2008 Federal Budget Commentary

BUDGET OVERVIEW

Federal Finance Minister Jim Flaherty tabled his third Budget yesterday February 26, 2008. With mostly a modification to existing tax programs, a commitment to reducing the debt and assisting individuals towards planned savings, we would expect that this Budget would not be of significant concern enough to trigger a much anticipated spring election.

While the Minister announced no new tax credits or changes to personal tax rates, the Budget proposes a new "Tax-Free Savings Account" to encourage savings, minor tax relief in the form of adjustments to Registered Education Savings Plans, Medical Expense Credits and Registered Disability Savings Plans.

For Canadian businesses, the Budget offers several measures to support the manufacturing sector, in which real output has declined by 3.4% in the last two years, and to encourage innovation among small and mid-sized businesses. The Budget also includes improvements to the scientific research and experimental development tax incentive program.

The Budget proposes to reduce the debt by $10.2 billion this year, with further reductions of $2.3 billion for 2008/09 and $1.3 billion for 2009/10.

PERSONAL TAX MEASURES

Dividend Tax Credit (DTC)

The DTC compensates the individual shareholder for corporate-level tax in order to integrate the personal and corporate tax systems at the federal level. "Eligible dividends" were introduced in 2006 and are subject to a higher gross-up and an enhanced DTC in order to recognize that these dividends are generally paid out of income taxed at a higher rate.

The Budget proposes to adjust the dividend gross-up and DTC for eligible dividends to reflect intended corporate tax rate reductions. The gross-up of eligible dividends will be reduced from 45 per cent to 44 percent effective January 1, 2010, 41 per cent effective January 1, 2011, and 38 per cent effective January 1, 2012. The enhanced DTC will also change on the same schedule from 11/18 of the gross-up amount to 10/17, 13/23 and 6/11.

Tax-Free Savings Account (TFSA)

The Budget proposes a TFSA, a registered account that individuals will be able to utilize for their savings. Commencing in 2009, Canadian residents, age 18 or over, will be able to contribute up to $5,000 annually (indexed annually after 2009) to a TFSA. Any portion of this $5,000 annual contribution limit not utilized in one year can be carried forward indefinitely to a future year. Any amounts withdrawn from the TFSA in a year will be added to the individual's limit in the following year. Any excess contributions over the available limit will be subject to a penalty tax of one per cent per month.

Although contributions to the TFSA will not be deductible for income tax purposes, the investment income earned within the TSFA will not be taxable. Withdrawals can be used for any purpose and will not be subject to tax or taken into account in determining eligibility for income-tested benefits or credits such as the age credit or Old Age Security benefits. Interest on money borrowed to invest in a TFSA will not be tax deductible. However, unlike RRSPs, individuals will be allowed to use their TFSA assets as collateral for a loan.

The income attribution rules will not apply to funds borrowed by a spouse or common-law partner to invest in his/her TFSA. A TFSA will lose its tax-exempt status upon the death of the individual. Consequently, investment income and gains that accrue after the individual's death will be taxable. However, an individual will be permitted to name his/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 the deceased's TFSA may be transferred to a TFSA of the surviving spouse or common-law partner.

An amount may also be transferred on the breakdown of a marriage or common-law partnership directly from the TFSA of one party to the TFSA of the other party. This type of transfer will not reinstate the contribution room of the transferor and will not reduce the contribution room of the transferee.

An individual who becomes a non-resident of Canada will be allowed to maintain his/her TFSA, which will continue to be exempt from tax. However, contributions will not be allowed while the individual is a non-resident and contribution room will not accrue for any year throughout which the individual is a non-resident.

The Canada Revenue Agency (CRA) will determine TFSA contribution room based on tax returns filed. Individuals who have not filed tax returns in prior years will be permitted to establish their entitlement by filing such returns or by other means acceptable to CRA.

Financial institutions eligible to issue RRSPs will be permitted to issue TFSAs. TFSA issuers will be required to file annual information returns to report the value of an account's assets at the beginning and the end of the year, as well as the amount of contributions, withdrawals and transfers made in the year.

A TFSA will generally be permitted to hold the same investments as an RRSP. However, a TFSA will not be allowed to hold investments in any entity with which the individual does not deal at arm's length, including an entity of which the individual is a "specified shareholder" (generally a 10 per cent or greater interest).

Registered Education Savings Plan (RESP)

A RESP must currently be terminated by the end of the year that includes the 25th anniversary of the opening of the plan unless the beneficiary of a single-beneficiary RESP qualifies for the Disability Tax Credit. In addition, contributions may not be made to a family plan for a beneficiary who is 21 years of age or older.

The Budget proposes to increase the time limits by an additional 10 years for 2008 and subsequent taxation years.

Registered Disability Savings Plans (RDSPs)

The Government is working with financial institutions to put the necessary mechanisms in place to allow them to offer RDSPs in 2008.

