Canadian legislation on foreign investment entities and non-resident trusts.

February 22, 2001

On February 22, 2001, TEI submitted comments on draft Canadian legislation relating to Foreign Investment Entities and Non-Resident Trusts. The comments, which took the form of a letter from TEI President Betty M. Wilson to Canada's Minister of Finance, Paul Martin, were prepared by the Institute's Canadian Income Tax Committee, whose chair is David M. Penney of General Motors of Canada Limited. Contributing substantially to the development of the submission were Vincent Alicandri of Hydro One Networks, Inc., and Alan Wheable of Toronto Dominion Bank.

On June 22, 2000, the Department of Finance released draft legislation relating to Foreign Investment Entities and Non-Resident Trusts. In response to public comments and consultations in respect of the draft proposals, the Department on September 7, 2000, announced modifications to the proposals, delayed the implementation date, and extended the consultation period. On behalf of Tax Executives Institute, I am writing to express TEI's objections to and concerns about the draft legislation.

Background

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,200 professionals manage the tax affairs of the leading 2,800 companies in Canada, the United States, and Europe and must contend daily with the planning and compliance aspects of Canada's business tax laws. Canadians constitute 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 eight geographic regions. Our non-Canadian members (including those in Europe) work for companies with substantial activities in Canada. 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 letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

TEI is concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government.

Overview

The draft Non-Resident Trust (NRT) and Foreign Investment Entity (FIE) legislation released by the Department of Finance on June 22, 2000, will replace the current rules in respect of foreign trusts in section 94 of the Income Tax Act (hereinafter "the Act") and the "offshore investment fund" rules found in section 94.1 of the Act. The current rules in sections 94 and 94.1 are anti-avoidance provisions that are intended to prevent taxpayers from inappropriately deferring or avoiding tax (including conversion of income gains to capital). Current section 94 applies where a person resident in Canada transfers or loans property to a foreign trust that has one or more beneficiaries resident in Canada. Current section 94.1 applies where a taxpayer has invested in an offshore investment fund and one of the main reasons for the investment is to reduce or defer the tax liability that would have applied to the income generated by the underlying assets of the fund if such income had been earned directly by the taxpayer.

In announcing the draft legislation, the Department's press release explains that the general purpose of the provisions is to expand the scope of the anti-avoidance rules:

   It is important that the income tax system not provide a means for
   Canadians to avoid Canadian income tax by transferring funds to offshore
   trusts or accounts. The proposed rules intend to provide a fair and
   workable approach to dealing with this complex area.

The desirability of amending the offshore investment fund rules to include specific foreign investment rules, however, was explicitly considered and rejected by the Mintz Committee. Specifically, the Report of the Technical Committee on Business Taxation states:

   While the offshore investment fund rules could be revised, so that they
   would operate on a more specific and targeted basis, such changes would not
   necessarily provide any additional protection to the Canadian domestic tax
   base.... We suggest that Revenue Canada review investments in foreign
   entities and aggressively apply the offshore investment fund provisions as
   appropriate.

Indeed, soon after the Mintz Committee's report was issued, the decision in Walton v. The Queen, (98 DTC 1780), was announced, which vindicated the policy underlying section 94.1 and enhanced the provision's efficacy in combating tax avoidance effected through offshore investment funds. Notwithstanding the government's victory in that case as well as the Mintz Committee's rejection of proposals to revise section 94.1, the government announced in its 1999 Federal Budget that it would propose new anti-avoidance provisions.

Regrettably, the scope of the proposed draft rules released in June goes far beyond the stated purpose of remedying deficiencies in the current anti-avoidance rules, including conversion of income gains to capital. The draft rules are extraordinarily complex, confusing, and, in the case of the FIE provisions, overlap and conflict with the operation of the entire foreign affiliate regime, including section 17 which governs loans to non-residents. Moreover, both sets of draft provisions are overbroad and will interfere with legitimate active business operations. In the case of the foreign trust provisions, Canadian companies will be placed at a competitive disadvantage with companies in other jurisdictions. In the case of the FIE regime, numerous provisions undermine current policies in the Act that foster international expansion by Canadian companies carrying on active businesses. Indeed, the FIE provisions act as a hidden tax increase on the foreign operations of multinational companies -- a result at odds with the government's current budget initiatives to broadly reduce corporate tax rates.

The complexity of these provisions will make it practically impossible for taxpayers to comply and we regret that many taxpayers will be inadvertently ensnared by provisions targeted at a few specific abusive transactions or investment structures. We also question whether auditors from Canada Customs and Revenue Agency (CCRA) will be able to properly administer these rules. In the absence of special justification for the complexity inherent in these rules, TEI urges the government to withdraw the draft provisions as unworkable.(1) To the extent that the government can identify specific abuses, it should propose narrower, targeted solutions.

In addition to foregoing general comments, we have a number of questions, comments, and concerns about specific provisions. We submit, however, that, even if all of TEI's recommended changes are adopted, the legislation will remain so fundamentally flawed that it should be withdrawn.

