Pending Canadian income tax issues: December 11, 1996.

December 11, 1996

On December 11, 1996, Tax Executives Institute held its annual liaison meeting with the Canadian Department of Finance on pending income tax issues. (TEI held a separate meeting on issues relating to the Goods and Services Tax and other commodity tax issues.) The Institute's agenda for the income tax meeting is reprinted below. The agenda was prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Alan Wheable of Canada Trust. J.A. (Drew) Glennie of Shell Canada Limited, the Institute's Vice President-Region 1, coordinated plans for the liaison meeting

Tax Executives Institute, Inc. welcomes the opportunity to present the following comments on several pending tax issues, which will be discussed with representatives of the Department of Finance during TEI's December 11, 1996, liaison meeting. If you have any questions about these comments, please do not hesitate to call either J.A. (Drew) Glennie, TEI's Vice President for Canadian Affairs, at [phone], or Alan Wheable, chair of the Institute's Canadian Income Tax Committee, at (519) 6631623.

Background

Tax Executives Institute is an international organization of approximately 5,000 professionals who are responsible -- in an executive, administrative, or managerial capacity -- for the tax affairs of the corporations and other businesses by which they are employed. TEI's members represent more than 2,700 of the leading corporations in Canada and the United States.

Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Consolidated Tax Returns

In 1985, the Minister of Finance issued a White Paper on consolidated tax returns for affiliated groups of companies (which was referred to as the "corporate loss transfer system"). At that time, TEI supported a proposal to permit consolidation of wholly-owned, or nearly wholly-owned, group members, urging that Canada alter its unique position among major trading countries in not permitting consolidation. More than ten years later, little has changed; indeed, the rules governing corporate groups may be even less competitive now compared with the rest of Canada's trading partners. Notwithstanding that "loss transfer" mechanisms exist for federal income tax purposes, effectuating such transfers involves substantial transactional costs; moreover, the losses remain unavailable for provincial income tax purposes. In addition, the attendant compliance costs associated with filing separate returns for subsidiaries remains as high as ever. Recent reports by Professor Mintz's Technical Committee on Business Taxation and the Auditor General acknowledge these economic and tax policy inefficiencies. Hence, we urge the government to "just do it" and implement a regime to permit consolidated income tax return filing for corporate groups. We invite the Department's views and comments.

Part I.3 Tax -- Deduction for Surtax Credits

Under current rules, the capital deduction claimed in the computation of the Part I.3 Tax on Large Corporations must be allocated among associated companies. Would consideration be given to revising the rule to apply the excess surtax credits over Part I.3 tax to other corporations within the same associated group in respect of which the capital deduction allocation was made?

Leasehold Improvements--Simplification Proposal

Determining the amount of the capital cost allowance (CCA) on Class 13 assets is very complicated. Each asset that forms a part of a leasehold improvement must be accounted for on a separate basis even though all the assets remain in a single class for purposes of the terminal loss and recapture rules. To simplify the system and permit both taxpayers and Revenue Canada to reduce the amount of resources devoted to the calculation and verification of CCA on such assets, we recommend that the Department of Finance adopt the same diminishing balance aggregate pool system for leasehold improvements as exists for most other assets. In addition, a transitional rule should be adopted permitting taxpayers to elect either to maintain the current rules for existing leasehold improvements or to transfer the balance into the new class of assets subject to the diminishing balance computation. We believe that the new rule and the transitional rule for existing leasehold improvements can be implemented in a revenue-neutral fashion. We would be willing to work with the Department to craft such a rule and invite the Department's comments.

Harmonization

There is currently much discussion at the federal and provincial levels about simplifying the tax system and improving the efficiency of Canada's revenue administration. The Minister signalled his commitment to those goals with the announcement of the Canada Revenue Commission (hereinafter, "the Commission") in the last budget message.

One of the objectives of the Commission is to develop a closer partnership with provinces in revenue administration. TEI believes that the federal and provincial governments as well as business taxpayers have much to gain from the increasing trend toward harmonized tax bases where similar taxes are imposed by different jurisdictions. Consequently, we appreciate the active and substantial leadership of the federal government in developing a harmonized sales tax system across Canada. Regrettably, no government body has yet assumed the leadership mantle in respect of harmonizing capital taxes. Consequently, we believe the Commission would serve as a catalyst for promoting such an initiative because the capital tax is another area where harmonization will be beneficial. Once a common capital tax base is agreed upon, federal and provincial rates should be reviewed in order to maintain revenue neutrality for both taxpayers and the respective tax authorities. Harmonization of capital taxes would facilitate compliance by taxpayers, lower the risk of double taxation, minimize audit disputes, and thereby reduce compliance and administrative costs for taxpayers and tax authorities alike. We invite the Department's comments on our proposal to make capital tax harmonization a goal of the Commission.

