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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 and 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.
After being bombarded with criticism, the Minister has responded by significantly scaling back the proposals and adding more transitional relief. During a speech on May 14, 2007, at the Toronto Board of Trade, he indicated that the proposals would be restricted to situations where a Canadian taxpayer obtains a “double dip” — an interest deduction in Canada and in the foreign jurisdiction in respect of the same financing. He provided very little detail about the revised proposals but a revised Notice of Ways and Means Motion was released by the Department of Finance after the speech.
Mr. Flaherty stated that the proposal is part of a “crackdown on tax havens” which will prevent “double dips and other tax avoidance schemes.” He stated that such structures would be eliminated after a five-year transition period. The Department of Finance release provides that interest expense and other borrowing costs of a Canadian taxpayer that are payable after 2011 and that relate to an investment in a foreign affiliate will be denied to the extent they can be traced to a “double dip.” It will be irrelevant whether or not the financing was entered into before or after budget date or the funds were borrowed from arm’s-length or non-arm’s-length lenders.
Interest deductibility on “single dips,” in which a taxpayer borrows to buy a foreign affiliate or make an equity investment in a foreign affiliate or a loan to a foreign affiliate, will continue to be allowed.
The Minister illustrated the type of structures with which he is concerned by depicting two types of double dip structures. In the first such structure, a Canadian company borrows to invest in the shares of an affiliate in a “tax haven.” That affiliate makes a loan to an affiliate that deducts interest against its income from carrying on business in a third country (the second “dip”). In the second structure, known as the “tower” structure, a partnership of Canadian companies borrows in order to finance an investment in the United States. Since the partnership is treated as a U.S. corporation for U.S. tax purposes, the interest expense on the debt is deductible for both Canadian and U.S. tax purposes. Both structures rely on a long-standing rule in the Income Tax Act that recharacterizes certain inter-company interest income paid between foreign affiliates as active business income. Mr. Flaherty stated that such structures are “inherently unfair” and it is unfair to ask hardworking Canadians to subsidize them.
These structures are widely used by Canadian multinationals expanding abroad, and therefore the proposals will still have a very significant impact. It is difficult to understand why a Canadian tax deduction should be denied because a deduction is allowed in a foreign country. The foreign country deduction has no impact on Canadian tax revenues, and is arguably of benefit to the Canadian tax system, since it increases the amount of after-tax income available to be returned to Canada.
Similar structures are used by multinationals located in other countries. Mr. Flaherty, however, denied that disallowing the deduction of interest expense in such circumstances would put Canadian companies at a disadvantage. In his view, the Canadian system will continue to compare favourably to those in other countries when considered as a whole, including in particular the announced corporate tax rate reductions.
International taxation is complex and comparisons with other countries can be difficult. We and many others have been asking the Minister to refer his interest deductibility proposals to a panel of experts for further study. As already stated in the Budget, the Minister has decided to create a panel of experts to recommend additional measures to improve “tax fairness”; however, it does not appear that the panel may have much, if any, scope to reconsider the interest deductibility proposals given his unequivocal remarks. He will ask the panel, which has yet to be created, to release an interim report by the end of 2007 and a final report in 2008. Another panel of experts will be asked to provide technical input on the drafting of the interest deductibility proposal, with the goal of releasing draft legislation in the Fall and passing it as soon as possible.
In his speech, the Minister stated that the panel of experts will be asked to consider such issues as “debt-loading” by foreign parents of their Canadian subsidiaries and the adequacy of Canadian thin capitalization rules.
The government should be applauded for narrowing the original proposal, but today’s announcement is still disturbing. The significant shift from the government’s proposal in the budget causes us to wonder whether the government is thinking clearly about these issues. Moreover, from a process perspective, why would the government feel the need to release and pass draft legislation on the interest deductibility proposal as soon as possible, given the reporting timetable to be imposed on the expert panel and the announced transitional period? It makes more sense to us for the government to incorporate its views in any terms of reference it intends to give the expert panel and ask the panel to specifically consider certain proposals.
It must be recognized that what the Minister now characterizes as “inherently unfair” was deliberate Canadian tax policy for 35 years. At a minimum, the government ought to ensure that it consider proposed changes in this area in the broader context. We support the formation of an expert panel and believe that the time is right to revisit the taxation of international income with a view to developing international tax policies that are good for Canada!
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