Comments on pending Canadian income tax issues, December 20, 1989.

Comments on Pending Canadian Income Tax Issues

December 20, 1989

I. Background

Tax Executives Institute is an international organization of approximately 4,300 professionals who are responsible--in an executive, administrative, or managerial capacity -- for the tax affairs of the corporations and other businesses that employ them. TEI's members represent almost 2,000 of the 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, or are otherwise affiliated with, companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distribution, wholesaling, and retailing; real estate; transportation; financial; and resource (including mining, pulp and paper, and petroleum). The comments set forth in this submission reflect the views of the Institute as a whole but more particularly those of our Canadian constituency.

TEI has historically been 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 in an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equiptable operation of the tax system. In furtherance of this principle, TEI is dedicated to supporting efforts to improve the tax laws and their administration at all levels of government.

Among TEI's principal objectives are the gathering and dissemination of information on tax issues of wide concern and the development of responsible positions that reflect not only the diversity and professional training of our members but also an appreciation for the practical aspects of tax administration and business decisions. In addition, we strongly believe that tax legislation should be fully consistent with the goals of economic growth, clarity, and international competitiveness.

II. Increasing Complexity and Burden of the Canadian Income Tax System

In his August 13, 1989, response to TEI's June 13 submission on the tax provisions of the Government's April budget, the Minister of Finance states that, "in terms of incentive to invest in productive capacity, there is strong evidence that Canada has maintained or increased its relative position. A recent international survey has placed Canada among the leaders in international competitiveness." We respectfully suggest that several facets of the Canadian tax system mark it as decidedly not "user-friendly" and, indeed, as increasingly burdensome for its domestic and international users. We come to this conclusion through comparison of the Canadian system to international standards on a number of elements:

* Tax Depreciation, Investment Tax Credits, and Other Incentives: Whereas Canada once possessed the overall advantage vis-a-vis the United States with respect to tax depreciation, investment tax credits, and other capital formation incentives, the results of Canadian tax reform have tempered the Canadian system's advantage. Today, the two countries maintain roughly equivalent systems.

* Legislative Complexity: With respect to business taxpayers, there can be little doubt that the United States leads Canada in legislative complexity. Such "faint praise" for the Canadian system should not be overemphasized, however, for the Canadian system is far from simple in any objective sense and, on a comparative basis, has achieved greater complexity in certain discrete areas (discussed below).

* General Anti-Avoidance Rule: In our submission of October 12, 1987, we advised that the General Anti-Avoidance Rule (GAAR) is more stringent than generally prevailing international standards and, in particular, is harsher -- and undeniably more fraught with ambiguity and uncertainty -- than the anti-avoidance deterrents in place in the United States (by virtue of a combination of legislation and jurispudence). We recognize that the disruptive nature of GAAR may be tempered by subsequent administrative and judicial developments in Canada, but suggest that the policy underlying the statutory rule remains one of legitimate concern.

* Application of Other Taxes: Canada has enacted a number of levies outside the scope of the income tax imposed under Part I. The list includes taxes on corporations under Parts I.3, II.1, IV.1, VI, And VI.1

The Cumulative effect of these taxes has been a significant increase in the overall effective tax rate on corporations. Moreover, in certain cases, these taxes have been purposely designed to be noncreditable in foreign jurisdictions. Few countries can boast such an array of taxes outside the scope of the normal income tax. In addition to raising the effective rate of taxation on Canadian business, these taxes inject additional confusion and complexity into an already confusing and complex tax system. Thus, they undermine what should be a guiding principle of a self-assessment tax system: the ability of taxpayers to conduct business affairs with certainty based on their knowledge of the Income Tax Act.

* Consolidated Tax Returns: The list of countries that permit corporate groups to file consolidated returns, or otherwise provide broad-based group relief, runs from Australia to Venezuela. Regrettably, however, it does not include Canada. (1)

* Necessity of Administrative Sanction: The Canadian system vests Revenue Canada-Taxation with considerable discretion and too frequently requires confirmation by Revenue Canada-Taxation that a proposed acquisition or restructuring does not contravene either GAAR or subsection 55(2), or that the taxpayer does not have term preferred shares acquired in the ordinary course of business, or taxable preferred shares, or taxable RFI shares, or short-term preferred shares, or guaranteed shares, or collaterized loss preferred shares. This makes it difficult to conduct affairs in a prudent, expeditious manner.

In previous submissions and during previous meetings, TEI has discussed the trend toward "zero tolerance" drafting -- the effort to ensure that all possible offenders are caught and that all possible revenue is garnered from the economy. Such an approach, however, not only produces an inordinately complex set of tax rules, but also forces prudent taxpayers to seek rulings from Revenue Canada on virtually all transactions. It thus unduly complicates the process of obtaining positive rulings as requested from Revenue Canada-Taxation on entirely business-driven transactions.

