared several months following the completion of research. They have also observed a reduction in tolerance for insufficiently detailed project descriptions that were previously considered sufficient. It is therefore critical to document SR&ED activities appropriately, and ideally as these activities are being conducted. Similarly, verbal interviews with the taxpayer s scientific staff, which were once considered as supporting evidence, also seem to have changed status as they are now excluded from the list of appropriate documents and evidence. It is even mentioned that appropriate documentation cannot be substituted by verbal interviews 3. The standard appears to have become more formal, especially when the taxpayer is not a first-time claimant. The manual outlines several deficiencies often observed in taxpayer claim files: descriptions focusing on the project s business targets rather than scientific or technical targets, fuzzy project descriptions making the research content difficult to quantify, descriptions emphasizing SR&ED results rather than protocol used, and unchanged or incorrect project descriptions over multiple periods. The Budget also contained an announcement that the objection process available to taxpayers when a review of the scientific consultant decisions is requested. From now on, an independent advisor team will perform a technical review as part of a new claims review process which should promote better fairness. The Government will also allocate additional public funds to research. This will be accomplished by doubling the resources of the Industrial Research Assistance Program ( IRAP ) and increasing the budgets granted by the National Research Council of Canada. The Government will also support, through $400 million of funds to invest in venture capital for the private sector and $100 million of risk venture funding provided and managed by the Business Development Bank of Canada. 1 On the first portion of 3 million in SR&ED expenses during a taxation year. 2 This manual is intended for CRA technology consultants that analyze the technical part of claims. Part of this manual is available to taxpayers. 3 Supra at 2, pages 5-20 to 5-27

3 TMT TAX UPDATE CHANGES IN INTERNATIONAL TAXATION THIN CAPITALIZATION RULES Currently, thin capitalization rules restrict interest deductibility for a company residing in Canada when its debt owed to certain non-residents exceeds a debt/equity ratio of 2 to 1. These rules apply to debts payable to a designated shareholder (defined as a shareholder or group of shareholders holding shares with over 25% of voting rights or corporate value) not residing in Canada. The Federal Finance Minister, concerned with erosion of the corporate taxation base, and following the 2008 recommendations of the Advisory Panel on Canada s System of International Taxation, is taking action to restrict abuse. Two of the changes announced in the recent Federal Budget require special attention for taxation years commencing after 2012: The debt/equity ratio will be established at 1.5 to 1 Non-deductible interest will be considered as dividend payments subject to non-resident tax withholding In some cases, certain corporations will need to take action quickly to comply with these new rules, as the equity portion of the equation is calculated based on the sum of the retained earnings4 at the beginning of the taxation year. Equity also includes a monthly average of paid-up capital (PUC) in shares and contributed surplus, except for PUC and contributed surplus of shares that are not held by non residents as determined by the company. The PUC is calculated on the very first moment of the month, which requires this capital, practically speaking to have existed at the end of the preceding month. This reclassification of non-deductible interest as a dividend may cause unpleasant surprises to some taxpayers. It will be important for corporation that are potentially affected by these new rules to properly plan ahead in order to comply with the new ratio, by adjusting the level of PUC or contributed surplus or the amount of debt owing to specified non residents. As a note, the non-deductible interest can only be determined with certainty after year end. However, if the interest deduction is disallowed under the thin capitalization rules, interest payment to nonresidents is deemed to be a dividend payment with an obligation to withhold taxes on dividends and to remit taxes withheld by the 15th of the month following the deemed payment. The budget proposals suggest it will be possible to allocate the non deductible portion interest to the later interest payments made during the taxation year. The fact remains that unless careful planning is made ahead of time, some companies might be in default for withholding taxes prior to determining if their debt/ equity ratio is met. 4 to the extent it was provided by a designated non-resident shareholder. PROVINCIAL CHANGES BRITISH COLUMBIA Effective September 1, 2010, the regulations are clarified to exclude cutscene productions from British Columbia s film tax credits. Instead, the regulations are amended to clarify that cutscene productions are eligible activities under the Interactive Digital Media Tax Credit, provided all other requirements of the credit are met.currently, the federal SR&ED investment tax credit associated with expenditures in Alberta reduces the eligible expenditure base used to calculate the Alberta credit in the following year. In order to increase the effectiveness of the credit and to reduce administrative complexity, this grind of the Alberta SR&ED tax credit will be eliminated effective for tax years ending after March 31, 2012, enhancing the program by approximately $25 million annually. ALBERTA SR&ED tax credit enhanced in Alberta The Alberta Scientific Research and Experimental Development (SR&ED) tax credit program provides a tax credit to corporations with a permanent establishment in Alberta for eligible expenditures incurred after December 31, The credit is worth 10% of a company s eligible SR&ED expenditures in Alberta up to a $4 million expenditure limit, for a maximum credit of $400,000, and it is refundable for all companies. Associated companies must share the $4 million limit. Currently, the federal SR&ED investment tax credit associated with expenditures in Alberta reduces the eligible expenditure base used to calculate the Alberta credit in the following year. In order to increase the effectiveness of the credit and to reduce administrative complexity, this grind of the Alberta SR&ED tax credit will be eliminated effective for tax years ending after March 31, 2012, enhancing the program by approximately $25 million annually. 3

