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Draft proposals on interest deductibility
On October 31, 2003, the Department of Finance released draft legislation regarding the deductibility of interest and other expenses for income tax purposes. The proposed amendments were drafted in response to recent decisions of the Supreme Court of Canada regarding interest deductibility, but appear to have much broader application. The draft legislation, if enacted, will become effective for taxation years commencing after 2004 to allow time for public consultation.

In general terms, the proposed amendments would deny losses claimed by a taxpayer if the taxpayer did not have, in that taxation year, a reasonable expectation of earning a cumulative profit in connection with the business or property that generated the expense. Capital gains are not to be considered when determining whether a taxpayer has a reasonable expectation of earning a cumulative profit.

Under the draft legislation, a taxpayer will be considered to have realized a non-capital loss in respect of a business or property for income tax purposes only if, in the taxation year, it is reasonable to assume that the taxpayer will realize a cumulative profit from the business or property over the duration of:

• In the case of a business, the time that the taxpayer has carried on the business, or can reasonably be expected to carry on the business.
• In the case of a property, the time that the taxpayer has held the property or can reasonably be expected to hold the property.
  

In summary, the draft proposals incorporate three key elements:  (1) the concept of cumulative profit; (2) the relevant time period for determining the cumulative profit; and (3) an objective test of reasonableness.

Cumulative profit
According to the technical notes published by the Department of Finance, the concept of “cumulative profit” means the aggregate profit or loss over the relevant time period. A taxpayer is not required to demonstrate an expectation of profit or actual profit in the particular tax year in question. Instead, the draft legislation requires an annual evaluation of the expectations of the taxpayer. 

For example, if in 2005 a taxpayer incurs a non-capital loss in respect of a business or property, but during the course of carrying on the business or holding the property, the taxpayer can reasonably expect to realize a cumulative profit in respect of the business or property, the loss will be deductible by the taxpayer. However, if in 2006 it is determined that the taxpayer no longer has a reasonable expectation of earning a cumulative profit, any losses incurred in 2006 will not be deductible, but losses generated in taxation years in which such a reasonable expectation did exist (e.g., 2005) would not be affected. The annual evaluation is intended to permit taxpayers to realize losses in certain years (such as the start-up phase of a business), provided there is a reasonable expectation of cumulative profit over the relevant time period.

Further, “profit," as used in the proposals, is intended to mean profit determined in accordance with generally accepted commercial principles (which includes generally accepted accounting principles) but explicitly excludes capital gains. The word profit is a "net" concept and may be distinguished from the concept of "income" as used in paragraph 20(1)(c) of the Income Tax Act (Canada) (which provides a deduction in respect of interest expense) that was interpreted by the Supreme Court of Canada to mean "gross income." Accordingly, the proposals would deny taxpayers the benefit of a non-capital loss in circumstances in which the taxpayer does not have a reasonable expectation of cumulative profit, but may have a reasonable expectation of gross income.

Profitability time period
As noted above, the concept of a reasonable expectation of cumulative profit is applied over the relevant time period (the “profitability time period”) and not year-to-year. The proposed amendments do not provide any specific rules for determining when the profitability time period commences and ends. Ultimately, this will be a question of fact. The profitability time period would likely commence when the taxpayer has acquired the property or commenced carrying on the business and could end when the property is sold or the business ceases. However, in certain circumstances this determination may not be straightforward.

Reasonableness
The third requirement is that the expectation of cumulative profit must be reasonable. The technical notes published by the Department of Finance suggest that this requirement is intended to ensure that the test is determined on an objective, and not a subjective, basis. Further, the determination of whether there is a reasonable expectation of cumulative profit is fact-specific, based on the particular circumstances of the taxpayer. 

Application
The proposed amendments would apply to taxation years commencing after 2004.  However, the proposed amendments do not contain "grandfathering" provisions that would exempt existing transactions, or transactions in effect prior to 2005.  Accordingly, existing transactions could be affected to the extent that they impact the taxable income of a taxpayer in taxation years commencing after 2004. We will keep readers advised on the progress of this draft legislation. In the meantime, taxpayers should review their investment and business strategies in light of these proposals.

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Non-competition payments
On October 7, 2003, the Department of Finance released a proposal to amend the Income Tax Act (Canada) with respect to the taxation of non-competition payments in response to the Federal Court of Appeal’s decision earlier in the year in Manrell v. The Queen (Manrell).

Developments in the taxation of non-competition payments
The Canada Customs and Revenue Agency (CCRA) has traditionally taken the position that non-competition payments received by the vendor as part of the proceeds of disposition related to a business. Thus, the payment would be treated as a disposition of capital property, resulting in a capital gain to the vendor. However, this position was challenged in two court cases.

The first case to challenge the CCRA’s position was Fortino v. The Queen, a 1997 decision in which the Tax Court of Canada concluded that the payments were non-taxable capital receipts. The Crown appealed this decision to the Federal Court of Appeal, but the appeal was dismissed.

