Income tax issues.

QUESTION

IV. Section 85 "Triangular Merger" with a Foreign Target Company

Canadian shareholders of an U.S. Company (Target) are unable to effect a tax-free rollover where a Canadian publicly held taxable corporation (Canco) acquires Target in certain transactions that permit U.S. shareholders of Target to obtain tax-free treatment. The steps in the transaction are, as follows. Canco incorporates Subco, an U.S. corporation. Subco merges with Target, also an U.S. company. Subco ceases to exist and Target, the same legal entity as existed before the merger, remains (New Targetco). All the issued and outstanding shares of Target owned by its shareholders before the merger are cancelled and converted to a right to receive shares of Canco. New Targetco issues common shares to Canco in consideration for Canco issuing its common shares to Targetco shareholders.

The purpose of structuring the acquisition in this fashion is to facilitate the acquisition of Target by Canco by means of a "triangular merger," which minimizes or even eliminates the U.S. tax effect for U.S. shareholders of Target. The outcome of the transaction is an acquisition of Target without a direct disposition to Canco of Target shareholders' shares. From the perspective of Target's shareholders, however, the transaction is equivalent to a direct share-for-share exchange, which is accorded tax-free rollover treatment under the Act. We believe that equivalent transactions should be taxed in a consistent fashion and, hence, recommend that the Department of Finance amend the Act to accord "triangular merger" transactions tax-free rollover treatment. We invite the Department's comments.

RESPONSE

Although there is no longer work currently underway on this issue, the Department of Finance may in the future review the treatment of Canadian shareholders in the context of a "triangular U.S. merger" with a view to determining what, if any, amendments should be made to the Act. Any proposed amendment allowing for rollover treatment to the Canadian shareholders of course would have to ensure, amongst other things, that all appropriate downward adjustments were made to Canco's adjusted cost base in its shares of Target to reflect any rollover to the Canadian shareholders.

QUESTION

XII. Part VI.1 Tax Creditable Against Part I and Part VI Tax

In reviewing the preferred shares legislation, we note what appears to be an inconsistency between the treatment of shareholders with a substantial interest (25-percent ownership) in the preferred-share dividend-paying corporation and the transfer of the Part VI.1 tax under subsection 191.3(1) where dividends are paid to a related party (i.e., a greater than 50-percent owner). Under the definition of "excluded shares," dividends paid to a shareholder with a substantial interest in the payer corporation are not subject to the Part VI.1 tax. The preferred shares rules also permit taxpayers to enter into agreements with related corporations for the assumption of the liability for the Part VI.1 tax on the dividends paid on taxable preferred shares.

Technically, a taxpayer may be able to organize its financing in a fashion that effectively transfers this tax to an unrelated corporation through a corporation with a substantial interest in the taxpayer. Specifically, corporation A can issue taxable preferred shares to corporation B, which holds a substantial interest in corporation A, and there would be no tax exigible on dividends paid in respect of these shares because they are excluded shares. Corporation B would then issue its own taxable preferred shares to a related subsidiary C, pay the Part VI.1 tax on dividends it pays, and enter into an agreement with one of its related corporations to transfer the Part VI.1 tax on these preferred shares. The result is as though corporation A transferred the tax directly to corporation C, the subsidiary of corporation B, an unrelated party that holds the substantial interest in corporation A.

In order to remove the inconsistency in the preferred shares rules, we recommend that the Act be amended to permit a taxpayer to enter into an agreement to transfer the tax on the dividends of a taxable preferred share to a corporation holding a substantial interest in the paying corporation or to a corporation related to the corporation holding the substantial interest. Such a change would also eliminate the tax trap that arises where, subsequent to a dividend payment, the taxpayer's ownership of the dividend-paying corporation subsequently falls below the 50-percent ownership threshold. In that situation, the transfer of the Part VI.1 tax to a related party is not permitted.

RESPONSE

The Department's representative noted that under the current law, while it might be technically possible to effect the transaction described, GAAR could be applicable. The fact that it may be possible to reach a particular result by an indirect route does not necessarily imply that the Act ought to provide a direct route.

Nonetheless, the Department is willing to consider the possibility of changing the required relationship for transfers of Part VI.1 liability. The preferred share tax effectively is only payable by issuers that are in a loss position or otherwise not paying Part I tax. The transfer of that tax liability to a person who can use it to offset Part I tax is thus a type of loss transfer. In the past, the Act has based some of its rules with respect to loss transfers on the related test - an example being the rules relating to acquisition of control. The amendment to subsection 69(11) in the last technical bill, however, represented a shift toward the affiliated person standard in this respect. Given that shift, the Department is willing to consider whether it may be appropriate to change the threshold for transferring Part VI.1 liability to the affiliated standard.

In some cases, the affiliated standard would be broader than the related standard, since it is based on control in fact rather than control in law. In other circumstances, it would be more restrictive, since it encompasses a more limited group of individuals.

QUESTION

XIV. Contingent Interest

In Barbican Properties, 97 DTC 5008, interest at a stipulated rate accruing daily but deferred for a period of time was determined to be non-deductible in the year of accrual owing to a contingency stipulated in the financing agreement. Moreover, since interest expense must be claimed as a deduction in the year during which it accrues on a day-to-day basis, the interest was determined to be non-deductible in the year paid.

The Barbican decision stands as a harsh reminder of the Act's anachronistic provisions in respect of the treatment of legitimate financing expenses (interest in this case) that arise from common commercial practices. Moreover, the Department of Finance has been reticent to address the rules governing the deductibility of interest in a comprehensive fashion because of the complex, interrelated issues that must be considered. Common financing techniques similar to that employed in Barbican, however, can easily be addressed by amending paragraph 20(1)(c) to read, as follows: "... an amount paid in the year or payable in respect of the year or of a prior year...." We recommend that the Department consider our proposal and modify the Act to better reflect commercial practices. We invite the Department's comments.

