Canadian foreign affiliate rules.

On March 21, 1997, Tax Executives Institute submitted the following comments to Canadian Finance Minister Paul Martin on a Notice of Ways and Means Motion setting forth proposed statutory language imposing substantial information reporting burdens in respect of the foreign affiliates of Canadian taxpayers. The Institute's comments were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Alan Wheable of Canada Trust.

On December 5, 1996, a Notice of Ways and Means Motion with Technical Notes for the 1996 Federal Budget was released. The Notice includes draft statutory language revising certain proposed foreign affiliate information reporting requirements that were tabled as part of the March 6, 1996, Budget Motion. On August 7, 1996, Tax Executives Institute submitted comments on the March version of the proposed foreign affiliate information reporting rules. On behalf of Tax Executives Institute, I am writing to express our comments on the latest version of the proposed legislation.

Background

TEI is an international organization of more than 5,000 professionals who are responsible -- in an executive, administrative, or managerial capacity -- for the tax affairs of the corporations and the other businesses by which they are employed. TEI's members represent the 2,800 leading corporations in Canada and the United States.

Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Proposed Foreign Affiliate

Reporting Requirements --

Phase II

The latest version of the draft legislation imposing a foreign affiliate information reporting regime is a significant improvement over the March 1996 draft proposals. The draft incorporates revisions and limitations urged by the Institute and other commentators and otherwise addresses a host of concerns fostered by the original proposals. Specifically, the revised legislation will narrow the scope and number of non-controlled foreign affiliates for which detailed information is required to be submitted. In addition, the new exception from the reporting rules for inactive or dormant affiliates will afford taxpayers important relief from filing unnecessary reports, provided Revenue Canada interprets the legislation in an appropriate fashion and supplies permissive criteria enabling taxpayers to avail themselves of the exception. For these reasons, we commend the Department of Finance for its consultations with taxpayers and taxpayer groups about the scope of the reporting rules.

The December draft proposal also expands the time period within which a taxpayer is required to file its affiliate information to a date 15 months subsequent to the close of the taxpayer's year. For most taxpayers, the additional time will increase their ability to file materially complete and accurate reports. The six-month deadline set forth in the original draft would have subjected taxpayers either (i) to inappropriate penalties for filing reports based on the best available -- though possibly incomplete or estimated -- information or (ii) to an obligation to amend or supplement the original data. As important, Revenue Canada's audit burden will likely be reduced since the expanded filing period will permit taxpayers to "get it right the first time" and minimize redundant auditor requests for supplemental or revised affiliate information.

Despite these very positive and welcome improvements, the legislation remains troublesome because it will impose substantial and costly reporting burdens on compliant taxpayers. While final regulations and forms consistent with the revised draft legislation are unavailable, we continue to believe that the relevant compliance enforcement information sought under the proposed foreign affiliate reporting rules is generally available as a matter of course during audits -- especially from taxpayers that compose the Large-File Corporate return group. Hence, we submit the following specific comments on the Ways and Means Motion. We anticipate filing additional comments on the revised forms and regulations as well.

Specific Comments

1. Due Diligence Exception to Avoid Penalties. Section 233.5 of the Notice of Ways and Means Motion would add a due diligence exception permitting taxpayers who omit certain information to avoid the imposition of penalties, where (i) there is reasonable disclosure that the information is not available; (ii) the person exercised due diligence in attempting to obtain the information; and (iii) the information is submitted not more than 90 days after it becomes available.

We applaud the government for recognizing that taxpayers should be accorded a due diligence exception from these reporting rules. As we commented in August, many taxpayers will be unable to timely obtain or report the requisite information in respect of certain foreign affiliates. Hence, a properly administered due diligence exception will ameliorate taxpayer concerns about their ability to comply with these rules and also mitigate concerns about unwarranted penalties.

We submit, however, that the purpose and effect of proposed section 233.5 is likely to be undermined by the inclusion of subsection (c). Subsection 233.5(c) circumscribes the due diligence exception by providing that it will not apply where the taxpayer knows "at the time of each transaction, if any, . . . that gives rise to the requirement to file the return or that affects the information to be reported in the return" that the information will not be available. Implicit within the due diligence exception is the notion that the taxpayer acts in good faith when it seeks the provision's protection. Hence, as a general matter subsection 233.5(c) is unnecessary. As drafted, moreover, proposed subsection 233.5(c) is confusing at best and, at worst, altogether defeats the purpose of the due diligence exception.

