TaxMatters@EY – November 2022

For more detail on topics such as personal tax for investors and for estate planning, see the latest version of Managing Your Personal Taxes: a Canadian Perspective

Michelle Fineberg and Matthew Mammola, Toronto

The 2022 federal budget introduced the concept of a “substantive CCPC” with the intention to restrict a Canadian-controlled private corporation (CCPC) from artificially losing its CCPC status prior to realizing a substantial amount of passive income that would otherwise be subject to the refundable portion of Part I tax.

These rules will typically apply to taxation years that end on or after April 7, 2022. To accommodate genuine commercial transactions, there is a limited grandfathering rule that will apply, such that the proposed measures will not impact transactions that were entered into pursuant to a written purchase and sale agreement with an arm’s-length purchaser prior to April 7, 2022. This exception will only be available for transactions that close before the end of 2022.

On August 9, 2022, the federal government released draft legislative proposals which, among other items, addressed measures announced in the 2022 federal budget.1

Background

Broadly speaking, a CCPC is defined in the Income Tax Act (the Act) as a private corporation that is a Canadian corporation other than a public corporation, or a corporation controlled by nonresident person(s) or public corporation(s).2

Corporations that are CCPCs throughout a taxation year are required to pay the refundable portion of Part I tax on their passive income — such as interest, dividends, royalties and taxable capital gains — for the taxation year.3

The refundable additional Part I tax on investment income earned by a CCPC is 10.67%. Therefore, the resulting federal rate applicable to investment income earned by a CCPC is 38.67% (i.e., 38% basic corporate income tax rate, less 10% federal tax abatement, plus 10.67% refundable additional Part I tax).

For example, in Ontario, this would amount to a tax rate of 50.17% — i.e., federal rate of 38.67% plus Ontario’s general income tax rate of 11.5% — of which 30.67% may be refunded on the payment of taxable dividends,4 subject to certain restrictions around the types of dividends paid as compared to the available balances in the refundable dividend tax on hand pools (i.e., non-eligible refundable dividend tax on hand (NERDTOH)) versus eligible refundable dividend tax on hand (ERDTOH).5 In comparison, a private corporation that is not a CCPC throughout a taxation year would be subject to a tax rate of 26.5% on passive income earned for the year in Ontario.

For additional information on the combined federal and provincial/territorial income tax rates applicable to active business income and passive income earned by a corporation, refer to the EY’s Canadian corporate income tax rate cards for active business income and investment income. Where funds are retained in the corporation, there is a tax deferral benefit obtained by earning that income in a non-CCPC.

In light of the above, corporations have sought to lose their CCPC status prior to realizing passive income to avoid the refundable portion of Part I tax levied and to take advantage of the tax deferral benefit. One way to achieve this was by migrating a corporation to a foreign jurisdiction, typically one with preferential, if any, tax rates. The corporation would remain a resident of Canada for tax purposes, as mind and management would still reside in Canada. However, as the corporation would no longer be a Canadian corporation, it would no longer meet the definition of a CCPC. Absent any commercial reasons for undertaking this migration, the CCPC status may be viewed as being lost artificially to take advantage of a tax deferral benefit.

Under the current legislation, the CRA may challenge the manipulation of CCPC status pursuant to the General Anti-Avoidance Rule (GAAR). Nonetheless, the government has decided to move forward with targeted measures against such planning.

The proposals

A substantive CCPC is defined in the draft legislative proposals as a private corporation other than a CCPC that at any time in a taxation year is controlled, directly or indirectly in any manner whatever, by one or more Canadian-resident individuals, or would, if each share of the capital stock of a corporation that is owned by a Canadian-resident individual were owned by a particular individual, be controlled by the particular individual.6

For example, consider the situation where a public corporation, Pubco, is given a right to acquire the shares of a CCPC, Target. As a consequence of the application of special rules in the Act,7 the signing of a legally binding agreement of purchase and sale prior to the date of closing that provides the public corporation with the right to acquire shares of Target can trigger Target’s change in status prior to the closing of the transaction. Therefore, at this point, Target will lose its CCPC status,8 but will become a substantive CCPC. Once the right to acquire the shares is exercised, Target will become a corporation controlled by a public corporation and will cease to be a private corporation. Once this occurs, Target will no longer be a substantive CCPC and will be treated as a genuine non-CCPC.9

The proposed legislation also includes anti-avoidance provisions for taxpayers trying to circumvent the substantive CCPC classification.10

Passive income earned by a corporation that is a substantive CCPC at any time11 in a taxation year will be subject to the refundable portion of Part I tax in the same fashion as would a CCPC. The proposed legislation thereby removes the incentive for a corporation to artificially lose its CCPC status to benefit from a tax deferral on its investment income.