We respectfully submit that, the Minister's statements to the contrary notwithstanding, the combined effect of these elements is to place Canada at a material competitive disadvantage, rather than in the position to which countries should aspire.

TEI has previously recommended that the Department of Finance modify the GAAR provisions to conform to international standards (see submission of October 12, 1987) and, further, that the Department evince a more practical approach to drafting. For example, a major improvement would be to redesign the Part VI.1 distribution tax to make it creditable in foreign jurisdictions. We also recommend that the Minister should, at the time of announcing a budget measure, table the related legislation, thereby ensuring that the structure and the underlying complexity of the proposal can be appreciated and, indeed, addressed in a timely manner.

Finally, we understand that the Joint Committee of the Canadian Institute of Chartered Accountants and the Canadian Bar Association has ear-marked the preferred share rules for a major simplification effort. TEI heartily supports this objective, believing there is both the need and a constituency for simplification. (2) We would be pleased to participate in a simplification project designed to bring the Joint Committee's recommendations to fruition.

III. Environmental Taxation Policy

A. Overview. The Government of Canada has committed itself to making the preservation of the environment a top priority. Obviously, the business community as a whole shares the Government's goal. To this end, corporations are making significant capital expenditures on air and water quality-control processes as well as on the development of new recycling processes. They are also devoting considerable resources to creating safer and healthier work environments and to developing new products to replace hazardous products. In some cases, this involves closing down the plants and processes involved and building new plants to produce environmentally friendly products as substitutes, whereas in others it involves substantial "retrofitting" of existing plants and equipment to achieve an environmentally desirable result. Finally, businesses are designing consumer products to make them both safer for the consumer and the environment.

The financial commitment required from industry to engage in these salutary activities is substantial. We submit that for Canadian business to remain competitive internationally, the federal government, in conjunction with the provinces, should develop taxation policies that encourage business to undertake environmental projects. The overall goal should be to accelerate investment on environmental projects rather than to punish corporations through the imposition of environmental tax levies. In other words, government and industry should work together in partnership to achieve common environmental goals. Our specific recommendations in this regard are set forth below.

B. Amendments to Classes 24 and 27. To further the Government's environmental goals, TEI recommends that the capital cost allowance (CCA) regulations for Classes 24 and 27 be amended to delete the requirement that the operations were commenced prior to 1974. Such an amendment would ensure that all corporations are given consistent treatment with respect to CCA for pollution-control equipment.

The regulations dealing with capital cost allowances on Classes 24 and 27 allow an accelerated write-off of pollution-control property over a period of three years (i.e., 25 percent, 50 percent, 25 percent). The property must meet certain criteria to qualify as Class 24 or 27 property, the most pertinent of which is a requirement that the environmental-control property be acquired by the taxpayer primarily for the purpose of preventing, reducing, or eliminating pollution resulting from "operations carried on and commenced before 1974 at a site in Canada."

Prior to tax reform, pollution-control equipment not falling within Class 24 or 27 because it was installed at a plant site that was placed in operation after 1973 would be treated as production machinery and equipment under Class 29 rather than as pollution-control equipment. Since Class 29 allowed an accelerated write-off over three years similar to that accorded Class 24 and 27 property, pollution-control equipment installed at a new operating location was generally treated on a consistent basis with pollution equipment installed at a pre-1974 operating site.

That consistency of treatment, however, no longer exists. Stage 1 of tax reform changed the write-off for production machinery and equipment from a three-year write-off under Class 29 to a 25-percent declining balance basis (approximately 10 years) under the new Class 39. Tax reform, however, properly left the three-year write-off for Classes 24 and 27 intact. As a result, an in-equity has been created, presumably inadvertently, for those corporations that are installing pollution-control equipment at locations at which operations were commenced after 1973.

For example, a corporation that must expand its operations after 1973 to a new operating site because it has no space left at the older site would be placed at a tax disadvantage vis-a-vis a competitor having the space to undertake a similar expansion of its operations at an existing site (at which operations commenced prior to 1974). If the first corporation installed pollution-control equipment during its expansion at the new operating site, it would be required to write this equipment off over a period exceeding 10 years. In contrast, its competitor which install the same pollution-control equipment during a similar expansion in the same year but at a pre-1974 operating site would be allowed a three-year write-off.

To eliminate this inequity and to encourage companies to install pollution-control equipment, TEI recommends that the CCA regulations for Classes 24 and 27 be amended to delete the requirement that operations to which the equipment relates must have commenced before 1974.