RESPONSE

The Department is of the view that for taxpayers who use accrual accounting, deduction in the year of accrual is the proper norm. The suggested amendment would dispense with that principle and effectively allow taxpayers the option of deducting interest in the year in which it is accrued or any future year. The goal of achieving a true picture of the taxpayer's income would not be served by such an open-ended rule.

The complexity with the current system is that it potentially requires that contingent interest be claimed in respect of a year only at a later date once it is no longer contingent. The Department will consult with Revenue Canada as to their practice on accepting re-filings for past years for this purpose. Re-filing would not be possible if the year of accrual had become statute-barred. However, a taxpayer with an interest liability for a year that is still contingent at the time when the year is about to become statute-barred could file a waiver to keep the year open.

The Department's representative indicated that if tax-payers have encountered problems with this type of situation in practice, the Department would like to receive details.

QUESTION

XVII. Rollover Treatment on Foreign-Currency Debt

When a taxpayer purchases a capital asset (e.g., shares of a foreign affiliate) denominated in a foreign currency, a debt instrument with a shorter duration than the expected life of the asset is frequently incurred to finance the asset's acquisition. In addition, the debt financing is generally incurred in the foreign currency of the country where the asset is purchased in order to maintain a so-called passive hedge. Under a passive hedge, fluctuations in the value of an asset arising from foreign-exchange movements are offset, in whole or in part, by changes in the value of the foreign-currency denominated debt used to finance the asset's purchase. Upon maturity of the original acquisition debt, the taxpayer will be compelled to renew its financing in the same currency in order to maintain the same net foreign-currency risk exposure. Under current rules, the taxpayer will realize a foreign-exchange gain or loss upon maturity of the debt. That gain, however, is matched with a corresponding, but unrealized, loss or gain on the asset. This is highly undesirable for tax and financial-reporting purposes.

Subsection 51.1 of the Act affords rollover treatment to a debt holder under certain circumstances, but there is no equivalent treatment for a taxpayer in the situation described above. Would the Department consider amending the Act to permit rollover treatment on foreign-currency denominated debt at maturity of the debt to the extent that the replacement debt is of the same or higher dollar value and in the same currency as the maturing debt? TEI's proposal would be limited to debt incurred to finance the acquisition of capital assets.

The rationale underlying the question is that, to the extent a taxpayer simply replaces a debt instrument, there is no economic benefit derived by the taxpayer. For example:

                                              Canadian $
Debt Characteristics             US $         Equivalent
Face Value at Issuance in US$    100          133
Redemption Value                -100          (154) loss of 21
Re-issued US$ Debt               100          154

RESPONSE

Such a rollover would make it possible for a taxpayer to recognize the taxpayer's accrued foreign exchange losses while deferring the recognition of the taxpayer's accrued foreign exchange gains.

Detailed rules should be introduced that would require foreign exchange gains and losses, on both assets and liabilities, to be recognized on an accrual basis. An extensive review and analysis of the area will have to be undertaken to develop a comprehensive and consistent system.

QUESTION

XIX. Deductions at Source

Regulation 100(3) provides that certain contributions (including contributions to a Registered Retirement Savings Plan (RRSP)) withheld from an employee's pay must be deducted when calculating the amount of the employee's income tax withholding. In connection with "regular" or periodic employee remuneration, this provision applies regardless of the amount of remuneration or contributions. According to new Regulation 100(3.2), which came into force on October 29, 1997, Regulation 100(3) does not apply to remuneration that is a:

* retiring allowance in excess of the amount transferred to a RRSP under subparagraph 60 (j.1)(ii);

* lump sum payment;

* bonus; or

* retroactive payment

and the payment of remuneration exceeds $10,000.

Situations

Income                   A                   B               C
Regular Salary         10,000               --              --
Bonus                      --            10,000          10,001
Contributions          10,000            10,000             100

Calculation of net remuneration for purposes of deductions at source

                            A                B               C
Income                   10,000           10,000          10,001
Contributions           (10,000)         (10,000)             --
Net Remuneration             --              --           10,001

In order to avoid unintended results (such as in situation C above), as well as limit the potential for a significant increase in the number of requests to reduce withholding under subsection 153(1.1), would the Department consider amending Regulation 100(3.2) by adding a condition that the contributions exceed $10,000?

RESPONSE

Revenue Canada, in a letter to the Department of Finance, (a copy attached which was provided to TEI) stated that they were discussing possible revisions to the Regulation with Client Services Directorate and Legislative Policy Division to address this issue. They also suggested the following answer to TEI's question: "The Department is aware of the issue concerning the application of paragraph 100(3)(c) and subsection 100(3.2) of the Regulations and, in response to concerns from employers and employees, amendments to the Regulation are being considered.

Tax Executives Institute's 1999 Canadian Tax Course

TEI's 1999 Canadian Tax Course, held September 19-24 at the Metropolian Hotel in Toronto, drew nearly 50 students from both above and below the border eager to hear the latest on Canadian tax issues. The program was sponsored by TEI's Canadian Income Tax Committee, led by 1998-1999 chair John Allinotte of Dofasco, Inc., and Canadian Commodity Tax Committee, led by 1998-1999 chair Munir Suleman. Pierre Bocti of Hewlett-Packard Canada, Ltd., TEI's 1998-1999 Vice President for Canadian Affairs, served as chair of the tax course.