Legislative proposals and draft income tax regulations relating to the treatment of foreign affiliates December 6, 2004.

On behalf of Tax Executives Institute (TEI), I am writing to express TEI's concerns about proposed technical amendments to the Income Tax Act (hereinafter "the ITA" or "the Act") and Income Tax Regulations that would substantially revise the treatment of foreign affiliates. The technical amendments are part of the Legislative Proposals and Draft Income Tax Regulations released by the Department of Finance on February 27, 2004 (hereinafter "the technical bill").

Background

Tax Executives Institute is the preeminent international association of business tax executives. The Institute's 5,400 professionals manage the tax affairs of 2,800 of the leading companies in Canada, the United States, and Europe. 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, and must contend daily with the planning and compliance aspects of Canada's business tax laws. 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, 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

The 400-plus page draft technical bill released in February 2004 affects numerous provisions in the Act and Income Tax Regulations. Many provisions are uncontroversial and were previously released in the December 2002 draft technical bill. For the most part, the technical bill will bring much-needed clarity and certainty of tax treatment for taxpayers and Canada Revenue Agency (CRA) alike thereby minimizing unnecessary disputes. We commend the Department for drafting the comprehensive bill and for affording taxpayers many ameliorative changes as well as beneficial transition rules.

In some areas, however, the technical bill goes far beyond effecting technical amendments and addresses real or perceived policy issues. Although TEI supports many of the proposed policy changes set forth in the bill, a number of provisions--especially those in Part 2 relating to the foreign affiliate regime--are overbroad, unnecessarily complex, and impose undue compliance burdens on taxpayers. We believe the foreign affiliate provisions would benefit from additional consultations, especially since many provisions have been significantly modified from the December 2002 draft technical amendments or are completely new.

In crafting a policy for taxation of foreign affiliates and investments, developed countries choose among policy options ranging from a territorial system of taxation (which, in turn, can range from direct exemptions for various types of income to indirect participation exemptions) to more complex foreign tax credit regimes supplemented by income and expense allocation rules. Historically, Canada has followed a middle path by adopting a foreign tax credit mechanism for a limited number of specified foreign investments and taxing the balance of foreign investments on the capital gains realized in excess of book value (i.e., including the exempt surplus).

Although some commenters have suggested that adoption of a purely territorial system for taxing foreign investments would enhance Canada's international trading status, TEI believes that the current system for taxing foreign investments has proven generally administrable and balances numerous fiscal and economic policy objectives, including taxpayers' compliance burdens. Indeed, a significant advantage of the current system is that operating businesses outside of Canada owned by Canadian resident shareholders can carry on their day-to-day business affairs on a level playing field with their host-country competitors. We regret that the proposed changes to the foreign affiliate regime would undermine that advantage by imposing a new tax burden or layering an additional set of labyrinthine compliance rules on an already complex regime. Either burden would effectively deter additional foreign investments by Canadian companies.

Moreover, if the technical bill's changes are adopted together with the proposed legislation for Foreign Investment Entities and Non-Resident Trusts, the complexity of Canada's system of taxing foreign investments would escalate exponentially. The adoption of either or both bills would impair the objective of promoting the global competitiveness. We urge the Department of Finance to heed a cautionary note sounded by the former U.S. Assistant Treasury Secretary for Tax Policy who said, in respect of the U.S. system:

   Viewed from the vantage
   point of an increasingly
   global marketplace, our
   tax rules appear outmoded,
   at best, and punitive of
   U.S. economic interests, at
   worst. Most other developed
   countries of the world are
   concerned with setting a
   competitiveness policy that
   permits their workers to benefit
   from gloBalization....
   [O]ur international tax policy
   seems to have been based on
   the principle that if we have
   a competitive advantage, we
   should tax it!

Thus, we encourage the Department to consider whether there are simpler means to address the government's concerns. A voluntary self-assessment system is not well served where the rules become so complex that taxpayers cannot reasonably comply or where a tax is triggered by technical "foot faults."

In addition to ongoing consultations on the substantive policy and technical issues identified below, the Department should expand the technical notes and elaborate on the underlying policy framework of many of the provisions. Given the complexity of the rules, more "real world" examples should be included in order to illustrate commonplace, but factually complex situations. For example, the current draft of the explanatory notes generally assumes that foreign affiliates have only a single class of shares outstanding. When applying the draft legislation to the simple fact patterns presented in the examples, the tax results are clear and simple. Where the facts are more complex, e.g., where multiple classes of shareholdings exist, the draft rules become far more ambiguous and challenging. We recommend that the explanatory notes include many more examples to illustrate the application of various provisions to more complex foreign affiliate capital structures.

Our comments below address specific provisions in the technical bill but, given the scope and complexity of the foreign affiliate regime as well the interaction of the draft provisions with the Act as a whole, our analysis remains ongoing.

Section 42

Section 42 of the Act provides rules governing warranties, covenants, and other conditional or contingent obligations given by a taxpayer in respect of the disposition of properties. The revisions to section 42 in the draft technical bill helpfully clarify the treatment of proceeds paid or received upon a disposition of property where the amount is paid or received subsequent to the year of disposition of the underlying property.

From a conceptual standpoint, it is unclear why the proposed amendment is included among the revisions to the foreign affiliate rules in Part 2 of the technical bill rather than with the general revisions in Part 1. TEI recommends that the Department include this proposed change in Part 1. If the Department believes that that provision should be incorporated in the foreign affiliate revisions, TEI encourages the Department to explain the connection between the provision and the foreign affiliate rules.

In order to obtain the benefit of the revision to section 42, taxpayers are required to hold their tax returns for the year of disposition open until the filing due date for the year in which the additional proceeds are paid or received. Where a tax attribute might be carried back, a taxpayer may wish to file its return for the year of disposition of the property well before the due date of a subsequent year's return. TEI recommends that taxpayers be permitted to elect to report all amounts subject to section 42 in the year that the amount subject to section 42 becomes receivable or payable. Such an election would permit taxpayers to file their returns without risk of under- or over-reporting income for the taxation year of the disposition of the property.

