NATIONWIDE - CANADA: An Introduction to Tax
Canada’s Changing Tax Landscape: increased Complexity and Decreased Certainty
Canada’s income tax system has become increasingly complex in recent years as the government has introduced a series of measures with the stated objectives of promoting tax fairness, enhancing transparency, and aligning Canada’s tax system with proposed international standards. These initiatives reflect Canada’s efforts to increase tax revenue and protect the Canadian tax base by tackling tax avoidance and introducing new taxes. While these new measures may have a defensible policy purpose, they add layers to an already intricate tax landscape and create rules that are challenging to navigate and result in additional compliance requirements for Canadian taxpayers and non-resident investors doing business in Canada.
Key Measures of Note
Global Minimum Tax Act
Canada recently enacted the Global Minimum Tax Act (the “GMTA”), which is designed to implement the Pillar Two component of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) initiative. The GMTA aims to ensure that large multinational enterprises are subject to a minimum level of tax (15%) on their global income, regardless of where it is earned. The GMTA came into effect starting with the fiscal years of qualifying multinational groups that begin after 30 December 2023. Perhaps unsurprisingly given the complex and technical nature of tax, the GMTA is relatively straightforward in concept but potentially triggers tax in a variety of circumstances that are inconsistent with the high-level policy purpose. It is expected that changes will continue to be made to the GMTA as the drafters work through the problems that are being identified by tax practitioners.
Excessive Interest and Financing Expenses Limitation Rules
As part of Canada’s commitment to the BEPS initiative, the government introduced the Excessive Interest and Financing Expenses Limitation Rules (the “EIFEL Rules”), which generally limit the amount of interest and financing expenses that certain taxpayers can deduct for tax purposes. More specifically, under the EIFEL Rules, the deduction of interest and financing expenses for certain entities is limited to 30% of its “adjusted taxable income”, which is generally a proxy for EBITDA, adjusted to reflect certain exclusions and inclusions. The EIFEL Rules apply to tax years beginning on or after 1 October 2023. The EIFEL Rules are simple in concept but extraordinarily complex in practice. A number of changes have already been made to the EIFEL Rules to make them more functional.
Digital Services Tax Act
The government of Canada’s legislative response to the OECD’s Pillar One framework was enacted in the form of the Digital Services Tax Act (the “DSTA”), which imposes a 3% levy on revenues earned by certain multinational digital service providers who operate in Canada. It is important to note that the USA strongly opposes the DSTA, arguing (correctly) that it disproportionately affects US-based multinational tech companies. If unresolved, the US could escalate the dispute by imposing retaliatory tariffs. Some service providers appear to simply be passing the cost of the taxes onto Canadian consumers in any event, which undermines any Canadian fiscal rationale for the tax. The DSTA became law on 28 June 2024 and applies retroactively from 1 January 2022. Entities meeting certain thresholds must register and file annual returns by June 30 each year, with the first payment due in 2025 for revenues dating back to 2022.
Expanded reporting obligations
In the name of improving transparency, the government of Canada has enacted a series of enhanced reporting rules that impose detailed reporting obligations on taxpayers. These new rules require businesses to report transactions that meet specific criteria to the Canadian tax authorities, with failure to comply potentially resulting in significant penalties and other adverse consequences.
The sheer scope of these revised or new reporting rules has led many Canadians to question whether they are appropriate, proportionate, and effective in achieving the goal of increased transparency, given the onerous compliance costs and the volume of information required to be reported to the Canada Revenue Agency (the “CRA”) by taxpayers engaging in what may be entirely innocuous transactions or business arrangements. Critics argue that the rules will generate vast amounts of data for the CRA with very limited prospects of improving enforcement outcomes.
For example, Canada’s Department of Finance and the CRA made headlines in 2024 with their rollout of new reporting requirements for certain trusts. These broad rules created uncertainty regarding their application to bare trust relationships. Just days before the deadline for annual trust returns, the CRA introduced temporary relief for bare trusts, exempting them from penalties for late or non-filing. The timing of the CRA’s administrative relief was widely criticised for coming at the eleventh hour, after taxpayers had already spent countless hours preparing to file the necessary reporting forms. Some media reporting estimated that the bare trust reporting rollout wasted over CAD900 million for taxpayers trying to comply. This controversy underscores the challenges of implementing sweeping transparency measures without clear objectives and guidance.
Amendments to the General Anti-Avoidance Rule
Canada’s domestic General Anti-Avoidance Rule (the “GAAR”) was amended with effect from 1 January 2024. The amendments were said to be designed to modernise Canada’s GAAR by enhancing its ability to prevent abusive tax practices. The expanded GAAR introduced an explicit economic substance test and expanded the already extremely broad scope of what constitutes an avoidance transaction that could be subject to the GAAR. New penalties associated with the GAAR heighten the downside risks of a GAAR assessment for Canadian taxpayers unless voluntary reporting is made. The amendments to the GAAR have increased the uncertainty for taxpayers operating in Canada.
Capital gains inclusion rate increases
The most recent Canadian federal budget proposed to increase the capital gains inclusion rate (the proportion of a gross capital gain which is included in a taxpayer’s taxable income) from 50% to 66.7% for annual capital gains exceeding CAD250,000 for individuals and for all capital gains realised by corporations effective from 25 June 2024. While the effective date for these changes has already passed, the measure has not yet been introduced as a bill before the Canadian Parliament or enacted into law. With a federal election looming and a minority federal government, there is uncertainty regarding whether the change to the capital gains inclusion rate will be enacted into law prior to a change in government and whether a new government will enact or abandon the change.
Clean energy incentives
The increase in complexity in the Canadian tax system is not limited to measures designed to protect the Canadian tax base. New investment tax credits (ITCs) and other incentive regimes have been enacted to encourage spending in Canada’s green economy. ITCs for clean technology, hydrogen production, and carbon capture are among the flagship initiatives. However, these programmes come with intricate eligibility criteria, requiring businesses to engage in detailed planning to obtain benefits. Determining which expenditures qualify – and ensuring compliance with environmental and operational conditions – adds another layer of complexity to the tax landscape. A key component to the economics of many such projects is the federal carbon tax, which the leading opposition party has promised to scrap. Meanwhile, “contracts for differences” have only been entered into by the existing government in limited situations, which has resulted in significant trepidation for many potential long-term project proponents.
Adapting to the New Landscape
The changing Canadian tax landscape is consistent with the global push for tax reform which encourages tax fairness and protects domestic tax bases. However, these changes also amplify compliance challenges for Canadian taxpayers and non-residents who do business in Canada.
The rising complexity of the Canadian tax system demands a comprehensive, forward-looking approach to tax planning. While the measures aim to create a fairer and more transparent tax system in Canada, in practice they significantly increase the cost associated with doing business in Canada, requiring businesses to prioritise tax planning and compliance as a strategic imperative.