Further, crucial thoughts on Morneau's CCA proposals

There will be further commentary about Morneau's fall economic statement this week, but fuzzy  accusations are already being posted about their effectiveness. For instance, Jack Mintz raised the following point in the Financial Post:

"As it stands, about three-fifths of Canadian corporations do not pay corporate taxes, according to the Canada Revenue Agency’s recent corporate tax statistics (a breakdown by sector or size of companies is not available)."

 While he does give an important qualification, he doesn't necessary point out that many corporations required to file returns are automatically exempt from income tax liability, including:

1. Charities and other non-profit corporations
2. Federal and provincial Crown corporations
3. Municipally-owned corporations
4. Bare trustees whose only purpose is to hold property on behalf of another individual or entity
5. Dormant and other inactive corporations

Why the CRA doesn't isolate those entities in its analysis does tend to make us wonder. I would also add the following groups for consideration, based on person observation:

1. Holding companies that act as trustees for trusts whose income flows directly to beneficiaries
2. Management companies whose expenses are offset by management fees charged to related parties

It's up for debate as to whether the underlying arrangements for these companies are legally valid, but that is a topic to be debated another time, especially as to why the CRA is not as aggressive as it should be in questioning them.

The current debate is as to whether the new measures for accelerated capital cost allowance will help to boost the economy. I am skeptical as to whether that will happen, because Canadian businesses have been historically notorious for underpaying and underinvesting:

• For these past decade, the cost of capital has been at historical lows, which would have made borrowing for business investment correspondingly cheap. Coupled with capital cost incentives that were much more attractive than their US equivalents, and given the economists' teaching that any project having a return greater than the cost of capital should be undertaken, we should have seen significant uptakes in investment. That, however, has not been the case.
• Even before that, when the Canadian dollar achieved temporary parity with the US dollar, we should have seen significant imports of capital equipment to upgrade our under-performing manufacturing plants. That did not happen either.
• We witnessed the existence of dead money, where corporations just sat on their cash instead of investing it.
• We have witnessed a massive waste of energy by business lobbies in promoting the concept that lower corporate tax rates will increase productivity, whether through the general rate or the small business rate. That hasn't worked either, because we have seen businesses using their improved cash flow to buy back their shares instead. That may very well be linked to the above point about dead money, but I have heard of no analysis published in that regard.
• As for the small business rate break, the UK abolished its small profits rate in April 2015, because it became quite obvious that it is an incentive to stay small, while Australia introduced a gross revenue test (subject to certain passive income limitations) in July 2017 to bypass the games corporations play to minimize their taxable income to qualify for the break.

In addition, there has always been an over-conservative tradition in Canadian business when it comes to investing. The first employer I worked for after graduation in the 1970s had an effective policy of only approving projects with a payback of less than a year, which really halted a lot of potential investment. I remember a financial analysis supervisor that wrote up a mock appraisal for acquiring an electrical pencil sharpener, and I believe she was able to justify it on the basis of an annualized rate of return of 3,078%! Another employer later on used a hurdle rate of 15% to identify projects that would make the cut for a formal appraisal. As that was an after-tax rate, even at a time when bank rates were around 20%, the tax rate of around 50% would still have made for an after-tax rate of about 10%, and the financial analysts there were wondering why a higher rate was being applied for projects that were essentially risk-free.

The new CCA rules, explained

All the hype over Bill Morneau's fall economic statement yesterday was really overdone, but, once you look into the details, many questions remain. I won't discuss the macroeconomic and political issues, as they are being fully debated elsewhere. I will, though, expand on my initial thoughts about the changes to the capital cost allowance rules, because they are more complex than were originally described.

Recap

As most CMAs will recall from their training, the NPV of capital investment for the regular declining-balance classes in Schedule II of the Income Tax Regulations is determined through two calculations:

Full-year rule

$ I  \left (1-\frac{td}{i+d}\right ) $

Half-year rule

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \right ] $

The new accelerated investment incentive rules

Morneau's proposals essentially displace the half-year rule for selected groups of assets, but the much advertised touting of these as providing 100% writeoffs for capital investment are not really that simple. We have to look at how the computations are expressed, and they ain't pretty.