Foreign Investment Entities -- Accrual Treatment -- Definitions

A. Carrying Value

Under the proposed rules, a non-resident entity that holds at least 50 percent of its assets in "investment property" is considered a FIE. Hence, the definition and measurement of "carrying value" for "investment property" are central to the application of the draft rules. Proposed subsection 94.1(1) defines the "carrying value" of property as the amount shown on the corporation's balance sheet, except where (i) the balance sheet is not prepared in accordance with accounting principles substantially similar to generally accepted accounting principles (GAAP) used in Canada, or (ii) the balance sheet is not distributed to the holders of the participating interests within three months after the date of preparing the balance sheet. We have the following questions and comments regarding the definition of "carrying value":

* What does the phrase "substantially similar" to generally accepted accounting principles in Canada mean? For example, are U.S. generally accepted accounting rules, which closely approximate but differ somewhat from Canadian accounting rules, substantially similar?

* Are differences in accounting rules that do not affect an entity's balance sheet ignored in determining whether the foreign rules are substantially similar to Canadian GAAP?

* Where foreign accounting rules are employed in the balance sheet presentation, will Canadian taxpayers be required (or permitted) to obtain an opinion from a recognized accounting firm confirming that the foreign accounting rules are substantially similar to Canadian accounting rules?

* Where a balance sheet is not prepared or distributed on a timely basis, what is the purpose of the rule in proposed paragraph 94.1(1)(b) that deems the carrying value equivalent to the value using Canadian GAAP? More important, how will taxpayers or the government develop the information necessary to calculate the substituted values based on Canadian GAAP? The only information available may well be the financial statements prepared on a non-Canadian GAAP basis.

* Will Canada Customs and Revenue Agency (CCRA) personnel be trained to recognize the differences among generally accepted accounting principles in different jurisdictions throughout the world in order to determine whether the accounting principles employed are substantially similar to Canadian GAAP?

* The Explanatory Notes to the draft legislation fail to explain which generally accepted accounting principles will be considered substantially similar to Canadian GAAP. TEI recommends that the Explanatory Notes include a reference to the pronouncements of accounting principles by accounting standard-setting bodies that the government would consider substantially similar to Canadian GAAP. For example, the government could refer to accounting standards or principles adopted by the Financial Accounting Standards Board in the United States, the International Accounting Standards Committee, or other similar national or international accounting standard-setting bodies.

* Many operating businesses consist of more than one company or entity and Canadian GAAP would require consolidation of the entities within the group. Hence, we wonder what the basis of the balance sheet presentation of the individual entities would be? In other words, how can the individual entities in the group have a non-GAAP (or unconsolidated) statement that conforms with Canadian GAAP?

* How will Canadian companies that employ U.S. GAAP, which is permitted under certain circumstances and for specific purposes (e.g., securities filings), be treated under these rules?

In summary, the notion of "qualifying" or defining entities with a measurement as flexible as "GAAP" (whether Canadian or "substantially similar" principles are employed) is fraught with difficulties and renders the operation and administration of the tax regime problematic.(2)

B. Exempt Interest

An investor is not subject to draft section 94.1 if a participating interest in a foreign entity is considered an "exempt interest." The most common forms of "exempt interests" include (1) a participating interest in a controlled foreign affiliate, and (2) shares in a company that are widely held, actively traded, and listed on a prescribed stock exchange where either (i) the corporation's principal business is not an investment business (as defined in subsection 94.1(1)) or (ii) the corporation is a "qualifying" corporation.

TEI believes the definition of an "exempt interest" is too restrictive and, consequently, will substantially inhibit Canadian business taxpayers from providing seed capital for non-resident corporations. For example, if a Canadian corporation acquires a 20-percent interest in a U.S. corporation whose shares are not publicly traded and whose active business is searching for investment opportunities, the U.S. entity will likely be a FIE because its main asset would be cash, at least until it makes an acquisition of an active business. Even though subsections 94.1(13) to (15) afford taxpayers a grace period within which to invest the funds,(3) the relief is insufficient. At a minimum, TEI recommends that the definition of "exempt interest" be expanded to include share investments in foreign affiliates of a Canadian taxpayer whose activities are substantially performed in, or ancillary to, an active business. TEI believes that the foreign affiliate regime provides sufficient safeguards to curb tax-motivated transactions.

Where a company is considered an "investment business," the only way it can qualify as an "exempt interest" is to satisfy the criteria for a "qualifying corporation." To be a "qualifying corporation," all or substantially all (i.e., 90 percent or more) of the assets must, throughout the tax period, consist of any combination of properties (other than "investment properties") and shares or debts in underlying corporations where such shares or debts directly or indirectly finance the active business operations of the underlying corporations. TEI believes the test for a "qualifying corporation" is overstringent. In essence, a publicly traded company would be required to ensure that 90 percent or more of the assets in each of the operating companies in the corporate group do not consist of investment property. This will severely restrict the ability of non-resident companies owned by Canadian taxpayers to accumulate liquid assets for expansion of their businesses. Moreover, subsidiaries with minority interests are by definition precluded from eligibility as a "qualifying corporation." TEI sees no policy reason to justify the requirement of 100-percent ownership in order to achieve "qualifying corporation" status.