The second case to challenge the CCRA’s position was Manrell. Relying on the Fortino decision, the taxpayer took the position that a payment received for a non-competition agreement was a non-taxable receipt. The Tax Court of Canada concluded that the definition of “property” included the right to compete.  As a result, the receipt related to the non-competition agreement was found to be on account of capital. The taxpayer appealed to the Federal Court of Appeal, which overturned the Tax Court’s decision on the basis that the receipts were not proceeds of disposition of “property”. The payments were reassessed as non-taxable capital receipts.

The proposed amendment overturns Manrell. The proposed amendment will treat non-competition payments as ordinary income for income tax purposes. This proposal appears to apply only to payments received or receivable after October 7, 2003. This does not include amounts received before 2005 that are made pursuant to a written agreement made on or before October 7, 2003 between parties dealing at arm’s length.

There is an exception to the inclusion in ordinary income. This exception is that an amount for the non-competition covenant can be included in the proceeds of disposition of the shares, to the extent that the covenant increases the fair market value of the shares. Therefore, only the amount received in excess of the amount included in the proceeds of disposition will be included in ordinary income.

Implications
Prior to October 7, 2003 it could be argued, based upon Manrell and Fortino, that proceeds received related to non-competition agreements were non-taxable capital receipts and therefore not included in income. Payments received after October 7, 2003, based on agreements concluded after this date, will be subject to the proposed amendments to the Income Tax Act as outlined above.

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Final rules for holders of foreign mutual funds
Final legislation, which will significantly impact Canadian taxpayers who held investments in certain foreign mutual funds or other non-resident investment vehicles in 2003, was released on October 30, 2003. These foreign investment entity (FIE) rules, which are effective as of January 1, 2003, will apply to deem income from holdings in foreign mutual funds to have been earned by Canadian taxpayers, thereby triggering tax on a current basis. These rules were originally introduced in 1999 as a measure to counter the tax advantages derived by Canadians who held interests in foreign-based investment funds, as opposed to those who held Canadian-based investment funds. However, in many respects, the rules go beyond their stated objective.

We first commented on the application of the FIE rules to investments in foreign mutual funds in the Spring 2003 issue of Executive Tax Breaks. The October 2003 legislation contains a number of changes from the versions previously released. 

While many of the most recent changes are welcome and are the result of representations by taxpayers to the Department of Finance, the bag of relieving measures and changes contains at least one lump of coal in the form of a retroactive denial of certain tax-deferred rollovers of FIE interests. The impact of the new FIE rules on some of the typical investments that may be held by individuals in foreign mutual funds is examined below; however, not all situations are discussed and certain consequences may arise that are not listed below. While the legislative release deals both with FIE and non-resident trusts, only FIEs are examined in this article.

Pre-2003 rules
For taxation years that began prior to 2003, investments in foreign mutual funds could be subject to the offshore investment fund property rules. This precursor to the FIE rules provided that, where one of the main reasons for acquiring, holding or having an interest in offshore investment property was to avoid Canadian tax, an annual amount of income would be imputed to the taxpayer. These provisions were rarely invoked by the Canada Customs and Revenue Agency (CCRA) due to the difficulty in demonstrating an avoidance motive. Further, the annual income imputation system was problematic because it resulted in an arbitrary amount being subject to tax that may have borne no relationship to the actual income accruing in the fund. However, this latter deficiency remains under the new rules.

What is a FIE?
A non-resident entity will generally be a FIE unless:

1. The carrying value of its investment property is not greater than 50% of the carrying value of all of its property at the end of its taxation year (the “asset-based test”).
2. Its principal business is not an investment business (the “business-based test”). An entity is defined to include an association, corporation, fund, joint venture, organization, partnership, syndicate and trust, but not a natural person.
   

In applying the asset-based test, the carrying value of investment property is calculated by including various passive-type properties, but excluding exempt property, such as property that is used, or held principally, in a business that is not an investment business. In computing the carrying value of a non-resident entity’s property, the amount at which the property is valued on the entity’s financial statements should be used unless the taxpayer elects to value the property appearing on the non-resident’s balance sheet at fair market value. This is an annual election. 

Financial statements are defined as the balance sheet and statement of income of an entity prepared under Canadian generally accepted accounting principles (GAAP) or accounting principles substantially similar to Canadian GAAP. U.S. GAAP and E.U. member countries’ national GAAPs are considered to be substantially similar to Canadian GAAP, but it is unclear what other forms of GAAP would be considered to be substantially similar thereto. The new rules and explanatory notes do not contain any guidance as to what other GAAP would qualify. If, under Canadian GAAP or other acceptable GAAP, consolidation is required, a taxpayer will be able to elect annually to use the non-consolidated statement. 

Finally, taxpayers can also elect annually to look through to the value of interests held by the foreign entity if the foreign entity holds a significant interest in the underlying entities (a significant interest is defined as at least 25% of votes and value). 

To determine whether a foreign entity’s principal business is an investment business, it is necessary to examine the facts and circumstances in the situation at hand or, if an election is made, to examine whether its net accounting income from investment property and from investment businesses is greater than that from other businesses.