First of all, under the current Notice of Ways and Means Motion,

• property acquired after 20 November 2018 (excluding property previously owned by the taxpayer or by another entity with whom the taxpayer does not deal at arm's length, whether by rollover or otherwise) that becomes available for use before 2028 is now identified as "accelerated investment incentive property", and
• the capital cost allowance prescribed rates are now multiplied by the following adjusted acquisition values:

$ ab + cd + ef + gh + 0.5i  $

all of which are described in the table below:

Group	CCA Class	Factor		Description
$ ab  $	not in respect of property included in ITR 1100(1)(v) (ie, a Canadian vessel) or in any of Classes 12, 13, 14, 15, 43.1, 43.2 and 53	$ a  $		0.5, in respect of property that becomes available for use before 2024, and 0, in respect of property that becomes available for use after 2023
		$ b = j - k  $	$ j  $	the total of all amounts that become available for use within the year
			$ k  $	the amount, if any, by which the amount determined for $ s  $ exceeds the amount determined for $ r  $ in the description of $ i  $
$ cd  $	Class 43.1 (ie, clean energy processing)	$ c  $		2 1/3, in respect of property that becomes available for use before 2024, 1 1/2, in respect of property that becomes available for use in 2024 or 2025, and  5/6, in respect of property that becomes available for use after 2025
		$ d = l - m  $	$ l  $	the total of all amounts that become available for use within the year
			$ m  $	same calculation as for $ k  $
$ ef  $	Class 43.2 (ie, certain clean energy processing equipment acquired before 2025 that would otherwise fall under Class 43.1)	$ e  $		1, in respect of property that becomes available for use before 2024, and 0.5, in respect of property that becomes available for use in 2024
		$ f = n - o  $	$ n  $	the total of all amounts that become available for use within the year
			$ o  $	same calculation as for $ k  $
$ gh  $	Manufacturing and processing equipment in Class 53 (if acquired before 2026) or Class 43 (if acquired after 2025)	$ g  $		1, in respect of property that becomes available for use before 2024,  1/2, in respect of property that becomes available for use in 2024 or 2025, and   5/6, in respect of property that becomes available for use after 2025
		$ h = p - q  $	$ p  $	the total of all amounts that become available for use within the year
			$ q  $	same calculation as for $ k  $
$ i  $	property subject to the half-year rule	$ i = r - s  $	$ r  $	the total of all amounts that become available for use within the year
			$ s  $	amounts received as proceeds of disposition for property

While the last factor is effectively the classic half-year rule computation, the other factors are essentially the top-up amount that will be added. They effectively lead to the following composite results:

1. Unless otherwise provided elsewhere, the CCA first-year claim is calculated at 1.5 times the standard rate for assets becoming available for use before 2024, after which the full-year rule will apply for assets becoming so before 2028, and then reverting back to the half-year rule thereafter.
2. For Class 43.1, the CCA first-year rate becomes 100% for assets available for use before 2024, 75% for those becoming so in 2024 or 2025, and 55% for those becoming so after 2025.
3. For Class 43.2, the CCA first-year rate becomes 100% for assets available for use before 2024, and then 75% for those assets becoming in 2024.
4. For Class 53 and Class 43 assets (depending upon the date they come into use),  the CCA rate becomes 100% for assets available for use before 2024, 75% for those becoming so in 2024 or 2025, and 55% for those becoming so after 2025.
5. The half-year rule continues to apply for those assets that do not qualify as "accelerated investment incentive property".

Therefore, the formula I was posting yesterday for calculating the effective tax shields on the new accelerated rates, being:

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+bi}{1+i}\right ) \right ] $

can be used as appropriate, after taking into account the appropriate top-up factors outlined above.

Thoughts on the federal 2018 fall economic statement

Bill Morneau was up to his usual stuff today, but there are some practical consequences on what he pulled out of the hat for accelerated capital cost allowances. This will accordingly affect some calculations I had presented five years back on how to compute the effective tax shield on what can be claimed.

