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Ottawa, November 17, 2005
2005-080

Minister of Finance Proposes Amendments Concerning the Income Tax Treatment of Certain Expenditures

Related documents:

• Backgrounder
• Notice of Ways and Means Motion to Amend the Income Tax Act

Minister of Finance Ralph Goodale today acted to protect the income tax base by ensuring that tax credits and deductions claimed by corporations are appropriate. Specifically, he tabled a Notice of Ways and Means Motion proposing amendments to the Income Tax Act to clarify that the amount of an expenditure allowable to a taxpayer, and upon which a tax credit or deduction may be claimed, is limited to the amount actually disbursed by the taxpayer.

The proposed amendments respond to a recent Tax Court of Canada decision involving shares issued under an employee stock option plan. The amount paid by the employees was less than the value of the shares at the time they were issued, and the Court allowed the corporation to treat the difference as a scientific research and experimental development (SR&ED) expenditure qualifying for SR&ED tax credits.

The proposed amendments are designed to ensure that, for income tax purposes, no expenditure will be considered to have been made by a taxpayer except to the extent of an actual outlay or expense incurred by the taxpayer.

A related proposal is meant to ensure that a taxpayer cannot deduct SR&ED expenditures, nor be eligible for investment tax credits, if the taxpayer takes more than the additional 12 months allowed to make a claim under the Income Tax Act.

In general, the proposal related to employee stock options applies to options granted and shares issued on or after today, and the proposal concerning SR&ED and investment tax credit claims applies on and after today.

The attached backgrounder provides additional information about these proposals. References to "Announcement Day" in the proposed legislation and explanatory notes should be read as referring to today’s date.

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Backgrounder

Canada’s income tax system in general provides tax recognition to expenditures incurred to earn income to the extent that a taxpayer disburses, or is obligated to disburse, money or money’s worth. However, a recent court decision has brought into question whether there is an expenditure in certain circumstances for which, traditionally, no expenditure had been recognized for income tax purposes. The background to this issue and the Government’s proposed response is discussed below.

The Amount of an Expenditure—Disbursement of Money or Money’s Worth

The income tax system generally recognizes an expenditure to the extent that a taxpayer has provided consideration in the form of money or money’s worth. Examples of non-monetary consideration include the provision of services, the provision of movable or immovable property and the assumption of a liability. The issuance of shares by a corporation, in exchange for the provision of goods or services to it, may also be treated as an expenditure for income tax purposes, but the amount of the expenditure made by the corporation has recently come into question.

The case law has traditionally allowed a corporation in such cases to consolidate two transactions into one: (1) the corporation provides consideration on the acquisition of an asset or service from the other person, and (2) the other person reinvests that consideration in the corporation on the issuance of capital stock of the corporation to the other person. When considered this way, if the other person’s obligation to pay the corporation for the issued shares is satisfied with an asset or the provision of services, the corporation is generally considered as having acquired the asset or incurred an expenditure in respect of the asset or services at a cost equal to the amount invested by the other person in the corporation, as reflected in the corporation’s share capital.

However, in a February 2005 decision of the Tax Court of Canada a corporate taxpayer was allowed to claim an SR&ED tax credit for the amount by which the fair market value of shares issued by the corporation exceeded the exercise price payable to the corporation for its shares under an employee stock option plan. The Tax Court noted that the value of the shares in excess of the exercise price did not increase the share capital. In other words, while the excess was not an amount invested in the corporation within the parameters of the above-mentioned traditional approach to providing cost recognition, the Tax Court found that the excess was an expenditure for SR&ED tax credit purposes.

Such excesses do not represent an outlay of a corporation; rather they generally represent a dilution of the value of the share equity of the other shareholders of the corporation. Such excesses were not intended to be considered expenditures under the SR&ED tax incentive program.

The rules announced today clarify that such an excess will not be recognized as an expenditure for income tax purposes. Similar clarifying rules are provided for cases involving the issuance of interests in partnerships and trusts. As well, the rules clarify that no expenditure arises solely by virtue of a taxpayer granting an option to acquire an interest in itself.

Late Claims for Tax Incentives

To be eligible for the SR&ED tax incentives and investment tax credits, taxpayers are required under the tax law to identify eligible expenditures on a prescribed form that is to be filed with the Minister of National Revenue no later than 12 months after the filing-due date for the tax return in respect of the taxation year in which the expenditures were made. This rule was first announced in the 1994 budget, and was added to stem a significant increase at that time in late claims for SR&ED tax incentives. The rule also applies to claims related to other amounts eligible for investment tax credits. However, under the Income Tax Act, the Minister of National Revenue does have the discretion to waive this deadline.

The ability to waive the 12-month filing deadline has come under increasing pressure as taxpayers have sought to file additional claims. The proposed amendments clarify with certainty that there will be no exception to the 12-month filing deadline for applications for investment tax credits and SR&ED treatment.