Draft legislation relating to foreign investment entities and non-resident trusts: May 13, 2003.

On May 13, 2003, TEI submitted the following comments on the October 2002 draft of Canadian legislation relating to Foreign Investment Entities and Non-Resident Trusts. The comments, which took the form of a letter from TEI President J.A. (Drew) Glennie to Minister of Finance John Manley, were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Ltd. Contributing substantially to the development of TEI's comments were Vincent Alicandri of Hydro One Networks, Inc., Carmine A. Arcari of Royal Bank of Canada, David M. Penney of General Motors of Canada Limited, and Alan Wheable of Toronto Dominion Bank.

On June 22, 2000, the Department of Finance (hereinafter the Department) 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 announced modifications, 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 2001. Subsequently, another draft of the legislation was released on August 2, 2001. Acknowledging that the August 2001 draft represented an improvement, TEI expressed continuing concerns about the revised FIE and NRT draft legislation, respectively, in separate letters dated October 25, and October 31, 2001.

On October 11, 2002, a Notice of Ways and Means Motion was released setting forth another revised draft of the FIE and NRT legislation. In view of the abbreviated period between the release of the revised legislation and the proposed implementation date of January 1, 2003, TEI submitted a letter on December 16, 2002, urging that the legislation be withdrawn or deferred in order to afford time for consultations and to permit taxpayers to modify information systems to comply with the roles. On behalf of TEI, I am writing to elaborate on our December 16 letter and provide detailed comments outlining our concerns about the October 2002 draft of the FIE and NRT legislation.

Background

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,300 professionals manage the tax affairs of 2,800 of the leading 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 concerns itself with important 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 Non-Resident Trust (NRT) and Foreign Investment Entity (FIE) legislation released by the Department of Finance on October 11, 2002, is intended to 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 draft legislation replaces the drafts released previously on June 22, 2000, and August 2, 2001.

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 to capital gains in specific situations). 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 June 2000 draft of the legislation, the Department's press release explained the provisions, as follows:

   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.

Although the government's objective of curbing illegitimate tax avoidance effected through "transfers to offshore trusts and accounts" is unassailable--and TEI supports such efforts because it will prevent shifts in the tax burden to already compliant taxpayers--we do not believe that the proposed new and complex FIE and NRT provisions are necessary to achieve the government's aims. Current sections 94 and 94.1 provide the government substantial tools to curb tax-motivated transfers. Moreover, the decision in Walton v. The Queen, 98 D.T.C. 1780, vindicated the policy underlying section 94.1 and enhanced that provision's efficacy in combatting tax avoidance effected through offshore investment funds. We urge the government to re-double its efforts to enforce the current provisions in the Act before adding new provisions.

As important, the government's announcement regrettably understates the scope, nature, and far-reaching effect of the proposed legislation because the draft rules go far beyond the stated purpose of combatting "tax avoidance." Indeed, the proposed legislation implements a comprehensive new regime for taxing indirect foreign investment. Moreover, the proposed FIE rules substantially overlap the foreign accrual property income (FAPI) system of taxing foreign affiliates. In contrast with the perceived rush to implement the proposed FIE rules, the FAPI rules were deferred, in most cases, from their introduction in 1972 until full implementation in 1976. The approach allowed the government to undertake a substantial study of the scope and potential effect of the FAPI rules. TEI submits that the FIE rules are as comprehensive in scope and far-reaching in effect as the FAPI rules and recommends that before the government moves forward with the proposed FIE rules that it undertake a similar study.

The October 2002 draft legislation includes important revisions from previous drafts, but the latest rules remain overbroad, extraordinarily complex, confusing, and, in the case of the proposed FIE rules, continue to overlap and conflict with the entire foreign affiliate regime, including section 17 in respect of loans to non-residents. As a result, the provisions will interfere with legitimate business operations. In addition, the proposed FIE rules simply do not mesh well with the proposed NRT rules.

Although the latest version of the draft legislation helpfully reduces the number of instances where a non-resident corporation operating an active business could qualify as an FIE, TEI continues to believe that, once an entity is trapped in the labyrinth of the FIE rules, compliance may prove impossible. We also continue to question whether Canada Customs and Revenue Agency (CCRA) will, anymore than taxpayers, have the resources to properly administer these rules. From both compliance and administrative perspectives, the rules would be vastly improved if they were more limited in scope and focused solely on remedying perceived abuses. To the extent that the government can identify specific abuses, it should propose narrower, targeted solutions. Otherwise, the compliance challenges posed by the proposed legislation will spawn inadvertent, unavoidable non-compliance by otherwise compliant taxpayers.

Fundamentally, we believe the draft legislation remains unworkable and we again urge the government to withdraw it because:

* It would apply to numerous, compliant taxpayers that are not attempting to avoid Canadian tax by "transferring funds to offshore trusts or accounts."

* The proposed legislation is overbroad, overlaps the foreign affiliate regime as well as section 17, and catches many legitimate commercial transactions.

* The information necessary to comply with the proposed legislation's myriad reporting requirements is either (1) unavailable generally or (2) likely unavailable to a Canadian taxpayer where, as will generally be the case, it is a minority investor and lacks the requisite control to obtain the necessary information.