As there is no purpose test for the application of the new substantive CCPC definition, the new rules will have broad application, and as a result will impact legitimate third-party transactions. In certain transactions, there would be a gap in time between signing and closing of a purchase and sale agreement for a variety of business reasons.

Where the purchaser was a nonresident or a public corporation, as discussed above, the target entity would cease to be a CCPC on signing of the agreement. In such a scenario, the target entity may have been able to use paragraph 111(4)(e) of the Act12 to realize a gain on its capital property that would no longer be subject to the refundable portion of Part I tax.13 The tax attributes generated from the gain (i.e., the capital dividend account and safe income) would then be available to increase the cost base of the shares of the target entity.

There are some instances where paragraph 111(4)(e) of the Act may still be used — for example, where the target entity has a loss balance that may otherwise be restricted in its usage following a loss restriction event (i.e., an acquisition of control).14 The target entity could designate a capital property to trigger a capital gain prior to the loss restriction event occurring. To the extent the loss balance covers the amount of the gain, it can be applied against the gain, such that no taxes, including the refundable portion of Part I tax, would be owing. As a result of the designation, the target entity would have an increased tax cost in the asset(s) on which the designation is made.

For other purposes of the Act, substantive CCPCs are considered non-CCPCs. For example, the low-rate income pool (LRIP) regime will apply to substantive CCPCs, such that passive income earned would be added to the corporation’s LRIP.15 Similar to a non-CCPC, taxable dividends paid by a substantive CCPC would first need to be in the form of non-eligible dividends to the extent of the LRIP balance prior to paying eligible dividends. As well, the tax period of a substantive CCPC would become statute barred after four years rather than the three-year statute-barred window that would apply to CCPCs.

Conclusion

The proposed amendments may have significant implications on existing CCPCs as well as on corporations that have previously migrated to a foreign jurisdiction. For corporations that have previously migrated to a foreign jurisdiction, consideration should be given as to whether this structure should remain in place. For additional information on these proposals and their potential impacts, consult your EY tax advisor.

