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Deloitte’s comments on foreign affiliate dumping and SR&ED provisions in the August 14, 2012 draft legislation


September 13, 2012

Tax Policy Branch
Department of Finance Canada
140 O’Connor Street
Ottawa, Ontario K1A 0G5

Dear Sir or Madam,

Deloitte’s comments on the draft legislation released August 14, 2012

We are writing to provide our comments on the legislative proposals released on August 14, 2012.  Our comments focus on policy considerations relating to the foreign affiliate “dumping” and the scientific research and experimental development (SR&ED) provisions.

We commend the Department of Finance for soliciting input in respect of these proposals – we believe that meaningful dialogue between Government and stakeholders will significantly enhance Canadian tax policy. 

Foreign affiliate “dumping” provisions
While we continue to regard these provisions as having overly broad application, we will not reiterate the points raised in our submission of May 31, 2012.  We are pleased that that the current version of the legislation includes more exceptions than the earlier version.

A welcome provision in the proposals is the ability, under certain circumstances, to elect to treat what would otherwise be a deemed dividend as a reduction of paid-up capital (PUC).  However, the circumstances under which an election would be available seem overly narrow.  For example, the election is not available if the corporation resident in Canada (CRIC) is held through a Canadian holding company.  The introduction of a joint election to be made by the “acquiring CRIC” and the “holding company CRIC” to reduce the PUC of the latter should be considered.  This election could be limited to an acquiring CRIC that is a subsidiary wholly–owned corporation (as defined in subsection 87(1.4) of the Act) of a holding company CRIC. 

Another concern with respect to the PUC reduction election is that under certain conditions, the election is only available where the CRIC has issued one class of shares.  It is not clear why the availability of the election is being narrowed in this manner.  Likewise, the reinstatement of PUC exception, while welcome, seems overly narrow.  For example, at present it would apply where cash has been contributed to a CRIC and the cash was used to acquire shares of a foreign affiliate.  However, it would not apply where the shares of the foreign affiliate were directly contributed to the CRIC.

As currently drafted, the reinstatement of PUC exception does not appear to be available where these rules apply as a result of the CRIC having acquired shares of a Canadian resident company.  We understand that the Department of Finance intends to amend the drafting such that it could apply.  We support this decision and would suggest that the Department consider further expanding eligibility for both the PUC reduction election and the reinstatement of PUC exception to address the above examples.

While the elective exception to the deemed dividend rule in subsection 15(2) is a welcome measure, we ask that the Government consider the extension of its application to loans or indebtedness in existence on March 29, 2012, rather than implementing its application only to loans or indebtedness arising on or after March 29, 2012.  Allowing the election to apply to existing loans will eliminate any uncertainty regarding debt repayments and subsequent loans. 

In order to allow for more flexibility in structuring investments from Canada, while still ensuring that all growth financed by the Canadian company would accrue to the Canadian company, consideration should be given to amending proposed subsection 212.3(14) of the Act to refer to the definition of subsidiary wholly-owned corporation in subsection 87(1,4) rather than that contained in subsection 248(1) of the Act.

We are concerned about the proposed new provision which extends these rules to the acquisition of shares of a Canadian company, where more than 50% of the value of the Canadian company is derived from investments in foreign affiliates.  This new provision appears to put CRICs (including public company CRICs) at a competitive disadvantage when contemplating an acquisition of a Canadian company that happened to derive more than half of its value from foreign affiliates.  To avoid the market distortions that this could create, an anti-avoidance rule that applied when, through a series of transactions, a Canadian resident company has been interposed to avoid the application of these rules would seem to us to be more appropriate.