Restrictive Covenants

The Department has expressed concern that amounts received in respect of restrictive covenants are not being subjected to tax even though such amounts are effectively proceeds of a disposition. TEI agrees that the Department's concerns warrant modifications to the Act, but the draft changes are overbroad, especially where the correlative draft amendment to section 68 applies, because the new provisions might apply to items that are neither income nor capital gains. For example, the definition of restrictive covenant would seemingly apply to the standard negative covenants in commercial loan documents. We believe the Department's objectives can be achieved and the definition narrowed by adding the phrase "related to the disposition of an eligible interest" after the phrase "whether legally enforceable or not" in section 56.4. Correlative changes should also be made to other draft provisions (e.g., subsection 6(3.1)) as well.

More broadly, we recommend that the Department limit the application of the restrictive covenant provisions in section 56.4 to cases where the consideration is expressly allocated to such covenants in a purchase-and-sale agreement. In addition, where the revised restrictive covenant regime applies, section 68 should be inapplicable. Finally, sections 56.4(3)(b) and 56.4(3)(c)(v) afford buyers and sellers joint elections in respect of the proper manner for allocating and reporting amounts paid for restrictive covenants given in connection with the disposition of property. The joint election procedures, however, would seemingly not be available where either party to the transaction is a nonresident. We do not believe this restriction is warranted and urge the Department to reconsider.

Interests in Trusts Held on Income Account

The technical bill would modify the treatment of capital gain distributions to holders of trust interests where the interests are held on income account. Specifically, such distributions would be taxed as ordinary income rather than capital gains. In addition, the bill includes a provision requiring some trust unit holders to effectively "claw back" and report as ordinary income some or all of the capital gains received and reported in previous taxation years --potentially as far back as 1972. The "clawback" provision would not apply to taxpayers that sold their trust units prior to the date of the provision's announcement.

Although changing the treatment of capital gain distributions to trust interests held on income account is justifiable on a prospective basis, the provision clawing back and recharacterizing as ordinary income in a post-enactment tax year amounts properly reported as capital gains in years prior to the technical bill's release is indefensible. Many groups, including TEI, have criticized the government for using retroactive legislation where such action is unwarranted. In 1995, the government released the Comprehensive Response of the Government of Canada to the Seventh Report of the Standing Committee on Public Accounts articulating its criteria for retroactive legislation. Although the criteria set forth in the Response are overbroad, the proposed clawback provision fails to satisfy even those criteria. We urge the Department to revise the legislation to not recharacterize or recapture capital gains distributions received prior to the date of announcement.

Section 17

Section 17 of the Act governs loans from a corporation resident in Canada to a non-resident. Where the loan is outstanding for more than a year and the resident corporation has not included interest from the loan in income, subsection 17(1) treats the corporation as having received interest on that amount, computed at a prescribed rate, at the end of each taxation year during which the amount is outstanding. Subsection 17(8) provides an exception for certain amounts. Draft subsections 17(8.1) and (8.2) of the technical bill would extend the subsection 17(8) exception to circumstances where:

i. The controlled foreign affiliate of the particular corporation resident in Canada has borrowed money ("new borrowings") from the particular corporation to repay previous borrowings from any person, provided

--the previous borrowings became owing after the last time that the affiliate became a foreign affiliate of the particular corporation, and

--the previous borrowings have at all times been used for a purpose described in subparagraph 17(8)(a)(i) or (ii), or

ii. the new borrowing is used to repay an amount owing by the affiliate in respect of the unpaid purchase price for property acquired after the last time that the affiliate became a foreign affiliate of the particular corporation, and certain other conditions are met.

It is unclear why the exceptions in the technical bill are limited to money borrowed or property acquired while the affiliate is a controlled affiliate of the "particular" corporation. TEI believes that qualifying loans should be exempt from subsection 17(1) irrespective of whether the previous borrowing arose prior to the corporation's becoming an affiliate of a particular Canadian taxpayer. We urge the Department to reconsider the scope of the draft exceptions.

Global Section 95 Elections

The technical bill would make a host of revisions to section 95 of the Act and Regulation 5907. The revisions have varying effective dates that apply to taxation years, of a taxpayer's foreign affiliates, that begin or end after various specified dates. If a taxpayer files an election (referred to in the explanatory notes as the "Global Section 95 Election") with the Minister of National Revenue before the taxpayer's filing due date for the taxation year that includes the day on which the draft amendments receive Royal Assent, the amendments will apply retroactively to all taxation years beginning after 1994 for all of the taxpayer's foreign affiliates. If the election is made, and notwithstanding subsections 152(4) and (5) of the Act (relating to statutes of limitation for assessments), the Minister of National Revenue can make any assessment of a taxpayer's tax, interest, and penalties payable under the Act for any taxation year in order to take the election into account.

The technical bill also provides for revocation of the Global Section 95 Election. Thus, where a taxpayer makes a valid Global Section 95 Election and subsequently files a notice with the Minister of National Revenue (on or before the taxpayer's filing due date for the taxpayer's taxation year that includes the day that is the third anniversary of the day on which the amending legislation enacting the bill is assented to) to revoke the election, the election is deemed never to have been made.

TEI has a number of comments and concerns about the Global Section 95 Election.

"All or Nothing" Approach. The February 2004 draft technical bill maintains the "all or nothing" approach to the Global Section 95 Election set forth in the December 2002 draft. Hence, if made, the election must apply to all foreign affiliates and all taxation years. Moreover, because of the constraints of the election, taxpayers will be unable to benefit from the relief afforded in comfort letters issued by the Department over the past several years.

