Letter to Canada's Department of Finance regarding subsection 17(8) of the Income Tax Act: March 9, 2006.

On March 9, 2006, TEI submitted a letter to Wallace Conway of the Canadian Department of Finance requesting the Department of Finance to consider developing a technical amendment to paragraph 17(8)(a) of the Income Tax Act of Canada. The letter follows up on an item discussed during the December 7, 2005 liaison meeting with the Department. TEI's letter was developed under the aegis of TEI's Canadian Income Tax Committee whose chair is David V. Daubaras of General Electric Canada. Contributing to the development of TEI's comments were Hugh D. Berwick of Alcan Inc. and Carmine A. Arcari of The Royal Bank of Canada.

During the December 7, 2005, liaison meeting between Tax Executives Institute and the Department of Finance, TEI queried whether the Department of Finance would consider introducing an amendment to the Income Tax Act to address a potential anomaly in the application of paragraph 17(8)(a) of the Act. The Department invited TEI to submit additional comments on its request for an amendment. On behalf of TEI, I am pleased to submit the following comments for your consideration.

Background

Tax Executives Institute is the preeminent global association of business tax executives. The Institute's 5,800 professionals manage the tax affairs of 2,800 of the leading companies in North America, Europe, and Asia and must contend daily with the planning and compliance aspects of Canada's business tax laws. The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

During the TEI's liaison meeting of December 7, 2005, with the Department of Finance, the following question was posed:

   There is a seeming anomaly in
   the application of paragraph
   17(8)(a) of the Act in cases of
   indebtedness arising in connection
   with the acquisition
   by a controlled foreign affiliate
   (CFA) of the shares of another
   CFA where the acquired CFA
   shares constitute "excluded
   property." Assume that CANCO
   (a taxable Canadian corporation)
   makes an interest-free
   loan to wholly owned CFA1,
   and CFA1 uses the funds to
   acquire shares of CFA2 (which
   shares are "excluded property"
   of CFA1). Paragraph
   17(8)(a) excludes the loan
   amount from the operation of
   section 17 if CFA1 uses the
   proceeds to earn active business
   income or to make a loan
   to another CFA that satisfies
   the conditions of subsection
   95(2). Paragraph 17(8)(a)
   does not, however, exclude a
   loan where the proceeds are
   used to directly acquire shares
   that are "excluded property"
   of another CFA in the same
   country. Would the Department
   consider recommending
   an amendment to paragraph
   17(8)(a) to exclude a loan
   amount owing by a CFA where
   clause 95(2)(a)(ii)(D) would
   apply to any interest on the
   amount owing if the amount
   were owing to another CFA?

During the ensuing discussion, the Department of Finance said that TEI's request for an amendment did not seem unreasonable and invited comments on whether, from a policy perspective, any restrictions should be imposed on the use of the loaned funds apart from a requirement that the acquired shares be "excluded property."

Discussion

After considering the Department's tax policy concerns, TEI believes the only restrictions should be that:

* the loan or advance by a Canadian parent ("CANCO") to a controlled foreign affiliate (CFA) be used by the CFA to acquire shares that are "excluded property" shares of another entity that is also a CFA of CANCO immediately thereafter; and

* the amendment apply for any period in a taxation year during which the shares are "excluded property."

In our view, no additional restrictions are necessary because the current foreign affiliate rules and section 17 sufficiently address any other concerns the Department may have relating to the use of the funds. As discussed below, an interest-free loan from a taxable Canadian corporation to a controlled foreign affiliate (CFA1) to acquire shares in another CFA (CFA2) will produce the same tax results as though the funds were contributed to CFA1 as share capital. Companies may prefer to make loans to CFAs (including interest-free loans) in order to fund share acquisitions because it is more expedient and efficient from business, legal, and tax perspectives to repay a loan to Canada than it is to restructure and reduce the legal share capital of a CFA.

The potential scenarios through which a loan from CANCO might be used by a borrowing controlled foreign affiliate (CFA1) to acquire shares of another controlled foreign affiliate (CFA2) that are "excluded property" are, as follows:

1. CFA1 can acquire newly issued shares of CFA2 from CFA2;

2. CFA1 can purchase shares of CFA2 from another CFA (hereinafter the "disposing CFA") of CANCO; or

3. CFA1 can purchase shares from a

party that is not a CFA of CANCO (i.e., purchase the shares from an arm's length third party).

In the first scenario, if CFA 2 uses the funds received from the issuance of its share capital to earn income from property or from a business other than an active business, the shares likely will not retain their status as "excluded property." In this case, TEI's proposed exception to subsection 17(1) would not apply. Even if the CFA2 shares were to retain their excluded property status, any foreign accrual property income (FAPI) earned by CFA2 would be taxable in Canada. In other words, the same tax results would follow as though CANCO contributed share capital to CFA1 (as opposed to making an interest-free loan to CFA1).

In the second scenario, the current foreign affiliate rules will apply to the disposing CFA. If the disposing CFA does not use the sale proceeds in its active business, any foreign accrual property income earned by the disposing CFA will be taxable in Canada. Again, the tax results are the same as though CANCO contributed share capital to CFA1 (as opposed to making an interest-free loan to CFA1).

In the third scenario, the actual use of the funds by a third party is irrelevant. To the extent that the shares of CFA2 are excluded property but residual FAPI remains in the entity, the current foreign affiliate rules would attribute the FAPI to CANCO.

Based on the foregoing discussion, we do not believe additional restrictions (beyond those already in the various provisions of the Act) on the use of funds loaned to a CFA to acquire shares of another CFA that are "excluded property" to the acquiring CFA are warranted or required.

TEI's comments were prepared under the aegis of its Canadian Income Tax Committee, whose chair is David V. Daubaras. If you should have any questions about TEI's comments, please do not hesitate to contact Mr. Daubaras at 905.858.5309 or Monika M. Siegmund, TEI's Vice President for Canadian Affairs, at 403.691.3210.