We also recommend that Class 24 and 27 property be expanded to include plant and equipment relating to (i) the replacement of production facilities for proscribed hazardous products with environmentally "friendly" products, and (ii) production facilities for products required by environmental legislation (e.g., emissions-control equipment).

C. Financing Mechanisms. The financial commitment to the environment in many industries is substantial and will doubtlessly intensify in the near future as more stringent standards and new requirements for air and water quality controls are put into law. Increased expenditures by industry to further the Government's environmental goals coincide with the independent pressure from international competition to invest heavily in new plants and "state-of-the-art" technology. The Government can ease the financial burden posed by the mounting environmental costs by exempting from tax the interest paid by businesses on bonds and debentures used to fund these costs. The adoption of such an approach would reduce industry's borrowing costs, thereby encouraging environmentally related expenditures.

Specifically, TEI recommends that interest paid on a debt instrument used to finance environmental-control facilities that conform to the requirements for inclusion in CCA Class 24 (water-pollution control) and Class 27 (air-pollution control) be exempt from tax in the hands of the recipient. TEI submits that the Government's legitimate concerns with respect to "SRTC"-type abuses can be more than adequately addressed by carefully crafting the operative rules. For example, we believe that the Department of Finance can safeguard against possible abuses by expressly requiring that the exemption will only be available in respect of pollution-control equipment approved in advance by Environment Canada.

Consideration should also be given to the issuance of tax-exempt government bonds to finance the Government's environmental initiatives, including the clean-up of abandoned waste sites. The issuance of so-called environmental bonds, which would be tax exempt in the hands of the holder, would tap public concern over environmental issues and stand as a tangible sign of the cooperation on environmental issues among government, industry, and the public. In this regard, TEI believes that the financing of government projects (such as the clean-up of abandoned waste sites) should come either from such government bonds or from general sources of revenue, rather than a targeted corporate tax levy.

IV. Issues from the April 26, 1989, Budget

A. Large Corporation Tax. Tax Executive Institute expresses its continuing policy and technical concerns with respect to the Large Corporations Tax (LCT) proposed in the April 27, 1989, Budget Papers (now reflected in Clause 48 of Bill C-28).

We believe that the imposition of the LCT on the capital of corporations contradicts the Government's previous pronouncements regarding a fair and competitive fiscal regime, particularly statements referring to establishing a "level playing field." The industries that will bear a disproportionate share of the LCT are industries that are capital intensive such as the manufacturing and resource industries; unfortunately, for companies within those sectors, the LCT comes at a time when the economic environment is, in many instances, already quite strained.

1. Creditability in Foreign Jurisdictions. The interaction of the LCT and the corporate surtax has an adverse effect on the U.S. foreign tax credit. The present surtax is considered an income or profit tax for U.S. tax purposes and, as such, is fully creditable under U.S. tax rules. In contrast, the LCT is imposed on the basis of capital employed and, thus, is not a creditable tax for U.S. tax purposes. Furthermore, the mechanics of the proposed LCT offset against the surtax will have the effect of either eroding or eliminating the amount of existing creditable surtax for U.S. foreign tax credit purposes.

We strongly recommend that the LCT proposal be revised to provide that the corporate surtax be creditable for purposes of determining the actual LCT liability. From the Canadian perspective, such a change would be revenue neutral and would, we understand, result in the surtax being fully creditable for U.S. tax purposes.

TEI discussed the creditability issue in depth not only in its June 13 submission on the Budget, but also in a letter dated October 31, 1989, to the Deputy Minister, and in testimony presented to the Legislative Committee of the House of Commons on December 7. The Institute has also prepared a draft legislative amendment, which would have the effect of inverting the LCT/corporate surtax credit mechanism. We would be pleased to provide the Department with copies of the draft amendment, as well as the Institute's previous submissions on this subject.

2. Transferability Within a Corporate Group. TEI renews its recommendation that the LCT be transferable within a related group so that the total LCT payable by the group not exceed that payable an individual corporate entity with the equivalent amount of taxable capital.

Making the LCT transferable will recognize the regulatory constraints imposed on various industries as well as business needs to maintain management independence and to limit liability as the reasons why businesses must frequently operate through separately incorporated entities.

By providing for transferability of the LCT, the Government can ensure equitable treatment regardless of whether the business affairs are conducted through a related group or one integrated company.

3. Acquisitons -- "Push-down" Accounting. One of the problems arising from the large number of recent acquisitions and reorganizations is the effect of "push-down" accounting. Under "push-down" accounting, a parent (acquirer) company would assign the fair market value purchase price of shares to the underlying assets of the acquired company (target) and make a corresponding adjustment to the "equity" of the target. This would presumably increase the taxable capital for LCT purposes. Where "push-down" accounting is not utilized, the acquired company (target) would use only historical net book value and related equity value in its LCT calculations.