1. Interested parties were invited to provide comments on the draft legislative proposals by September 30, 2022. As such, the proposals described in this article may undergo further amendments before they are tabled in a bill. For additional information on the proposals, refer to EY Tax Alert 2022 Issue No. 37, Finance releases draft legislation for remaining 2022 budget measures.
2. Subsection 125(7) of the Act.
3. Section 123.3 of the Act.
4. An amount totalling 30.67% of the investment income is added to the CCPC’s non-eligible refundable dividend tax on hand account. The additional refundable tax, as well as a portion of the regular Part I tax paid on the investment income, is refundable to the CCPC at a rate of 38.33% of taxable dividends (other than eligible dividends) paid in the year.
5. Broadly speaking, NERDTOH generally includes refundable taxes paid by a CCPC under Part I of the Act on investment income, as well as Part IV tax paid for the taxation year less Part IV tax added to the private corporation’s ERDTOH account. ERDTOH is typically made up of refundable taxes paid under Part IV of the Act on eligible portfolio dividends received from non-connected corporations and Part IV tax paid by a private corporation on eligible or non-eligible intercorporate dividends received from connected corporations to the extent such dividends result in the paying corporation receiving a dividend refund from its own ERDTOH account. For more information on these rules, see “Federal budget proposes revised refundable tax regime for passive investment income” in the June 2018 issue of Tax Matters@EY.
6. Definition of “substantive CCPC” in subsection 248(1) of the Act, as proposed in the August 9, 2022 draft legislation.
7. Paragraph 251(5)(b) of the Act.
8. Pursuant to subsection 249(3.1) of the Act, there will be a deemed year-end immediately before the change in status.
9. Explanatory notes to the August 9, 2022 draft legislative proposals.
10. Proposed subsection 248(42) of the Act.
11. This is different than the definition of a CCPC, where a corporation is required to be a CCPC throughout an entire taxation year for certain provisions to apply.
12. Paragraph 111(4)(e) of the Act allows certain taxpayers to use capital losses that would otherwise expire on a loss restriction event, such as an acquisition of control. A corporation may designate proceeds of disposition to trigger a capital gain on capital property that is eligible and owned immediately prior to the loss restriction event occurring. The designated proceeds of disposition must be an amount between the property’s adjusted cost base and fair market value. The property is then deemed to be reacquired at a cost equal to the elected proceeds of the disposition amount.
13. The corporation would no longer be subject to the refundable portion of Part I tax as it was not a CCPC throughout the taxation year in which the taxation year end was triggered (under subsection 249(4) of the Act) by the loss restriction event (i.e., the taxation year beginning after the status change and ending immediately before the loss restriction event).
14. A loss restriction event creates a barrier across which the ordinary carryforward or carryback of losses and other tax deductions is restricted. Generally speaking, non-capital losses carried forward can be deducted only if the business that the non-capital losses relate to is carried on with a reasonable expectation of profit throughout the taxation year in which the non-capital losses are sought to be used. In addition, generally, non-capital losses carried forward can be deducted only to the extent of income from the same or similar business. Net capital losses expire on a loss restriction event; thus, these losses cannot be carried forward or back following an acquisition of control.
15. A corporation’s LRIP balance typically consists of income that has benefited from preferential tax rates. A non-CCPC can typically pay eligible dividends so long as it does not have a balance in its LRIP. If there’s a balance in its LRIP, non-eligible dividends would have to first be paid to clear this balance. An eligible dividend is taxed in the hands of the end individual shareholders at a lower personal tax rate than a non-eligible dividend. For further details on the combined federal and provincial/territorial income tax rates applicable to individuals, refer to EY’s Canadian personal tax calculator and personal tax rates cards.

This case concerned a restaurant and its system for dealing with tips paid electronically by its customers. The CRA assessed the restaurant to treat the tips as giving rise to contributions or premiums under the Canada Pension Plan (CPP) and Employment Insurance (EI), respectively. Both the Tax Court of Canada (TCC) and Federal Court of Appeal (FCA) found that electronic tips were effectively income from the server’s employment and paid by the employer, and thus gave rise to CPP contributions and EI premiums.

Relevant statutory provisions

CPP and EI are contributory social security programs jointly administered by the CRA and Employment and Social Development Canada. Employers must deduct employee contributions and premiums from employees’ pay and remit them to the CRA, in addition to making employer contributions.

Under the CPP, an employer must make contributions for a year in which remuneration in respect of pensionable employment is paid to the employee.1 Similarly, under EI, an employer’s premium is calculated according to the employee’s insurable earnings, which in turn is based on amounts paid to the employee in respect of insurable employment.2

Background and facts

The employer maintained a somewhat complex system for administering its servers’ tips. The system took into account the fact that some customers settled their restaurant bills wholly in cash while others paid electronically. Servers retained all cash amounts.

At the end of each shift, each server prepared a cash-out sheet showing the total electronic tips left through credit and debit card payments, as well as the cash amounts. The employer would retain a small percentage to redistribute to kitchen staff and to cover processing charges. The remaining amount of electronic tips, minus the cash, was referred to as the “due back” and was paid to the particular server by electronic transfer the following day. The servers would also make further cash “tip out” payments to support staff and managers at the end of their shifts.

The appeal centred solely on the treatment of the due-back amounts paid to servers and not on the cash tips or the tip-out payments.

The employer did not include the electronic tips in computing pensionable salary and wages for CPP purposes or insurable earnings for EI purposes for 2015, 2016 or 2017. The CRA assessed the employer on the basis that the due-backs were amounts the employer paid to the servers in respect of their employment. Therefore, the due-backs were contributory salary and wages for CPP purposes and insurable earnings for EI purposes.

The employer appealed to the TCC.