The "all or nothing" approach to the Global Section 95 Election is regrettable. Because the Global Section 95 Election encompasses far too many provisions, it will be extremely challenging and time consuming for taxpayers to ascertain whether the benefits of the election outweigh its costs. In addition, since the draft legislation is still evolving, it would be unproductive for taxpayers to undertake to determine whether the election is beneficial prior to its final adoption. Hence, the time available to analyze the election will be brief, especially if the legislation receives Royal Assent late during a taxpayer's taxation year. Moreover, for many taxpayers, the need to study the legislation's effects will coincide with their heaviest workload during which the corporate tax returns are prepared.

In addition, the definition of a controlled foreign affiliate was expanded in recent years to include foreign affiliates controlled by five or fewer unrelated Canadian residents. As a result, a taxpayer can easily own a minority interest in a foreign affiliate but still be considered part of the group of controlling shareholders. Lacking effective control over such an entity, a taxpayer may be unable to obtain sufficient information to determine whether the foreign affiliate (1) is a controlled foreign affiliate, (2) is subject to the election, or (3) participates in transactions with tax consequences to the taxpayer (e.g., by dealing with other entities that would be deemed to be on a non-arm's length basis). Since the Global Section 95 Election covers all foreign affiliates, even those over which a taxpayer has little or no effective control, a taxpayer may discover--after the period for the election's rescission ends--a controlled foreign affiliate that is covered by the Global Section 95 Election. The discovery of the previously unknown controlled foreign affiliate may expose the taxpayer to reassessments of tax, interest, or penalties. Moreover, if the time for rescinding the Global Section 95 Election has passed, the taxpayer may be unable to revoke an election that it might not have otherwise made had it been aware of the affiliate's status.

Rescission and Rescission Period. We commend the Department for providing taxpayers with a right to rescind a Global Section 95 Election. As drafted, a taxpayer's right to rescind the election will expire three years from the date of Royal Assent for the legislation. Rather than adopt an artificial date for such an important action, TEI recommends that taxpayers be permitted to revoke the Global Section 95 Election within three taxation years of the date the election was first due. TEI's recommended approach would better align taxpayers' tax return and election filing deadlines, the beginning and end of the election's rescission period, and CRA's reassessment period.

Statute of Limitations and CRA Assessments. Where a taxpayer makes the Global Section 95 Election, statute-barred years will be open to assessment or reassessment by CRA. Although the taxpayer must accept this risk as a condition for making the election, the statute imposes no time limit on CRA's review of the taxpayer's election or the previously statute-barred years. In contrast, taxpayers have a very limited time (perhaps as little as six months) within which to determine whether the Global Section 95 Election is beneficial. More important, if CRA does not timely review the election or the statute-barred years and makes taxpayer-adverse determinations or assessments beyond the end of the taxpayer's three-year period for rescinding the election, the taxpayer may be irreparably harmed by its election and CRA's untimely review. TEI recommends that the bill set a time limit on CRA's review of the taxpayer's Global Section 95 Election as well as the previously statute-barred years that are opened by the election. Just as taxpayers have only three years within which to rescind their elections, we recommend that the Department of Finance adopt a three-year limitation period for CRA's assessment or reassessment of taxation years affected by the Global Section 95 Election. The Act currently incorporates a similar approach with respect to the time limit for reassessments following a loss carryback.

Definitions--Subsection 95(1)

A. Investment Business

In the real estate development and natural resource industries, separate entities are frequently established to hold legal ownership of individual projects. In addition, another entity within a corporate group may provide financing while others employ the personnel that perform the operating activities for the business group. The legal entity structure is created in order to limit the assets at risk to those specific to each project.

In Technical Interpretation 2000-0044387 (October 26, 2000), CRA said that, in the real estate development industry, the "mother ship" operating entity carried on an active management service business and the income that it derived from management fees charged to the development entities would qualify as income from an active business for purposes of subsection 95(1) of the Act. The interpretation added that paragraph 95(2)(a) would not apply to the individual development entities unless it could be established that each development entity employed the equivalent of more than five full-time employees in the active conduct of its business throughout the period in question, taking into consideration the services provided by the employees of the "mother ship" company. In effect, CRA refused to consider the group's operations as a single, integrated business carried on by multiple entities. Technical Interpretation 1999-9622545 (September 2, 1999) reached a similar conclusion in respect of the operating entity structure of a taxpayer in the natural resource industry.

CRA's interpretations put Canadian multinational corporations in certain industries at a competitive disadvantage vis-a-vis local country competitors because of the adverse Canadian income tax consequences from using an organization structure that is standard in non-Canadian jurisdictions. TEI recommends that the Department consider developing an amendment that would permit taxpayers to aggregate the employees of related affiliates (or partnerships of related affiliates that are qualifying members) where the entities are actively engaged in the conduct of similar businesses. In addition, there should be no restriction on the identity of the employer for purposes of determining the "equivalent to more than five full-time employee" test within a group of related affiliates (or partnerships of which related affiliates are qualifying members) that are actively engaged in the conduct of a similar businesses. Adoption of TEI's recommendations would enhance the competitiveness of the affected industries.

B. Controlled Foreign Affiliate

Under paragraph (c) of the current definition of controlled foreign affiliate, any five Canadians with sufficient voting power can be deemed a control group even though they may be unaware of one another's existence or ownership. The draft technical bill would expand this rule and apply the deemed control provision to even more facts and circumstances.

TEI objects to the expansion of this provision. Simply because shareholders are all from the same country they do not necessarily share a common interest that compels them to act in concert in order to obtain the information necessary to comply with the Act. This is especially the case in respect of public companies where most shareholders do not know the identity of other shareholders. The application of this provision will be especially difficult where one Canadian shareholder holds a large minority shareholding in a company. Depending on the number of other shareholders, the foreign affiliate may drift in and out of controlled foreign affiliate status. The draft amendment compounds the problem inherent in the current statutory regime because it expects unrelated shareholders to know whether all persons are dealing with one another at arm's length. Thus, taxpayers may inadvertently fail to comply with the Act simply because they do not know, and cannot obtain information about, the residence of, and relationships among, other interest holders.