Notwithstanding the substantive goals that evolve for the Commission, we urge that the Government, in its efforts to harmonize business tax systems, adhere to certain key principles that we believe are fundamental to sound tax policy and administration. Among the core principles are revenue neutrality, simplification of the tax system, minimizing the burden of compliance, promoting common or uniform administration and tax regimes without material exceptions, fostering extensive taxpayer consultations, providing timely, prospective legislation and form release, and ensuring adequate transitional rules. With the announcement of such guiding principles, harmonization efforts would enlist TEI's active participation.

Provincial Allocations -- Netting of Interest Charges

Where the taxpayer's provincial allocation is revised on audit, and assuming that the proper correlative adjustments are made in all other jurisdictions, the taxpayer will owe additional tax in some jurisdictions and be entitled to refunds in others. In addition, the taxpayer will be assessed interest on tax underpayments and be entitled to receive interest on overpayments. In total, the amount of tax and interest will likely entirely offset. The interest on the refund amounts, however, is taxable whereas interest charges on income taxes is not deductible. As an administrative concession, will the Department of Finance permit taxpayers to net the interest payable and refundable from all jurisdictions and only treat the net amount as either taxable (in the case of net refund interest) or nondeductible (in the case of net arrears interest)?

Interest Charges and the Competent Authority Process

The purpose of the competent authority process is to prevent double taxation in respect of cross-border transactions. Owing to the complexity of the issues involved, taxpayers must invest substantial time and resources to resolve competent authority issues. Even where the process ultimately results in the elimination of double taxation, the denial of a deduction for interest levied on tax deficiencies on one of the affected taxpayers will produce a result economically equivalent to double taxation where interest on the tax refund is taxable to the related party. Such a result is inconsistent with the overall thrust of the competent authority process. Consequently, we recommend that the Department permit a deduction for interest expense on Canadian tax deficiencies arising from competent authority issues, at least for the amount of interest accruing beyond the normal statute of limitations period. Would the Department support such a deduction?

Regulation 105

Regulation 105 requires a Canadian taxpayer to withhold a 15-percent tax on all services performed in Canada by non-residents. Moreover, waiver of the withholding requirement (or the application of a reduced treaty rate) must be sought in advance on a contract-by-contract basis. Non-resident service suppliers will often refuse to perform work for a Canadian company unless the service recipient agrees to bear the cost of the withholding tax via a costly gross-up. Moreover, for smaller, non-resident service companies, the cost of hiring an accountant to file a Canadian tax return in order to obtain a refund of the tax is onerous and will likely reduce substantially, if not eliminate, the expected profit on the services rendered. Would the Department of Finance reconsider the application of Regulation 105, especially for non-resident U.S. companies?

Non Resident Withholding

Unlike most filing and paying obligations under the Income Tax Act (hereinafter "the Act"), there is no effective limitation period for the obligation to withhold and remit tax under section 215 because no assessment is issued except in extraordinary situations. Would the Department support an amendment to the Act, perhaps by way of amendment to subsection 227(10), requiring the Minister to assess the filer's liability in respect of Part XIII, at least on an elective basis? If an elective provision is acceptable, could the proposal be implemented on the basis of a check-the-box feature on the appropriate filing forms?

Foreign Tax Credits

In Question V of last year's liaison agenda, TEI inquired about the Department's support for clarifying subsection 126(2) in order to permit taxpayers to claim foreign tax credits for certain amounts paid to foreign jurisdictions in connection with production-sharing agreements (PSAs). Many foreign countries permit exploration for, and production of, petroleum resources within their jurisdiction only on condition that (i) the state-owned oil company be part of a PSA and (ii) specified tax levies be imposed on production under the PSA. The liaison agenda submission requested that the Department consider whether ambiguity in the treatment of those tax levies promoted or impeded the Canadian petroleum industry's competitive position vis-a-vis companies operating in foreign jurisdictions that clearly permit tax credits for such payments. The Department's response invited the submission of additional information from both Revenue Canada and taxpayers.

In one situation reviewed by the Rulings Directorate of Revenue Canada, a PSA provided that the Canadian taxpayer and the PSA counterparty, the state-owned oil company in the foreign jurisdiction, would each receive a share of the production. As part of the consideration for its "agreed share" of production, the state-owned oil company agreed to make the taxpayer's tax payments to the state fiscal authorities. The agreement addressed the tax treatment of the taxpayer under the tax laws of the foreign jurisdiction and also protected the taxpayer from subsequent changes in the tax structure. In addition, the PSA clarified the manner in which the Canadian taxpayer's taxable income arising from its activities was to be determined. Notwithstanding the provisions in the PSA, the income tax was levied under the terms of the foreign jurisdiction's general taxing statutes. The Directorate ruled adversely to the taxpayer, concluding that the taxes imposed on the taxpayer do not constitute "income or profits" taxes that are creditable under subsection 126(2).

