Taxation of outbound direct investment
Taxation of inbound direct investment
Non-resident withholding taxes
Administration, compliance and legislative process
Next steps

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On December 10, 2008, the Advisory Panel on Canada’s System of International Taxation released its report. The Panel of business executives and tax experts was created by the Minister of Finance, James Flaherty, in November 2007 with a mandate to recommend ways to improve the competitiveness, efficiency and fairness of Canada’s system of international taxation, minimize compliance costs and facilitate administration and enforcement by the Canada Revenue Agency (the CRA). The Panel consulted widely with business and professionals and commissioned studies of other countries’ tax systems for benchmarking purposes.

The most significant of the Panel’s recommendations include:

• A broadening of Canada’s exemption system to include all foreign active business income wherever earned and capital gains from the disposition of shares of foreign affiliates carrying on an active business;
• No additional restrictions on interest deductibility relating to the financing of foreign affiliates (other than an anti-avoidance rule relating to “debt dumping,” discussed below) and the repeal of the government’s anti-double dip rules which are scheduled to come into force in 2012;
• Tightening of the thin capitalization rules including a new 1.5 to 1 debt-to-equity ratio; and
• IIntroduction of an anti-avoidance rule targeted at non-resident parent companies which transfer foreign subsidiaries to their Canadian subsidiaries in exchange for debt (“debt dumping”).

In general, however, the Panel took a pragmatic approach and did not recommend any radical changes to Canada’s current tax rules. The Panel concluded that Canada’s international tax system is a good one that has served Canada well. The key recommendations for improvement made by the Panel are described below.

Taxation of outbound direct investment
The Panel expresses a strong concern for protecting the competitiveness of Canadian businesses and ensuring that they not be subject to more onerous tax rules than their foreign competitors when operating internationally. The recommendations relating to outbound investment reflect this concern. 

Broaden the existing exemption system to cover all foreign active business income earned by foreign affiliates. Pursue tax information exchange agreements (TIEA) on a government-to-government basis without resort to accrual taxation for foreign active business income if a TIEA is not obtained.

Currently, active business income earned by foreign affiliates resident in or carrying on business in a country with which Canada does not have a tax treaty is taxable when repatriated in the form of dividends, subject to a credit for foreign tax paid. The government had introduced legislation to exempt such dividends from Canadian tax, similar to the treatment of active business income earned in treaty countries, but only if the relevant country has signed a TIEA with Canada. If the foreign government has refused to do so, such earnings would eventually be taxed on an accrual basis. The Panel recommends that the exemption not be linked to either the existence of a tax treaty or a TIEA, and that it be available in respect of all active business income of foreign affiliates.

Extend the exemption system to capital gains and losses realized on the disposition of shares of a foreign affiliate where the shares derive all or substantially all of their value from active business assets.

Combined with the first recommendation, this recommendation may allow for the simplification of the tax system by eliminating the need to compute and track “exempt” and “taxable” surplus of all foreign affiliates for the purpose of determining the taxation of dividends from foreign affiliates and capital gains from the disposition of the shares of foreign affiliates.¹ The Panel is concerned about the compliance and administration burden imposed by the current system.

¹ If these proposals were implemented, the only remaining need for a “taxable surplus” account would be to track foreign accrual property income earned by non-controlled foreign affiliates.  The report suggests some alternatives for eliminating the need to track this surplus.

These recommendations would represent a great simplification of the system as well as facilitating the tax-free repatriation of funds invested in foreign affiliates.  In Appendix B of the Report, the Panel proposes a complete amnesty for existing taxable surplus balances since little tax is now collected on taxable surplus dividends. As also noted in Appendix B, these recommendations would allow the proposed “suspended surplus” rules, which the Panel agrees are an “extreme reaction” to related-party transactions giving rise to surplus, to be abandoned.

Review the “foreign affiliate” definition, taking into account the Panel’s other recommendations on outbound taxation, the approaches of other countries, and the impact of any changes on existing investments.

The Panel’s Consultation Paper raised the possibility of increasing the threshold for foreign affiliate status to require ownership of a particular percentage of the votes or value of the shares of the foreign corporation. For example, the ownership of a class of non-voting preferred shares might not be sufficient to create foreign affiliate status if the ownership of a percentage of the voting shares was required. Response to this suggestion during the consultations was mixed and the Panel recommends that the government undertake thorough consultation and consider appropriate transitional rules before taking any action in this area. If the government were to tighten the definition, the Panel recommends a flexible approach that would allow an investment to meet one of several tests (e.g., 10% of any one of votes, share capital or value).