C. Entity

The definition of "entity" in the technical bill includes a "fund," but there is no definition of what constitutes a fund. TEI urges the Department to provide guidance on the nature of a fund.

D. Excluded Property

The explanatory notes state that paragraph (b) is being amended to clarify that shares will qualify as excluded property only if all or substantially all of the fair market value of the property of the other foreign affiliate is attributable to property of the other affiliate that is excluded property. The current definition refers to "all or substantially all" the property and does not include a reference to fair market value. Does the technical bill's "clarification," in effect, impose a requirement that shareholders obtain annual valuations of their foreign affiliate investments? This would be extremely burdensome.

E. Foreign Accrual Property Income (Description of B)

Under the technical bill, the definition of Foreign Accrual Property Income (FAPI) will be amended to include capital gains arising from "dispositions of excluded property to which any of paragraphs (2)(c), (c.2), (d), (d.1), (e), (e.3) to (e.5) and (f.4) and 88(3)(a) applies." The intent of the provision is to subject gains from excluded property that is part of a reorganization transaction and that is not rolled over to a FAPI inclusion. The description, however, is ambiguous and arguably treats all subsequent gains on ordinary business transactions involving the rolled-over property as potentially giving rise to a FAPI inclusion. We do not believe that result is intended and recommend that the provision be clarified to state that future gains on property that has previously been subject to these paragraphs do not give rise to FAPI. The determination of the FAPI inclusion should be tested at the time of the reorganization transaction; subsequent events or transactions involving the property should not be relevant under the above cited paragraphs.

Subsection 93(2)

Subsection 93(2) of the Act provides rules for the purpose of determining the loss of a corporation resident in Canada from the disposition of a share of a foreign affiliate of the corporation or the loss of a foreign affiliate of the corporation from a disposition of a share of the capital stock of another foreign affiliate of the corporation that is not excluded property to the foreign affiliate that disposed of the share. In previous submissions and liaison meetings, TEI has urged the Department to propose repealing this subsection. The Department has declined because it believes the subsection addresses potential abuses. TEI invites a discussion of the Department's concerns and the potential abuses that this provision is intended to address. TEI believes a more targeted provision than the current proposal would effectively address those concerns.

Even though we believe the best solution is to repeal or significantly narrow subsection 93(2), TEI welcomes the proposed modifications to exclude foreign currency fluctuations from the calculation, at least insofar as the items are hedged on a taxable basis in Canada. Regrettably, the relief afforded by the proposed provisions is not expansive enough to address a number of situations in which relief is warranted. Specific comments are, as follows:

* Foreign exchange gains on income account: Proposed subparagraph (b)(i) in the description of D in subsection 93(2) is too restrictive because it applies to losses on income and capital account but does not apply to gains on income account. This restriction would discriminate against Canadian financial institutions, among other taxpayers, because they hedge their foreign affiliate investments with foreign currency deposits. (Foreign exchange gains on such deposits are taxed on income account pursuant to an administrative agreement between CRA and the Canadian Bankers Association). The restriction would also be inconsistent with proposed subparagraph (b)(ii), as well as recent amendments to subparagraphs 95(2)(a)(v) and (vi) and paragraphs 95(2)(d.1), (e.1), and (g), which address income account items as well as capital account items. Thus, TEI believes the scope of subparagraph (b)(i) should be expanded to include income account gains. The statutory language could be similar to paragraph 95(2)(g).

* Foreign exchange gains earned or realized in prior years: Subparagraph (b)(i) applies only to foreign exchange gains realized in the year in which foreign affiliate shares are disposed of. This proposal is too restrictive because it does not address the foreign exchange gains realized by the taxpayer in years preceding the year of disposition. For example, where a Canadian corporation provides debt financing to foreign affiliates and the debt is renewed periodically, the offsetting foreign exchange gain would be included in income in a prior taxation year. In other cases, a company may hedge foreign affiliate investments with a series of hedging instruments that will almost always mature prior to the disposition of the foreign affiliate shares. Moreover, restricting subparagraph (b)(i) to current year gains is inconsistent with proposed subparagraph (b)(ii), which encompasses prior-year gains in respect of other hedging arrangements. In addition, the subparagraph (b)(i) restriction creates an unfair asymmetry between the description of D and the existing description of B because B includes all exempt dividends and is not limited to the amount of the exempt dividends in the year of disposition. TEI recommends expanding the scope of subparagraph (b)(i) to include any gains earned or realized before the disposition (i.e., use the same statutory language as in the description of B in subsection 93(2)). In addition, TEI urges the Department to remove the phrase "for the taxation year that includes that time" from subparagraph (b)(i).

* Foreign exchange gains earned or realized by related entities: Paragraph (b) applies solely to the foreign affiliate or to the gains realized by the corporation that owns the foreign affiliate shares. TEI believes this proposal is also too restrictive because it does not encompass the gains earned or realized by members of the related group. Thus, the provision discriminates against taxpayers that centralize their hedging activities in a separate entity that does not own foreign affiliate shares. As in the preceding comment, the restriction also creates an unfair asymmetry between the description of D and the existing description of B, because B includes exempt dividends received by related corporations. The scope of subparagraph (b)(i) should be broadened in order to include hedging gains earned or realized by related entities. The Department could employ the same language as that in the existing description of B.

