Draft Canadian legislation on the tax treatment of interest expense.

On May 1, 1992, Tax Executives Institute filed the following comments with the Canadian Department of Finance relating to draft legislation on the tax treatment of interest expenses. The comments took the form of a letter from TEI President Reginald W. Kowalchuk to Ian Bennett, Senior Assistant Deputy Minister for Tax Policy and Legislation. The comments were prepared under the aegis of the Institute's Canadian Income Tax Committee whose chair is Hugh D. Berwick of Alcan Aluminium Limited; their submission was coordinated by Andrew G. Kenyon of the Canadian Imperial Bank of Commerce, who is the Institute's Vice President-region I.

On behalf of Tax Executives Institute, I am pleased to submit the following comments on the Department of Finance's Release 91-141, Draft Legislation on the Tax Treatment of Interest Expenses, which was released on December 20, 1991.

Background

Tax Executives Institute is an international organization of approximately 4,800 professionals who are responsible - in an executive, administrative, or managerial capacity - for the tax affairs of the corporations and other businesses by which they are employed. 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 companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial; and resource (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole but more particularly those of our Canadian constituency.

General Comments

At the outset, TEI wishes to express its support for incorporating into written law the tax policies with respect to deductibility of interest that are embodied in the June 2, 1987, Notice of Ways and Means Notion and its periodic renewals. Regrettably, TEI believes that the December 20, 1991, draft legislation fails to do that. More fundamentally, we fear that the draft legislation will create serious problems to many corporations carrying on business in Canada. The problems include the following:

* higher financing costs,

* higher administrative costs,

* a relative disadvantage compared

with foreign businesses,

* uncertainty, and

* unnecessary complexity.

The proposed rules dealing with borrowings for the purpose of distribution are of primary concern. The shortcomings of the proposed rules are so pronounced that the policy underlying them should be fully reconsidered. In the comments that follow, we first review the key concepts underlying these rules and then proceed to more technical comments on the various proposals.

Money Borrowed

for Distribution

Financial administration in recent years has become more sophisticated. Companies are able to manage money to reduce unnecessary interest expense. The treasury function is frequently centralized, with funds accumulated in one place for use throughout the business. Borrowed monies can usually be traced to an eligible use for deductibility of interest purposes under current administrative policies of Revenue Canada. One of those uses, however, is the payment of dividends or other distributions. TEI believes that, under the proposed rules, many companies will be compelled to spend considerably more money and time to minimize non-deductibility of interest on money borrowed for distribution.

Proposed sections 20.1 and 20.2 of the Income Tax Act adopt a property measurement test for the purpose of determining the deductibility of interest on monies borrowed by corporations and partnerships to make distributions. TEI's principle concerns about the test relate to the measurement of assets at tax cost and the exclusion from "equity" of shares in companies owned 10 percent or more by the Canadian taxpayer. Indeed, we believe these two issues alone are more than enough reason to scrap section 20.1 in its entirety.

1. Use of Tax Cost. The borrowing of money for the purpose of making distributions is widely recognized as an appropriate method of doing business and the cost of such borrowing is recognized as a cost of doing business. The measurement of assets at tax cost, however, has no relationship to the need or use of borrowed money by the taxpayer. In addition, tax cost has no relationship to the requirements of lenders who, in deciding the propriety of making a particular loan, will be concerned with the actual value of the assets, as well as other factors. Book value of the assets gives lenders a preliminary basis for measuring the asset values.

Use of the tax cost of assets to measure equity would seriously prejudice established companies. For example, several years ago tax depreciation greatly exceeded book depreciation, with the gap between tax and book depreciation of assets for some companies exceeding one billion dollars. This large gap is not as a result of tax avoidance, but rather is a direct consequence of timing incentives specifically accorded by the Government. The use of tax cost to value assets effectively penalizes companies that act upon the incentives by exacerbating the possibility of interest on loans for distributions being non-deductible.

Although tax and book depreciation rates do not currently differ as much as they did in earlier years, the differences are likely to remain. Hence, the use of tax cost of assets in measuring equity will continue to disadvantage Canadian companies wishing to expand or update their businesses. For example, capital expenditures on scientific research and experimental development carried on in Canada may be fully written off for tax purposes, but this incentive to carry on R&D in Canada will be undercut by the requirement that the taxpayer not include the capital equipment in equity. In addition, cash is depleted by current expenditures on scientific research and experimental development. The R&D does, when successful, produce something of value that is not included in equity. In the cases of both capital and current R&D expenditures, TEI believes it is improper and counterproductive to discourage such expenditures by the use of tax cost in measuring asset values.

Finally, we note that the base for the Part I.3 tax is the GAAP balance sheet. If the concept of "equity" were to be retained in the rules, TEI believes that it too should be based on the GAAP balance sheet.

2. Exclusion of Shares from Equity. Under the draft legislation, shares of corporations of which a taxpayer holds 10 percent or more are excluded from equity. The Department of Finance's rationale for the exclusion is essentially that including the value of shares in "equity" would result in the underlying assets being counted twice and would expand the overall deductibility of interest available to the companies involved. TEI believes that this stated reason is clearly wrong with respect to shares of foreign affiliates and ignores many of the realities of business.