4 4 PROVINCIAL CHANGES (CONT.) MANITOBA New Data Processing Investment Tax Credit in Manitoba In order to encourage businesses to make investments in Manitoba by way of creating high technology data processing centres, the 2012 Manitoba Budget announced a new refundable corporate income tax credit for property purchased or leased by an eligible corporation after April 17, 2012 for use in Manitoba. The corporation must have a permanent establishment in Manitoba and its primary business activity, including the activities of its affiliates, must be data processing. This new credit will effectively offset the Manitoba sales tax on qualified property. Qualified property includes new buildings and new machinery or equipment. The tax credit will be equal to 4% of the cost of new buildings and 7% of the cost of new machinery or equipment. The property must be purchased or leased by the company for use in its data processing centre in Manitoba and be available for use after April 17, 2012 and before New property that replaces property that previously qualified for the credit will also be eligible. ONTARIO The government will continue to review the effectiveness of tax credits for business research and development (R&D). The government will also seek advice from the new Jobs and Prosperity Council with respect to improving R&D support that would result in an increase in R&D expenditures in Ontario and simplifying compliance and administration under the tax system. QUÉBEC Introduction of a refundable credit for Initial Public Offering (IPO) issuance costs relating to a Québec Stock Savings Plan II (SSP II) In its Budget tabled on March 27, 2012, the Quebec Government announced certain measures to help businesses obtain appropriate capitalization, including those considering an IPO through the SSP II program launched in 2005 and enhanced in This is good news as it will boost a program that has not experienced great success since inception six years ago. Quebec lags behind other provinces with respect to IPOs. As a reminder, the SSP II is a small business capitalization assistance plan. Shares qualifying under this plan are common stock with voting rights and no fixed dividend in a Canadian corporation with less than $200 million in total assets, for which senior management is Quebec-based, and over half of the payroll is paid to employees located in Quebec-based operations. Shares in a corporation using the SSP II plan for its IPO provide the shareholder (an individual) with the right to deduct from its income (only for Quebec tax purposes) the entire share issuance cost of these shares in the year of acquisition 5. Although it provided generous tax deductions to shareholders, the SSP II plan had little success, as the IPO costs to the issuer where high. The refundable credit lowers IPO costs to the issuer. The refundable credit represents 30% of eligible issuance costs incurred and paid in a year (or in a previous year) and after the Budget date according to a visa granted under the SSP II plan. Eligible issuance costs must not exceed the lower amount of 15% of the gross proceeds from share issuance and $3 million. Eligible issuance costs include legal fees for producing the prospectus and its approval, accounting and audit fees for the reports disclosed in the prospectus, brokerage fees and prospectus printing costs. Finally, one should note that this credit will be taxable in the year it is deemed received. Enhancement of the Québec tax credit for the production of multimedia titles This tax credit was created to attract to Quebec the numerous businesses working in the video gaming industry, among others. The changes described below were proposed in the most recent Quebec budget and aim to provide tax relief to taxpayers in this industry. As a reminder, there are two types of multimedia tax credits available: the first is the refundable tax credit for multimedia titles

5 5 QUÉBEC (CONT.) (general) and the second (specialized) is geared to businesses whose main activities are in the production of multimedia titles. The second credit is frequently used by multimedia businesses due to the fact that the claiming corporation is not required to get a certificate from Investissement Québec for each title published. The company simply needs to justify its global activities as a multimedia title publisher and obtain a certificate applicable to its global activities. The 2012 budget proposes to provide greater accessibility to this credit by only requiring that 75% of corporate activities be related to the production of multimedia titles, whereas it previously required that over 90% of its activities be related to such production. The refundable credit rate (calculated on eligible labor costs) will vary according to the titles availability in French or English 6. For corporations that wish to claim the tax credit for multimedia titles (specialized), the credit rate depends on the origin of the company s income, for instance, if over 75% of the income originates from French titles that were not ordered 7, the tax credit rate would have been 37.5% prior to the budget. The budget proposes to eliminate the condition that the title be subject to an order. In the future, it will no longer be relevant whether or not the title is subject to a specific client order to establish the eligible tax credit rate. On the other hand, titles designed for professional training will now result in a reduced tax credit rate of 26.25%. Corporations engaged in editing multimedia titles frequently use sub-contractors, related or unrelated, to perform the eligible production work. In these cases, the current rule stipulates that the sub-contractor is entitled to claim the tax credit. Seeing that it is not logical to allow the party not bearing the economic risk related to the production of the multimedia title to claim the credit, the Budget will now allow the client to be entitled to the credit. In addition, the definition of eligible production work is broadened to include the optimization work with respect to the multimedia title s performance as eligible. These changes are generally applicable from the budget date. 5 but without exceeding 10% of the individual s taxable income 6 The credit rate will be of 37.5% if the title is available in both official languages, and 30% if it is not available in French. 7 And not intended for professional training, which is a new condition in the changes provisioned in the budget. If you have any questions concerning this publication, please consult a BDO Technology, Media & Telecommunications professional. Anne-Marie Dupras Montreal amdupras@bdo.ca Ext Scott Rodie Montreal srodie@bdo.ca Stuart Chalmers Calgary schalmers@bdo.ca Ext Alexandra Hardy Kitchener/Waterloo ahardy@bdo.ca John Keserich Vancouver jkeserich@bdo.ca Steve Meilleur Ottawa smeilleur@bdo.ca Ext Daphna Smuckler Toronto dsmuckler@bdo.ca The information in this publication is current as of May 15, This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it. BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.