Other comments on the definition of an "exempt interest" are, as follows:

* The terms "widely-held" and "actively traded on a regular basis" are undefined and, hence, likely to engender disputes with CCRA.

* We question how a taxpayer can determine, other than for controlled foreign affiliates, whether an investment qualifies as an exempt interest. Where a taxpayer owns less than 50 percent of an affiliate, we doubt whether sufficient information will be available to make a determination whether an interest is "exempt."

* Finally, what is the policy reason for not exempting all investments in shares of corporations that are widely held, actively traded, and listed on a prescribed stock exchange?

C. Foreign Investment Entity

Generally, a FIE is any non-resident entity unless at the end of its taxation year the carrying value of all of the entity's "investment property" is less than 50 percent of the carrying value of all of the entity's assets.

* The definition of investment property encompasses all investment assets regardless of whether the assets are used in an active business. TEI believes that the definition of investment property is overbroad and should be modified to exclude all assets employed in an active business.

* Only assets recorded on an entity's balance sheet are considered in determining whether 50 percent or more of the entity's assets are investment property. For non-resident entities with significant, self-created intangible assets that are not reflected on the balance sheet, this definition is unworkable. For example, a substantial portion of the value of the assets of high-tech companies consists of internally developed intellectual property (IP). But for the crude definitions in the FIE regime, such property would generally not be considered investment property because it is used in connection with an active business. Moreover, because such assets are not reflected on the balance sheet, a foreign entity possessing a significant amount of cash from operations in addition to the internally developed IP would be treated as a FIE even though it should qualify as an active operating business. As a result, a Canadian taxpayer that owns a foreign business with significant IP could be classified as a FIE and would, under the mark-to-market method, pay current Canadian tax on the unrealized increase in the value of its internally developed IP. Surely, such a result is unintended.

* Similar issues can arise where for valid business reasons, the ownership of business assets and the operation or management of those assets are conducted through separate entities. Such arrangements are common in industries where long-lived assets are financed on a long-term basis through leasing or licensing arrangements (e.g., airplanes, power plants, hotels, and rail cars). For example, in the hotel industry the operating or management company with liability for employee payrolls is frequently separate from the entity with legal ownership of the underlying hotel building properties. Similarly, where companies face significant legal exposures because of their operations (e.g., from environmental cleanup or product liabilities), it is common to separate the legal ownership of the physical assets from the management of those assets. The FIE definition will nearly always result in one or more of such entities being classified as a FIE even though on a combined basis the entities are operating as an active business.

* The requirement to restate financial statements of the FIE into Canadian (or substantially similar) GAAP for purposes of applying the 50-percent investment property test must be completed within two months of year-end in order to permit Canadian corporations with a taxable income inclusion from a FIE to compute and pay their final tax instalments. The requirement to restate the financial statements within two months is not only a substantial administrative burden on all taxpayers, but also poses a risk of exposure to penalties and interest for understatements of instalment payments. As important, even within the accounting profession there are frequently contentious disputes about the application of generally accepted accounting principles to various transactions. Hence, the restatements of the FIE's financial statements to comport with Canadian (or substantially similar) GAAP would seem fertile ground for contentious and unproductive disputes between taxpayers and CCRA. It would seem an inefficient use of CCRA's audit resources to require auditors, who may not be well trained in the nuances and permutations of generally accepted accounting principles, to verify that the FIE's restated financial statements comport with "Canadian GAAP."

At a minimum, we recommend that the government consider the following changes to the draft legislation:

* The requirement to restate the foreign financial statements to Canadian GAAP should be eliminated. Adopting this change would more closely conform the proposed rules to the controlled foreign affiliate regime, including the rules for computation of exempt surplus, taxable surplus, etc.

* The definition of "investment property" should be amended to explicitly exclude assets that are used in or ancillary to an active business process.

D. Investment Business

Subsection 94.1(1) sets forth a list of financial businesses that qualify for an exception from the definition of an "investment business," including foreign banks, trust companies, credit unions, and insurance companies, the activities of which are regulated under the laws of a foreign jurisdiction. The list of exceptions in subsection 94.1(1) omits securities dealers and certain other active financial businesses and the Explanatory Notes imply that the omissions are intentional. We are uncertain what policy goal is served by having one list of exceptions from the definition of "investment businesses" for purposes of subsection 94.1 and another set of exceptions for purposes of the FAPI rules in section 95(1). The inconsistency between the potentially overlapping provisions compounds the challenge of complying with the provisions and operates as a trap for the unwary. TEI recommends that the list of businesses qualifying for exception from the definition of "investment business" in subsection 94.1(1) be revised and made consistent with the broader list in section 95(1).

E. Investment Property

In the June draft of the FIE provisions, the definition of "investment property" in section 94.1(1) includes real estate. Since the definition is as expansive and inclusive as possible, many assets -- including real estate or property, plant, and equipment affixed to real estate that are necessary and helpful in carrying on an active business -- will be improperly classified as "investment property" for all active businesses thereby increasing the risk that the company will be classified as a FIE or fail the test for a "qualifying corporation." The news release issued by the Department of Finance on September 7, 2000, helpfully states that the definition of "real estate" will be narrowed to exclude real estate held in an active business. In revising the provision, the Department should make the carve-out for active real estate property as broad as possible and include all fixtures above or below the land, including buildings, poles, wires, tracks, pipelines, and stations that are used in an active business.

