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The federal Finance Minister shocked the business community in his budget of Monday, March 19, 2007, by including several measures affecting cross-border financing and the taxation of foreign affiliates. A draconian measure is proposed to virtually eliminate interest expense incurred with respect to the investment in foreign affiliates. On a positive note, taxpayers can expect the elimination of withholding tax on interest paid between residents of Canada and the United States.

Restriction on deductibility of interest for investments in foreign affiliates
The most significant budget proposal would severely restrict the deductibility of interest and other borrowing costs on money borrowed to invest in foreign affiliates. Interest on money borrowed to invest in a foreign affiliate is currently deductible, even if dividends from the affiliate are exempt from tax in Canada. The proposal would generally be applicable:

• after 2007 for debt entered into on or after March 19, 2007 (unless the debt related to an agreement in writing entered into before that date);
• after 2008 for existing non-arm’s length debts (or the date of expiry of the current term of the debt if that date is earlier); and
• after 2009 for existing arm’s-length debts (or the date of expiry of the current term of the debt if that date is earlier).

Interest on money borrowed to invest in a foreign affiliate will be broadly defined and will include borrowed money used to acquire a share or debt of a foreign affiliate of the taxpayer or a non-arm’s length person or to lend to or contribute to the capital of such a foreign affiliate. The proposal also applies to an amount payable for property that is a share or debt of such a foreign affiliate.  It will also include borrowed money that may reasonably be considered (having regard to all the facts and circumstances) to have been used to assist, directly or indirectly, a non-arm’s length person or partnership to invest in a foreign affiliate. That would presumably apply to prevent the use of Canadian intermediaries to facilitate the investment. In addition, a specific anti-avoidance rule is proposed that will apply to amounts payable that may reasonably be considered to be in connection with a transaction or event or series of transactions or events a main purpose of which was to avoid the application of the proposed rules.

The disallowed interest expense will be pooled and carried forward and may be deducted to the extent the taxpayer recognizes taxable income from the investment through foreign accrual property income (FAPI), interest on indebtedness owed by the foreign affiliate or taxable capital gains from the disposition of shares or debt of the foreign affiliate. However, it appears that the interest may not be deducted until the taxable income from the investment exceeds non-taxable income from the investment such as exempt surplus dividends and deductions for foreign accrual taxes. The disallowed interest pool will be eliminated if control of the taxpayer is acquired.

These proposals can be expected to have a significant impact on the ability of Canadian companies to compete internationally, and it is expected that there will be considerable protest from the business community.

Related changes to FAPI and surplus rules
Currently, Canadian rules provide an exemption for dividends paid out of exempt surplus of a foreign affiliate. Exempt surplus generally includes active business income earned in a country with which Canada has a tax treaty. Dividends paid out of taxable surplus are included in income with an effective credit in respect of foreign taxes paid.  Taxable surplus includes, among other items, active business income earned in countries with which Canada does not have a tax treaty.

In light of the proposed restriction on interest deductibility, the budget proposes to extend exempt surplus treatment to non-treaty countries, but only those countries with which Canada has entered into a tax information exchange agreement (TIEA). However, if the other jurisdiction does not agree to enter into a TIEA within 5 years of being requested to do so by Canada, income earned in that jurisdiction will be taxed in Canada on an accrual basis as FAPI, which is punitive compared to the current treatment as taxable surplus. In the case of circumstances where Canada is already in the process of negotiating a TIEA with a country, taxation as FAPI will only occur if the TIEA has not been completed before 2014.

The budget also proposes to restrict a foreign affiliate’s ability to earn deemed active business income on certain transactions with related parties. For taxation years of affiliates that begin after 2008, income earned by a foreign affiliate from certain transactions with related non-residents, such as loans, royalties, rent and factoring income, will be included in FAPI unless the payor is a foreign affiliate of the taxpayer in which the taxpayer has a “qualifying interest” (generally shares representing a direct or indirect interest of 10% of the votes and value of the payor).

An extensive package of draft legislation to amend the foreign affiliate rules has been outstanding for several years. To some extent certain of these proposals could be viewed as inconsistent with the budget proposals. The budget documents state that these proposals will be reviewed and evaluated in the light of the budget measures “to ensure the appropriate functioning of the system at a technical as well as a policy level”.

In addition, the Minister will create an advisory panel of tax experts with a view to “identifying additional measures to improve the fairness of Canada’s system of international taxation”. The panel will be asked to make recommendations for consideration in the 2008 budget.

Canada-U.S. treaty negotiations: Elimination of withholding tax on cross-border interest payments
The budget does contain some good news for taxpayers. The budget announced that an agreement in principle has finally been reached on changes to the Canada-U.S. tax treaty, with formal negotiations expected to be concluded in “the very near future”. As expected, the parties have agreed to eliminate withholding tax on payments made to arm’s-length lenders. This will occur as of the first year after which both countries have signed and ratified the new treaty. U.S. negotiators have also succeeded in obtaining a phased elimination of withholding tax on interest paid to non-arm’s length lenders, an idea long resisted by Canada. For the first year after the treaty is ratified, the withholding rate will be reduced from 10% to 7%; in the second year the rate will be 4% and in the third and subsequent years the rate will be 0%.

Once these phased reductions are in effect, the government has stated that it will eliminate all domestic withholding tax on interest paid to arm’s-length lenders, regardless of their country of residence.

The government also announced that agreement in principle has been reached, as expected, to extend treaty benefits to U.S. LLCs. There will also be harmonization of the tax treatment of pension contributions in Canada and the U.S. and new rules to clarify the treatment of stock options.

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