SR&ED provisions
Canada’s SR&ED regime has been widely viewed as an important positive factor in encouraging innovation investment in Canada.  We believe that the proposals to reduce government support of the SR&ED program make Canada’s incentive regime less attractive than those of competing countries who are improving their incentive programs.  In fact, Canada’s ranking in tax incentive generosity has already declined from 3rd to 5th for small companies (9th to 13th for large companies) from 2008 to 2012.[1]  With the changes announced in the 2012 budget, we anticipate that these rankings, especially for large companies, will drop further. Our recent post-budget survey of Canadian companies confirms that reactions to the reduction in government support through the SR&ED program have generally not been positive and suggests that Canada’s R&D tax regime will be less attractive after the changes.[2]

In our view, the elimination of incentives for capital expenditures does not recognize that capital investments are needed to perform R&D and that certain industries will be put at a disadvantage as a result of this measure.  For example, the software industry requires computers and related equipment in order to undertake R&D.  Rather than completely eliminate all capital costs, we recommend that the Government distinguish between short term capital expenditures, such as computers and related equipment, and longer term ones, and treat the short term capital expenditures in the same manner as material costs, eligible for SR&ED tax credits.

In addition, rather than introducing a broad elimination of eligibility of capital expenditures for SR&ED incentives, we recommend the introduction of a limitation process.  For example, an approach similar to that for shared-use equipment could be considered.  Alternatively, the proposals could introduce a cap on the amount that that would qualify as a capital expenditure for this purpose in order to prevent particularly large expenditures from being eligible for the SR&ED incentives.

Should the proposals relating to capital expenditures be retained, we recommend that the draft legislation be refined to introduce greater certainty.  We welcome the provision that allows expenditures, such as labour, incurred in developing capital property to be eligible for SR&ED.  However, we feel that the legislation is unclear on how the Government will ensure that these expenditures will be allowed, particularly for subcontracted labour.  As currently drafted, the legislation requires a subcontractor to identify the amount of capital expenditure reflected in a payment by an R&D performer.  However, we question how this requirement will be administered and monitored in an effective and efficient manner so as to ensure that subcontractors provide the correct information.

In our opinion, the proposals restricting the inclusion rate for third party arm’s length payments seem to have too broad an application.  Specifically, we believe that subjecting such payments to universities and research institutes to the reduced inclusion rate of 80% is unfair and unnecessary.

As we had noted in our pre-budget 2012 submission of October 20, 2011, we believe that Canada’s R&D tax regime should be improved by allowing the SR&ED tax credit to be partially refundable for all businesses, as is the case in other countries and in some Canadian provinces.  Expanding the refundable credit to all businesses would more appropriately reward the risks inherent in carrying out SR&ED in Canada, rather than applying credits only to profitable years when the credits are less necessary.  Long-term planning is made difficult for many organizations, particularly those that operate in cyclical industries and cannot easily predict when they will have sufficient corporate tax liability to benefit from the SR&ED tax credits.  In addition, refundability is particularly important to U.S.-based multinational enterprises for which the interplay of the Canadian and U.S. tax regimes makes a non-refundable credit less, if at all, relevant.  From an accounting perspective, a refundable credit is preferable because it is considered an increase in earnings before income taxes (EBIT) and its visibility enhances its relevance in innovation investment decisions and also in foreign direct investment attraction.  In fact, for similar reasons, the United Kingdom has announced an “above the line” (i.e., refundable) R&D tax credit for large businesses that will be available in 2013.[3]


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We would welcome the opportunity to meet with you to discuss our views on the matters discussed herein.  Please feel free to contact the undersigned with any questions or to arrange a meeting.

Yours truly,

Deloitte & Touche LLP


Albert Baker, FCA                                            Natan Aronshtam
Tax Policy Leader                                             National R&D Leader

Copies to:  Mr. Brian Ernewein
                 General Director, Tax Policy Branch                  
                 Department of Finance Canada

                 Mr. Shawn Porter     
                 Director, Tax Legislation Division, Tax Policy Branch     
                 Department of Finance Canada

[1] Stewart, L.A., J. Warda, and R.D. Atkinson. July 2012, “We’re #27: The United States Lags Far Behind in R&D Tax Incentive Generosity”, published by The Information Technology & Innovation Foundation.
[2] The results of our survey are summarized in our July 11, 2012 R&D Tax Update, “Budget 2012’s impact on innovation investment: Survey results and opportunities”.
[3] United Kingdom, H.M. Treasury, “Research and Development (R&D) tax credits: response to further consultations” (December 2011).


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