Given the prevalence of PSAs in a globalized and highly competitive petroleum industry, we renew our inquiry whether the Department will support policy or legislative changes to temper the relative disadvantage visited upon Canadian companies that are not permitted to credit such taxes. Canadian employment in the petroleum industry may be diminished should companies restructure their operations in order to avoid the adverse tax consequences of rulings such as the aforementioned one. Has Finance requested and received additional information from Revenue Canada in respect of Revenue's denial of credits for such foreign taxes, thereby permitting Finance to resolve this issue?

Treaties

A. Withholding Taxes

The Government's policy of seeking reduced withholding tax rates in certain areas, such as dividends, interest, and computer royalties, has been implemented in only a few treaties. What progress can be reported in implementing the goal? In particular, the timing for review of further reductions in withholding taxes with our major NAFTA partner, the United States, would seem propitious. Can you provide a report on the prospects for, and likely outcome of, such a review?

High withholding taxes are a significant disincentive to increasing the level of foreign investment in Canada. Moreover, reluctance to negotiate reciprocal reductions in withholding tax rates increases the tax burden for Canada's global corporations conducting business overseas. Hence, TEI urges the government to review the results of reducing various withholding tax rates in the Canada-U.S. protocol with a view to moving to the European and, indeed, the U.S. model with a zero rate as the target for inter-group dividends, interest, and royalties.

B. Negotiation Update

We request that the Department provide a brief report on the status of its pending treaty negotiations with various countries worldwide. In particular, we understand that some European countries have expressed a desire to renegotiate expeditiously their treaties with Canada. Within the limits of government policy and inter-governmental confidentiality agreements, please comment on whether such requests have been made and will be accommodated.

Foreign Affiliates -- "Investment Business"

A. Swaps and Other Interest-Rate Management Products

As a result of 1994 amendments to the Act, in order for a controlled foreign affiliate's investment income to avoid generating foreign accrual property income (FAPI) to its Canadian resident shareholders, a business must be carried on principally at arm's length. Under subsection 95(2.1), "agreements that provide for the purchase, sale or exchange of currency" will, under certain circumstances, be considered to be arm's-length transactions for purposes of the investment business definition when concluded between a controlled foreign affiliate and a related Canadian financial institution. Specifically, to the extent that the relevant transactions consist of hedging operations ancillary to third-party business conducted by the controlled foreign affiliate, this is an appropriate result.

Following enactment of the new rules, Revenue Canada has taken the position that interest-rate swaps do not involve a "purchase, sale or exchange of currency" within the meaning of subsection 95(2.1) of the Act, notwithstanding explicit references to swaps and other interest-rate management products in paragraph 95(2.1)(b). Revenue Canada's interpretation causes interest rate swaps entered into between a Canadian financial institution and its related offshore affiliates to be considered as non-arm's-length transactions for purposes of the FAPI rules. This improperly disadvantages taxpayers where such transactions are no more than tools for managing interest-rate risk arising from the foreign financial institution's third-party business.

Since Revenue Canada has interpreted the Act in a fashion that undermines the legislative intent, will the Department of Finance make necessary technical amendments on a retroactive basis? A retroactive amendment is likely required because the consolidated integration of worldwide treasury operations in financial groups inevitably results in significant levels of on-balance-sheet intragroup assets and liabilities, which under current rules count as nonarm's length.

B. Request for New Deeming Rule

In order for the business of a controlled foreign affiliate that earns interest, dividends, or other property-type income to avoid generating FAPI to its Canadian shareholders, an "investment business" of the subsidiary must adhere to certain conditions under subsection 95(1), including a requirement that "throughout the period in the year during which the business was carried on" it be carried on principally with persons with whom the affiliate deals at arm's length. In Interpretation Bulletins IT-290 and IT-371, Revenue Canada ruled that the issue whether a business is carried on principally at arm's length is determined with reference to the revenues and assets of the affiliate.

The arm's-length requirement applies regardless of whether a related party revenue stream or asset position is deemed under subsection 95(2) to be from an active business (subject to an exception for certain qualifying non-arm's-length derivative transactions entered into by a controlled foreign affiliate and a related Canadian financial institution, provided for in subsection 95(2.1) of the Act). Thus, even where the related-party revenue stream or asset position is generated by underlying third-party assets or revenues of the related-party payer, the intra-group position will count as non-arm's length for purposes of the test in the "investment business" definition.