First, the assets of a foreign affiliate are not included in the "equity" of any Canadian taxpayer. The foreign affiliate, however, is a very real part of the Canadian shareholder's assets. The earnings of a controlled foreign affiliate are generally earnings in the consolidated account of the Canadian parent and may well be relevant in determining the dividend expectations of the shareholders of the Canadian parent. Thus, TEI recommends that shares of foreign affiliates not be excluded from "equity."

Similarly, shares of a Canadian company are clearly part of the assets of the parent company. It cannot be assumed that underlying companies will always pay dividends immediately before the shareholding company makes a distribution. Indeed, we believe that to do so disregards the realities of business:

* minority shareholders cannot

dictate the dividend policies of

the company;

* majority shareholders cannot

ignore responsibilities to the

minority shareholders;

* in regulated businesses, there

may be various limitations on

the payment of dividends (or

on borrowing to do so);

* borrowing by a subsidiary to

pay a dividend may be more

expensive than borrowing by

the shareholders; and

* needs for cash by a subsidiary

and needs for cash by the

shareholder will often conflict.

In summary, decisions on how to best manage the monies should not be impeded by the interest deductibility rules.

The exclusion of shares from "equity" further aggravates the international tax competitiveness situation for many corporate groups that are not able to pay tax on a consolidated basis. In addition, the exclusion of shares eliminates from "equity" goodwill acquired in a purchase of shares which is not excluded in an acquisition of assets. Finally, we believe that the exclusion from equity of partnership interests of 10 percent or more is inequitable for essentially the same reasons as the exclusion of shares.

3. Suitable Policy. As the foregoing comments demonstrate, TEI believes that the policy problems raised by using tax cost to measure assets and excluding shares from "equity" are fundamental and cannot be righted with technical corrections. We believe the proposals should be eliminated and the policy behind the limitation of deductibility of interest on borrowings for distributions be fully reconsidered. Interest on borrowings for the purpose of distribution should be considered as a deductible business expense, by way of section 9 of the Income Tax Act or otherwise.

If a limitation on the deductibility of such interest is to be based on a property measurement test, the following principles should apply:

* the property measurement test

should apply by reference to an

amount determined by reference

to generally accepted accounting

principles;

* it should reflect the value of all

assets of the corporation of relevance

to potential lenders;

* it should only have to be applied

once for any particular

borrowing;

* it should not apply retrospectively

to past borrowings;

* it should not interfere with corporate

reorganizations that can

be effected on a tax-free basis;

and

* it should minimize complexity.

TEI would be pleased to meet with you to discuss these points and technical items that must be addressed to implement these principles.

Technical Issues

1. Effective Date. The "Background and Overview" of the December 20, 1991, Release states that "a fixed date has not been set for the implementation of any of these changes." TEI understands the changes would not apply prior to the introduction of final rules. There remains, however, a question about deductibility of interest from the beginning of 1992 until any new rules take effect. TEI recommends that the Notice of Ways and Means Motion be extended until any new legislation takes effect.

2. Paragraph 20(l)(qq). This provision allows relief only with respect to shares not acquired for the purpose of earning income therefrom or from a business. The various Notice of Ways and Means Motions also covered other assets. TEI recommends that the actual law not be narrower than the Notice of Ways and Means Motions.

3. Subsection 20(3.1)(a)(iii). This provision allows relief only when the shareholder acquires shares in the particular corporation, as opposed to shares in any subsidiary. This may require that unnecessary shareholdings be put in place in order to obtain interest deductibility. A more complex corporate structure may result without any general business advantage. Consequently, the Institute recommends that subparagraph 20(3.l)(a)(iii) be broadened to cover acquisitions of shares not only of the particular corporation, but also of other taxable Canadian corporations controlled by the shareholder, the particular corporation, or a group of persons of which the shareholder or the particular corporation is a member.

4. Paragraph 20(3.1)(b). Interpretation Bulletin IT-445 states that proceeds of a loan must have been used to earn income subject to Part I tax. The proposed change states that the loan proceeds must have been used to earn Canadian source income. Thus, the provision will deny the deductibility of interest where the funds are used by a foreign branch. TEI believes that such a result is improper and recommends that the condition remain that the loan must have been used to earn Part I income.

5. Subsection20.1(1). In many cases, it will not be possible to trace the use of borrowed money explicitly to a purpose of earning income from business or property or to the making of a distribution. The new rules do not expressly deal with this problem. A company may be unable to fully deduct interest under paragraph 20(l)(c) of the Income Tax Act, and also be unable to prove that any specific portion of that interest is deductible under the proposed section 20.1. Of more concern is the very real likelihood that a company will not know, until after audit - and possibly objection and appeal - how the funds from a loan will be considered to have been used. In such a case, the company may be unable to determine in advance whether interest that it will pay will be deductible. It is important not to introduce such uncertainty. TEI recommends that a taxpayer be required to show only that the borrowings were used for one purpose or another, as long as either use sanctions deductibility. Use of an amended section 20.1 provision will allow this to be done, but use of a section 20.1-type limitation makes it impossible.