In addition, as a result of the broad definition of investment property, nearly all non-resident real estate businesses will be treated as FIEs since most such businesses are operated as multi-party joint ventures. By definition, any foreign, multi-party joint-venture entity will fail to satisfy the exemption for controlled foreign affiliates (or the requirements for making the CFA election) and most, if not all, will fail to satisfy the requirements as a "qualifying corporation." TEI does not perceive the abuse that these rules are intended to address and therefore recommends that the rules in respect of the quantum of ownership of active foreign real estate businesses be reduced.

Subsections 94.1(2) to (4)

Where sufficient financial information is available and the taxpayer files an election in the earliest year in which the draft provisions apply to a FIE, a Canadian taxpayer owning an interest in a FIE is permitted to report its pro-rata share of the FIE's income on an accrual basis. TEI has the following concerns and comments about the accrual election.

* The proposal will require taxpayers to currently report all of the entity's income, not just the passive investment income, on an accrual basis. The concept of current inclusion is radically contrary to the general principles of the Canadian tax system that taxation of active business income is deferred until repatriated and that tax is paid only on realized gains and income. Moreover, the nature of the income may change since amounts that would otherwise be reported as capital gains (or losses) upon disposition of shares would be reported currently as income. This adds insult to injury for Canadian corporations with international active business operations where the foreign entity is not a controlled foreign affiliate.

* While income is reported on an accrual basis, accrued FIE losses are deductible only to the extent of previously taxed FIE income. This is an extremely inequitable and one-sided tax policy.

Subsections 94.1(5) and (6)

Subsections 94.1(5) and (6) provide the framework for computing the accrual-basis income of the FIE reportable by the Canadian taxpayer.

* Income of the foreign entity is to be computed under Canadian tax rules and regulations. Few Canadian taxpayers, however, will possess sufficient information to permit the computation of "income" in accord with Canadian tax rules throughout the life of the investment. For example, what taxpayers can be absolutely certain at the commencement of an investment of any duration that it will be able to provide all the information that CCRA may subsequently request in respect of FAPI income from the investment or transaction structure.

* Where a taxpayer is unable to provide information requested by CCRA, the investment can be recharacterized as an investment in a FIE and, under subsection 94.1(16), would be subject to the mark-to-market default method for reporting the entity's income. The risk that a long-term investment will be recharacterized at a subsequent date and subject to the mark-to-market regime is unacceptable for commercial operations where mark-to-market accounting is difficult or impossible to apply. Is the intent of these rules to curb Canadian participation in international commercial businesses? We can foresee no other result.

* In the unlikely event that sufficient information is available to enable the Canadian taxpayer to compute the "income" of the FIE on an accrual basis, we question whether the taxpayer will be able to compute the fair market value of its interest as a percentage of the fair market value of the total participating interests. Again, if the taxpayer fails to comply with this requirement, the taxpayer is required to default to the mark-to-market method for computing income.

Because of the limitations on employing the accrual method, we question the purpose served by the legislation's labyrinthine complexity. So few Canadian taxpayers will be able to avail themselves of the relief accorded by the election that it represents a false promise of relief, if not a trap for taxpayers who must continually monitor the availability of the entities' information in order to prevent their accrual election from being revoked.

Subsection 94.1(11)

A corporation is considered to have a "significant interest" in an entity -- whether a corporation, partnership, or non-discretionary trust -- where its interest represents at least 25 percent of the votes and value of the entity. Where a taxpayer holds "significant interest" in an entity, "look through" rules apply and the lower-tier company assets are aggregated with the upper-tier corporation owner's assets for purposes of determining whether the upper tier companies are considered FIEs.

TEI questions whether a company owning a 25-percent interest in a subsidiary entity will possess sufficient control of the underlying entity to obtain the information necessary to apply the "look through" rule. A similar concern was voiced when the government announced the draft 1995 proposals amending the foreign affiliate regime (i.e., adding the prescriptive rules that address the treatment of investment income) and also when the government announced the recent modifications to section 17. In each case, the government was persuaded to revise the draft legislative provisions in order to accommodate incorporated joint ventures. Hence, both the foreign affiliate regime and the arm's-length exemption in subsection 17(3) adopt a 10-percent-of-votes-and-value test.

After considering the differing percentage of ownership rules for applying the "significant interest" test and the foreign affiliate regime, TEI is unable to form a specific recommendation about which ownership threshold is preferred. On one hand, applying differing ownership threshold tests for the FIE regime and the foreign affiliate regime will cause considerable complexity. On the other hand, lowering the ownership threshold in the FIE rules to a 10-percent-of-votes-and-value test for application of the "look through" rules would increase the number of taxpayers unable to obtain the information necessary to comply with the FIE provisions. Hence, we make no recommendation on the proper level of ownership for a "significant interest." We simply note that the differing ownership tests are additional evidence that the entire FIE legislation is poorly conceived and irreconcilable with the foreign affiliate regime.

