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The federal budget of March 19, 2007, announced the most fundamental change to the tax treatment of foreign investments since the tax reform of 1972. And it came as a complete surprise to the Canadian business and tax communities.
The budget proposed to severely restrict the deductibility of interest on money borrowed to invest in foreign affiliates. Our special edition of TaxBreaks, “Canadian federal budget proposes important changes to cross-border financing,” discusses the proposal in detail.
The proposed changes have caused concern among our clients and partners — concern that Canadian companies will be put at a disadvantage compared to their competitors in other countries.
On March 28, 2007, we wrote to Minister of Finance Jim Flaherty expressing our concerns about this measure and the consequences it will have for the competitiveness of Canadian businesses in the global arena.
Deloitte’s perspective — a grim future for Canadian competitiveness
The proposal will result in the disallowance of several billions of dollars of interest expense, significantly increasing the after-tax cost of capital for Canadian companies seeking to expand outside of Canada. The economy continues to globalize, and Canadian-based companies are disappearing at a steady rate. We are concerned that this proposal removes a key source of fiscal competitiveness for Canadian companies at a time when they can least afford it. We fear this proposal will contribute to the disappearance of more Canadian-based companies as well as the jobs they represent.
Budget documents indicate that this proposal may have originated with a concern about tax havens, but the proposal is not targeted to money borrowed to invest in tax haven countries. The proposal would disallow the deduction of interest on money borrowed by a Canadian company to buy a competitor based in any country. We understand the Department of Finance intends that the proposal would also apply to deny a portion of the interest expense on money borrowed to buy a Canadian competitor if that Canadian target company had any foreign operations.
Any Canadian company seeking to expand its operations would be at a disadvantage compared to competing bidders based in other countries, particularly the United States. U.S. tax law allows U.S.-resident multinationals to deduct interest expense in both the circumstances described above, subject to some restrictions in the case of a foreign acquisition. The proposal sets out only very limited grandfathering and transitional rules, and would seriously undermine the ability of Canadian-based companies to grow and expand, adversely impacting job creation and economic growth in our country.
The budget estimates that this change will raise $10 million in the government’s 2008 fiscal year and $40 million in 2009, suggesting the measure is almost inconsequential. Based on our experience with companies operating from Canada in the global marketplace, we believe the effect would be many multiples of the estimates presented and far from inconsequential.
Complex issues call for broad consultation and an integrated approach
It does not appear that the government considered alternative “international tax fairness” measures or consulted others for ideas and input. We believe strongly that consultation with business and advisers to business is an important part of any fair and reasoned process. Further, we believe broad consultation ensures that government brings appropriately balanced views to such significant economic policy changes and avoids unintended consequences, particularly in what have become extremely complex taxation matters.
We are encouraged by, and applaud, the government’s stated intention to create an advisory panel of tax experts to review the fairness of Canada’s system of international taxation. However, the treatment of interest deductibility should be one of the issues considered by that panel.
We believe the treatment of interest deductibility should be addressed in an integrated manner with the treatment of low-taxed foreign income and the availability of incentives in the outbound taxation area. These policy choices should also be coordinated with the thin capitalization provisions in the context of investment inbound to Canada. And finally, Canada's policies regarding withholding tax, as reflected in domestic law and tax treaties, are also an important part of our international tax system that should not be addressed in isolation from the parts noted above. The relaxation of withholding tax on cross-border interest, also part of the 2007 budget, does not serve as a rationale for eliminating interest deductibility.
The last time Canada reviewed these tax policies in a meaningful way was in the 1997 report of the Technical Committee on Business Taxation. Even then, the Committee had a broader mandate than international taxation and was constrained by its terms to ensure that all of its recommendations, taken together, were revenue neutral. In any event, much has changed since then. Corporate tax rates in Canada and around the world have been significantly reduced, although the total Canadian tax burden on business remains relatively high. Foreign takeovers of Canadian companies have continued unabated while Canadian-based companies struggle to compete in the international arena. We believe the federal government now has more fiscal flexibility than ever to help foster the competitiveness of Canadian-based companies in meaningful and effective ways.
Taking part in an important debate
We at Deloitte believe it is important that we share our views on this issue with the government and have done so. This interest deductibility proposal represents the most significant change to the taxation of foreign income since 1972, and to proceed without consultation with tax experts and the broader business community would not serve the best interests of Canadian taxpayers. We have strongly recommended to the Minister of Finance that these proposals be deferred and considered as part of a broad-based international tax policy review.
Deloitte is the largest professional services firm in Canada, and our clients from across the country have made us aware of many cases where the proposal will have a significant negative impact. We are asking our clients to share their views with us, and if they consider it appropriate, their MP and/or the Minister of Finance.
We hope to learn that our views, and similar views expressed by the broader tax and business communities, will be heard by the Minister of Finance. In the meantime, if you may be immediately or imminently affected by this proposal, we encourage you to discuss options with your Deloitte representative.
Read about our web cast on April 24, 2007.
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