* The information that would permit taxpayers to take advantage of one or more of the relieving provisions or elections in the proposed legislation is either (1) unavailable generally or (2) likely unavailable to a Canadian taxpayer where, as will generally be the case, it is a minority investor and lacks the requisite control to obtain the necessary information.

* The Minister, in certain circumstances, is accorded the seemingly untethered authority to make various determinations, including whether a business is an investment business, property is exempt, and an entity is an FIE or a qualifying entity. Moreover, taxpayers seemingly have no rights of appeal of various determinations.

Finally, taxpayers need far more time to analyze the proposed legislation and--to the extent possible--make necessary changes to their information systems. Hence, at a minimum, the implementation of the proposed legislation should be delayed substantially in order to afford taxpayers time to undertake a proper analysis, consult with the government, and implement the necessary information system changes in order to comply.

In addition to the foregoing general observations, we have a number of questions, comments, and concerns about specific provisions, as set forth below.

Foreign Investment Entities--Accrual Treatment--Definitions

A. Carrying Value

Under the proposed rules, a nonresident entity that holds at least 50 percent of its assets in "investment property" may be considered an FIE. Hence, the definition and measurement of "carrying value" for "investment property are central to the application of the draft rules. The explanatory notes issued with the draft legislation provide that "carrying value" of a property held by an entity means:

   The amount at which the
   property would be valued at
   that time for the purpose of
   the entity's balance sheet, if
   the balance sheet were prepared
   in accordance with generally
   accepted accounting
   principles used in Canada or
   accounting principles substantially
   similar to generally
   accepted accounting principles
   used in Canada and
   included property that is
   deemed under paragraph
   94.1(2)(j) (i.e., property held
   by certain entities in which
   the entity has a significant
   interest) to be owned by the
   entity at that time, or

   If the taxpayer elects in writing
   in the taxpayer's return
   of income for the taxpayer's
   taxation year that includes
   that time, the carrying value
   is the amount representing
   the fair market value of the
   property at that time as determined
   in accordance with
   generally accepted accounting
   principles used in Canada
   or generally accepted accounting
   principles substantially
   similar to generally accepted
   accounting principles
   used in Canada. (Emphasis
   added.)

First, TEI is pleased that the legislation has been revised in order to permit taxpayers to submit financial statements prepared in accordance with either Canadian generally accepted accounting principles (GAAP) or, as provided by new draft paragraph 94.1(2)(c), GAAP used in the United States or a country that is a member of the European Union. For investments in the United States or European Union countries, the new exception will eliminate the administrative burden of restating financial statements in accordance with Canadian GAAP. We believe the legislation would be improved by extending the revised policy and recommend permitting taxpayers to submit financial statements prepared in accordance with GAAP prescribed by countries that are members of the International Accounting Standards Committee.

In addition, we have the following specific questions and comments regarding the definition of "carrying value" in the revised draft legislation:

* For financial statements prepared for entities outside of the United States and the European Union, what does the phrase "substantially similar" to generally accepted accounting principles in Canada mean?

* How will the many differences in industry accounting rules and practices be taken into account in determining whether the foreign rules are substantially similar to Canadian GAAP?

* How will taxpayers and government auditors 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.

* In order to apply the proposed legislation, CCRA personnel will need to be trained to recognize and understand the differences among Canadian, U.S., E.U., and "other" countries' generally accepted accounting principles. We question whether CCRA will have sufficient resources to properly train its auditors to determine whether the accounting principles applied by an entity are substantially similar to Canadian GAAP.

* How should a taxpayer ascertain the fair market value of the assets of a corporation for purposes of determining whether to elect to base "carrying value" on fair market? If the taxpayer makes the election, will the value of intangible property not on the balance sheet be recognized?

* There are frequent disputes within the accounting profession about the application of generally accepted accounting principles to various transactions. Hence, the requirement to restate financial statements of an entity into Canadian (or substantially similar) GAAP will be fertile ground for contentious and unproductive disputes between taxpayers and CCRA. The audit disputes, in turn, will increase the cost of business for Canadian taxpayers conducting business outside Canada thereby rendering them less competitive with local businesses.

We recommend that the requirement to restate certain foreign financial statements to Canadian GAAP in any circumstances be eliminated. Adopting this change would more closely conform the proposed rules to the controlled foreign affiliate (CFA) regime, including the rules for computation of exempt surplus, taxable surplus, etc. At a minimum, the explanatory notes should refer to pronouncements of accounting principles by accounting standard-setting bodies (apart from those in the United States or European Union) that the Canadian government would consider substantially similar to Canadian GAAP.

B. Designated Cost

For participating interests acquired before 2003, the definition of "designated cost" requires the taxpayer to include in such cost the amount by which the fair market value of the participating interest at the end of the last taxation year that begins before January 1, 2003, exceeds the cost amount to the taxpayer. TEI remains of the view that most taxpayers will not have access to information that will permit them to compute the fair market value at the designated time. Hence, they will not be able to determine the initial "designated cost" of a participating interest.

C. Entity

The definition of "entity" includes a "fund," but TEI is uncertain what enterprises, operations, or entities the government intends to include within the term "fund." Accordingly, we reiterate our recommendation that the Department provide a definition of "fund."

D. Exempt Interest

An investor will not be subject to proposed section 94.1 if a participating interest in a foreign entity is considered an "exempt interest." The most common forms of "exempt interests" include:

* A participating interest in a controlled foreign affiliate (CFA), including an affiliate that is a CFA because of an election made under paragraph 94.1(2)(h).