TCC judgment

The TCC reviewed the relevant case law and determined that the test to be applied was whether the employer had paid the tips to the servers.3 The term “paid” was to be construed liberally. Since the tips had been paid to the restaurant via electronic means, they had not previously been paid to, or been in the possession of, the servers. As a result, the due-backs constituted contributory salary and wages of an employee paid by the employer for CPP purposes and insurable earnings for EI purposes.

The employer appealed to the FCA.

FCA analysis

The two main questions the employer raised in its appeal were whether the due-backs were paid in respect of a server’s employment and whether the due-backs were paid by the employer. For the employer to succeed in its appeal, at least one of these questions would have to have been answered in the negative.

The employer argued that the due-backs were not paid in respect of a server’s employment because they simply represented the difference between the cash amounts and the electronic tips owed to servers. The due-backs were not calculated by reference to hours worked or sales the server made, but instead their amount depended simply on whether customers settled their bills by cash or by electronic means.

However, the FCA found that but for the servers’ employment with the employer, they would not have received the due-backs. The legislation does not require an amount to be calculated in a particular way — for example, by reference to hours worked — for it to be “in respect of” employment. The only requirement is that the amount was received in relation to, or in connection, with employment and, in the FCA’s view, the due-backs met that description.

The second question the employer raised turned on whether the due-backs were actually paid by the employer or whether, as the employer claimed, the employer was simply converting the electronic tips into cash and paying it to the employee. The FCA reviewed the relevant case law, focusing on the leading cases of Canadian Pacific and Lake City Casinos.4 In Canadian Pacific, the Supreme Court of Canada stated that the word “paid” can mean mere distribution by the employer. Similarly, in Lake City, the FCA stated that the word “paid” should be interpreted liberally. Specifically, the FCA stated that for the CRA to succeed, it had to demonstrate that the tips had come into the employer’s possession before being remitted to the employees.

The employer argued that there were two distinct groups of previous cases, which the employer referred to as the distribution cases and the conversion cases. In the distribution cases, the employers received the tips and then determined how they would be distributed among the employees. In contrast, the employers in the conversion cases did not take possession of any cash tips and merely exchanged any electronic tips for cash that was then paid over to the employee. While the employers in the distribution cases were liable to pay CPP contributions and EI premiums on the tips, those in the conversion cases were not. The employer argued that its case was a conversion case and so it was not required to pay CPP contributions or EI premiums in respect of the due-backs.

In its analysis, the FCA rejected the distinctions the employer drew between its case and the distribution cases. The employer had emphasized in its arguments that in its case, for example, tips were not pooled and the employer did not come into possession of cash tips.

However, the FCA reasoned that the distribution cases were not decided on the basis of those factors. According to the FCA, the TCC had correctly identified the relevant test as being whether the employer paid the tips to the server, with the word “paid” being liberally construed.

The FCA also found no error in the TCC’s application of the relevant test to the facts in the case. As indicated above, the TCC concluded that the employer paid the tips to the servers because the tips came into the employer’s possession first and were then distributed to the servers — that is, the tips were not previously in the servers’ possession.

Lessons learned

An increasing number of payments are made using electronic means rather than by cash, so employers need to be aware of the ramifications of any policy they put in place for administering tips among staff. In Ristorante a Mano, the FCA clearly stated that the word “paid” must be interpreted liberally, and in the employer’s case this resulted in the due-backs giving rise to CPP contributions and EI premiums. The FCA seemed unwilling to recognize the factors the employer considered to be relevant in distinguishing between distribution and conversion cases.

It remains to be seen whether the broad interpretation given to the word paid could cover situations where a tip is paid electronically to the employer and the full amount is returned to the server.

1. Subsection 9(1) of the Canada Pension Plan.
2. Sections 67 and 68 of the Employment Insurance Act and subsection 2(1) of the Insurable Earnings and Collection of Premiums Regulations.
3. Ristorante a Mano Limited v MNR, 2021 TCC 22.
4. Canadian Pacific Ltd. v. Canada, [1986] 1 SCR 678 and Lake City Casinos Limited v. Minister of National Revenue, 2006 TCC 225 (aff’d by 2007 FCA 100).