Subsection 94.1(12)

Subsection 94.1(12) permits a Canadian taxpayer to make an irrevocable election to treat a qualifying FIE as a controlled foreign affiliate (CFA), provided that the taxpayer's interest in the FIE represents at least 10 percent of the votes and value of the FIE. To qualify for the election, the principal business of the FIE must be either an "excluded investment business" or a business that is not an investment business. An "excluded investment business" is essentially a holding company whose principal business consists of holding shares or debt of related corporations within the group whose principal businesses are not considered "investment businesses." An "investment business" is generally any business whose principal purpose is to derive income from property, including interest, dividends, rents, and royalties. We have the following comments.

   * The policy basis for distinguishing between a CFA, for which the Canadian
   shareholder is required to currently report FAPI, from an FA, for which no
   amount is currently taxable, is that the Canadian taxpayer is generally
   unable to compel a dividend payment from an FA. Because of the inherent
   unfairness of subjecting a Canadian taxpayer to a deemed inclusion where it
   cannot compel the distribution, the FAPI income of an FA is added to
   taxable surplus and taxed when repatriated. Requiring a taxpayer to treat
   an FA as a CFA in order to escape the application of the FIE provisions
   represents a substantial and, we submit, radically unfair policy change,
   especially since the government has not established that taxpayers are
   abusing the FAPI regime.(4)
   * The definition of "excluded investment business" appears to permit only a
   single level of holding company within a corporate group. In other words,
   the definition seems to disqualify any company that holds shares in a
   second- or lower-tier holding companies that hold shares in operating
   companies. Under the definitional provisions, the top-tier holding
   company's business would be considered an "investment business" that does
   not qualify as an "excluded investment business" because its investment in
   the second-tier company would be considered an investment in a company that
   carries on an investment business -- arguably an "exempt" investment
   business but an investment business all the same. Denying the CFA election
   for corporate groups with multiple tiers of holding companies seems
   inappropriate because such ownership structures are common in many
   industries. TEI recommends that the Department reconsider the definitions
   in order to permit multiple tiers of holding companies within a corporate
   group.
   * Many taxpayers who wish to avail themselves of the subsection 94.1(12)
   CFA election for shares of a foreign affiliate are likely to be frustrated
   by the requirement that "all or substantially all" of the assets of an
   "excluded investment business" consist of "qualifying assets." In many
   cases, if even one material property held by a corporation fails to satisfy
   the test, it is likely that the corporation holding that property will fail
   to satisfy the "all or substantially all" test for its assets. As a result,
   shares in that corporation held by an upper-tier corporation will likely
   constitute a "bad asset" in applying the "all or substantially all" test at
   the upper-tier company. In multi-tier companies, the disqualification of
   one company as a qualifying asset will likely cause a cascading
   disqualification of nearly every company up the chain of ownership from the
   lowest "disqualified" company to the highest level. As a result, the
   top-level holding company will be unable to make the election and an
   interest in it will constitute an interest in a FIE that is not an "exempt
   interest." In order to avail themselves of the election, companies will be
   required to substantially reorganize their asset holdings.
   * In addition, intra-group finance centres or holding companies that
   possess surplus cash will likely fail to satisfy the "all or substantially
   all" test for qualification as an "excluded investment business." We are
   uncertain why the traditional means of redeploying capital in foreign
   operating businesses should be subject to the onerous FIE regime. Morever,
   ordinary business hedging activities may cause an operating company or an
   intra-group finance centre to fail the test. So long as hedging activities
   offset the risks of an active operating business, we see no reason why
   there should be any risk of creating a FIE.

Where the CFA election is made, Canadian taxpayers will be able to provide seed capital to a foreign affiliate that would otherwise constitute a FIE. Hence, while the CFA election is a welcome oasis in the desert of the FIE rules, the elective relief is too circumscribed to be practicable. Indeed, few Canadian taxpayers will be able to obtain the information necessary to calculate FAPI for non-controlled entities and, hence, they will likely be precluded from making the election. To be effective, the relief must be substantially broadened.

Valuation Issues

When the mark-to-market regime for taxation of financial institutions was initially proposed, the draft provisions applied to substantially more forms of property than were reflected in the final legislation. In scaling back the scope of those rules, the government heeded taxpayer and practitioner concerns about the difficulty of valuing many types of properties under a mark-to-market regime. Specifically, the challenge of valuing unique (e.g., real estate and intellectual property) or non publicly traded assets would have increased the difficulty and administrative burden of taxpayer compliance and exacerbated the frequency, scope, and degree of disputes between the government and taxpayers. TEI believes that the draft FIE rules suffer from the same malady. The sheer complexity of the mark-to-market rules, the inherent difficulty of valuing many forms of property held by foreign affiliates, and the scope and complexity of the entities and transactions affected by the FIE regime will challenge taxpayers' good faith efforts to comply with the tax law and will invite numerous, frequent, and protracted valuation disputes with the government.

Subsection 94.2(4)

Items (F) and (B) of the mark-to-market calculation set forth in subsection 94.2(4) refer to the fair market value of the FIE's property at the beginning and end of the year, respectively. We question how a Canadian taxpayer will obtain such values for a non publicly traded FIE. Are taxpayers required to obtain annual valuations for affected entities?