* A participating interest in an FIE resident in a country where there is a prescribed stock exchange if the interests are listed on a prescribed stock exchange and are widely held and actively traded and there is no tax avoidance motive (as determined pursuant to paragraphs 94.1(2)(k) to (n)) for acquiring the interest. Paragraph 94.1(2)(f) provides that a participating interest will be deemed to be widely held and actively traded if at least 150 persons own such participating interests and each of those persons owns participating interests with a total value of at least $500; the participating interest owned by the taxpayer or an entity with which the taxpayer does not deal at arm's length does not exceed 10 percent of the fair market value of the FIE; and the participating interest is qualified for distribution to the public under the relevant securities law of the country in which the entity was formed and governed and the interest may be purchased and sold by any member of the public in the open market.

* A participating interest in a "qualifying entity."

* A participating interest held by the taxpayer in an FIE that was formed, organized, or continued under and is governed by the laws of a country (other than a prescribed country) with which Canada has entered into a tax treaty and under that treaty if (a) the FIE is resident in that treaty country, (b) participating interests in the FIE that are identical to the participating interest are widely held and actively traded, and (c) the taxpayer did not have a tax avoidance motive, as determined pursuant to paragraphs 94.1(2)(k) to (n), for acquiring the interest.

The revised draft legislation eliminates the requirement that all investors be at arm's length in order for an entity to be considered an "exempt interest," and TEI welcomes that change. Because of the practical challenge of obtaining the information to establish that an entity is an "exempt interest," few companies will likely qualify for the relief that the Department intends. The challenges that taxpayers face in satisfying the "exempt interest" criteria include the following:

* The names of the shareholders of companies listed and traded on a public stock exchange are generally not available to other shareholders. Accordingly, how will a taxpayer be able to determine whether there are at least 150 shareholders?

* The "residence" test is a legal question that depends on all the facts and circumstances and in many cases the information necessary to determine the residence of an entity may be unavailable. For example, under many countries' corporate laws, the location of a company's board of directors meetings is relevant in determining the corporation's residence. How will a taxpayer obtain that information in order to determine the residence of the corporation? Moreover, the policy rationale for incorporating a residence test is unclear. For example, TEI believes it should make no difference under the proposed legislation whether a corporation listed on the New York Stock Exchange is resident in the United States or Bermuda.

* How will the taxpayer determine whether each of the required 150 or more shareholders holds participating interests having a total value of at least $500?

* The definition of "entity" excludes natural persons. As a result, how will a taxpayer determine, for purposes of subparagraph 94.1(2)(f)(ii), whether the taxpayer's holdings exceed 10 percent of all the holdings of the entity being tested? In addition to increasing the challenge of determining whether the taxpayer's holdings exceed 10 percent of the total holdings, it is unclear why shares held by individuals should be excluded from the denominator. The practical effect is that a corporate shareholder may be precluded from availing itself of the "widely held and actively traded entity" exception.

* The determination whether an entity is a "qualifying entity" will require access to detailed financial and other information generally unavailable to most shareholders. Additional comments on this issue are set forth below.

Despite the improved definition of "exempt interest" in the most recent draft legislation and despite the government's likely intent to afford taxpayers meaningful exceptions and broad relief from the FIE rules, TEI believes that only a participating interest in CFAs will qualify as an "exempt interest." A lack of access to sufficient financial and other information will likely stymie most taxpayers' efforts to ascertain whether their investment interests qualify as an "exempt interest."

E. Foreign Investment Entity

Generally, an FIE is any non-resident entity unless at the end of its taxation year the "carrying value" of the entity's "investment property" is less than 50 percent of the "carrying value" of all of the entity's assets. An FIE does not include an entity with respect to which its principal business is not an investment business.

TEI welcomes the exclusion from FIE status for entities whose principal business is not an investment business. The determination whether an entity's principal business is an investment business is based on a facts-and-circumstances test or, if the taxpayer elects, by comparing "net accounting income" from investment properties and investment businesses with "net accounting income" from the entity's entire business.

Subparagraph 94.1(2)(e)(i) provides that the principal business of the entity is determined by reference to the facts and circumstances, including the carrying value of assets used in the activities carried on by the entity during the year, the amount of time spent by the entity's employees in carrying out those activities, the amount of expenditures incurred by the entity in respect of those activities, and the net accounting income derived by the entity from those activities. In TEI's view, the facts-and-circumstances test will not be available to most taxpayers because this level of detailed information is not available to minority shareholders.

Moreover, the election to base the determination of the entity's principal business activity on a comparison of "net accounting income" from investment properties and investment businesses may also not be available to taxpayers. A net-income-oriented test requires access to a greater level of detailed information (e.g., cost of goods sold and other expenses) than a revenue-based test and we question whether taxpayers will have sufficiently detailed financial information to make a net-income based determination. In similar tests under the Act (e.g., the definition of a leasing business), the entity's principal business is determined based on a comparison of revenues. In addition, under a net-income test, an entity sustaining business losses from a substantial operating business might be considered to be engaged in an investment business simply because it owns a minor investment property that produces a positive yield during a loss year. The latter result is clearly inequitable and perhaps unintended. TEI recommends that the government revise the elective test and base it on revenues rather than net income.

