Tax Angles The 1987 Tax Reform a quagmire for investors

Last week, the Minister of Finance, Michael Wilson tabled the government’s long-awaited proposals for tax reform. In general terms, the proposals call for a broadening of the income tax base for both corporations and individuals along with general reductions in income tax rates. In addition, the Minister tabled discussion papers containing alternatives for a broadly based, multi-stage sales tax that would replace the existing federal sales tax.

The reform proposals are less dramatic than expected, and are certainly much less extensive than those enacted in the United States in 1986. Because of concerns with the deficit and the delay in a decision on sales tax changes, neither personal nor corporate income tax rate reductions are as significant as those in the United States. As a result, Canada’s income tax rates will continue to be higher than those in the United States. Mining Industry Changes

Mining corporations are projected to pay more taxes because of measures to broaden the income base despite a reduction of the federal corporate tax rate from 36% to 28% effective July 1, 1988. One significant proposed change to the basic resource tax structure is a phase-out of the earned depletion and mining exploration depletion allowanes. The rate at which these bonuses can be earned will be reduced from the current 33.33% earning rate to 16.66% for expenses incurred after June 30, 1988 and to nil for expenditures incurred after June 30, 1989. Grants under the Canadian Exploration and Development Incentive Program (cedip) for oil and gas exploration are to be phased out over approximately the same period as earned depletion.

The phase-out of depletion allowances will be felt by those companies that do reinvest in exploration and new mine development and by companies relying on flow-through share financing. One wonders if these groups are the appropriate target for base- broadening.

Other “base-broadening” proposals with application to the mining industry are: * cca rates applicable to certain classes of depreciable property will be reduced, generally for acquisitions after 1987, to levels considered to be more in line with actual depreciation rates. The current 30% per year declining balance deduction for most mining assets will be reduced to 25% per year on a declining balance basis. However, the half year rule for cca claims in the year of acquisition of depreciable property will no longer apply to the accelerated allowance for certain resource extraction property acquired for a new mine or major mine expansion. * After 1989, a “put in use” rule will apply to determine the year in which cca may first be claimed. Under this rule, no cca claims will be permitted until the earlier of the year an asset is put in use and the year in which construction of an asset is completed. * The cost of mine shafts and main haulageways constructed after a mine reaches production will be deductible as Canadian Development Expenses (cde), at 30% per year on a declining balance basis instead of being fully deductible as Class 12 property. cde is deducted after resource allowance whereas cca is deducted before resource allowance; this change will increase resource allowance deductions. * Designated overburden removal costs are to be deducted as an operating cost. In the past a taxpayer could elect to capitalize such costs as Class 12 property.

For some time, the Prospectors and Developers and others have been lobbying the government for an “after-tax” financing mechanism for new mine assets, so that a small or new developer would have the same tax relief as a profitable major company. It is ironic that the government has chosen to “level the playing field” by imposing a “put in use” test for depreciation claims, thus removing the tax advantage to major companies. Expenses of issuing securities and borrowing money Currently, companiesmay deduct in the year incurred the costs of raising equity capital and borrowing money. These costs include fees of underwriters, sellers, legal and accounting advisers, registrars and transfer agents and expenses of printing and filing.

It is proposed that such expenses incurred after 1987, for securities issued or money borrowed after 1987, be capitalized and amortized. Expenses of issuing or selling shares, units of trusts or partnership interests, will be amortized over 5 years. Expenses of borrowing will be amortized over the greater of 5 years or the term of the debt, including renewal periods. This change will effectively increase financing costs for mining companies. Preferred Share Financing

Preferred shares have been an attractive form of financing for Canadian corporations which pay little or no tax. However, where such corporations have used this form of financing, the granting of tax relief to the shareholder (through either a dividend tax credit or an intercorporate dividend deduction results in a perceived current loss of tax revenue to the government).