When is a taxpayer subject to the FIE rules?
Individuals are subject to the FIE rules in respect of their participating interest in a FIE unless it is an exempt interest.  An interest in a foreign mutual fund will be an exempt interest in two circumstances: 

1. If it is an arm’s length interest in a mutual fund resident in a country with a prescribed stock exchange and identical interests are listed on a prescribed stock exchange.
2. If it is an arm’s length interest in a mutual fund that is governed, exists, and is resident, for purposes of the treaty, in a country with which Canada has concluded a tax treaty. 

In both cases, the absence of a tax avoidance motive in respect of the participating interest will be required. A tax avoidance motive is deemed not to exist with regard to U.S. mutual funds if they are “Regulated Investment Companies” pursuant to the U.S. Internal Revenue Code. An arm’s length interest is defined as a participating interest in which:

1. It is reasonable to conclude that there are at least 150 persons who hold identical participating interests that have a fair market value of at least $500.
2. No more than 10% of the total fair market value is held by the taxpayer or non-arm’s length entities.
3. It is reasonable to conclude that identical interests can be purchased and sold by the public in the open market.  

The “arm’s length” replaces the “widely held and actively traded” test of previous versions of the legislation.  In short, this is a slight loosening of the rules. There is no longer an absolute requirement that the above test be met in fact. Instead, it must now be reasonable to conclude that the test is met.

Impact of the FIE rules
If an individual has a participating interest in a FIE, the interest will be subject to an income imputation inclusion, referred to as the “prescribed rate of return regime.” This method requires a taxpayer to include in income, on an annual basis, an amount equal to the interest’s designated cost multiplied by the prescribed interest rate. The prescribed rate will be equal to the 3-month Treasury Bill rate + 2% (currently 5%). If a participating interest in a FIE was acquired prior to 2003 and was not subject to the old offshore investment fund property rules, a step-up or step-down to fair market value (FMV) will be required in computing the designated cost of the FIE interest. The amount of the annual FIE income inclusion is added to the taxpayer’s adjusted cost base of his or her interest in the FIE.

The latest draft FIE rules provide some relief in respect of capital losses on the sale of an interest in a FIE if annual income imputations would have increased the capital loss on the disposition. For example, if an interest in a FIE had a FMV of $1,000,000 on January 1, 2003 and a FMV of $500,000 on December 31, 2003, the imputed income would be $50,000 for that year (calculated as the designated cost of $1,000,000 times the prescribed rate). If the interest were disposed of in 2004, the capital loss would have been $550,000 under the former draft rules (calculated as the new designated cost of $1,050,000 less proceeds of $500,000). Under the new proposed legislation, the capital loss will be limited to $500,000 and a deduction on account of income of $50,000 will be permitted.

There are two alternative methods to the default imputation regime. The first is the mark-to-market method, which is mandatory for interests in foreign insurance policies, but otherwise only applies, by election, if the interest has a readily obtainable FMV. Under this method, the annual increase or decrease in the interest’s FMV is either included in income, or deducted. 

The second alternative method is the accrual regime, which is not available in respect of a tracking interest. In most situations, an interest in a mutual fund would normally not be a tracking interest. Under this method, income earned by the FIE is computed in a prescribed form and annual income resulting from the interest is added to a taxpayer’s income for the year.  In any event, a small investor in a mutual fund will not normally have access to the information required to make this election.

An unpleasant surprise in the latest FIE release is the denial of certain tax-deferred rollovers of interests in a FIE, including share-for-share transfers. This amendment had not been anticipated and may have an extremely adverse impact on transactions that took place in the first ten months of 2003, prior to the release of the rules. The retroactive nature of this legislative provision will likely raise questions about the fairness of the legislation.

What should taxpayers do?
Individuals must now determine whether their interests in foreign mutual funds or other foreign entities are FIEs and whether the new rules will apply to them. The rules are effective for taxation years beginning after 2002 and therefore impact individuals’ taxes in 2003. In many cases, individuals will have some difficulty in obtaining financial information in respect of the foreign funds and corporations in which they have invested as they may not have access to detailed financial information or to the underlying structure of the entities in which they hold interests. 

If it is determined that a taxpayer’s interest in a foreign entity is a FIE interest that is not an exempt interest, the taxpayer will be required to choose whether to elect for the mark-to-market method to apply (or, in limited cases, to elect accrual treatment). 

For example, mark-to-market treatment is likely preferable if the FMV of the investment will increase at a lower rate than the prescribed rate of return.  In any case, such an election must be made once and for all in the first year the rules apply to an interest in a FIE. Individuals should determine the FMV of their interest as of January 1, 2003 (as of the beginning of the first taxation year beginning after 2002 in the case of a corporation) in order to set the designated cost thereof and, in the case of mark-to-market elections, will need to determine the FMV again on December 31, 2003. 

The compliance burden has not been alleviated by the final legislation. Consequently, this compliance burden (both in terms of cost and effort) should be undertaken sooner rather than later.

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