In addition, the concerns expressed above in respect of the definition of "carrying value" will make it very difficult for taxpayers to determine whether an entity is an FIE and, in turn, determine whether it should elect to base the reported "carrying value" on the fair market value of the assets.

Finally, for purposes of determining whether the principal business of an entity for the year is an investment business, the Minister may demand additional information pursuant to subparagraph 94.1(2)(e)(iii). If the taxpayer fails to supply information satisfactory to the Minister within 60 days (or such longer period as determined by the Minister) the principal business of the entity will be deemed to be an investment business. As a practical matter, it is unlikely that additional detailed information will be available under either alternative. Accordingly, taxpayers will likely not be able to avail themselves of this exclusion from the FIE definition. Moreover, there appears to be no appeal from the Minister's determination that an entity carries on an investment business. This is unacceptably arbitrary. We recommend that a determination whether an entity carries on an investment business be subject to appeal.

F. Investment Property

Under paragraph (k) of the definition of "investment property," a derivative financial product is generally classified as part of the investment property of an entity. No explicit exception is provided for derivatives employed to hedge the risks of non-investment properties or business transactions that are undertaken in the ordinary course of an active business. As a result, the provision is overbroad. TEI recommends that paragraph (k) be revised, as follows:

   except where the derivative financial
   product can reasonably
   be determined to be related
   to the hedging, in whole
   or in part, of risks of the business,
   a derivative financial
   product (other than a commodity
   future to which the
   exception in paragraph (g)
   applies); or.... (Emphasis
   added to highlight the new
   language.)

Indeed, paragraphs (g) (relating to commodities and commodity futures), (j) (relating to currency), and (1) (relating to interests or options in respect of property described in paragraphs (a) to (k)) similarly lack explicit exceptions for property used in whole or in part to hedge other business property or transactions. Furthermore, the carve-out in paragraph (g) for exempt commodities should be expanded to encompass all commodity transactions related to the hedging, in whole or in part, of risks of the business. Finally, we reiterate our previous recommendation that the Department reconsider whether the definition of investment property should be revised so that fluctuations in the value of hedged property and the hedging item are treated symmetrically.

G. Qualifying Entity

The definition of "qualifying entity" is relevant for determining whether (1) a participating interest in an entity is an "exempt interest" and (2) certain property is "investment property." A "qualifying entity" is an entity all or substantially all of the carrying value of the property of which, throughout the period, is attributed to the carrying value of the following types of property:

* Properties other than investment property;

* Participating interests in or debts of other entities in which the entity has a significant interest (i.e., shares having at least 25 percent of the votes and value of the other entity) or a "strategic interest" (i.e., an interest that satisfies the conditions of clause 94.1(1)(b)(ii)(B) of the definition of qualifying entity), if the other entity is an entity whose principal business is not an investment business; or

* Investment property that is held by the particular entity and acquired within the preceding 36 months as a result of qualifying activities.

We question whether any minority shareholder will be able to obtain the necessary financial and other information in order to determine whether an entity is a qualifying entity. The challenge will be compounded when an entity has a participating interest in a second-tier company and the investor is attempting to ascertain whether the participating interest is a "significant interest" or whether the upper-tier entity exercises "significant influence" over the lower-tier entity. We reiterate the recommendation that the government provide a more efficacious definition of "qualifying entity" because few investors in non-investment businesses will be able to obtain the information necessary to satisfy the definition of a qualifying entity.

H. Significant Interest

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 a "significant interest" in an entity, "look through" rules apply to aggregate the lower-tier company assets 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 by TEI and others when the government announced the draft 1995 foreign affiliate proposals (i.e., adding the prescriptive rules that address the treatment of investment income) and also when the government announced modifications to section 17. In each case, the government was persuaded to revise the draft legislative provisions in order to accommodate incorporated joint ventures by adopting a 10-percent-of-votes-and-value test for foreign affiliates and for the arm's length exemption in subsection 17(3).

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 for the FIE and foreign affiliate regimes are additional evidence that the entire FIE legislation is not integrated with the foreign affiliate regime.

Rules of Application

A. Paragraphs 94.1(2) (a) and (b)--Consolidated and Non-Consolidated Financial Statements

These paragraphs will permit taxpayers to use consolidated financial statements for purposes of applying both the "prescribed rate of return" and the "mark-to-market" methods for non-resident entities. TEI welcomes the change from the previous draft legislation to permit taxpayers to employ consolidated financial statements. We note, however, that there may be incorrect cross references included in the explanatory notes, as follows:

* The first line of the second paragraph of the explanatory notes for paragraphs 94.1(2)(a) and (b) refers to paragraph 94.2(2)(a); we believe the reference should be to paragraph 94.1(2)(a).

* The second line of the fourth paragraph of the same note refers to paragraph 94.2(1)(a). Again, we believe the reference should be to paragraph 94.1(2)(a).

B. Paragraph 94.1(2)(d)--Participating Interests in a Non-Resident Entity (NRE) that are Exchangeable or Convertible

The interaction among the definition of "participating interest," the rule of application in paragraph 94.1(2)(d), and the imputed income inclusion provisions will potentially give rise to odd results. Draft paragraph 94.1(2)(d) is a deeming rule that states that, for purposes of applying sections 94.1 and 94.2, exchangeable or convertible participating interests (e.g., exchangeable or convertible debt or shares) in an FIE are deemed (a) to have been exchanged for or converted into the number and types of participating interests in the specified NRE for which the exchangeable or convertible participating interests of the particular NRE are exchangeable or convertible, and (b) except in applying paragraph 94.1(2)(d), not to exist at the particular time. In addition, each entity that holds an exchangeable or convertible participating interest in a particular NRE is deemed to have acquired the number and types of exchanged or converted participating interests in the specified NRE for which the exchangeable or convertible participating interests of the particular NRE are exchangeable or convertible.