The new first-year allowance

This calculation is dead simple, as the tax shield is the full amount of corporate tax relief on the investment in question, and so the net present value of the investment is:

$ I \left (1-t \right ) $

The bonus depreciation scheme, aka the "accelerated investment incentive"

The revised tax shield available for capital costs other than those eligible for the new first year allowances in the next five years, will now result in a NPV on the investment of:

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+bi}{1+i}\right ) \right ] $

where I is the investment cost, t is the applicable corporate tax rate, d is the normal CCA rate for the property concerned, and b is the bonus factor for multiplying into the first-year CCA claim (in Morneau's proposal, it's 1.5).


I will work out some graphs shortly on what the impact of these measures will be. Stay tuned.

The ever-expanding scope of the corporate profile

I suppose I've been rather old-fashioned in my approach to setting up corporate and ownership structures, as I've always believed in the efficacy of Occam's Razor being applied:

• every component entity should have genuine economic substance
• the simplest solution is the best
• oftentimes it is also the cheapest to administer

That's why I'm often bemused when I see owners devising a web of relationships when setting up their affairs, such as this one that was filed in a 2009 CCAA proceeding:





The owners' identities here (anonymized in the court filings here as AR, MF and PB) can be easily determined through a standard Internet search, but their beneficial ownership in these companies (upon analyzing the investment flows) comes out to 12.5%, 12.5% and 75% respectively in the destination company of White Birch Paper Company, being an unlimited liability corporation incorporated in Nova Scotia. The choice of intermediaries was most likely driven by US tax law, as Canadian ULCs, limited partnerships, S corporations and limited liability companies (the latter two being uniquely American in nature) are regarded as flow-through entities for income tax purposes there. The fact that the three principals gained their primary wealth from real estate development may also explain their preference for such ornate ring-fencing of assets.

White Birch, in turn, was the parent company for all the group companies shown below:

The problem with ornate structures

Setups like this are especially problematic when organizations are working to secure financing, as it's only logical to assume that investors need to know with whom they are placing their money. Knowing who the principals are, and their previous experience (whether notorious or benign) is only common sense, but the stories concerning securities scandals, phoenix activities, money laundering and terrorism financing that pop up in the business papers only too frequently remind us that this is a matter that should never be taken for granted. Canada, unfortunately, has been relatively naïve in guarding against this, resulting in what has been called "snow washing", and our financial institutions and professional advisers still need to get up to snuff with the rest of the world.

The current controls

The Financial Transactions and Reports Analysis Centre of Canada (FINTRAC)currently governs what financial institutions and other money handlers must do to deal with the risks of money laundering and terrorism financing in the Canadian financial system. In that regard, there are specific guidelines dealing with:

• "know your client" requirements, including those for
• properly identifying individuals and entities
• identifying their business relationships
• determining significant beneficial ownership interests in entities
• identifying any third parties that may have effective control over entities
• identifying any politically exposed persons and those connected with them
• ongoing monitoring of such information
• reporting any suspicious transactions or suspected terrorist property concerning such persons to FINTRAC

Much of this is self-explanatory, but some expansion is required to explain what is covered by the concept of "politically exposed persons". The following table will help to identify who is included:

Class of persons	Description
Foreign PEP	head of state or head of government;   member of the executive council of government or member of a legislature;  deputy minister or equivalent rank;   ambassador, or attaché or counsellor of an ambassador;  military officer with a rank of general or above;  president of a state-owned company or a state-owned bank;  head of a government agency;  judge of a supreme court, constitutional court or other court of last resort; or  leader or president of a political party represented in a legislature.
Domestic PEP	Governor General, lieutenant governor or head of government;  member of the Senate or House of Commons or member of a legislature;  deputy minister or equivalent rank;  ambassador, or attaché or counsellor of an ambassador;  military officer with a rank of general or above;  president of a corporation that is wholly owned directly by Her Majesty in right of Canada or a province;  head of a government agency; judge of an appellate court in a province, the Federal Court of Appeal or the Supreme Court of Canada;  leader or president of a political party represented in a legislature; or  mayor or other head of a municipal council
Head of an international organization (HIO)	the head of an international organization established by the governments of states; or  the head of an institution established by an international organization.
Family member of a PEP or a HIO	their spouse or common-law partner;  their child;  their mother or father;  the mother or father of their spouse or common-law partner; and  a child of their mother or father (sibling) Note: in this case, a child does not include a step-child
Close associate of a PEP or a HIO	business partners with, or who beneficially owns or controls a business with, a PEP or HIO;  in a romantic relationship with a PEP or HIO, such as a boyfriend, girlfriend or mistress;  involved in financial transactions with a PEP or a HIO;  a prominent member of the same political party or union as a PEP or HIO;  serving as a member of the same board as a PEP or HIO; or   closely carrying out charitable works with a PEP or HIO.  Note: the above list is not exhaustive