One difficulty with the proposed statutory language is that every time the reporting form changes, the scope of what the taxpayer should have known "at the time of each transaction" seemingly changes as well. In other words, how is the taxpayer to know "at the time of each transaction" what its reporting obligation is to be when that obligation may well depend upon a subsequently developed form? As important, without substantially more guidance, it will be difficult for taxpayers and tax auditors to discern what aspect or manner of a transaction "affects the information" to be reported.

Another difficulty with the draft section is that the "post-amble," or flush language, of subsection 233.5(c) will apply in the same fashion to the reporting requirements imposed on trusts by section 233.2 and to reporting requirements imposed by section 233.4 with respect to controlled foreign affiliates. The former section is intended to provide a device to monitor and preclude potentially abusive and evasive transfers to foreign trusts -- i.e., to preclude transactions whose principal effect is to remove assets or income from Canada's taxing jurisdiction. The latter section elicits information about cross-border business transactions -- transactions where a Canadian taxpayer either is on one side of a transaction directly or controls (or is deemed to control) affiliate transactions wholly outside of Canada. The difference in the scope of the sections, however, is that in the conduct of global business activities, transactions routinely occur on a cross-border basis where there is no tax avoidance purpose or effect. The essential defect of subsection 233.5(c) is that it casts a net so wide that it catches all post-March 5, 1996, business transactions with or by a controlled foreign affiliate. We do not believe business taxpayers should be required, as a condition of the due diligence exception, to analyze every transaction with an eye toward whether the "transaction...affects the information to be reported..." on the form.

At a minimum, subsection 233.5(c) seemingly precludes the application of the due diligence exception for any foreign affiliate conducting business activity in a jurisdiction where the taxpayer knows "in advance" that the information, including the tax returns for the affiliate, cannot be supplied within 15 months of the close of the taxpayer's year. In its August 1996 comments, the Institute identified several circumstances where a taxpayer would be unable to comply with a six-month reporting obligation. Although an expanded 15-month reporting deadline is better than the original 6-month deadline, foreign affiliates in some jurisdictions will still be unable to supply complete information for the proposed Form T1134. For example, some jurisdictions maintain strict confidentiality laws. Under the rule, therefore, a taxpayer lacking de facto control of a company in such a jurisdiction will be unable to comply with the reporting obligation.

We urge the government to reconsider and delete draft subsection 233.5(c) from the legislation. At a minimum, we recommend that the reference to section 233.4 be eliminated from subsection 233.5(c) in order to limit subsection 233.5(c) to transfers to trusts reportable under section 233.2.

2. Transfers and Loans to Foreign Trusts. Section 233.2 imposes new and substantial reporting obligations on transfers of property to foreign trusts, including loans to such trusts. TEI's previous submission did not address the reporting obligations arising from such transfers since trusts are not commonly employed to conduct ordinary business operations. Nonetheless, trusts -- or entities that may be deemed trusts under the rules -- can be used for everyday business operations in some foreign jurisdictions and the scope of proposed section 233.2 is broad enough to apply to arm's-length business transactions conducted with such a trust.

For example, assume a Canadian exporter sells goods to an arm's-length foreign entity conducting business in a form that qualifies under the proposed rules as a trust. In such case, the exporter may be subject to the trust reporting provisions simply because a Canadian taxpayer might, directly or indirectly, become a beneficiary of the trust. The existence of a remote, contingent, or even future Canadian beneficiary of the foreign trust will be very difficult for Canadian taxpayers to identify in the course of due diligence for ordinary business transactions.

In addition, some of the so-called non-arm's-length indicators for loans to, or debts from, such trusts may well apply to arm's-length commercial transactions. For example, the requirement in clause 232.2(2)(a)(iii)(C) and subparagraph 232.2(2)(b)(iii) that all interest unpaid at the end of the calendar year be paid within 180 days of the end of the year could trigger reporting as a result of an ordinary commercial loan to a foreign entity that subsequently defaults on its obligations. In addition, a Canadian exporter may, as a sales incentive, provide financing to a foreign customer (or the customer's customer) conducting business in such an entity. Should the vendor's financing terms permit deferred interest payments (or otherwise fall outside the tests of either proposed subparagraph 233.2(2)(a)(iii) or paragraph 233.2(2)(b)), the exporter will be subject to the foreign trust reporting obligations.

