S T E P. S o c i e t y o f T r u s t a n d E s t a t e P r a c t i t i o n e r s

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1 S T E P S o c i e t y o f T r u s t a n d E s t a t e P r a c t i t i o n e r s Federal Budget 2008: STEP Canada Summary By Stewart Lewis, CEO And Robin MacKnight, Chair, Technical Committee In our inaugural Budget report, we set out some of the highlights from the 2008 federal Budget that could have an impact on members of STEP Canada and their clients. The most notable change affects the process for obtaining s. 116 clearance certificates; however, as the following analysis shows there is room for further input to the Finance Department from STEP. The Finance Minister is also proposing to revive an investment concept the much-lauded Tax-Free Savings Account. Below we review its origins and the potential opportunities of this concept for advisors. Many of the proposals take effect in Section 116 Clearance Relief? One of the biggest irritants for non-residents is the process of getting an exemption from Canadian tax on the gain realized on the disposition of an asset that is excluded from Canadian tax by the express provisions of a tax treaty (a treaty-protected property ). The process historically took only a few weeks, but now routinely takes several months. Many transactions now close on the basis of soft assurances that the clearance certificate will be forthcoming. The risk of not obtaining a clearance certificate has always been on the purchaser. The solution for the purchaser is to withhold a portion of the gross purchase price, and to remit that amount to the Canada Revenue Agency. Recently, the CRA has allowed purchasers to delay remitting the amounts withheld while it processes applications for clearance certificates. This is an extraordinary administrative concession by the CRA, without statutory support. Ottawa proposes three changes to streamline and simplify the rules applicable to non-resident dispositions of treaty protected assets. While these changes are welcome, three issues remain. First, these changes are only effective for dispositions after Second, and more troubling, these changes do not address the concerns practitioners have raised about distributions from Canadian trusts and estates which appear to still require clearance certificates. Finally, it is far from clear that these changes will have the desired effect. The onus still rests with the purchaser to make factual and legal determinations as to the treaty-protected status of the underlying assets. The proposed changes do not absolve a purchaser who exercises reasonable due diligence, but makes a determination that ultimately turns out to be wrong. It may turn out that these relieving

2 provisions will only be used in non-arm s length transactions. Hopefully these issues can be addressed before final legislation is introduced. The first change Ottawa proposes to make is to exempt from the withholding requirements of section 116 any disposition of a treaty protected property. Where the non-resident vendor and purchaser are related, the purchaser must send a notice to the Minister of National Revenue within 30 days of the disposition setting out basic information about the transaction and the vendor. The second change expands the concept of the purchaser s reasonable inquiry into the nonresident vendor s ability to claim treaty protection. Under current rules, the purchaser is relieved of withholding obligations only if it undertakes reasonable inquiries to conclude that the vendor is not a non-resident of Canada. These proposals will extend the purchaser s relief if: The purchaser concludes after reasonable inquiry that the vendor is resident, for treaty purposes, in a country with which Canada has a tax treaty; The property would be treaty-protected property if the vendor were resident in that country for treaty purposes; and The purchaser sends a notice to the Minister of National Revenue setting out basic information about the transaction and the vendor within 30 days of the date of acquisition of the property. The second condition above is the problem. Determination of the status of the property being acquired is a mixed question of fact and law. There is no relief for a purchaser who exercises due diligence but comes to the wrong conclusion on the interpretation of a tax treaty. Why would a purchaser take the risk? The third change will exempt some non-residents from the need to file a Canadian tax return in respect of their disposition of the treaty-protected property. Currently, a non-resident must file a tax return in Canada, even if no tax is payable because of the treaty exemptions. Ottawa proposes to exempt non-residents form filing a Canadian tax return where all of the following conditions are met: No tax is payable by the non-resident under Part I for that tax year; The non-resident is not liable to pay any amount in respect of any previous tax year (other than an amount for which security has been posted); and Each property disposed of by the non-resident is either excluded property under section 116 (which will now include treaty-protected property as a result of the first change noted above), or property in respect of which the Minister has issued a clearance certificate. While these proposals may be good news for American venture capital investors, it s not clear there is good news for Canadian trust and estate advisors and administrators.

3 Ottawa unveils an Old Tax-Savings Vehicle Idea under a New Name Ottawa is proposing to introduce the Tax-Free Savings Account as a complement to the present RRSP. Beginning in 2009, Canadians 18 or older will have $5,000 of TFSA contribution room each year and the unused contribution room will be carried forward without limit to future years. The key difference between an RRSP and the TFSA is that contributions to a TFSA will not be deductible, and neither investment income nor withdrawals will be included in income. This harks back to an idea first explored in the 2003 federal Budget by the then-liberal federal government, which proposed the Tax-Prepaid Savings Plan that would treat deductions and withdrawals in the same manner as the TFSA. The key drivers behind the TPSP were providing motivation for low and middle-income Canadians to save more, and potential new opportunities for the investment industry. The C.D. Howe Institute began lobbying Ottawa to establish the TPSP in 2001, citing other countries which have such a tax-savings vehicle. The TPSP idea was discussed again in the 2004 Budget, but in 2005, the Liberals backed away from it in favour of increasing RRSP limits. Notably, in comparing the RRSP and TSFA in the 2008 Budget, Ottawa says that an RRSP will provide a net rate of return higher than the TFSA when the effective tax rate on the withdrawal is lower than the effective tax rate on the contribution, and a net rate of return lower than the TFSA when the effective tax rate on the withdrawal is higher than at the time of contribution. Advisors will need to keep this key fact in mind when discussing options with their clients. Meanwhile, Ottawa emphasizes that the news savings vehicle has flexibility to allow it to be used for needs other than retirement. Primarily directed at saving for retirement, RRSP funds can be withdrawn within in prescribed limits to help fund first-time homebuyers or life-long learning. However, TFSA funds can be withdrawn for any purpose, and any amounts that are withdrawn will be added to the individual s contribution room for the following year. Investment earnings and withdrawals will not affect eligibility for the guaranteed income supplement or other federal income-tested benefits and credits. We can only hope the provinces follow this lead with respect to clawing back provincial social service benefits. A TFSA will generally be permitted to hold the same investments as an RRSP including mutual funds, publicly-traded securities, government and corporate bonds, guaranteed investment certificates and, in certain cases, shares of small business corporations. If an individual transfers property to the individual s spouse or common-law partner, the income tax rules generally treat any income earned on that property as income of the individual. The attribution rules will not apply when individuals take advantage of the TFSA contribution room available to them using funds provided by their spouse or common-law partner. Income earned in a TFSA that is derived from such contributions will not be taxed in the hands of the transferring individual.