One might think that such controls might already be comprehensive enough, but the Canadian rules have a lot of holes built into them, as has been noted by Transparency International here. We still have a long way to go to comply with the principles adopted by the G20 in 2014 concerning the disclosure of beneficial ownership in entities.

Identifying who controls an entity

Trusts that earn income and/or make distributions are required to file form T3APP, together with a copy of the instrument creating the trust, in order to obtain a trust account number for reporting purposes.

As of July 2017, Canada adopted the Parts XVIII and XIX of the Income Tax Act, which respectively implemented the mandatory identification of US persons subject to IRS reporting obligations, as well as the Common Reporting Standard which mandates the disclosure of a passive non-financial entity's controlling persons. Disclosure is by way of filing form RC519 (or one with equivalent information) with the entity's financial institution.

The next steps underway

In December 2017, Canada's ministers of finance issued an Agreement to Strengthen Beneficial Ownership Transparency, which stated that all jurisdictions had agreed in principle to ban the use of bearer shares by Canadian corporations, and to compel them to maintain registers of beneficial ownership to show who really are the significant investors in them.

Bearer shares

While shares are ordinarily subject to entry on a register to record who owns them, bearer instruments do not require registration at all in the company records, and they can be controlled merely by whoever holds possession of them. Their abolition is definitely a no-brainer for establishing another formal link in tracing their real owners.

Canada chose to implement this in 2018 as part of Bill C-25, which was advertised as being primarily a measure promoting gender equity on boards. It received Royal Assent on 1 May 2018, whereby the Canada Business Corporations Act had the following new section inserted:

29.‍1 (1) Despite section 29, a corporation shall not issue, in bearer form, a certificate, warrant or other evidence of a conversion privilege, option or right to acquire a share of the corporation.

(2) A corporation shall, on the request of a holder of a certificate, warrant or other evidence of a conversion privilege, option or right to acquire a share of the corporation that is in bearer form and that was issued before the coming into force of this section, issue in exchange to that holder, in registered form, a certificate, warrant or other evidence, as the case may be.

One problem immediately comes to mind on reading this, in that there is no requirement for existing bearer shares to be converted into registered form by a specific date. That appears to preserve existing arrangements that may now be in effect, and it suggests that Canada will still be offside on the world stage in this matter.

Beneficial ownership

While financial institutions and others handling money have been obliged to maintain records on beneficial ownership of their corporate clients for some time, corporations have not had the same duty to maintain such records internally. It had essentially been a guessing game on the outside, where arrangements had been seen to be opaque. I can also easily see that bureaucratic inertia or wilful blindness could impede upon the due diligence that would be necessary to make these controls effective.

Bill C-25 turned the screws partially on this as well, by amending another provision of the CBCA to read as follows:

153 (1) Shares of a corporation that are registered in the name of an intermediary or their nominee and not beneficially owned by the intermediary must not be voted unless the intermediary, without delay after receipt of the prescribed documents, sends a copy of those documents to the beneficial owner and, except when the intermediary has received written voting instructions from the beneficial owner, a written request for such instructions.

That should bring some of these arrangements out into the open. However, we still need more complete information as to who those beneficial owners may be at any given time, and not just at shareholder meetings.

It's coming as Part 4, Division 6, in Bill C-86 that was introduced in the House of Commons on 30 October 2018. The latest of the increasingly weighty omnibus finance bills, to become known as the Budget Implementation Act, 2018, No. 2, that particular portion within it will amend the Canada Business Corporations Act to provide "for a corporation that meets certain criteria to keep a register of individuals with significant control and requirements respecting the information to be recorded in it." It's very notable that no press release has been issued for this particular matter, so we should pay special attention to it as a result.