* Linkage requirement: Paragraph (b) applies only to foreign-exchange gains on debts, shares, and other agreements that can reasonably be considered to have been incurred, issued, entered into, or acquired in relation to or in connection with the foreign affiliate share. This proposal is too restrictive because it fails to include pre-existing liabilities and other foreign-exchange positions that are frequently used to hedge foreign-affiliate shares. Sophisticated taxpayers often employ a consolidated hedging strategy whereby new hedging instruments are entered into only when the consolidated position creates a net exposure to a particular currency. Consider a simple example where a corporation incurs a US$100 liability on January 1 and hedges the debt with a forward purchase of US$100. If the corporation makes a US$100 investment in a foreign affiliate on June 1, the most pragmatic hedging approach would be to close the forward purchase and use the pre-existing "short" position created by the liability to offset the "long" position in the foreign affiliate investment. The 2004 proposal, however, would require the corporation to leave the forward purchase in place and enter into a separate forward sale of US$100 on June 1 in order to satisfy the "entered into or acquired" requirement. This approach significantly increases taxpayers' trading commissions, accounting complexity, credit risks, and operational risks. We do not believe this is the intended result and encourage the Department to expand the scope of the provisions by adopting a more flexible linkage between the hedge and the hedged asset or liability.

* Imperfect hedges: Subparagraph (b) applies only to gains on agreements acquired or entered into for the principal purpose of "hedging the foreign exchange exposure." It is unclear whether this would cover gains from agreements that create an imperfect or partial hedge of a taxpayer's foreign exchange exposure. A partial hedge has exactly the same economic consequences as a complete hedge, except to a lesser degree, and thus should be afforded the same tax treatment for subsection 93(2) purposes. We suggest that the language used in the description of D be incorporated in the definition of "hedge" in subsection 20.3(1), thereby including gains on arrangements that reduce the foreign exchange exposure through a partial hedge.

* Definition of foreign exchange hedges: Subparagraph (b)(ii) applies only to gains from an agreement "that provides for the purchase, sale or exchange of currency." The scope of these provisions should be expanded to include other hedging arrangements that may not require the purchase, sale, or exchange of currency (e.g., a "net-cash settled" derivative contract that requires a single payment depending upon the relative movement of the underlying reference rates). We recommend that the language in subparagraph (b)(ii) be conformed with that currently in paragraphs 95(2.1)(b) and 95(2.5)(a) of the Act.

* Loss-Limitation Formula. The revisions to the loss-limitation formula are seemingly intended to allow recognition of losses but only to the extent that related foreign currency gains were subject to tax. The formula, however, does not achieve its objective where dividends received are in excess of the loss and the foreign currency gain.

Paragraph 95(2)(a)

The technical bill expands the scope of the provisions governing the characterization of income and helpfully clarifies many rules, especially those governing related foreign affiliates where the taxpayer does not hold a "qualifying interest." In addition, the change in clause 95(2)(a)(ii)(D) eliminating the requirement that affiliates be part of a consolidated group is a significant improvement. Regrettably, though, the same country restriction has been retained. TEI urges the Department to consider relaxing the same country restriction, especially for areas governed by free trade agreements such as the European Union and North America. By treating such regions as a single country, the tax rules would align better with economic, business, and legal realities.

Finally, the proposed rules would integrate losses into income and income and losses into losses, as the case may be, and thereby remedy a number of anomalies under the Act. TEI commends the Department for making these changes.

Paragraph 95(2)(b)

TEI has expressed concerns previously about paragraph 95(2)(b) of the Act. The provision is inconsistent with the demands of modern business operations where global competitiveness demands that operations be located in centres of excellence. Moreover, the proposed modifications will exacerbate the Act's current defects by creating disincentives for basing international operations in Canada. The changes to these base-erosion provisions contrast sharply with the direction of the proposed amendments to paragraph 95(2)(a).

Companies generally structure their operations in order to avoid the creation of FAPI. Hence, the proposed changes to paragraph 95(2)(b) in the technical bill are unlikely to produce more revenue. Nonetheless, the provision will impose a significant compliance burden on taxpayers and create potential tax traps because of fluctuations in foreign currencies as well as because of differences between Canada and the host jurisdictions in respect of the timing of income and expense recognition. If the Department is concerned about improper reductions in investment business income through inter-affiliate transactions, we suggest that this type of income be added to the definition of "investment business" in subsection 95(1). We also recommend that the other proposed changes in this section be dropped and that the Department encourage CRA to use section 247 to curb abuses.

Paragraphs 95(2)(k) to (k.7)--Fresh Start Rules

Paragraphs 95(2)(k) to (k.7) of the technical bill set forth the so-called fresh start rules. Although the draft rules in the technical bill represent an improvement over the December 20, 2002, version, the provisions remain exceedingly complex.

[beta] Under the Act, gains and losses are considered realized upon a deemed disposition or acquisition of a business. As a result, the net gains could be treated as part of the exempt surplus of the foreign affiliate and paid out free of Canadian tax. Under the proposed fresh start rule (i.e., upon conversion from an active to a nonactive business), gains and losses arising from the deemed disposition or acquisition will automatically be deferred until the underlying property is actually disposed of. As a result, the assets and properties of the business must be disposed of before the exempt portion can be paid out. Under the proposed reverse fresh start rule (i.e., upon a conversion from a non-active to an active business), gains and losses would be realized upon a disposition or acquisition but recognition of the gain or loss can be deferred under an election accorded to taxpayers. TEI welcomes the inclusion of an election to defer gains and losses on a conversion from a non-active to an active business. To be effective, though, the rules should be symmetrical because a particular affiliate may drift in or out of active business status. Hence, we recommend that taxpayers be accorded an election to defer gains and losses on a conversion from an active to a non-active business.

Corporate Reorganizations

A. Section 88 "Bump."

Proposed paragraph 88(1)(d.4) appears to limit the "bump" unduly by pre-acquisition-of-control dividends. The policy basis for limiting the "bump" by the amount of these dividends is not transparent. We recommend that the purpose of the amendments be explained in the explanatory notes.