TEI submits that "push-down" accounting should be viewed as an internal transaction and should not increase the LCT liability when it is used.

4. Consistency with Provincial Systems. All the provinces that impose a capital tax (with the exception of Quebec) allow an adjustment for the excess of the net book value of assets over the tax basis of assets. By including deferred income taxes in the capital base, the provinces display a consistency, inasmuch as they are following a taxable capital concept.

The Budget Papers adopt a tax-based capital concept when they provide that the LCT will require the inclusion of all reserves (including deferred income taxes) in the LCT base. By including deferred income taxes in the LCT base, the LCT would be glaringly inconsistent with provincial systems if it did not also permit a net book value/tax adjustment similar to that allowed by the provinces.

Consequently, TEI recommends that the LCT legislation reflect an adjustment for the excess of net book value of assets over the tax basis of assets.

5. Joint Instalments of Part I.3 Tax and Part I Tax. The Minister's letter of August 13, 1989, advises that TEI's request for joint installments of the Part I.3 tax and the Part I tax merits further study. The importance of this issue is increased by the failure to amend paragraphs 157(a)(ii) and (iii) to take into account the estimated LCT credit for the current year in those years in which the historical instalment base does not reflect the full effect of such credit.

We request a status report on this matter.

B. Preferred Shares Dividend Tax Deduction. In discussing the principles underlying the Part VI.1 tax and the related paragraph 110(1)(k) deduction, the June 18, 1987, White Paper on Tax Reform stated:

The new approach will ensure that inappropriate tax penalties do not arise when preferred shares are issued by taxpaying corporations for non-tax reasons.

...[A] non-tax paying corporation can take advantage of the dividend relief by issuing preferred shares even though the income out of which the dividend has been paid has not borne tax.... The new tax is designed to ensure that tax has been paid with respect to dividends on preferred shares when relief is given at the shareholder level. As such it will affect dividends by non-taxpaying corporations and will have no impact on a taxpaying corporation issuing preferred shares.

The rationale given in the April 26, 1989, Budget for reducing the amount of the paragraph 110(1)(k) deduction from 5/2 to 9/4 times the Part VI.1 tax paid is that the combined federal-provincial corporate tax rates for large corporations generally exceed 40 percent. The reduction in the amount of the paragraph 110(1)(k) deduction was deemed necessary to "ensure that the deduction does not provide a greater offset for the share issuer than is appropriate."

The 9/4 deduction equates to a tax rate 44.44 percent. In actuality, combined federal-provincial tax rates across Canada range from approximately 32 percent to 42 percent. (This variance from the 40 percent rate set forth in the Budget Papers is attributable to lower provincial tax rates and the manufacturing and processing deduction.) The amount, if any, of the unintended benefit is minimal. In fact, even at the original deduction of 5/2 (250 percent), preferred shares issued by Canadian corporations would have been subject to additional tax of up to eight percent. By reducting the deduction from 5/2 to 9/4, taxpayers that issue preferred shares will be subject to additional tax ranging from 4 percent to 11 percent.

T

This proposed change is contrary to the principles enunciated in 1987 when the government's "new approach" was introduced. It does have a very significant negative effect on taxpaying corporations issuing preferred shares. This negative effect will increase as the manufacturing and processing deductions are phased in.

TEI recognizes that it is impractical to adjust the paragraph 110(1)(k) deduction for differences in provincial tax rates; we do suggest, however, that the deduction be increased for those corporations eligible for the manufacturing and processing deduction to more properly reflect their actual tax rate. We also submit that it is improper to retroactively adjust the deduction for shares issued prior to April 26, 1989, inasmuch as the pricing on such shares was conditioned on legislation in effect at that time. (3)

C. Reassessment Period. In our submission of June 13, 1989, we enquired why the changes to paragraph 152(4)(c), which would extend the general reassessment period back to four years would be retroactively applied to all open years at April 27, 1989. We noted that when changes were made to reduce the reassessment period to three years (effective for 1983 and subsequent taxation years), those changes were made prospective only. We also aked for confirmation that the time period under subparagraph 152(4)(b)(iii) would not be extended.

The Minister did not respond to these issues in his letter of August 13. We do note, however, that Bill C-28 (which would implement the budget proposals) would make the extension of the reassessment period retroactive; moreover, subsection 152(4) would be extensively redesigned and subsection 152(3.1) would be added to ensure that the reach of subparagraph 152(4)(b)(iii) -- relating to related party transactions -- would extend the reassessment period a minimum of seven years. The application of subsection 231.6(7) further serves to extend such time period for all transactions, not just foreign transactions covered by paragraph 152(4)(b)(iii). (4)

The foregoing actions to extend the reassessment period have effectively rendered the "statute of limitations" a nullity, especially in respect of such foreign transactions. TEI recommends that the Department of Finance take action to rectify this situation.