The Panel did not discern any strong support for extending the exemption to foreign branch income, although it was widely agreed that such a move makes sense in theory.

No changes were recommended to the taxation of foreign branch income.

In light of the Panel’s recommendations on outbound taxation, review and undertake consultation on how to reduce overlap and complexity in the anti-deferral regimes while ensuring all foreign passive income is taxed in Canada on a current basis. Review the scope of the base erosion and investment business rules to ensure they are properly targeted and do not impede bona fide business transactions and the competitiveness of Canadian businesses.

A number of technical comments were made concerning improvements that should be considered to the foreign accrual property income (FAPI) rules, and related foreign investment entity and non-resident trust rules. The Panel recommends that the government undertake a fresh review to coordinate and simplify these regimes, and that this review should entail full consultation.

The Panel strongly believes that Canada should retain its current rule that treats…payments between foreign affiliates, which would otherwise be FAPI, as income from an active business.

The Panel supports the retention of the “deeming rule” that deems certain inter-affiliate payments to be active business income, and does not support the introduction of a same-country limitation for such payments.

In the “Looking Forward” section of the Report, the Panel states that consideration should be given in the future to allowing Canadian corporations to carry out certain functions in Canada that would otherwise be performed by foreign affiliates, such as financing, leasing and licensing. Such income could be exempt from tax or taxed at a preferential rate.

Impose no additional rules to restrict the deductibility of interest expense of Canadian companies where the borrowed funds are used to invest in foreign affiliates. Section 18.2 of the Income Tax Act should be repealed.

The Panel rejects the possibility of introducing interest deductibility restrictions such as those in Germany and Australia in view of concerns for the competitiveness of Canadian companies and the deteriorating capital markets. 

In addition, although the Minister had stated that a reconsideration of section 18.2 is not part of the mandate of the Panel, the Panel, like the Competition Policy Review Panel which reported earlier this year, recommends that the provision be repealed. Section 18.2, also known as the anti-double dip legislation, was passed in December 2007 but is not due to come into effect until 2012. The rule will eliminate the deductibility of interest and other borrowing costs on debt traceable to an inter-affiliate debt (a borrowing giving rise to an interest deduction in Canada and a foreign jurisdiction). This recommendation will be heartily applauded by most businesses and tax advisers.

The Panel rejects the replacement of the current thin capitalization rules with earnings stripping rules or an arm’s-length test. The Panel also rejects the extension of the rules to apply to arm’s-length debt or debt guaranteed by related parties, although they recommended that the government continue to monitor developments in other countries and the use of such debt in Canada. 

However, the Panel considers the debt-to-equity ratio of 2:1 to be too high relative to world standards and actual Canadian industry ratios and recommends lowering the permitted ratio to 1.5:1. In addition, the Panel recommends that the government enter into consultations on extending the rules beyond corporate borrowers. The government should also consider whether non-deductible interest should be taxed as a deemed dividend and should strengthen the anti-avoidance rule concerning back-to-back loans.

Curtail tax-motivated debt-dumping transactions within related corporate groups involving the acquisition, directly or indirectly, by a foreign-controlled Canadian company of an equity interest in a related foreign corporation while ensuring bona fide business transactions are not affected.

The Panel states that interest expense should not be restricted when a Canadian company borrows to make a foreign investment “with ordinary business motives.” However, the Panel is concerned about “debt dumping” transactions under which Canadian subsidiaries are leveraged to acquire the shares of foreign related companies, particularly where the shares are preferred shares:

“Where there is no other connection between the businesses conducted by CanSub and ForSub and especially where CanSub does not take part in the management of ForSub or share or benefit from an increase in the value of ForSub’s operations…such a transaction has the effect of inappropriately reducing CanSub’s tax liability.”

The Panel notes that other countries have introduced specific anti-avoidance rules to counter such transactions and recommends that Canada do the same. The Panel states that such a rule should apply to the acquisition of both preferred and common shares and should be “robust, easy to administer, and narrowly targeted to ensure it does not impede acceptable business transactions that benefit the Canadian economy.” 

The Panel’s Report discusses two potential options for such a rule, the first being the denial of interest expense on debt traceable to such acquisitions and the second being a deemed dividend subject to withholding tax in respect of the purchase price of the shares. The Panel recommends that these options be the subject of further study and consultation. The Report states that the second option has the advantage of ensuring that no transitional or grandfathering relief would be needed to ensure existing structures are not affected. 