The nub of the problem is that the proposed trust reporting rules paint with too broad a brush. The rules taint ordinary arm's-length, commercial transactions with the hue of tax avoidance inherent to familial or related-party transfers. Hence, we recommend that the foreign trust reporting provisions of proposed section 233.2 be revised and targeted more narrowly. Specifically, the government should include an exemption from the section 233.2 rules for all transactions arising in the ordinary course of business. Without such an exemption, Canadian financial institutions and exporters will be subject to unnecessary reporting obligations.

3. Proper Test for Imposing Higher Information Reporting Burden. Under the proposed legislation, two different levels of foreign affiliate information returns are contemplated: a detailed return for "controlled" foreign affiliates and a simplified return for "non-controlled" foreign affiliates. For purposes of distinguishing controlled foreign affiliates from foreign affiliates generally, the proposed legislation employs the artificial control rules set forth in subsection 95(1).

In some cases, the control test in subsection 95(1) will impose the higher reporting burden on Canadian taxpayers even where no one Canadian taxpayer-shareholder or group of Canadian taxpayer-shareholders can actually or legally compel the foreign affiliate to supply the requisite information. For example, in some joint-venture arrangements control over operations and information reporting may be delineated through operating agreements among the venture's participants. Such agreements may vest control over operating and reporting decisions with a non-Canadian minority owner and manager. In such cases, whereas Canadian taxpayers possess the majority of the equity in the venture, their stake may be of a passive investment nature and hence, the Canadian taxpayers may not be able to assert sufficient management control to comply with the higher reporting burden that their equity ownership might otherwise entitle them.(1) As a result, we recommend that consideration be given to incorporating a true test of affiliation, i.e., actual control by the Canadian taxpayer, before the higher reporting and disclosure burden is imposed.

4. Delegation of Authority to Revenue Canada. In the Institute's submissions on the foreign affiliate reporting rules, we have emphasized three broad taxpayer goals for the legislation: The rules must be administrable; they should avoid imposing substantial new reporting burdens where the information is generally available on audit; and finally, appropriate relief provisions are necessary because no matter how fair and well-crafted the rules, unique facts and circumstances exist (or will arise) that will preclude some taxpayers from fully complying with the requirements. Hence, whereas the due diligence exception is the principal means of ameliorating taxpayer reporting burdens (especially if revised in the manner that we recommend), more can be done to add flexibility to the administration of the law.

We believe that all three goals can be advanced by delegating to Revenue Canada the authority to prescribe conditions and procedures under, and through, which taxpayers may obtain additional relief from the foreign affiliate reporting obligations. For example, Revenue Canada should be permitted to prescribe conditions under which specified information could be retained at the taxpayer's Canadian offices and made available on audit in lieu of filing the annual report. In addition, Revenue Canada should be permitted to enter into an agreement with a taxpayer that limits the amount and scope of information to be reported. The scope of such agreements could be tailored to the taxpayer's facts and circumstances, taking into account the availability, materiality, and relevance of the information for the taxpayer, as well as Revenue Canada's judgment of the taxpayer's compliance risk profile. The agreement could be as narrow, say, as one particular controlled foreign affiliate, or broadly applicable to several categories of information for all of the taxpayer's foreign affiliates. Hence, we recommend that the legislation be revised to include a delegation of authority to Revenue Canada to prescribe additional conditions and procedures through which such arrangements may be made.

Conclusion

TEI is pleased to have this opportunity to present its views in respect of the latest draft legislation concerning foreign affiliate reporting requirements. The comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is Alan E. Wheable of Canada Trust. If you should have any questions about these comments, please do not hesitate to contact Mr. Wheable at [phone] or J.A. (Drew) Glennie, TEI's Vice President for Canadian Affairs, at [phone].

(1) Moreover, in some jurisdictions local minority shareholders are granted rights that hinder the majority equity owner's exercise of its control.