The definition of "participating interest" refers not only to property that is "convertible into or exchangeable for," other property but also to property that "confers a right to acquire" other property. Regrettably, the last phrase--confers a right to acquire--is omitted from the deeming rules set forth above. As a result, there is confusion about whether an option or warrant will be deemed exercised under the deeming rule.

Under the October 11, 2002, draft of the legislation, paragraph 94.1(2)(d) has been expanded (in the preamble) to apply "for purposes of sections 94.1 and 94.2." The comparable provision in the August 2001 draft--paragraph 94.1(15)(d)--was much more limited in scope, its application limited to a determination of whether there was an FIE or exempt interest. TEI questions whether the expansion of the provision to encompass seemingly all purposes of sections 94.1 and 94.2 was intentional. If the expansion of the scope and application of the provision was not intended, we recommend that the Department narrow the scope of the provision. If the Department intended to expand the scope of the provision, we suggest that guidance is needed on the relevant "cost" of the property following the exchange or conversion for various purposes under the FIE rules, including investment property, income inclusion, etc. Consider an example where a Canadian resident or CFA invests in a warrant that enables the holder to acquire shares of a U.S. corporation that qualifies as an FIE. Assume the warrant was acquired for a nominal value, but carries a substantial exercise price. Under either the mark-to-market or prescribed-interest rate regimes there may be a significant income inclusion, but it is unclear how the cost of the investment property or the amount of the income inclusion would be determined.

C. Paragraph 94.1(2)(e)--Determining Whether the Principal Business Is an Investment Business

Please refer to the foregoing comments under the definition of "Foreign Investment Entity."

D. Paragraph 94.1(2)(f)--Widely Held and Actively Traded

Please refer to the foregoing comments under the definition of "Exempt Interest."

E. Paragraph 94.1(2)(h)--Entity Treated as a Controlled Foreign Affiliate

Where a taxpayer's interest in an FIE represents at least ten percent of the votes and value of the FIE, paragraph 94.1(2)(h) would permit a Canadian taxpayer to make an irrevocable election to treat a qualifying FIE as a CFA. For many taxpayers, making the election to treat an FIE as a CFA would ease the administrative burden of coping with these rules. Hence, TEI is pleased that the revised draft legislation maintains this election. The administrative relief the government intends to accord taxpayers, however, may be unduly circumscribed without additional changes and clarifications. Specifically, under paragraph 94.1(2)(i) a taxpayer's election to treat an FIE as a foreign affiliate will be rendered invalid unless the taxpayer can demonstrate to CCRA within 60 days of a written demand by the Minister that the FAPI income of the entity has been properly reported. Since few Canadian taxpayers will be able to obtain the information necessary to calculate FAPI income for non-controlled entities, most taxpayers will not be able to avail themselves of the CFA election. The relief intended to be provided by this subsection should be substantially broadened in order to be effective.

Document Requests Under Paragraphs 94.1(2)(e), (p), (q), and (r)

Under paragraphs 94.1(2)(e), (p), (q), and (r), the Minister may request certain additional information. If the taxpayer does not supply the information within 60 days of the request (or such longer period as determined by the Minister) or if the information is unsatisfactory to the Minister, the taxpayer is denied the benefit of certain rules. In addition, in any subsequent appeal of the Minister's decision, the taxpayer is seemingly permitted to rely only upon information previously submitted to the Minister.

TEI believes that the 60-day time frame to respond to a request from the Minister for additional information is insufficient. By definition, the taxpayer is not in control of an FIE and, thus, will likely be unable to obtain the documentation on demand. In the unusual case where information might be available, taxpayers should be accorded a reasonable period of time, which depends on all the facts and circumstances of the taxpayer's relationship to the entity, in order to produce the additional documents.

In addition, the provision denying the taxpayer the opportunity to provide supplementary information at a later date is punitive and should be reconsidered.

Finally, the provisions fail to prescribe (a) the contents of the Minister's notice of demand for information, (b) the conditions under which the Minister may demand supplemental information, (c) standards for determining the clarity, reasonableness, and relevance of the Minister's demand, and (d) a standard or process through which the taxpayer can establish that its response should be considered satisfactory to the Minister. In order to avoid arbitrary decisions and inconsistent treatment of taxpayers, TEI recommends that the scope and particulars of the Minister's demand for information be subject to a reasonableness requirement and a relevance standard. In addition, taxpayers should be accorded a right to judicial review of whether the Minister's demands are reasonable and relevant and whether the documents produced should be considered to satisfy the Minister's request for information.

