TaxBreaks, April 2004

Long-awaited SR&ED modification
The entertainment expense deduction in Québec gets more complicated
Withholding tax on director’s fees paid to non-resident directors
Did you know that . . .

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Long-awaited SR&ED modification

The federal budget tabled March 23, 2004 introduced a technical change to the tax legislation that was long overdue. The purpose of this change is to facilitate access for certain Canadian-controlled private corporations (CCPCs) to the refundable tax credit on scientific research and experimental development  (SR&ED) expenditures.

To better grasp this change, it must be understood that in the Canadian financial environment, the shares of many corporations are held by the same investment institutions. This phenomenon is typically Canadian, because, among other things, our financial market is smaller than the U.S. market. Due to the smaller market, corporations can find themselves in a situation where a group of investment institutions holds the majority of their outstanding shares and therefore effectively controls, as a group, these corporations. If more than one corporation is controlled in this manner by the same group of investment institutions, the corporations are considered “associated” from a tax point of view, even if they are not linked in any other way, commercially or otherwise. In fact, it could occur that one of these corporations would not be aware of the existence of the other “associated” corporation, and vice versa.

Shared tax credit
The fact that such corporations are considered associated with each other implies that they have to share the 35% refundable tax credit that tax legislation allows on the first $2 million of SR&ED expenditures incurred by the associated group.

The result was that CCPCs engaged in SR&ED activities could lose, fully or partially, their access to the 35% refundable tax credit on SR&ED expenditures, even though they would otherwise have been entitled to claim this credit.

The new measure
The federal budget of March 23, 2004 announced that, for taxation years ending after March 22, 2004, where CCPCs have a common group of investors and the Minister of National Revenue is satisfied that the group was not formed to gain access to multiple expenditure limits for the SR&ED tax credit, CCPCs will not be required to share the $2-million expenditure limit solely because two or more investors collectively have a majority interest in the shares of each corporation.

The new federal measure follows Québec legislation
It is interesting to note that the new measure addresses a shortcoming in federal law that was first noted years ago and that the Québec Ministry of Finance corrected in its legislation in 2000.

Before the changes made in 2000, the Québec rules limited access to the provincial SR&ED tax credit when two corporations, by reason of being controlled by the same group of persons (including venture capital corporations owned by the Crown), were considered associated. As a result, each corporation had to take into account the other corporation’s assets in addition to its own. This meant that they could lose their rights to a tax credit calculated at the higher rate when their combined assets exceeded ceilings determined under the tax legislation. To facilitate access to venture capital and preserve corporations’ rights to claim the SR&ED tax credit calculated at the higher rate, the government of Québec adopted rules that would allow two corporations in such circumstances not to be considered associated.

By introducing a measure similar to the rules implemented in Québec, the federal government has made it easier for small, private, Canadian corporations undertaking innovative activities to gain access to venture capital.

Yan Boyer, Montréal

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The entertainment expense deduction in Québec gets more complicated

Before June 12, 2003, the deduction granted to a taxpayer who incurred expenses for food, beverages, or entertainment as a result of income-generating activities from business or property (hereinafter called “entertainment expenses”) was limited to only 50% of the amount actually spent. This treatment of entertainment expenses still prevails at the federal level.

In the budget tabled on June 12, 2003, the Québec government announced the introduction of an annual additional limit of 1% of the taxpayer’s annual sales for a given year, thereby transforming the deduction for entertainment expenses into a real headache. Many taxpayers have expressed dissatisfaction with respect to this new measure; they have demanded that significant relief measures be taken with respect to this ceiling, and even suggested that it be dropped.

In the budget tabled on March 30, 2004, the Finance Minister partially responded to these demands by announcing certain relief measures, thereby complicating the calculation of the deduction.

Contrary to what was announced in the budget of June 12, 2003, the new ceiling will not be calculated separately for each of the taxpayer’s businesses, but will rather apply to the taxpayer’s total annual sales. For the purposes of this calculation, the annual sales figure used corresponds to the gross sales recorded by a business in a given taxation year, excluding capital gains. Entertainment expenses that are already excluded from the 50% limit are not subject to this new ceiling.

If the taxpayer’s income is earned through a partnership, the limitation on entertainment expenses applies to the partnership as a whole. As a result, a partner could no longer deduct an additional amount as entertainment expenses, over and above those deducted by the partnership of which he or she is a member.

Application of new measures
The ceiling of 1% announced in the budget of June 12, 2003 applies to taxation years ending after that date. For a taxation year that includes June 12, the distribution of entertainment expenses and annual sales must be calculated on a pro rata basis with respect to the number of days after that date included in the taxation year. However, this ceiling will be modified when this taxation year ends after March 30, 2004, when the last budget was tabled. In fact, for a taxation year that includes June 12, 2003 but ends after March 30, 2004, the percentage of the applicable ceiling will be 1.25% for businesses with annual sales of $52,000 or more. Other ceilings are also applicable, depending on the business’s annual sales. Since March 31, 2004, the applicable ceilings are as follows:

Example
The following example illustrates the impact of the end of the taxation year on the applicable ceiling when:

• the taxpayer’s entertainment expenses for the fiscal period total $10,000, and the deduction is limited to $5,000 as a result of the application of the 50% limit, and
• the taxpayer’s annual sales for the fiscal period total $350,000.

Based on the fiscal period, the deductible portion of entertainment expenses will vary as follows:

The non-deductible portion of entertainment expenses in Québec is therefore now $6,192 ($10,000 – $3,808), compared to $5,000 as calculated prior to the introduction of the 1% ceiling.