V. "Available for Use" Rule-Draft Legislation

Draft legislation has been released concerning the "available for use" rules, which provide that, with respect to property acquired after 1989, taxpayers may not claim capital cost allowance or investment tax credits until the property is "available for use." These rules are extraordinarily complex, and it is not possible to envisage all the complications that may result in the future. Our preliminary review of the provisions, however, reveal the following issues.

A. The present wording of the long-term project election rule can have the effect of penalizing a taxpayer for putting property into use two years after it was acquired as opposed to an even later time. This is because the cost of such property would reduce the "threshold amount" in subsection 13(29).

For example, assume that property is put in use in year three. The cost of such property would be deemed available for use in year three pursuant to paragraph 13(27)(b) and, because the property actually did become available in year three, paragraph 13(29)(c) would require that its cost be excluded from the threshold amount. In contrast, property that is not put into use until year four would still be deemed available for use in year three pursuant to paragraph 13(27)(b) but, by operation of paragraph 13(29)(c), would not reduce year threehs threshold amount.

Presumably, the intention was to exclude from the threshold amount the capital cost of property that "became available for use at or before the end of the inclusion year other than pursuant to paragraph 13(27)(b) of (28)(c)." TEI recommends that the Department of Finance take action to rectify this situation.

B. In the long-term project rule (subsection 13(29)), the exclusion from the threshold amount (paragraph 13(29)(c) minus paragraph 13(29)(d)) of amounts available for use other than pursuant to the two-year rolling start rule can produce anomalous results. Taxpayers can actually be worse off from a tax standpoint by accelerating usage of capital property.

[Editor's Note: In its submission, the Institute provided two examples to illustrate the foregoing point. Anyone wishing to obtain a copy of the two examples should send a written request to TEI Headquarters.]

TEI believes that the elimination of property available for use other than by paragraph 13(27)(b) or 13(28)(c) will have extremely limited revenue effect on the government and that it will unnecessarily complicate the Income Tax (as evidenced by the two examples). Specifically, we recommend the provisions be simplified by deleting from paragraph 13(27)(c) the following words:

"and that has not become available for use at or before the end of the inclusion year or that, but for paragraphs (2)(b) and (28)(c) and this subsection, would not have become available for use at or before the end of the inclusion year."

C. Subsection 13(29) identifies an amount that becomes available for use, but does not necessarily identify to which year's additions that amount is attributable. This becomes relevant in computing the two-year rolling start amount.

For example, assume five years of expenditures of $1 million each. The first year's property is put in use in year two and the remaining property is put in use in year five. In this example, no amount is available for use in year three pursuant to subsection 13(29), but in year four, $1 million becomes available for use pursuant to subsection 13(29). If this $1 million is attributable to year three's expenditures, Revenue Canada may argue that year three's expenditure of $1 million does not become available for use in year five pursuant to paragraph 13(27)(b) and the half-year rule would apply. However, if the $1 million that becomes available for use in year four pursuant to subsection 13(29) is attributable to year four's expenditure, then presumably all of year three's expenditure becomes available for use in year five pursuant to paragraph 13(27)(b) and the half-year rule would not apply.

This creates uncertainty about what amounts are subject to the half-year rule. To resolve this matter, when a taxpayer makes an election under subsection 13(29), the eligible amount should be attributed to the most recent year's expenditure.

D. Subsection 13(27) does not specify the time at which property becomes available for use pursuant to subsection 13(29). This leaves open the argument that property becoming available for use in year three pursuant to subsection 13(29) also becomes available for use in year four when actually put in use or in year five under the two-year rolling start rule. These issues should be clarified.

E. Subsection 13(27) defines "available for use" for the purposes of subsection (26). "Available for use" is used in subsections 13(28), (29), and (30) as well as subsections 20(28), 37(1.2), and 127(11.2). Although subsection 248(15) incorporates the definition of subsection 13(27) for the purposes of the entire Income Tax Act, subsection 13(27) could be read to provide for a limited application of the definition.

TEI recommends that, for simplicity's sake, subsection 13(27) apply for purposes of the Act. The inclusion in section 248 of a reference to the definition would also be helpful. (5)

F. Our analysis leads us to conclude that the taxpayer always obtains undepreciated capital costs of property as fast or faster by making a subsection 13(29) election than by not making the election. (If a taxpayer is in, and anticipates being in, a loss position for a long period of time, he may wish to forgo claiming CCA, but it does not appear that the taxpayer can actually be in a worse tax position by making the election than by not making it.) This being the case, we recommend that taxpayers be deemed to automatically make a subsection 13(29) election unless they expressly elect out of the provision.