Mark-to-Market--Additional Definitions--Readily Obtainable Fair Market Value

The definition of "readily obtainable fair market value" is relevant in determining whether a taxpayer may elect to apply the "mark-to-market" regime in respect of a participating interest in a non-resident entity. A "readily obtainable fair market value" of a particular interest in a non-resident entity will be considered to be available--

(a) where participating interests identical to the participating interests are widely held and actively traded (as determined under paragraph 94.1(2)(f)) and are listed on a prescribed stock exchange, or

(b) where identical participating interests have conditions attached that require either the non-resident entity or the holder of the interest to redeem or purchase the interest at a price equal to its fair market value. The redemption price must be a price that would have been acceptable to entities dealing at arm's length and the conditions must attach to the security "throughout the particular period." [Hereinafter, condition (b) is referred to as "the second condition."]

In respect of whether interests are widely held and actively traded, please see the concerns expressed above about paragraph 94.1(2)(f). In respect of the second condition, we have the following comments and questions:

* If the mirror-image put/call options described above were not included as part of an ownership interest that was issued prior to January 1, 2003, will the mark-to-market regime ever be available to the taxpayer? Alternatively, if participating interests issued prior to January 1, 2003, can be amended after that date in order to include the specified conditions, will the requirement that the conditions attach "throughout the particular period" be satisfied for the shares such that the mark-to-market regime will be available for the participating interests?

* Few, if any, corporations are likely to issue a security instrument or participating interest that satisfies the requisite conditions. Such provisions in a security instrument would wreak havoc with the corporation's debt-equity ratios because the holders can have their interests redeemed at any time. Moreover, such securities may cause a company to be in violation of its debt covenants.

* The second condition seems far too restrictive when applied to an FIE that is similar to a mutual fund trust or mutual fund corporation where the redemption price (either by the issuer or by the holder) is determined and payable by reference to the fair market value at pre-established periodic periods within the year (e.g., monthly or quarterly). We believe that entities whose securities fulfill this condition should qualify as having a "readily obtainable fair market value."

Since few, if any, corporations will actually issue an instrument that satisfies the second condition, the mark-to-market regime will likely be available only for participating interests in a non-resident entity that is widely held, actively traded, and listed on a prescribed stock exchange.

Subsection 94.2(9)--Tracked Property

If the principal business of an entity is an "exempt" business under subsection 94.1(4), the entity will not be treated as an FIE. Moreover, the assets related to an exempt business are excluded from "investment property" for purposes of the accrual regime. Under the tracked-property regime of subsection 94.2(9), however, assets related to an exempt business may still be considered "investment property." Although there may be a tax policy rationale for not automatically excluding an entity from the tracked-property regime even where the entity's principal business is an exempt business, it is unclear why the assets of an entity's exempt business should ever be included in investment property. An "exempt" business, by definition under the FIE provisions, is exempt; hence, it is unclear why the assets related to an exempt business should give rise to an income inclusion. In order to avoid unintended results, we recommend that the definition of "investment property" be revised by striking out the text of the parenthetical exception, as follows:

   "investment property," of a
   particular entity at any time,
   does not (except for the purpose
   of applying the definition
   "investment business" in
   this subsection [begin strikethrough] or definition
   "tracking entity" in sub-section
   94.2(1)[end strikethrough]) include exempt
   property of the particular
   entity, but does include
   property of the particular entity
   that is at that time....

Subsection 94.2(10)

Draft subsection 94.2(10) will apply where a taxpayer (other than an exempt taxpayer) holds, at any time in a particular taxation year, an interest in a "foreign insurance policy." For this purpose, a "foreign insurance policy" is one that is not issued in the course of carrying on business in Canada and the income from which is subject to tax under Part I of the Act. Where subsection 94.2(10) applies, new subsection 94.2(11) prescribes the treatment under section 94.2 of an interest in the foreign insurance policy.

In many foreign jurisdictions insurance policies are commonly used for, and are a generally accepted method of, providing funding for pre-and post-retirement employee benefit plans. When used in this fashion, the "foreign insurance policies" support the ongoing business operations and purposes of legitimate companies that are carrying on active businesses. Regrettably, the draft proposals accord the same tax treatment to all "foreign insurance policies" regardless of the policies' purposes. Thus, where foreign insurance policies owned by a CFA or foreign branch of a Canadian taxpayer are used to provide employee benefit programs and where such policies have an investment component, the draft proposals would subject the policies to the mark-to-market regime and subject the Canadian company to a competitive tax disadvantage vis-a-vis its foreign-based competition. The draft proposals are especially punitive to Canadian companies with U.S.-based CFAs or branches. Under United States tax law, neither the annual investment growth of the policy nor the policy proceeds is subject to tax. As a result, a U.S.-based company (or a U.S. company with a non-Canadian parent) would enjoy the beneficial U.S. tax treatment, but a CFA or foreign branch of a Canadian corporation located in the United States would be subject to an annual mark-to-market income inclusion and be taxed in Canada. Compared with U.S.-based competitors, the costs of funding employee benefit programs for CFAs or branches located in the United States would be higher by the amount of the additional tax on the policy income. We urge the Department of Finance to reconsider the competitive disadvantage the proposed tax treatment would impose on Canadian taxpayers.

Subsection 94.2(20)

Subsection 94.2(20) provides that, in certain circumstances, amounts subject to an income inclusion under subsection 94.2(4) in respect of a participating interest in a non-resident entity may be reported as capital gains and losses rather than as income from property. The subsection may be utilized when all or substantially all of the amount required to be added or deducted in computing the taxpayer's income relates to realized or unrealized capital gains or losses. We are concerned that investors with minority interests will not have access to the detailed level of information necessary to obtain the intended relief.