The non-deductible portion of entertainment expenses in Québec is therefore now $5,501 ($10,000 – $4,499), compared to $5,000 as calculated prior to the introduction of the ceiling.

Exceptions
The Québec Finance ministry outlines exceptions for taxpayers whose activities are normally carried out at locations that are 40 kilometres or more from their place of business, or whose activities require sales agencies.

Regular travel. To account for operating conditions specific to certain industries, such as the transportation industry in which businesses are subject to more significant entertainment expenses incurred in regular travel that is inherent to their activities, the ministry will not apply the ceiling to businesses within this industry if certain conditions are respected. As a result, this ceiling will not apply to food and beverage expenses incurred by a taxpayer through business-related activities, if they occur 40 kilometres or more from the taxpayer’s place of business and if such activities are regularly carried out in a location that far from the place of business.

Sales agencies. This exception solely targets sales agencies that endeavour, on a commission basis, to identify markets for property held in inventory by another taxpayer. In this case, the calculation of annual sales and of the ceiling on entertainment expenses would be applied as follows:

The impact
As you can see, these new measures not only complicate the law, but also create an additional cost for taxpayers operating a business.

Benoit Perreault and Marie-Claude St-Georges, Saint-Hyacinthe

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Withholding tax on director’s fees paid to non-resident directors

In Canada, director’s fees are considered income from an office or employment and are subject to income tax withholdings similar to salary or wages. As a general principle, every person paying salary, wages or other remuneration shall withhold and remit from the payment, on account of the employee’s tax, the amount determined in accordance with the Income Tax Regulations. To facilitate the payroll withholding process, the Canada Revenue Agency (CRA) has issued Payroll Deductions Tables in accordance with the Regulations.

Previously, as an administrative policy, the CRA accepted withholding tax at the rate of 15% from director’s fees paid to non-residents for services rendered in Canada. Where services were rendered in the province of Québec, an additional 9% tax was withheld.

Effective January 1, 2004, the withholding tax on director’s fees paid to non-resident directors is to be calculated in the same manner as for Canadian resident directors. The withholding tax is applicable only with respect to director’s fees received by a non-resident for services rendered in Canada. To determine the appropriate amount of income tax withholdings, payers are required to use the monthly Payroll Deductions Table applicable to non-residents of Canada. Both federal and provincial income tax ductions are required to be withheld from the payment of director’s fees. In determining the applicable provincial income tax to be deducted, various factors must be considered. Generally, payers are required to withhold provincial income tax from director’s fees in respect of the particular province in which the employer has an establishment to which the director reports for work or is deemed to report for work.

The income tax withholdings do not represent a final tax, but rather are considered a payment on account of the non-resident’s overall tax liability to Canada and the relevant province. The foreign director would be required to file Canadian and Québec (if applicable) tax returns to declare the director’s fees received and calculate the applicable taxes. Under certain circumstances, a tax treaty between Canada and the country of residence of the non-resident director providing services in Canada may provide relief from Canadian income tax. In such situations, a waiver may be obtained from the CRA to reduce the income tax withholdings.

Canada or Québec Pension Plan (CPP/QPP) contributions on director’s fees are generally not required if the services are performed wholly or partly outside of Canada by the non-resident director. In situations where all of the services are rendered in Canada, the taxpayer and the payer may be exempt from making CPP/QPP contributions pursuant to a social security agreement between Canada/Québec and the country of residence of the director. Further, Employment Insurance (EI) premiums should not be deducted from resident or non-resident director’s fees.

Director’s fees paid to a non-resident for services performed in Canada should be reported on a T4 Statement of Remuneration Paid. If the services are rendered in the province of Québec, the amount should be reported on a Relevé 1 Employment and Other Income slip as well. The T4 and Relevé 1 slips should be filed with the CRA and Minister of Revenue of Québec, respectively, by the last day of February following the year in which the services were rendered.

Terri Spadorcia, Montréal

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Did you know that . . .

•  How to get your tax refund in days. If you are entitled to an income tax refund, you may be able to receive it within eight business days of filing your income tax return, provided you file the return electronically. If you also arrange direct deposit into your bank account, you may get your refund even faster. To arrange direct deposit, you have to file a request with the Canada Revenue Agency.
• Filing your tax returns late could cost you dearly. The deadline for most individuals to file their tax returns is April 30. If you miss the deadline for filing your federal or Québec return, you will have to pay a penalty of 5% of the amount that was owing and unpaid on April 30. In addition, you will have to pay a 1% penalty for each full month of lateness, up to a maximum of 12 months. If you have not yet filed to report your 2003 income, now is the time.
• Prescribed interest rates for the second quarter of 2004. The Canada Revenue Agency has announced the prescribed interest rates that will apply for income tax purposes for the second quarter of 2004. The rates that will be in effect from April 1 to June 30, 2004 are: 7% on overdue taxes, Canada Pension Plan contributions and Employment Insurance premiums; 5% on overpayments; 3% on taxable benefits for employees and shareholders from interest-free or low-interest loans. In Québec, the rates are 7%, 2% and 3% respectively. These rates are the same as those in effect during the first quarter of 2004.
• Ten-year limit to collect federal tax debts. The Income Tax Act will be modified to establish a ten-year limitation period for the collection of federal tax debts, effective March 4, 2004. Previously, the Act did not prescribe a limitation period. With respect to taxes that became payable before March 4, 2004 and remain unpaid, the ten-year limitation period starts to run on that date.

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