B. Specified Purchaser.

Many of the proposed changes affecting corporate reorganizations involve the concept of a "specified purchaser." The definition of a specified purchaser is extremely broad and can easily sweep in unrelated parties with no connection to the reorganization transaction. An example of how far reaching the provisions are and the inappropriate results that flow from them can be illustrated by the following example:

   Canco owns 10 percent of a series
   of non-voting preference
   shares of Forco A. Canco also
   owns 100 percent of foreign
   affiliate, Forco D. Forco A is
   controlled by Forco B which
   also controls Forco C. As an
   investment, Forco C buys 0.5
   percent of a publicly traded
   foreign partnership, Forpart
   A. Forpart A invests a small
   part of its excess funds in
   publicly traded trust, Trust
   A. Trust A is a "specified
   purchaser" with respect to
   Forco D.

To prevent such indirect ownership structures from creating this result and to narrow the scope of the draft provisions, TEI urges the Department to eliminate paragraphs (d) through (f) from the definition of "specified purchaser."

C. Non-Excluded Property.

According to the explanatory notes, the principal objective of the proposed amendments is to prevent transactions from "inappropriately" creating surplus. We believe the proposed changes in the technical bill do far more than that. Indeed, the proposed amendments to subsection 88(3) and paragraphs 95(2)(d) and (e) represent a fundamental change to the longstanding operation of the foreign affiliate reorganization provisions. If the proposed changes are adopted, taxpayers will no longer be able to carry out certain reorganization transactions on a non-recognition basis unless the shares of the corporations involved are not "excluded property." This result is inconsistent with taxpayers' and tax practitioners' understanding of the Act and is likely to prove highly prejudicial to taxpayers that have relied on the current rules in structuring their affairs. We do not believe it is necessary to make the far-reaching changes proposed in the technical bill to achieve the desired result.

The non-recognition provisions in subsection 88(3) and paragraphs 95(2)(d) and (e) are important planning tools in executing internal reorganizations for non-tax business reasons. These provisions have been relied on for decades, and their elimination with respect to shares that are not excluded property will impede many routine transactions. Moreover, the determination whether shares are excluded property will be extremely challenging and, in many cases, will require costly valuations and timeconsuming analysis. As a result, the availability of the rollover provisions will be significantly limited.

i. Cascading Effect of Small Amounts of Excluded Property. One of the most significant defects in the proposed statutory scheme is that if lower-tier companies in a group hold de minimis amounts of non-excluded property, the shares of upper-tier holding companies will be tainted as non-excluded property. This will occur even where substantially all of the assets of a corporate group are employed in active businesses.

The diagram below illustrates the cascading effect of the excluded property test. Even though only approximately seven percent {[(Co. D) 9 + (Co. H) 11] / (Co. A) 300} of the value of the consolidated assets in the group below are tainted, the shares of the top company (Co. A) will not qualify as excluded property because the test is performed on a non-consolidated, bottom-up approach. In this case, Co. F is considered to be a tainted asset because more than 10 percent of its assets are passive [(Co. H) 11 /(Co. F) 100]. Moreover, although both Co. B and Co. E are active assets, Co. A fails the Excluded Property test because 33 percent {(Co. F) 100 / (Co. A) 300} of its assets are considered tainted.

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ii. Interpretative Issues. A plethora of interpretative issues arise from the various proposed changes. Among the issues are the following:

a. Is cash considered surplus or ancillary to the business? There have been numerous disputes between taxpayers and CRA about this question.

b. Most large Canadian multinational companies, especially those with a substantial U.S. presence, have inter-affiliate loans and cross shareholdings. Identifying these loans and shareholdings--especially where some of the foreign affiliates are disregarded--can be very difficult. As a result, determining whether the loans or shares are excluded property will be daunting. For example, cash concentration accounts, which are commonplace in large corporate groups, generate myriad inter-affiliate loans. Tracing the sources and uses of funds from a cash concentration account is difficult at best and grows more challenging with each day's transactions.

c. Similarly, consider a simple situation where foreign affiliate 1 (FA1) owns foreign affiliate 2 (FA2), which in turn owns foreign affiliate 3 (FA3). Assume FA3 uses the proceeds from the disposition of an asset to fund an upstream loan to FA2 and FA2 uses the loan proceeds to purchase an income-producing asset. Assume further that FA2 relies on subparagraph 95(2)(a)(i) in order to characterize its income as active business income. In this example, FA2 must be absolutely certain that it can rely on subparagraph 95(2)(a)(i) so that FA3 may, in turn, rely on subparagraph 95(2)(a)(ii) in order to characterize the loan as excluded property.

d. To the facts in C, add the assumption that FA1 would otherwise be an Investment Business but for its ability to demonstrate to CRA that it satisfies the requirements of the carve-out in subparagraph (b) of the Investment Business definition. In this case, it will be difficult to determine whether the loan in FA3, or by extension the shares of FA3, are excluded property. It will be equally difficult to determine whether the shares of FA2 are excluded property. Finally, in this example, FA1 must not be an Investment Business. Apart from the Act, there is very little guidance regarding the definition of Investment Business or the application of subparagraph 95(2)(a)(i). Moreover, given the fact-intensive nature of most of the issues, CRA will be unlikely to provide rulings.

e. The determination of excluded property status requires a detailed, asset-by-asset valuation, which will be expensive to obtain, are otherwise unnecessary under the Act, and will be subject to challenge by CRA. Hence, there will be little or no certainty whether the property is excluded or not.

D. Netting of Gains and Losses.

Reorganizations frequently involve a number of properties, some with inherent gains and others with inherent losses. The technical bill's disparate treatment of gains and losses will produce inappropriate results because it does not permit netting of those gains and losses. In the change-of-control context, losses and gains can be offset. We urge the Department to reconsider the rules affecting the treatment of the gains and losses in reorganizations and to model the revised rules on the change-in-control provisions.