Section 94.3--Prevention of Double Taxation

Where a taxpayer has a foreign affiliate (FA) earning active business income that is distributed during the year, the amount of the distribution is subject to tax under both the FIE regime and the FA 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 an FIE and operating under the mark-to-market method, 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 for the dividend would be lost. This result appears to be unintended and should be corrected. In addition, if an FA is an FIE operating under the imputation regime, the benefit of the exempt surplus regime for the dividend will also be lost to the extent income is includible under the imputation regime. This result should also be addressed.

Double taxation of distributed income will also arise frequently from the interaction of the proposed FIE rules and section 17. Assume, for example, that a corporation is an FIE with active business income of $100 and such 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. On these facts, the tax consequences would seem, as follows:

The FIE income is $100 (the aggregate of the amount distributed and the increase in fair market value under the mark-to-market regime) plus some other amount includible under the accrual regime, unreduced by the $50 distribution that is assumed to be deductible in computing taxable income under section 113. (See the calculation prescribed in new draft section 94.3.) The section 90 income is eliminated by a section 113 deduction of $50. Finally, the section 17 income is $100 (pursuant to subsection 17(1), via subsections 17(2) and (3), with no offset available under subsection 17(1)).

TEI recommends that the Department of Finance amend the FIE provisions to eliminate the potential double taxation arising from the interaction of section 17 with the FIE provisions.

The double taxation of distributed income will likely be exacerbated by the potential for a third level of tax on a sale of the underlying investment in the non-resident entity. Specifically, under the FIE provisions, Canadian taxpayers will not be able to use the exempt surplus that otherwise would have accumulated in order to reduce the Canadian tax on the sale. Concededly, since the investment is marked to market on an annual basis, the gain on the sale in many cases will not be large; nonetheless, there will be exceptions and, more important, the result is inconsistent with the current foreign affiliate rules that permit the exempt surplus to be used to reduce the gain on disposition.

Finally, it is unclear how the 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 many unintended instances of double taxation will arise from the sheer complexity of the FIE and FA rules and their interaction with provisions in the Act governing such transactions.

Non-Resident Trusts

TEI continues to believe the proposed Non-Resident Trust (NRT) provisions are unworkable in their current form and should be withdrawn. In many cases, it is inconceivable that a Canadian taxpayer will have sufficient information to determine whether the NRT regime applies. In other cases, it is unlikely the Canadian taxpayer will have sufficient influence or control over the trust to ensure that the trust files Canadian tax returns or provides information to the beneficiary in order to file a return on its own behalf. Foreign trusts are used for many legitimate business purposes, but the draft legislation seems to treat all foreign trusts as illegitimate tax avoidance schemes. This discrimination against the trust form of business for foreign operations is also inconsistent with Canada's desire to attract foreign investment.

TEI's specific concerns with the NRT provisions are, as follows:

A. The Legislation is Overbroad

The proposed NRT provisions are highly detailed and overbroad. Hence, they unintentionally catch many transactions and taxpayers that are not engaged in tax avoidance transactions. An example is the definition of "restricted property" set forth in subsection 94(1), which is relevant to the definitions of "arm's length transfer" and "exempt foreign trust" as well as the operation of paragraph 94(2)(u). While complex, the term seemingly encompasses standard distress preference shares and any preference shares issued pursuant to an internal reorganization. These shares are, of course, held directly or indirectly by nearly all Canadian banks and many other listed Canadian companies. Comparable investment instruments are also issued and held by many foreign companies. Since the definition of restricted property includes any property the fair market value of which is derived, in whole or in part, directly or indirectly from restricted property, the shares of the companies holding such shares would also be tainted as "restricted property." Since these companies are, in turn, held by many investors--and form a part of most stock index investments--nearly all publicly traded stocks could be swept into the definition of restricted property.

Another example of the excessive breadth of the proposed legislation is the "employee benefit plan" (EBP) exception in the definition of an exempt foreign trust. To qualify for the EBP exception, numerous stringent conditions must be satisfied. For example, the prohibition against investing in restricted property may cause considerable difficulty since employer stock or a tracking stock is often included in the EBP.

Even assuming that the threshold definitional requirements for an exemption can be satisfied, the EBP's exempt status may be lost because of events beyond the control of the EBP trust. For example, assume a Canadian employer establishes an EBP for 100 of its offshore employees. Several of the employees are Canadian expatriates and at least one maintains Canadian residence. The plan is a three-year plan, is established for future services, and is intended to retain employees. All employees are awarded their interests in the EBP while working offshore. Fifteen months after the plan begins operations, one of the Canadian expatriates with Canadian residence accepts a job back in Canada. Under these facts, even though the Canadian resident will be taxed eventually on the payments in Canada, the single job transfer will disqualify the EBP trust's exempt status--possibly on a retroactive basis. The myriad facts and circumstances that could cause foreign EBP trusts to lose their exemptions are staggering.

B. Interaction with Sections 17 and 247

TEI expressed a number of concerns in our February and October 2001 submissions about the interaction of the proposed FIE and NRT provisions with sections 17 and 247. Regrettably, the concerns have not been addressed in the latest draft of the legislation. Indeed, since section 17 itself suffers from many of the same flaws as the FIE and NRT proposals, we believe the failure to address their interaction with section 17 poses a serious impediment to taxpayer compliance.