If an RDSP beneficiary ceases to be eligible for the Disability Tax Credit, the current RDSP rules require that the proceeds of the plan be paid out to the beneficiary and the plan collapsed. There is a concern that this requirement could, contrary to the wishes of the parent, enable the beneficiary to rescind his/her Disability Tax Credit certification and gain full access to the funds.

Consequently, the Budget proposes to provide instead for a mandatory collapse of the plan only when the beneficiary's condition has factually improved to the extent that the beneficiary no longer qualifies for the Disability Tax Credit.

This proposal will be effective for 2008 and subsequent taxation years.

Medical Expense Tax Credit

The Budget proposes to add a number of items to the list of medical expenses eligible for the tax credit effective for 2008. The Budget proposes to clarify that, effective for expenses incurred after February 26, 2008, eligible drugs and medications must be purchased with a prescription.

Mineral Exploration Tax Credit

The mineral exploration tax credit is a benefit, in addition to the deduction of Canadian exploration expenses, equal to 15 per cent of specified mineral expenses incurred in Canada and renounced to the shareholders. The Budget proposes to extend eligibility for this credit to flow-through share agreements entered into by March 31, 2009, which can support eligible exploration until the end of 2010.

BUSINESS TAX MEASURES

Scientific Research and Experimental Development (SR&ED)

Under the current system, Canadian-controlled private corporations (CCPCs) are entitled to a tax credit or a cash refund of investment tax credits (ITCs) based on the following formula:

Eligibility for the 35% rate is phased out if the corporate group's taxable capital (as calculated for Large Corporation Tax purposes) exceeds $10 million and/or if the corporate group's taxable income exceeded $400,000 in the preceding taxation year.

The Budget proposes to increase both the expenditure limit eligible for the 35% rate and the phase-out ranges for taxation years that end on or after February 26, 2008 (subject to proration for straddle years):

SR&ED Carried on Outside of Canada

A taxpayer can not currently claim an ITC for SR&ED expenditures carried on outside Canada. The Budget proposes that certain salaries or wages incurred outside of Canada ("foreign salaries") on or after February 26, 2008; (subject to proration for straddle years) will be eligible for ITCs. More specifically:

• The taxpayer must directly undertake the activities outside of Canada solely in support of SR&ED that the taxpayer carries on in Canada.
• Foreign salary eligibility is limited to 10% of the total salaries and wages incurred.
• Foreign salaries will not include salaries and wages based on profits or bonus or salary or wages subject to tax in the foreign country.

Administrative Measures

In order to facilitate ITC claims, the CRA will introduce a new SR&ED claim form and guide and eligibility-assessment tool.

Manufacturing and Processing (M&P): Accelerated Capital Cost Allowance (CCA)

The Budget has extended the qualifying period for assets subject to accelerated CCA rates to those acquired in 2009. The Budget further adjusts CCA rates on M&P equipment over the next several years.

Remittance of Source Deductions

The Budget proposes to adjust the penalty provisions on any late remittance of source deductions.

DONATIONS

Donations of Exchangeable Securities

Currently donations of publicly traded securities are afforded favourable tax treatment. The Budget proposes to extend this treatment to donations made on or after February 26, 2008, of publicly traded securities acquired in exchange for unlisted securities, if certain conditions are met.

Private Charitable Foundations

Private foundations are restricted regarding the percentage of the shares of any class of a corporation that they can own. The Budget proposes to exempt unlisted shares held on March 18, 2007, from these restrictions.

INTERNATIONAL

Section 116 Certificates

The Budget proposes to eliminate the need for a Section 116 Certificate after 2008 if:

• the taxable Canadian property ("TCP") being disposed of is a treaty-protected property, or
• the purchaser, after reasonable inquiry, concludes that the TCP is treaty-protected and that the vendor was resident in that treaty country.

In the first case, a related purchaser must report the transaction to the CRA within 30 days of the disposition. In the second case, all purchasers must report the transaction to the CRA within 30 days after the disposition.

If no Canadian taxes are payable by the non-resident, the vendor may not have to file a Canadian tax return to report the disposition.

SALES, EXCISE TAX AND OTHER MEASURES

GST/HST Health Measures

Effective February 27, 2008, the Budget will extend GST/HST exempt status to a range of health care services, prescription drugs and medical devices. The Budget will also extend zero-rated status to certain other medical and assistive devices as well as supplies of prescription drugs.

Various other measures are proposed dealing with GST/HST on long-term care facilities, leases for wind and solar powered equipment as well as tobacco and alcohol excise taxes.

NOTICE TO READER

The contents of this report are of a general nature only and are not intended to be a full and complete analysis of the topics discussed. The issues contained herein are not intended to be nor should they be construed as, either the offering or giving of financial advice on any matter.

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