 Non-resident withholding taxes
Consider further reducing withholding taxes bilaterally in future tax treaties and protocols to the extent permitted by the government’s fiscal framework and its agenda regarding additional corporate tax rate reductions.

The Panel Report indicates that the reduction of withholding taxes is, on balance, desirable for Canada, and Canada should continue to reduce withholding taxes on a bilateral basis. However, in light of the fiscal cost to government and the preference of business for general tax rate reductions over withholding tax rate reductions, withholding taxes should only be reduced to the extent Canada’s fiscal situation permits. 

The Report also states that no new measures are required to address “treaty shopping” by non-resident investors. While there are situations in which inappropriate access to tax treaties can arise, the Panel believes that Canada has adequate resources and tools in its treaties, domestic law and in international jurisprudence to police treaty shopping.

Administration, compliance and legislative process
Take immediate action to enhance the dialogue among taxpayers, tax advisors and the Canada Revenue Agency to promote the mutual responsibility and cooperation required to uphold Canada’s self-assessment system.

During consultations, the Panel heard numerous negative comments concerning the relationship between businesses and the CRA. The Panel recommends improved communications and consultations between the government and taxpayers to reverse this trend. The government should allocate more resources to the international tax area and consider interchanges with the private sector.

Take steps to improve administration of the transfer pricing rules in resolving disputes, centralizing knowledge for better consistency, and resolving technical issues.

A Transfer Pricing Subcommittee issued a separate report which the Panel recommends as the basis for consultations in this area.

Eliminate withholding tax requirements related to services performed and employment functions carried on in Canada where the non-resident certifies the income is exempt from Canadian tax because of a tax treaty.

Regulations 105 and 102 impose requirements to withhold tax on payments made for services rendered in Canada by non-residents. These requirements are onerous. In many cases, the non-resident will not ultimately be liable for tax in respect of those services, and the amount will eventually be refunded.

The Panel recommends that Canada adopt a system similar to the U.S. certification system for service providers (both employees and contractors). Under this system, a non-resident certifies in a form provided to the payer that the non-resident will not be subject to tax on the income due to the application of a tax treaty. The payer need not withhold tax unless the payer knows or has reason to know that any fact or statement on the form is false or cannot be readily determined. 

Other administrative measures are recommended in circumstances where the income is not exempt from tax under a tax treaty.

Eliminate withholding tax requirements related to the disposition of taxable Canadian property where the non-resident certifies that the gain is exempt from Canadian tax because of a tax treaty. Exclude the sale of all publicly traded Canadian securities from notification and withholding requirements under section 116 of the Income Tax Act.

Currently, non-residents must apply for a section 116 clearance certificate upon disposing of “taxable Canadian property.” If such a certificate is not obtained, the purchaser must withhold 25% of the proceeds. A non-resident is subject to tax in Canada in respect of such dispositions unless a tax treaty provides relief. Recent amendments were designed to simplify or eliminate the requirements relating to clearance certificates in situations where a treaty applies. However, the Panel does not consider that these amendments go far enough.

The Panel encourages the government to make every effort to achieve more transparency and avoid retrospective legislation.

The Panel report indicates that the legislative process should include more open and timely consultation, and resort to confidentiality only where policy changes could affect financial markets or have a material revenue impact.

Retroactive or retrospective legislation should be avoided. Proposed legislation that remains outstanding for a long period can be problematic, especially for companies that must prepare their financial statements in accordance with substantively enacted legislation.

Develop a comprehensive, long-term plan to optimize tax information collection, and set up the information management systems needed to efficiently process and analyze this information.

The Panel expresses concern about the difficulty in obtaining date needed to evaluate the international tax system and assess other options.

The federal and provincial governments should work together to consider how a tax consolidation system could operate in Canada. 

Unlike most other developed countries, Canada does not have a tax consolidation or loss transfer system.

Next steps
When he created the Panel, the Minister of Finance originally stated that he hoped to include some of the recommendations of the Panel in his 2009 federal budget. However, the timing for the 2009 budget has been moved up to January 27, and it seems doubtful that the government will have the time to properly evaluate these recommendations before the budget. The Minister has thanked the Panel for their work and we must now wait and see which, if any, of the recommendations will ultimately be accepted by the government.

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