Subsection 94.2(9)

"Tracked interests" are separate classes of shares or other forms of participating interests issued by companies in order to provide investors or joint venture partners with a direct interest in the production, revenues, profits, cash flow, or appreciation of a business or group of properties that are part of a larger entity. TEI believes that subjecting tracked interests, especially non-publicly traded interests, to a mark-to-market regime is a prescription for endless disputes over the separate value of the tracked interest vis-a-vis the value of the entire enterprise of which the tracked interest is a part.

In addition, tracking shares are frequently issued as a means of effecting a synthetic "spin off" of a subsidiary company. The government recently -- and helpfully -- clarified the Act to accord relief to Canadian investors who receive stock from U.S. companies as a result of spin-off transactions. The draft FIE provisions on tracked interests, however, seem at odds with that relief since they will impose tax on Canadian taxpayers' unrealized gains. We recommend that the government reconsider and clarify the interaction between the tracked-interest provisions in the draft FIE legislation and the spin-off relief.

Subsection 94.2(10)

Unless an exception under subsection 4(2) of the Excise Tax Act is satisfied, premiums paid by Canadian residents on insurance policies issued by foreign insurance companies are subject to a special 10-percent excise tax under section 4(1) of the Excise Tax Act. Subsection 94.2(10), in effect, imposes an additional tax burden on such premiums. What purpose is served by the additional tax burden imposed by the FIE provision? Does the government intend to repeal section 4?

Compliance Issues

The draft legislation will impose substantial administrative and compliance burdens on taxpayers carrying on legitimate foreign operations. The greater the international scope of a Canadian enterprise, the greater the additional compliance burden. The complexity of the rules will require extensive training of staff, even those familiar with the current foreign affiliate regime, because of contradictory provisions and overlapping policy objectives of the two regimes. Indeed, we question whether taxpayers will be able to comply with the mind-numbing complexity of the more abstruse FIE provisions. For example, in order to apply the principal rule of draft paragraph 95(2)(g.2), a taxpayer must first analyze and apply 12 separate subparagraphs. Each of the 12, in turn, directs the taxpayer to apply a separate section of the Act -- with specified hypothetical changes to the principal rule in the Act -- in order to determine the effect of the FIE rules. The provision is simply incomprehensible and legislation that taxpayers cannot reasonably comply with is bad tax policy.

Accrual vs. Mark-to-Market Accounting

Few taxpayers will have sufficient financial information to utilize the accrual or CFA elections. Accordingly, taxpayers with significant foreign operations will be subject to the mark-to-market regime, which not only accelerates their tax payments but also converts all capital gains to ordinary income. As a result, the tax cost of investing outside of Canada will likely be higher than that of domestic investments thereby curtailing international expansion.

Under the accrual method, taxpayers will prepay the tax on the active business income component of their foreign affiliates. This result will also occur under the mark-to-market method because the increase in the value of the entity will include the active business component. The taxation of active business income, however, is contrary to the FAPI regime, especially in the case of non-controlled foreign affiliates where the taxpayer cannot control the distribution of the affiliate's earnings.

Under the draft legislation, a taxpayer is not permitted to make a late election to use the accrual method. As a result, where a taxpayer obtains the information necessary to comply with the accrual-basis rules subsequent to filing the returns, it will be unable to amend its return. The difficulty of obtaining such information from a foreign company is especially acute where a taxpayer's investment is less than a controlling interest. We recommend that taxpayers with a 50-percent-or-less interest in a foreign affiliate be permitted to make an accrual election where the requisite information necessary to comply with the accrual rules is obtained subsequent to filing the return.

Determining a market value for a private company will be very difficult since a taxpayer would need access to information that is generally not available to a minority shareholder. Even if the taxpayer paid a qualified appraiser to prepare a valuation for a private company, access to adequate and reliable information will be a daunting obstacle to the valuation process. Since a Canadian taxpayer's final instalment of tax for a taxation year is due two months after the end of the year, an additional challenge is obtaining the information on a timely basis to make the computation for the instalment payment. Hence, in addition to incurring the costs for an appraiser's fee, a taxpayer could incur interest on late or underpaid tax instalments.

Double Taxation

Where a taxpayer has an FA earning active business income that is distributed during the year, the amount of the distribution is subject to tax under the FIE regime pursuant to section 94.3 and the foreign affiliate regime. If an FA were resident in a designated treaty country and the dividend paid out of the FA's exempt surplus, the dividend would generally not be taxable in Canada. If the FA were also a FIE and operating under the mark-to-market method, however, there would be an income inclusion, the deduction provided by section 94.3 would be nil because the dividend would be offset by the section 113 deduction, and the benefit of the exempt surplus regime would be lost for the dividend. This result appears to be unintended and should be corrected.