C. Conflicts with Treaty Provisions

The interaction of the NRT proposals with Canadian tax treaty provisions is, at best, unclear and, at worst, potentially violative of Canada's treaty obligations. Indeed, the proposed NRT provisions seemingly assert jurisdiction to tax some foreign trusts that treaty partners may view as resident in their respective countries. To the extent that the proposed NRT provisions undermine our treaty partners' legitimate expectations, the provisions may prove both counterproductive and injurious.

As important, the rate of tax to be applied under subsection 104(7.01) on distributions to non-Canadians remains improper. Using the 48-percent tax rate assumed in the example set forth in explanatory notes, the implied tax rate under subsection 104(7.01) would be 28.8 percent rather than the 25-percent withholding tax rate that would apply if a distribution were paid directly to a recipient and no treaty applied. For residents in a treaty country, the difference in the tax treatment with and without the application of the proposed NRT provisions may be even more pronounced. Specifically, in the explanatory notes to the proposed NRT provisions the tax rate applied to a distribution to a trust resident in a treaty country is 16.8 percent. Very few Canadian treaties, however, have a withholding tax rate in excess of 15 percent and some are as low as 10 percent or even 5 percent. Moreover, the implied 16.8 percent tax rate would apply even where the relevant treaty would exempt a direct payment from Canadian withholding tax. We urge the Department of Finance to revisit how the proposed NRT provisions will interact with Canada's tax treaties.

D. Arm's Length Transfer

We remain concerned about the definition of arm's length transfer set forth in the proposed NRT provisions and recommend that arm's length transfers per se be excluded from the reach of the proposed NRT legislation. In addition, we request the Department of Finance reconsider paragraph 94(1)(e), which states, in effect, that multiple agreements taken as a whole cannot be considered together for purposes of determining that the agreements are part of the same arm's length transaction. Loan and security agreements are frequently structured separately, but must be read and considered as a whole. Requiring each agreement to stand alone for purposes of testing whether it is an arm's length agreement is inconsistent with commercial practices. Multiple agreements are commonly used in order to improve the clarity of the drafting of 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 the transaction that is not subject to registration, a separate agreement may be used.

In addition, the latest draft of the NRT legislation excludes from the definition of "arm's length transfer" transactions in "restricted property." Thus, the proposed NRT provisions may apply to many commercial transactions, such as securities lending transactions, undertaken in the ordinary course of business between unrelated parties. We urge the Department to reconsider this result.

Clause 94(1)(b)(ii)(B) of the definition of arm's length transfer illustrates the challenge of complying with the rules as well as the odd results that can occur under reasonably common facts and circumstances. Assume that a corporation issues one million shares for $1 million and subsequently issues another million shares for $2 million. The stated capital per share overall is thus $1.50 per share. All the publicly issued shares are listed on a prescribed exchange and are widely traded. The corporation decides to reduce its stated capital by $1.25 per share and pays each shareholder accordingly. Assume a trust holds some shares. If the shares held in the trust can be traced back to the second issuance, the payment to the trust would be considered an arm's length transfer. If the shares held by the trust were traceable to the first offering, however, the transfer to the trust would not be considered to be at arm's length. This result is not only inequitable, but it is unlikely that the corporation could ever trace shares held by the trust, which likely have been purchased and sold hundreds or thousands of times, back to their original issuance. As a result, the corporation would never be able to determine whether the proposed NRT rules apply to the transfer to the trust.

E. Application to Foreign Businesses

TEI remains concerned that the proposed legislation fails to accord an exemption to taxpayers and their CFAs for transactions undertaken in the ordinary course of their offshore businesses with a non-resident trust. The lack of an "ordinary course of business" exception will place Canadian businesses at a competitive disadvantage when compared with local competitors that bear no compliance or administrative burden similar to that imposed by the non-resident trust provisions.

Requirement for Foreign Income or Profits Tax

In order to qualify as an "exempt foreign trust," paragraphs (d) and (g) of the definition of exempt foreign trust include a requirement that the foreign country impose an income or profits tax. As a result, non-resident trusts established for either charitable operations or employee benefit plans in countries that do not impose such taxes will not qualify as "exempt." In TEI's view, this seems inappropriate. Charities established and operating in countries that lack an income or profits tax are no less deserving of support simply because the jurisdictions in which they operate do not levy an income- or profits-based taxes. Similarly, employees working in countries that do not impose an income or profits tax are no less deserving of superannuation benefits that a qualified employee benefit plan trust would provide simply because the host country imposes no income- or profits-based tax. We recommend eliminating the proposed requirement that a foreign jurisdiction impose an income or profits tax.

Conclusion

Despite the many helpful changes that the government has incorporated in the revised draft of the FIE and NRT legislation, TEI believes, for the reasons noted above (especially those noted on page four), that the proposed legislation remains unworkable. Hence, TEI recommends that the government withdraw the proposed FIE and NRT legislation and, to the extent that specific abuses are identified, craft targeted solutions to address those transactions or investments that circumvent the current anti-avoidance rules.

TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments.

TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is Monika M. Siegmund. If you should have any questions about the submission, please do not hesitate to call Ms. Siegmund at 403.691.3210, or Glenn G. Wickerson, TEI's Vice President for Canadian Affairs, at 403.233.1135.