VI. New Issues

A. Deductibility of Goods and Services Tax -- Income Tax Deductibility of GST. The Government's White Paper on the Goods and Services Tax provides that in certain circumstances taxpayers will be denied full input credits.

TEI recommends that the Department clarify that all GST incurred net of such input credits should be fully deductible for income tax purposes. This would be consistent with current FST provisions and preclude the situation where a taxpayer is caught in a "double jeopardy" position vis-a-vis both taxes.

B. Section 22 Elections. Under section 22 of the Income Tax Act, a taxpayer who transfers all or substantially all of the property used in a business may make an election in respect of the accounts receivable transferred in such circumstances. The election allows the purchaser to deduct the future bad debt expense on the acquired debts. This mechanism is not available, however, where less than 90 percent of the property used in the business is transferred.

TEI recommends that the applicability of section 22 be expanded to any circumstances wherein accounts receivable are transferred and the taxpayers so elect.

C. Paragraph 85(1)(e.2) Benefits. From previous discussions, we understand that the Department of Finance did not intend for the revised wording of paragraph 85(1)(e.2) (i.e., the reference to benefit rather than gift) to apply to transfers of property to wholly-owned subsidiaries. Revenue Canada-Taxation did not initially subscribe to this view.

We understand that at the Canadian Tax Foundation's 1989 Conference, a representative of Revenue Canada-Taxation stated that the Department of Finance would be proposing an amendment to the provision to clarify this situation. What is the status of this matter?

D. Alternative Minimum Tax on Severance Pay of Terminated Employees. The minimum tax rules were introduced to increase the fairness of the tax system by ensuring that high-income taxpayers who reduce their taxes by various tax incentives and deductions pay a minimum amount of tax. In operation, however, the rules have frequently, and presumably inadvertently, led to the imposition of the tax with respect to severance payments to low-to-middle-income employees; this has occurred notwithstanding the rollover provisions for retiring allowances ($40,000 limit).

We respectfully suggest that these employees (who are generally between 50 and 60 years of age) were not intended to fall within the ambit of the minimum tax rules and, further, that the tax is imposed at a time in their lives when they most need the cash flow. This inequitable situation can be remedied without violating the policy underlying the minimum tax rules by providing a de minimis rule that would apply with respect to such employees; the rule should be crafted to ensure that at least a portion of their severance pay will not be subjected to the minimum tax.

E. Penalties on Late Remittances of Source Deductions. Because of the magnitude of the dollars involved, some of the large corporations have incurred penalties with respect to late remittances of source deductions in excess of $250,000. The reasons for delay of these remittances are usually quite innocent, such as employee vacations, accidents, and equipment failures, and not because of volitional noncompliance.

TEI submits that penalties of this magnitude are excessive. We recommend that the Income Tax Act be amended to give the Minister of National Revenue the discretion to waive the penalties in appropriate circumstances. We further recommend that a cap of $100,000 be imposed and that consideration be given to imposing the penalty only where the taxpayer has exhibited a pattern of non-compliance or careless behavior; thus, the penalty would be applicable only with respect to third and subsequent offenses.

The adoption of these recommendations would not adversely affect the adequacy of the penalty provisions (which would continue to discourage late tax remittances, especially since the penalties are not deductible for tax purposes). More fundamentally, the balanced nature of the revised penalties would more equitably reflect the need for cooperation between government and taxpayers. It would also give recognition to the fact that the Government itself is neither infallible (witness the sometimes terminally slow processing of transactions) nor totally accommodating to taxpayers (for example, repeated requests for electronic funds transfer). (6)

With respect to penalty provisions generally, we note that the U.S. Congress recently enacted a broad-based penalty reform package. The U.S. legislation embraced two principles with respect to source (or deposit) penalties that TEI recommends be imported into the Canadian system. First, the legislation gives taxpayers a statutory right to have a penalty waived where the taxpayer's noncompliance is attributable to reasonable cause and the taxpayer has made a good faith effort to comply. (7) Secondly, the revised penalty for failure to make a timely deposit of taxes includes the concept of "time sensitivity"; that is to say, a one-day delay in depositing such taxes would prompt, a lesser (or no) penalty than would a longer delay. The time sensitivity provision would have the effect of encouraging taxpayers to correct their errors.

TEI was extremely active in the development of penalty reform legislation in the United States and would be pleased to share our submissions to Congress, as well as other background materials, with the Department.

