Canadian legislation on non-resident trusts: October 25, 2001.

On October 25, 2001, TEI submitted the following letter to the Canadian Minister of Finance, Paul Martin, commenting on draft legislation relating to Non-Resident Trusts (NRT). For TEI's comments on the latest draft of the FIE provisions, see the related comments in this issue. The NRT comments follow up on a submission on an earlier draft version of the legislation sent by TEI in February 2001. TEI members also met with representatives of the Department of Finance in May to discuss the legislation. (For TEI's comments on the previous draft of the NRT and FIE legislation, see the March-April 2001 issue of The Tax Executive.) TEI's earlier comments were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is David M. Penney of General Motors Canada Limited. Contributing significantly to the development of TEIs comments was Alan Wheable of Toronto Dominion Bank, TEI's Vice President--Region I.

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On June 22, 2000, the Department of Finance released draft legislation relating to Foreign Investment Entities (FIE) and Non-Resident Trusts (NRT). In response to public comments and consultations on the draft proposals, the Department on September 7, 2000, announced modifications to the proposals, delayed the implementation date, and extended the consultation period. Tax Executives Institute submitted comments on the modified draft in February 2001 and met with representatives from the Department of Finance in May. TEI is pleased that the Department afforded us the opportunity to discuss the draft legislation and to elaborate on our written comments. Subsequently, another draft of the legislation was released on August 2, 2001. While the draft legislation has been improved, TEI remains concerned about the draft legislation relating to Non-Resident Trusts (NRT). Under separate cover, we will be submitting comments on the latest draft of the Foreign Investment Entity provisions.

Background

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,300 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 of Draft Legislation and TEI Comments

The draft NRT legislation, together with the related provisions addressing foreign investment entities (FIE), 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.

The August 2001 draft NRT legislation incorporates a number of helpful changes that respond to concerns expressed by TEI. While the draft legislation has thus been improved, we continue to be troubled by the mind-numbing complexity of the provisions. In addition, the reach of the provisions still far exceeds the scope of the problems that the government seeks to address. As a result, our principal recommendation is to urge the government to withdraw the draft provisions and propose narrower, targeted solutions.

The latest draft provisions relating to non-resident foreign trusts also fail to address the concerns TEI expressed about the interaction with sections 17 and 247 of the Act. Finally, the proposals still 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 our specific concerns.

Treaty Overrides

Proposed subsection 104(7.01) applies a tax of nearly 25 percent to matters addressed by Part XIII of the Act, even where a treaty might exempt or reduce the Part XIII tax otherwise due. As a result, income items that are both "designated income" and income ordinarily subject to Part XIII would be subjected to a punitive combined tax rate. The rationale for imposing this additional tax, as well as for overriding current treaty provisions, is neither obvious nor explained in the notes. Moreover, both actions--increasing the tax and overriding treaties--are at odds with the government's efforts to make the Canadian tax system more competitive by negotiating lower treaty withholding tax rates on cross-border interest payments. In addition, we fail to understand the policy basis for treating Canadian source payments made to a Canadian resident taxpayer through a deemed resident trust differently from payments that pass through a trust actually resident in Canada.

In order to avoid treaty overrides and mitigate the punitive rate of tax, we urge the government to revise proposed subparagraph 104(7.01)(b)(ii), as follows:

   (ii) all amounts not included, in (i) or included in the income of a
   beneficiary resident in Canada under 104(13), each of which is the treaty
   factor percentage of an amount paid or credited in the year to the trust
   that would, if this Act were read without reference to subparagraph
   94(3)(a)(v) and sections 216 and 217, be an amount as a consequence of the
   payment or crediting of which the trust would have been liable to tax under
   Part XIII, and.... (Emphasis added.)

In addition, the following definition of "treaty factor percentage" should be added to subsection 94(1):

   "treaty factor percentage" shall mean, where the trust would, if this
   section did not apply, be resident in a designated treaty country (1) and
   the amount would be subject to a reduced rate of withholding under the
   applicable treaty (i.e., the reduced treaty rate), a percentage equal to
   twice the reduced treaty rate, and, in any other case, 50%.

As important, the interaction between the draft legislative proposal and current tax treaty rules on residence and sourcing of trust income should be clarified. 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 in-come. We believe that asserting this position will damage the government's credibility in international treaty negotiations and urge the government to reconsider this position.

Arm's Length Transfer

The definition of an "arm's length transfer" has been substantially improved, thereby reducing the scope of potential controversies that may arise. The revised definition, however, remains overbroad and will likely still catch bona fide arm's length transactions. Specifically, under paragraph 94(1)(e) the effect of multiple agreements taken as a whole cannot be considered for purposes of determining that all the agreements are part of the same arm's length transaction. This flies in the face of business judgment and legal practice because in many complex commercial transactions the elements of a multifaceted business deal are frequently recorded in multiple agreements. (2) For example, a loan transaction may involve a loan agreement and one or more separate security arrangements. In such cases, both the loan and the security arrangements are relevant to the pricing of the loan and, hence, for both practical business reasons (as well as for all other tax and legal purposes), the separate agreements must be read as a whole. A strict interpretation of paragraph 94(1)(e), however, would preclude this. To remedy the statute, TEI recommends that a new alternative condition, subparagraph (v), be added to paragraph 94(1)(e), as follows: "or (v) the contributor is at arm's length from the trust."

In addition, the treatment of the purchase of a treasury interest in a foreign mutual fund is far from clear. Under paragraphs 94(2)(r) and (q), such a transaction should be excluded from the application of the NRT provisions but that may not be the result if the transaction produces income from property. Should the government intend to exclude such items from revised section 94, we recommend that a specific clause be added to explicitly exclude such interests.

Operations in Foreign Entities

A foreign branch of a Canadian company would seemingly be subject to the draft NRT 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 the government to revise the rules to make them inapplicable to foreign branches. Otherwise, Canadian suppliers will be at a competitive disadvantage to local suppliers. We recommend adding a new paragraph (c) to the definition of "resident contributor" in subsection 94(1), as follows:

   (c) an entity in regard to a contribution that can reasonably be regarded
   to be in relation to the carrying on of a business of the entity in a
   country other than Canada.

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 [phone], or Alan Wheable, TEI's Vice President for Canadian Affairs, at [phone].

(1) The term "designated treaty country" should have the same definition as in Regulation 5907(11).

(2) Multiple agreements are commonly used in order to improve the clarity of the drafting of the agreements. In addition, parts of a transaction may be subject to a public registration requirement whereas other parts are not. To preserve the confidentiality of the portion of a transaction not subject to registration, a separate agreement may be used.