4 Upon death, an individual s TFSA will lose its tax-exempt status. However, an individual will be permitted to name his or her spouse or common-law partner as the successor account holder, in which case the account will maintain its tax-exempt status. Alternatively, the assets of a deceased individual s TFSA may be transferred to a TFSA of the surviving spouse or common-law partner, regardless of whether the survivor has available contribution room, and without reducing the survivor s existing room. Capital Gain Donation Credit extended Donors of publicly traded securities to registered charities currently enjoy a double benefit: first, their capital gain on the donation is deemed to be nil [see paragraph 38(a.1) of the Income Tax Act]; and second, they get a charitable donation equal to the fair market value of the donated securities. This has led to dramatic increases in philanthropy. In the 2008 Budget, Ottawa proposes to extend these rules to capital gains realized on the exchange of unlisted securities for public securities -- under certain conditions. This is a significant extension of these charitable donation rules, and broadens the world of potential philanthropists to include all those entrepreneurs who sold private company shares to multinationals on a tax deferred basis. Their tax minimizing exit strategies should now include philanthropy. Consider a situation where a Canadian resident exchanged shares of a Canadian (private) operating company for exchangeable shares of an acquisition subsidiary of a multi-national. So long as those unlisted exchangeable shares included, at the time they were issued, a provision allowing the holder to exchange them for shares of the publicly listed parent, and further provided the shareholder received no consideration other than parent public shares, the shareholder can donate those parent public shares to a registered charity within 30 days of the exchange, and get the double benefit described above. These measures will apply to donations made on or after February 26, Regulation of Private Foundations modified The 2007 Budget extended the capital gains exemption for donations of publicly listed shares to private charitable foundations. At that time, concern was expressed that persons with close connections to the foundation might abuse their personal and foundation shareholdings for their own benefit. An excess corporate holding regime was introduced to prevent such abuse. In the 2008 Budget these constraints are relaxed somewhat. Certain holdings of shares that are not listed on a designated stock exchange and that were held on March 17, 2007 will be exempt from the excess corporate holding regime. However, a number of other technical amendments are proposed to deal with entrusted shares, the substitution of shares, and an extension of the anti-avoidance rule to address shares held through trusts. The effective dates of these amendments vary.

5 RESP time-limits extended Under present tax rules, contributions to Registered Education Savings Plans are limited to 21 years following the year in which the plan is entered into. An RESP must be terminated by the end of the year that includes the 25th anniversary of the opening of the plan. These limits are extended to an additional four years for single-beneficiary RESPs if the beneficiary who qualify for the Disability Tax Credit. Ottawa proposes to extend each of these limits by an additional 10 years. These changes will apply for the 2008 and subsequent taxation years. Dividend Tax Credit adjusted Through the dividend tax credit, Ottawa attempts to compensate individuals for corporate income taxes that are presumed to have been paid, thereby avoiding double-taxation. Since 2006, "eligible dividends," which generally include dividends received from large corporations, have been subject to a higher gross-up and an enhanced dividend tax credit in recognition that these dividends are generally paid out of income that has been taxed at the general corporate rate, rather than the lower small business rate. In the 2007 Economic Statement, Ottawa reduced the general corporate income tax rate to 15% by Yesterday s Budget proposes to adjust the dividend gross-up factor and dividend tax credit rate for eligible dividends to reflect those corporate income tax rate reductions as they are implemented. Preventing the Premature Collapse of a Registered Disability Savings Plan In 2007, Ottawa introduced the Registered Disability Savings Plan to help parents and others save to assist in enabling the long-term financial security of a child with a severe disability. Eligibility to establish an RDSP is contingent on qualifying for the Disability Tax Credit. Under the enabling legislation, which has received Royal Assent, only a plan-holder can collapse a plan. However, says Ottawa, concerns have been raised over the possibility that the beneficiary of a parent-initiated plan might be able to force the premature collapse of the plan by rescinding his or her disability tax credit certification. This would enable the beneficiary to gain full access to the RDSP savings, which, says Ottawa, could be contrary to the wishes of the parent. To address this concern, Ottawa is proposing to amend the RDSP rule that provides for a mandatory collapse of the plan if the beneficiary ceases to be DTC-eligible. Instead, mandatory collapse will be required when the beneficiary s condition has factually improved to the extent that the beneficiary no longer qualifies for the disability tax credit. This will be effective for 2008 and subsequent tax years.

6 The Bottom Line The Budget proposals offer some relief and opportunities for clients and their advisors. Work remains to be done to make these proposals administrable and effective, but STEP Canada will be involved in that process.