F. Use of Related Group Capital Losses. In a parent/subsidiary relationship, where a wholly owned subsidiary has capital losses and the parent has an apprecited capital asset it wishes to dispose of to a third party, the Income Tax Act allows parent to transfer the capital asset under section 85 on a tax-free basis to the subsidiary; the subsidiary in turn can sell the asset to the third party, thereby enabling the capital gain to be offset against the subsidiary's capital losses. Revenue Canada-Taxation, in a number of different forums, has confirmed that such a transaction is acceptable.

If the situation were reversed, however, with the parent having the capital losses and the subsidiary owning the capital asset, section 55 would apparently deny an intercorporate, tax-free transfer unless the taxpayer satisfies the complex requirements of the paragraph 55(3)(b) exemption. The Rulings Directorate of Revenue Canada appears content with this result, which is at odds not only with Revenue Canada's position in the reverse case but also with the Department of Finance's position on the transfers of assets within a wholly owned corporate group to more fully utilize losses (thereby diminishing the need for formal tax consolidation).

TEI requests the Department's comments on this matter.

G. Retirement Compensation Arrangements. Related corporations may decide to establish separate Retirement Compensation Arrangements (RCAs). When employees transfer between related corporations, it is often administratively practical to transfer amounts in the RCA of the transferror company in respect of the transferring employee to the transferee company's RCA. Currently, however, there is no mechanism for such RCA transfers to be made without withholding the 50-percent refundable tax contemplated under subsection 103(7) of the Income Tax Regulations.

To avoid the need to apply such withholding upon transfer and having the transferror RCA recover the 50-percent tax on the original contribution, TEI recommends that no withholding be required on inter-RCA transfers. Such a result could be parallel to inter-RRSP transfer provisions.

H. Offset of Interest Charges. Where a taxpayer has overpaid taxes for certain taxation years and, in subsequent taxation years, underpaid its taxes, the fairest method of application of the overpayment for interest calculation purposes would be to apply the overpayment to the "underpayment" years in chronological order, giving credit for the overpayment as of the date on which the overpayment arose. TEI recommends that such a rule be adopted. (8)

Alternatively, consideration should be given to allowing a deduction for interest charges assessed under section 161 of the Income Tax Act to the extent that there is an amount of interest income computed by virtue of section 164 of the Act, when both amounts accrue over the same period but in respect of different taxation years.

I. Employee Profit-Sharing Plans. When employees leave a company (as a result of terminations, layoffs, or otherwise), frequently a company's contributions since the last withdrawal entitlement date are forfeited. Such employees will, of course, receive their own contributions plus any accumulated return thereon, but the forfeited amount reverts to the plan for redistribution among the remaining members of the plan. Subsection 144(9) provides that when forfeitures occur, the affected employee will receive a tax credit of 15 percent of the amount forfeited. This provision has been in place without change since 1956.

In our view, the 15-percent tax credit allowed by subsection 144(9) is inadequate and unfair. An employee who suffers such a forfeiture is effectively taxed on income he will never receive. This tax is collected at a rate equal to the difference between the employee's marginal tax rate and 15 percent. Given that the marginal combined federal-provincial tax rate can approach or exceed 50 percent (depending on the employee's province of residence), this amounts to a penalty of 35 percent on the forfeited income. The inequity of the situation is exacerbated by the fact that forfeitures typically occur in unplanned situations, such as terminations and lay-offs.

We recommend that subsection 144(9) be amended to provide for a deduction from income of any such forfeitures in place of the existing tax credit.

J. Stock Options Plans. Employees who are entitled to buy stock of their company at a price below fair market value receive a taxable benefit (subsection 7(1)). That benefit may be reduced depending upon the sale price and the market value at the time the purchase agreement is made (paragraph 110(1)(d)).

What is the rationale behind this two-step calculation? The employer knows, when Forms T-4 are issued, what the net taxable benefit is to the employee. This two-step procedure creates hardship for the employees who pay withholding taxes upon a benefit that is overestimated, and an administrative burden for the employer who must identify the available deduction. To remedy this situation, the benefit should be included directly at 66-2/3 percent of 75 percent rather than having a full benefit and a possible reduction for the employee.

K. Interest-Free Loans. Under subsection 17(1), interest is imputed on a loan to a non-resident where interest is not charged at a reasonable rate. This provision has the effect of exacting a tax penalty on Canadian exporters of goods for use in long-term projects abroad where (when as a condition of sale) they must agree to participate in the financing of such projects through a long-term loan without interest. For valid business reasons, the purpose of such a loan cannot be achieved through extended terms of payment for exported goods. Nevertheless, although no interest is formally charged, the price of goods sold to the arm's-length customer includes the recovery of the financing costs of the Canadian exporter's long-term loan.

Under such circumstances, Revenue Canada would assess the Canadian seller for income tax on deemed interest and, in addition, would include the full price of the goods sold in income, resulting in double taxation to the extent of tax paid on "deemed interest." Consequently, the result would increase Canadian exporters' costs and effectively present a barrier to exports.