This builds upon s. 11.1 of the Proceeds of Crime (Money Laundering) and Terrorist Financing Regulations (SOR/2002-184), which requires financial institutions and others handling money to keep records of this matter, and specifically with respect to:

(a) in the case of a corporation, the names of all directors of the corporation and the names and addresses of all persons who own or control, directly or indirectly, 25 per cent or more of the shares of the corporation;
(b) in the case of a trust, the names and addresses of all trustees and all known beneficiaries and settlors of the trust;
(c) in the case of an entity other than a corporation or trust, the names and addresses of all persons who own or control, directly or indirectly, 25 per cent or more of the entity; and
(d) in all cases, information establishing the ownership, control and structure of the entity.

It's only logical that the corporations themselves will now have a positive duty to maintain and regularly update this information. It's not unique, as similar requirements are being instituted around the world, and the UK adopted its particular scheme in April 2016 under Part 21A of the Companies Act 2006 and the connected The Register of People with Significant Control Regulations 2016 (2016 No. 339).


The current federal Bill will provide, effective six months after Royal Assent, for any corporation constituted under the CBCA to maintain a register, updated annually, that would include:

• the names, the dates of birth and the latest known address of each individual with significant control;
• the jurisdiction of residence for tax purposes of each individual with significant control;
• the day on which each individual became or ceased to be an individual with significant control, as the case may be;
• a description of how each individual is an individual with significant control over the corporation, including, as applicable, a description of their interests and rights in respect of shares of the corporation;
• any other prescribed information; and
• a description of each step taken annually to ensure that the above information is accurate and up to date.

And who is an "individual with significant control"?

• A holder of a significant number of shares, whether as a registered holder, beneficial owner, or someone with "direct or indirect control or direction over them".
• Each of two or more individuals that hold an interest or rights in a significant number of shares, or where a right is subject to any agreement or arrangement by which such a right is to be exercised jointly or in concert by such individuals.
• In each of the above cases, a "significant number of shares" is any number of shares that constitute 25% of either the voting rights or market value.
• Someone "who has any direct or indirect influence that, if exercised, would result in control in fact of the corporation".
• Any other individual "to whom prescribed circumstances apply."

"Influence" and "control in fact" are not defined, but similar guidance in the UK suggests that:

• "control" is where a person can direct the activities of a company
• "significant influence" is where a person can ensure that a company adopts activities that are desired by him/her
• possessing an absolute veto over activities (other than for protecting minority interests), or over appointing a majority of the board of directors, will definitely suggest such power
• neither factor has to be exercised with a view to gaining economic benefits from the policies or activities of the company
• control can also occur where someone directs or influences a significant section of the board, or where the board regularly consults with, and is therefore influenced by, that person; this also extends to similar influence over a majority of the shareholders' votes

Any corporation that is a "reporting issuer" under any provincial securities act, a member of a "designated stock exchange" under the Income Tax Act,  or a member of a prescribed class, will be exempt from maintaining such a register. That effectively restricts the régime to private companies.

What are we not yet doing?

There are still some significant matters being addressed elsewhere that Canada has not yet touched:

• identifying the ultimate beneficial owner of an entity
• disclosing the controlling persons of active non-financial entities
• identifying the settlors, trustees, beneficiaries and controlling persons of trusts and similar arrangements (but that is scheduled to change in 2021)
• greater duties placed on nominee shareholders and directors in disclosing who they represent (as in this guidance from Guernsey)
• more stringent requirements for entities to possess a genuine economic substance, as opposed to being just a mere shell or conduit (as is currently being discussed in Jersey)
• more formal obligations on individuals and entities (such as what this bank is requesting in the Isle of Man) to disclose their rationale for being in business and operating an account at a financial institution, as well as more basic information such as their actual residential address (as opposed to an address for service of documents)

I know some managers at these institutions are more diligent than others in gathering this data, but there are many clients (and professional advisers) out there that are somewhat less than forthcoming in giving it. I regard that last attitude as being more wasteful in time than being upfront would otherwise be. I've operated with the latter attitude in my affairs, and it really does work.