E. Rollovers.

The rollover rules currently reflected in subsection 88(3) and paragraphs 95(2)(d) and (e) permit businesses to structure their operations efficiently through various non-recognition transactions. It is essential that these transactions be preserved in the foreign affiliate rules in order to permit business to restructure their foreign operations as needed. Indeed, expanding the rollover approach in the foreign affiliate area would advance the Department's goal of avoiding the "inappropriate creation of surplus." In TEI's view, the proposed surplus suspension rules in the technical bill should be limited to circumstances that were not previously addressed in the foreign affiliate rules. If there are circumstances where the current rollover provisions facilitate the "inappropriate" creation of surplus, the Department of Finance should address that concern, but care should be taken in drafting the changes to ensure that FAPI is not created by a wholly internal reorganization transactions.

F. "Absorptive Mergers."

Where a foreign affiliate holds shares in one or more different merging foreign corporations, paragraph 95(2)(d) currently applies subsection 87(4) to the foreign merger. As a result, a foreign affiliate is accorded rollover treatment on the disposition of shares of the merging corporation(s), but rollover treatment is not automatically afforded to the assets where the merging corporations are foreign affiliates. CRA generally takes the position that the foreign commercial law governs whether a merger causes a disposition of the assets of one or both of the merging corporations. And in the case of "absorptive mergers," only the entity absorbed is viewed as disposing of its assets. CRA's position thus permits subsidiaries to merge into a parent corporation without concern whether the parent has disposed of its assets for Canadian tax purposes.

The proposed changes to paragraph 95(2)(d) in some respects mirror the changes being made to subsection 88(3).

* The provision will apply where one or more of the merging entities and the merged entity are foreign affiliates of a taxpayer resident in Canada.

* The provision ignores the foreign commercial law characterization of the transaction and bases non-recognition treatment for the disposition of assets of a merging foreign affiliate on whether a particular property is excluded property.

* A shareholder foreign affiliate will be deemed to have disposed of its shares in a predecessor corporation that are excluded property for proceeds of disposition that, unless a greater amount is elected, are equal to the adjusted cost base.

* There are no rules governing the disposition of shares that are not excluded property. Presumably the foreign merger rules in subsection 87(8) of the Act will apply in this case.

The proposed changes will significantly limit taxpayers' ability to use paragraph 95(2)(d) to effect reorganizations, but the changes are not warranted if their purpose is to avoid the "inappropriate creation of surplus." As important, there is no reason why an internal merger transaction among members of a corporate group should create a taxable disposition of all non-excluded property of the merging entities. For example, assume a small foreign affiliate subsidiary is merged into a much larger foreign affiliate holding company. In a properly structured transaction under the current rules, only the subsidiary foreign affiliate is considered to have disposed of its assets in an absorptive merger. Under proposed paragraph 95(2)(d), the taxpayer would also be required to determine whether the assets of the holding company foreign affiliate are also excluded property, which can be a more daunting task. To minimize the tax risks inherent in the proposed rules, the transaction may be restructured as liquidation of the subsidiary foreign affiliate into the holding company parent, but a liquidation transaction may not always be possible because of legal restrictions on the transfer of certain assets or because of exorbitant transfer taxes. In any case, there seems no good policy reason to preclude the use of absorptive mergers as a valid form of reorganization.

Concededly, proposed paragraph 95(2)(d.1) will accord non-recognition treatment to many more transactions than under the current Act, but there are many internal reorganization transactions that will not satisfy the more stringent requirements of the proposed rules. For example, if any part of a merger transaction is taxable under foreign law, paragraph 95(2)(d.1) will not apply. Also, if a Canadian company does not hold a 90percent surplus entitlement percentage in the merging foreign affiliate entities, paragraph 95(2)(d.1) will not apply. Thus, even where two merging entities are a parent and subsidiary or wholly owned subsidiaries of the same parent, the non-recognition protection will not be available to the Canadian company if it does not wholly own the members of the group. Joint venture enterprises, entities with preferred share issues, and other minority shareholders (including employees) may all be denied the non-recognition treatment.

In question 31 of TEI's agenda for the December 2003 liaison meeting with the Department of Finance, we pointed out that certain ownership structures cause Canadian companies to be considered to hold less than a 90percent surplus entitlement percentage. This result penalizes Canadian multinationals where--for legal, regulatory, tax, or other purposes--the ownership of foreign affiliates is split among two or more related Canadian corporations. TEI believes that a "related party" concept should be introduced in the definition of surplus entitlement percentage in order to address this inequity. The introduction of a related-party test would be consistent with other provisions in the Act that address foreign affiliates, including proposed paragraph 95(2)(n) and subsection 17(13). The proposed changes to paragraphs 95(2)(d.1) and 95(2)(e.1) make it more urgent that such a related-party concept be adopted.

Although paragraph 95(2)(d) of the current Act is not the sole means of effecting internal merger reorganizations, it is important in many cases and has been available for many years. Concededly, some changes may be necessary to limit the opportunity to create exempt surplus on a foreign merger, but it is unnecessary to preclude taxpayers from using paragraph 95(2)(d) to structure their foreign affiliate operations.

On the dissolution of a foreign affiliate where the dissolving foreign affiliate transfers shares of other foreign affiliates to a shareholder that is also a foreign affiliate, paragraph 95(2)(e) currently provides that the dissolving foreign affiliate is considered to have disposed of the shares for proceeds of disposition equal to their "relevant cost base." In addition, the shareholder foreign affiliate is deemed to dispose of its shares of the dissolving foreign affiliate for proceeds of disposition determined by reference to the dissolving foreign affiliate's proceeds of disposition for its foreign affiliate assets plus the fair market value of other properties that are distributed to the shareholder foreign affiliate. Thus, although the provision applies to more than just controlled foreign affiliates, paragraph 95(2)(e) is essentially similar to subsection 88(3) because rollover treatment will be available in respect of the disposition of the dissolved foreign affiliate shares held by the shareholder.