To counteract this loss of tax revenue, it is proposed that, with respect to dividends paid after 1987 on most preferred shares (“taxable preferred shares”) issued after June 18, 1987, a special tax be paid by the payor company. Shares issued after that time will be grandfathered, provided they are issued pursuant to an agreement in writing, a prospectus, a preliminary prospectus or other similar document entered into or issued prior to that time. Many companies that previously relied upon this type of financing will find it is no longer attractive. Capital Gains

Major changes are proposed for the taxation of capital gains. * The portion of capital gains to be included in a taxpayer’s income will increase from 50% in 1987 to 66.66% in 1988 and 1989 and to 75% in 1990. * The maximum lifetime capital gains exemption will be limited to the 1987 ceiling of $100,000. * The amount of capital gains eligible for the capital gains exemption will be reduced by cumulative net investment losses, including interest expense and cee, claimed after 1987. Expense Accounts

Significant new limitations are proposed on legitimate business expenses, presumably in pursuit of “fairness”. * Deductions for business meals, entertainment expenses and meal costs at conventions will be limited to 80% of their cost. * New rules will reduce the deductibility of expenses of owning and running automobiles used for business purposes by employees and self-employed persons. It is proposed that the capital cost for cca purposes of a passenger vehicle be limited to $20,000 (with a corresponding limit for leased vehicles) and that interest expenses be limited to a maximum deduction of $250 per month. For individuals the deductible portion of cca and interest will be further restricted to 20% of the cost where business use is less than 90% of total use. Personal tax changes

A new rate structure will be introduced effective for 1988. The current 10 Federal tax brackets which currently extend to a maximum of 34% on taxable income above $63,347 are to be reduced to 3 as follows:

Taxable Income Rate

0 – $27,500 17% $27,500 – 55,000 26%

over – $55,000 29% The existing 3% federal surtax will continue until sa les tax reform is implemented. Assuming a provincial tax rate of 55% – the present national average – the combined top marginal rate in Canada will be about 46% in 1988, down from about 54% in 1987.

Personal exemptions and a number of special deductions will be converted to tax credits. The tax savings of the new credits will generally be lower than that of the equivalent current deduction at the top tax rate.

The increased contribution limit for rrsp’s and pension plans will be implemented, but phased in more slowly than previously announced.

A number of “base broadening” changes applicable generally to individuals are also proposed. * The $1,000 interest and dividend deduction will be eliminated after 1987. * The dividend gross-up and credit, reflecting both proposed federal and assumed provincial dividend tax credits, will be reduced from 33.33% to 25% in 1988 and thereafter. * New limitati
ons will apply to cca deductions claimed on certified feature films acquired after 1987 and on murb’s acquired after June 17, 1987. For taxation years ending after 1990, the special cca deductions for murb’s will no longer be available at all. * Major changes are proposed to the deductibility of farm losses. * Limited partnership “at-risk” rules are to be extended to resource expenditures such as cee. These rules will limit the addition to a partner’s cee pool where the allocated share of expenditures incurred by the partnership and of itc’s earned in the partnership exceed the amount of the investment at risk in the partnership. Flow-Through Shares

No changes were announced to the flow-through share mechanism nor to the entitlement to deduct up to 100% of cee. However, further restrictions will be imposed on shares qualifying for flow-through treatment.

While the mechanism remains unchanged, a number of the proposals described above will combine to significantly increase the after-tax cost of investing in flow- through shares. These changes are: * Phase out of depletion allowances will reduce the deduction available to investors. * Reductions in personal tax rates reduce the tax saving generated by an investment. * Limiting the capital gains exemption to capital gains that are in excess of cumulative net investment losses including cee deductions) after 1987. * If the exemption is not available, the portion of the gains included in income will increase from 50% in 1987 to 66.66% in 1988 and 75% in 1990.

It is important to note that an investor in flow-through shares will not realize a fully exempt capital gain on their sale unless he or she has other investment income after 1987 in an amount at least equal to the cee and interest expense claimed after 1987.

The following table summarizes the effect the proposals will have on after-tax cost and illustrates the sale proceeds break-even point to an individual investor who buys and sells his share investment in the same time period. The table assumes 100% of the investment qualifies for mining exploration depletion allowance and assumes effective combined federal and provincial income tax rates of 52.7% in 1987 and 45% thereafter: See insert…..

The proposals will significantly increase the required break-even proceeds in the future and will reduce the premium at which flow- through shares can be issued. This will increase the cost of future exploration, particularly to junior mining companies. The flow- through share has been retained but its value will diminish significantly, after 1987.

We foresee an even greater than usual surge in demand for quality flow-through share investments this fall. Mining companies should review their exploration programs for 1988 to see which programs can reasonably be moved into 1987 and the first 60 days of 1988 to take advantage of this anticipated demand. There’s more to come

Prior to June 18, statements by officials of Mr. Wilson’s department had left the impression there would be really fundamental tax changes proposed. This is not the case, and the first reaction of the mining industry and of investors therein has been `that wasn’t so bad after all]’ This conclusion is premature. Let’s wait to see the final form of the proposed sales tax changes before passing judgement on the reform package as a whole.