A second situation where double taxation may occur is a result of the interaction of the proposed FIE rules and section 17. Assume, for example, that a corporation is a FIE with active business income of $100. Assume further that the income arises primarily from a loan to a related non-affiliated company (e.g., a U.S. sister company). The interest income is deemed to be active business income by subparagraph 95(2)(a)(ii) and the company pays a dividend of $50 from the deemed active business income. The tax consequences would seem to be, as follows:

   The FIE income is $100, unreduced by the $50 distribution that is assumed
   to be deductible in computing taxable income under section 113. (See the
   calculation in section 94.3.) The section 90 income is eliminated by a
   section 113 deduction of $50. Finally the section 17 income is $100
   (subsection 17(1), via subsections 17(2) and (3), with no offset available
   from subsection 17(1)).

The double taxation of distributed income is exacerbated by a potential tax on the sale of the investment because the Canadian taxpayer will not be able to use exempt surplus that would otherwise have accumulated in order to reduce the Canadian tax on the sale. Since the investment is marked to market, there will likely not be large gain on sale; nonetheless, this result is inconsistent with the current foreign affiliate rules that permit the exempt surplus to be used in computing the gain on disposition.

Finally, it is unclear to us how the draft FIE rules will be harmonized with the mechanics of the current FA rules, especially in respect of corporate mergers, liquidations, and reorganizations. We believe that there will be many unintended instances of double taxation that arise from the sheer complexity of the proposed rules and the interaction with current provisions of the Act governing such transactions.

Exchangeable Shares

Exchangeable shares are employed to effect many bona-fide business purposes and transactions. The most common and longstanding use of such shares is to facilitate cross-border mergers and acquisitions of companies with substantial Canadian business operations. Since the FIE rules apply to interests of a Canadian corporation that are exchangeable into shares of a non-resident corporation, nearly all holders of exchangeable shares must consider and address the effect of the FIE provisions. TEI questions whether the provisions were intended to affect the holders of exchangeable shares and recommends that the Department of Finance reconsider whether the FIE provisions should be revised to diminish their effect on corporate combinations involving Canadian business operations.

Recommendation in Respect of The FIE Provisions

TEI submits that companies that refrain from investments that are designed to avoid FAPI and that carry on active businesses through foreign entities should be excluded altogether from the FIE regime. Legitimate businesses operating through foreign affiliates are already subject to a complex foreign affiliate regime that provides an equitable balance between the government's interest in curbing tax avoidance transactions and the taxpayers' interest in deferring taxation on unrealized foreign gains and unrepatriated earnings. Moreover, the complexity of the proposed rules is enormous, providing perhaps as many unintended opportunities for abuse of the bright-line tests adopted in the FIE rules as traps for unwary taxpayers. More likely, the legislation is so comp]ex that few taxpayers will be able to foresee when the rules will apply, and we question whether CCRA auditors will be able to properly apply them. Accordingly, we urge the government to withdraw the proposed FIE rules and, to the extent specific abuses are identified, craft targeted solutions to address those transactions or investments that circumvent the current anti-avoidance rules.

Overview of Draft Non-Resident Trust Legislation

As with the FIE provisions, the draft provisions relating to non-resident foreign trusts are aimed at curbing tax-motivated transfers of property outside of Canadian tax jurisdictions. Regrettably, the provisions are overbroad and redundant to the anti-avoidance purposes of sections 17 and 247 of the Act. In addition, the proposals seemingly abrogate treaty obligations on a unilateral basis and, hence, may well undermine the government's ongoing negotiations with treaty partners.

The following comments elaborate on specific concerns relating to the Non-Resident Trust provisions.

Treaty Overrides

Proposed subsection 104(7.01) would apply a tax of nearly 25 percent to matters addressed by Part XIII of the Act even where a treaty exempts or reduces the Part XIII tax otherwise due. The rationale for the additional tax or for overriding current treaty provisions is not apparent. For example, assume a Canadian taxpayer establishes a U.S. securitization trust consisting of conventional Canadian mortgages. The trust would be subject to a current withholding tax of 10 percent, but if the draft provisions were adopted, the tax rate would increase substantially. This seems inappropriate and at odds with the government's efforts to negotiate lower treaty withholding tax rates on cross-border interest payments.

More fundamentally, the interaction between the draft proposals and current tax treaties is unclear. The Explanatory Notes to proposed subsection 94(3) imply that a foreign trust can be declared resident in Canada and subject to tax regardless of the trust's actual residence or its source of income. While the overreaching scope of these provisions will likely be challenged by affected parties, the mere attempt to impose such a tax will damage the government's credibility in international treaty negotiations.

Administration

The proposals purport to require that all affected non-resident trusts comply with the reporting obligations and burdens of Canadian law. The Canadians deemed to be "involved" in the non-resident trusts, however, will rarely have sufficient influence or control of the non-resident trust to ensure compliance with the rules. Indeed, the primary effect of the proposals will be to discourage non-Canadian trusts from dealing with Canadian entities thereby putting Canadian businesses at a competitive disadvantage.