TEI recommends that subsection 17(1) be amended to rectify what appears to be an unintended consequence.

L. Subsection 93(1) Election. The Department has informally indicated that the technical amendments bill that is expected in early 1990 will include a provision permitting a subsection 93(1) election in respect of a deemed gain under subsection 40(3) where the property at issue is a share of a foreign affiliate of the taxpayer.

Would the Department please confirm that such an amendment will be included in the forthcoming legislation?

M. Deduction for Reserve of Unsettled Losses. Regulation section 1400 provides tht an insurance corporation may deduct reserves that do not exceed the lesser of (i) a reasonable amount in respect of the liability as at the end of the year, and (ii) the reserve in respect of the liability reported by the corporation in the amount reported for the year to the Superintendent of Insurance for Canada (or of a Province). Since a foreign insurance company, which is typically organized for insurance as opposed to tax purposes, does not file with the specified regulatory authority, a question arises whether such a company is denied a reserve deduction.

TEI requests that the Department clarify this situation and, further, in the event a reserve deduction is denied in such a situation, recommends that an amendment be made to the regulations to place foreign insurance companies on the same footing as domestic insurance companies.

N. Renumbering of Income Tax Act. TEI has previously communicated its concerns about including the Income Tax Act within the proposed consolidation of the Statutes of Canada to both the Department of Finance and the Department of Justice. In a March 19, 1987, letter to the Deputy Minister of Justice, the Institute outlined several specific concerns and concluded that including the Income Tax Act within the consolidation process could impose substantial increased costs of the Government and taxpayers without any corresponding return on the investment.

We understand that the Department of Justice has recently confirmed its intention to proceed with the renumbering of the Income Tax Act as part of the consolidation process. We request the Department of Finance's comments on this situation. In addition, we invite comment on TEI's earlier recommendation that Income Tax Regulations be renumbered to correspond with the pertinent section number of the Income Tax Act. This system of numbering is used by the Province of Quebec and is viewed by government and taxpayers alike as very effective.

O. Possible Protocol to Canada-U.S. Tax Treaty. We understand that consideration is being given to negotiating a protocol to the Canada-U.S. income tax treaty which would address legislative changes in both countries since the treaty came into force (in particular, the enactment in the United States of several "treaty-override" provisions).

What is the time table for negotiation of the treaty protocol and what are the issues that the Department envisages being addressed by the protocol?

VII. Conclusion

Tax Executives Institutes appreciates this opportunity to present its comments on several pending tax issues. We welcome the opportunity to discuss these comments with you during the Institute's January 11, 1990, liaison meeting. In the meantime, if you should have any questions about this submission, please do not hesitate to call either James Hutchison, TEI's Vice President for Canadian Affairs, at [phone], or James F. McFall, chair of the Institute's Canadian Income Tax Committee, at [phone].

(1) The Department of Finance itself recognized the desirability of a corporate loss transfer system in its May 1985 Discussion Draft. TEI addressed the merits of permitting consolidation or some other type of group relief in a submission to the Minister dated November 6, 1985, and has regularly reiterated its concerns (most recently in the submission that was filed with the Department on November 28, 1988).

(2) There can be little dispute that the current rules are unduly complex and complicated; their effect is not only to prevent potential abuses to frustrate a wide range of legitimate activities and bona fide transactions.

(3) In his August 15 letter, the Minister stated that the rate at issue is that of the lender; we suggest, however, that this assertion is not supported in the Technical Notes that were submited to Parliament in respect of the original 1987 legislation.

(4) The Technical Notes to Bill C-139 (issued June 30, 1988), Clause 176, which discuss new subsection 231.6(7)), suggest thast the changes would be limited to foreign transactions.

(5) There is a similar need for clarification in respect of the definitions of "public corporastion," "private corporation," and other phrases in section 89 and elsewhere.

(6) With respect to electronic funds transfers, TEI recommends that the Government's acceleration of instalment payments makes it imperative that Revenue Canada-Taxation accept payment by electronic transfer. Indeed, in view of the Goods and Services Tax and attendant increase in the volume of transactions, there is an immediate need for the Minister of Finance to accelerate consideration of this matter and to press ahead with appropriate representatives of Canada's financial institutions to develop legislation that would effect that result.

(7) TEI recommends that "reasonable cause" be deemed to exist where (i) a taxpayer establishes reasonable business procedures to ensure compliance with its obligation, and (ii) the taxpayer makes a good faith effort to comply with those procedures.

(8) This approach would be especially welcomed by taxpayers because credit interest is taxable in the taxpayer's hands whereas debit interest is not deductible.