The proposed amendments to paragraph 95(2)(e) provide that, on the dissolution of a foreign affiliate where another foreign affiliate that is a shareholder of the dissolving foreign affiliate receives property, the dissolving foreign affiliate is deemed to dispose of the property for fair market value unless the property is excluded property. If the property is considered excluded property, the property will be considered disposed of for proceeds equal to its cost base. The shareholder foreign affiliate's proceeds of disposition of its shares in the dissolving foreign affiliate are determined by reference to the foreign affiliate's proceeds of disposition for the assets distributed to the shareholder foreign affiliate on the dissolution. As a result, there will be many circumstances where a dissolution within a corporate group will not benefit from the broad protection afforded by paragraph 95(2)(e.1). TEI believes the introduction of the "excluded property" requirement for non-recognition treatment under paragraph 95(2)(e) is unwarranted and urges the Department to reconsider this change.

In addition, we have the following technical observations about the corporate reorganization provisions:

* The opening phrase of proposed subsection 88(3) refers to a "redemption of shares," while proposed paragraph 88(3)(c) refers to "the redemption, acquisition or cancellation of shares." TEI recommends that subsection 88(3) be conformed with paragraph 88(3)(c). In addition, the reference to "acquisition" should be clarified to mean a reference to an acquisition of a share by the issuer of the share.

* The opening phrase of proposed subsection 88(3) seemingly contemplates four separate categories of transactions: liquidations, redemptions, dividends, and "a distribution of property." Proposed paragraph 88(3)(d) is seemingly intended to apply to the latter two transactions while proposed paragraphs 88(3)(e) and (f) apply only to the final category of transactions. Each transaction, however, can be considered to involve a "distribution of property." Thus, significant confusion may arise in respect of whether proposed paragraph 88(3)(f) applies to the first three transactions. We recommend that these provisions be clarified to eliminate the ambiguity.

* Taken together, proposed paragraphs 88(3)(e) and (f) may not afford shareholder a complete tax-free return of capital where there has been averaging of capital under Canadian corporate law. In other words, a distribution on a share that is legally a return of paid-up capital might not be considered to have been contributed in respect of that share even though the shareholder has contributed capital in respect of the shares in excess of the amount being returned. This may occur where a shareholder subscribes for shares of the same class for different prices at different times. (TEI's comments assume that draft subsection 88(3) is intended to address all the consequences for all distributions from foreign affiliates. If that assumption is correct, subparagraph 53(2)(b)(ii), which addresses returns of capital from all non-resident corporations, would require a carve-out for foreign affiliates.)

* Under the phrasing of proposed paragraph 88(3)(e), a shareholder may not be able to recover capital contributed "in respect of a share" following amalgamations, share-for-share exchanges, reorganizations of shares (consolidations, conversions, etc.) or similar transactions involving shares. Following such transactions, the capital and surplus would be considered to have been contributed in respect of the predecessor share rather than for the share currently held. TEI recommends that a substituted property rule be introduced to ensure that contributed capital can be returned tax free.

* It is unclear why, to the extent amounts are included in income under paragraph 88(3)(f), the amounts are treated as "income from property that is the shares" rather than dividends. The payment is the practical equivalent of a dividend. Treating the payment as a dividend would be consistent with the treatment accorded to similar amounts under section 84 of the Act.

* The term "specified vendor" is used in proposed paragraph 95(2)(d), but is not defined for purposes of this paragraph.

* Proposed subparagraph 95(2)(d)(i) deems a disposition of property to take place on a merger, but the provision does not specify when the disposition is deemed to occur. Presumably the disposition occurs immediately before the merger. Proposed subparagraph 95(2)(d)(v) provides that the taxation years of the predecessor corporations that would otherwise include the time of the merger are deemed to have ended immediately before that time. Thus, the consequences of the deemed dispositions on the merger are not taken into account in computing the surplus accounts of the merging foreign affiliates or, by virtue of Regulation 5905(3), the merged foreign affiliate. TEI's interpretation is based on the current regulations. The increased probability that deemed dispositions will occur under proposed paragraph 95(2)(d) makes the lack of recognition for the deemed disposition more significant. Hence, we urge the Department to clarify the time of the deemed disposition and its effects in a fashion consistent with TEI's interpretation.

* The term "specified purchaser" is used in proposed paragraph 95(2)(e), but is not defined for purposes of this paragraph.

* Proposed subparagraph 95(2)(e)(vii) deems the taxation year of the dissolving foreign affiliate to end immediately before the dissolution. Proposed Regulation 5907(9)(a) provides that, "subject to paragraphs 95(2)(e) and (e.1)," the taxation year of the dissolving foreign affiliate is deemed to end immediately before the time at which 90 percent of the foreign affiliate's assets have been disposed of. Proposed Regulation 5907(9)(b) establishes rules for determining the deemed proceeds of disposition of the property disposed of on the liquidation.

Regrettably, the actual time that property is liquidated will not always fall within the taxation year that is deemed to have ended under Regulation 5907(9)(a). In addition, the disposition of the shares of the dissolving affiliate is not addressed by the regulation. As a result, there may be timing mismatches between the recognition of the gains on the assets disposed of in the liquidation process and the creation and treatment of the corresponding surplus. This timing mismatch does not arise under current Regulation 5907(9).

Conclusion

TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments and recommendations. TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David V. Daubaras. If you should have any questions about the submission, please do not hesitate to call Mr. Daubaras at 908.858.5309 or David M. Penney, TEI's Vice President for Canadian Affairs, at 905.644.3122.