Recovery Limit

Subsection 94(3) imposes tax on the non-resident trust as though it were a trust resident in Canada for the entire year. If the trust fails to pay the tax, each "contributor" or "beneficiary" is jointly and severally liable for the full amount of the trust's tax liability. Subsection 94(7) sets a limit on the amount otherwise recoverable (the recovery limit) from persons jointly and severally liable for the tax. Regrettably, the recovery limit fails to achieve any proportionality between the tax liability of the "contributor" and the value of the contribution made. For example, where a person makes a loan on a commercial basis to a non-resident trust that fails to pay its proper tax liability, the person making the loan is liable to tax for up to the full face amount of the loan. Similarly, where a service is provided to a trust, the recovery "limit" is the value contributed to the trust or, in other words, the full value of the service. Under the operative rules, there is no deduction for payments made by the trust for the service nor is there any relief for a taxable inclusion under section 247. It also appears unlikely that subsection 248(28) would apply to mitigate the potential double taxation of any Canadian person.

Scope

The fundamental flaw in the foreign trust provisions, as with the FIE provisions, is their overbreadth and the astounding number of ordinary transactions that are treated as "transfers" or "contributions" to a trust. Under the rules of application in draft section 94(2), almost any transfer, loan, or service to or for a trust will be treated as a "contribution." An exception is provided to exclude trust administrative services from being considered a "contribution" to the trust, but the scope of the exception is unclear on its face and Canadian taxpayers' experience under a similar trust administrative services exemption in the Excise Tax Act suggests that there will be frequent disputes with CCRA over its scope and meaning.

More important, it appears that many arm's-length commercial transactions will fail the test set forth in paragraph b of the special definition of an "arm's-length transfer." Specifically, in order to be arm's length for purposes of section 94(1), as well as for purposes of the rules of application in subparagraph 94(2)(b)(iii), "it must be reasonable to conclude that the reasons for which the property was transferred or loaned to the recipient did not include the relationship between the transferor" and certain parties. (Emphasis supplied.) The key word is relationship -- a term undefined by the draft statute. Many arm's-length transactions require the existence of some previous relationship. For instance, an arm's-length lender will rarely make a loan until it has developed a level of confidence in the good faith of the borrower. Hence, the undefined term will be difficult to apply. Consider the following example:

Assume for valid business purposes -- perhaps for asset securitization purposes -- U.S. Company A, a railroad, desires to contribute a portion of its property to a trust. In order to accomplish its purposes, it will engage a third-party service provider and submits requests for proposals to various providers. Assume that Canadian manufacturing company B is a long-time supplier of equipment for Company A. As a result of the long-term supply arrangement, Company A and Company B have established a good "working relationship."(5) If Company B were to win the trust servicing business, the trust could be deemed a resident of Canada and subject to the draft rules as a result of a pre-existing "relationship." Canadian Company B would also be subject to the Non-Resident Trust rules.

Operations in Foreign Entities

A foreign branch of a Canadian company would seemingly be subject to these rules whereas a foreign affiliate would not. We do not believe the tax result should turn on the form of the foreign entity and we urge that the government revise the rules to make them inapplicable to foreign branches. Otherwise, Canadian suppliers will be at a competitive disadvantage to local suppliers.

In addition, trusts for the benefit of employees take many different forms in different jurisdictions all over the world. TEI recommends that the government establish a general exception for trusts that benefit broad classes of employees (i.e., trusts other than those intended to primarily benefit specified shareholders). Paragraphs 94(1)(e) through (h) of the definition of an exempt foreign trust seem intended to achieve this result, but other countries' employee trust provisions may not mirror the Canadian model. Hence, we urge that the rules be clarified to exempt all foreign trusts that benefit broad classes of employees.

Accounting Profit

As with the accompanying FIE proposals, there are few accountants who understand the meaning of the phrase "in accordance with accounting principles substantially similar to generally accepted accounting principles used in Canada." (Emphasis supplied.) At a minimum, the technical notes should provide guidance on the meaning of this key phrase by, for example, including a reference to the accounting principles or standards adopted by other countries' accounting standard-setting bodies, including the U.S. Financial Accounting Standards Board or the International Accounting Standards Committee.

Conclusion

TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney. If you should have any questions about the submission, please do not hesitate to call Mr. Penney at 905.644.3122, or Sabatino Meffe, TEI's Vice President for Canadian Affairs, at 514.339.4446.

(1) We note that in the 1999 Budget papers projected a nominal revenue effect. Hence, we question whether the level of complexity and the many, likely unintended, consequences of the proposed legislation can be justified.

(2) As one example, generally accepted accounting principles are occasionally revised or applied in a new or different fashion. Will taxpayers be required (or permitted) to apply revised Canadian (or substantially similar foreign) GAAP rules? Are the effective dates for the application of revised GAAP rules the same for tax and financial reporting?

(3) For purposes of determining whether a corporation is a FIE, subsections 94.1(13) to (15) provide a grace period within which to invest new funds contributed for a "qualifying issue." The carrying value of a "qualifying issue" is deemed to be nil at the end of the year in which a qualifying disposition or qualifying issue took place. As a result, a taxpayer has the year of the "qualifying issue" plus the succeeding year to invest the funds.

(4) Concededly, if the CFA election is made for an FA in order to escape FIE status and there is no FAPI as determined under the CFA rules, there would be no current tax.

(5) In defining the term "relationship," the Canadian Oxford English Dictionary uses the example of a "good working relationship."