6. Subsection 20.1(1). Measurement of "equity" at both the beginning and the end of the year creates uncertainty, since the year-end number is unknown at a time of borrowing. The requirement to measure "equity" in future years with respect to a past borrowing causes even more uncertainty. TEI presumes that the words "at the end of the particular year" in draft subparagraph 20.1(l)(c)(ii) (instead of "at the beginning of the following year") were used for a specific reason. For example, it seems that 1992 depreciation may not be claimed at the end of 1992 and can only be claimed after 1992 is completed. Hence, the 1992 year-end computation of "equity" seemingly does not require the subtraction of 1992 capital cost allowance, but does require taking account of 1992 acquisitions and dispositions of assets. Is this interpretation correct? Also, can 1992 taxes be "owing" at the end of 1992 considering that 1992 taxes cannot be calculated until 1992 is fully completed?

7. Subsections 20.1(2)(a)(iv) and (v). The exclusion from "equity" of land subject to the interest deductibility restrictions in subsection 18(2) and of property in respect of which interest costs would not be deductible by virtue of subsection 18(3.1) is improper. Such assets are very real assets of a real estate developer and form part of the asset base for the purpose of earning income. As long as the property is to be used for business (or for the purpose of earning income from the property), TEI recommends that such property be included in the computation of equity.

8. Subsection 20.1(6). If the proposed rules were actually in force, designations would almost certainly be made with incorrect amounts allocated to various properties. Although subsection 20.1(6) affords a taxpayer some opportunity to correct his designation, TEI believes a correction should also be permitted after confirmation of an assessment that was objected to, as well as after a court decision on an appeal.

9. Paragraph 20.1(7)(e). Where borrowed money is used to acquire a property that is excluded from "equity" - whether by way of paragraph 20.1(2)(a) or 20.1(7)(b) - any amount owing in relation to the acquisition of that property is still subtracted from "equity." Such a result is clearly improper. Particularly with respect to land referred to in paragraph 20.1(2)(a) and to shares and partnership interests referred to in subparagraphs 20.1(7)(b)(v) and (vii), the amounts involved could be substantial. A pure holding company with modest debt could have a negative equity. Inclusion of the assets in "equity" would be a partial solution.

10. Section 20.2. Although this subsection on current distributions will apparently not apply until the legislation is introduced in a final form, the rules of this subsection would appear to apply not only to borrowings made after December 20, 1991, but indeed to all borrowings used to make distributions; the only limitation is that a balance be outstanding after the legislation takes effect. TEI strongly objects to the proposed retrospectivity of section 20.2. A taxpayer who relies on the outstanding law and administrative practice in order to become satisfied that interest on a borrowing would be deductible should not be penalized. Thus, we recommend that loans outstanding when the legislation is introduced in final form be grandfathered.

The concept behind the measurement of assets in subsection 20.2(2), despite some problems, is better than the concept in section 20.1. The sub- section 20.2(2) definition does not use tax cost nor does it exclude from the computation some of the significant business assets which are excluded from "equity" in section 20.1.

The reduction of adjusted equity by the amount of any profits and gains from dispositions to non-arm's length parties is improper where the profit or gain has been reported for purposes of computing income. In comparison, paragraph 20.2(3)(c) seems to reduce the carrying value to the distributor of property received from a related party only where it was received on a tax rollover basis. TEI recommends that paragraph 20.2(2)(c) not exclude from adjusted equity any taxable profits or gains on a disposition to a non-arm's length party.

Integrated businesses generally start with raw materials to produce base products which are sold to related companies - often in the United States or other foreign countries - for further processing. By the time the products are sold to arm's-length parties, substantial profits have been realized both for book and tax purposes. The exclusion of these profits from the carrying value of property is inequitable. In addition, the accounting for such profits in items that have transferred ownership and gone through transformation or processing several times would be complex and expensive, if the necessary information for transactions completed prior to the effective date could be retrieved at all.

Where a company is part of an integrated business group having substantial inventory sales to related parties, it will be fully taxable on these sales of inventory. Nevertheless, under the draft legislation, it can be penalized in the computation of adjusted equity in comparison with a similar company selling to unrelated parties. This does not appear to be equitable. Under the legislation, the adjusted equity reductions on sales of property to a non-arm's length party would not be made up on the eventual sale to an arm's-length party.

Where a subsection 85(l) or subsection 85.1(3) rollover of property is effected, TEI questions whether the gain should be excluded from adjusted equity. We believe that section 245 alone should be used as the tool to restrain taxpayers from using the rollover provision for the purpose of augmenting adjusted equity. Alternatively, the use of the general anti-avoidance provision will prevent the application of specific rules to butterfly transactions and other situations where the proposed rules may create inequity.

In conclusion, TEI believes that the current distribution rules set forth in the draft legislation are inequitable and unreasonably broad and we recommend their significant revision.

Conclusion

Tax Executives Institute appreciates this opportunity to present its comments. If you should have any questions, please do not hesitate to call either Andrew G. Kenyon, TEI's Vice President for Canadian Affairs, at [phone] or Hugh D. Berwick, chair of the Institute's Canadian Income Tax Committee, at (514) 848- 8235.