The foreign business of a multinational financial group will often result in the balance sheets of related foreign financial institutions reflecting high levels of intra-group assets and liabilities. For example, the treasury services for a group of related companies operating in a particular foreign jurisdiction or geographic sector will typically be provided by a single (usually the largest) institution within the group. Centralization of the treasury functions permits the group to achieve efficiencies and economies of scale by minimizing the costs for staff and investments in costly trading rooms in every location where financial services are offered to the public. Thus, liquidity arising from, for example, customer deposits at a particular foreign branch will often be loaned to the treasury unit of the corporate operating group business unit.

The need to manage a foreign group's liquidity and interest-rate and currency risks in a centralized manner exposes many of the group's companies to the hazard that their businesses will be deemed to be carried on principally with persons with whom they are not at arm's length. The difficulty is not so much with their related-party asset positions and revenue streams (which will normally give rise to deemed active business income under special rules) as with the income derived directly from third-party borrowers, which may be taxable in Canada as non-excepted investment business income.

As the statute is currently drafted, the arm's-length test must seemingly be met at all times throughout the taxation year of the controlled foreign affiliate. TEI submits that the costs of monitoring compliance with the arm's-length requirement on a continuous basis combined with the likelihood of errors by employees unfamiliar with, or occasionally forgetful of, detailed Canadian tax rules exposes Canadian financial institutions to exacting -- even unreasonable -- standards. A simple and elegant solution to this problem would be to deem intra-group assets and revenue streams that generate deemed active business under the various provisions of subsection 95(2) to count as arm's length for purposes of meeting the requirements of an investment business. In order for income to qualify as deemed active business income, it must arise from an active business of a related company, i.e., a business that is carried on principally with persons with whom the affiliate deals at arm's length. If adopted, the requested change would extend the existing policy without penalizing intragroup transactions that relate to the underlying third-party active business of the group.

Foreign Group of Companies

Subclause 95(2)(a)(ii)(D)(v) requires that the interaffiliate interest payments be relevant for purposes of computing the liability for income taxes of the members of a group of corporations composed of the second affiliate and one or more other foreign affiliates of the taxpayer (the shares of which are excluded property). Most taxpayers and tax professionals interpret subclause (v) as providing that only foreign affiliates whose shares are excluded property are to be considered as part of the group in applying the test in subclause (v). At the 1996 Canadian Tax Foundation's Corporate Management Tax Conference Roundtable, however, representatives from Revenue Canada, in commenting on the application of subclause (v) to interaffiliate payments involving a U.S. consolidated group, said that foreign tax laws determine the composition of the group rather than Canadian tax law. Will the Department of Finance confirm whether the intended meaning for subclause (v) is that only foreign affiliates whose shares are excluded property are to be considered? If the Department agrees with taxpayers' interpretations, will the Department support an amendment to clarify the interpretation?

Stop-Loss Rule -- Subsection 93(2)

Subsection 93(2) of the Act reduces the amount of permitted deduction for a loss arising from the disposition of a share of a foreign affiliate by the amount of any dividends received on the share that are deductible under paragraph 113(a), (b), or (c). In certain cases where the disposition is to an affiliated corporation, any loss on the disposition of the share would be deemed nil by virtue of proposed paragraph 40(3.6)(a) and, under proposed paragraphs 40(3.6)(b) and 53(1)(f.2), the disallowed loss would be added to the adjusted cost base (ACB) of any remaining shares. Where the loss is disallowed by subsection 93(2) rather than subsection 40(3.6), however, there would be no corresponding increase in the ACB of the remaining shares of the foreign affiliate.

There is a notable distinction between the situations to which subsections 93(2) and 112(3) apply. The latter section will apply to a loss on a share of a subsidiary that paid a dividend from earnings realized prior to the parent's acquisition of the subsidiary shares. In such a case, the dividend will not reduce the ACB of the share. In the case of foreign affiliates, however, dividends paid from pre-acquisition surplus automatically reduce the ACB of the shares. In the subsection 93(2) situation, the dividends that are considered are those that have already borne the appropriate foreign tax. It therefore seems appropriate to increase the ACB of other shares where subsection 93(2) applies. TEI recommends that an amendment be introduced to adjust ACB in circumstances where a loss was denied by virtue of subsection 93(2). We invite the Department's comments.

Pooled Fund Trusts

Section 206 imposes a tax on "foreign property" held by Registered Pension Plans (RPP) in excess of prescribed limits. Except as set forth in regulations, an interest in a trust can be considered to be foreign property. One exception excludes an interest in a pooled fund trust from the definition of foreign property In order to qualify as a pooled fund trust, at least 80 percent of the trust's assets must consist of shares, bonds, mortgages, marketable securities, life insurance policies in Canada, and certain annuities. Many of the investment pools marketed for investments by RPPs are pooled fund trusts. These funds are fully redeemable at the option of the investor, but are not themselves publicly traded. As a result, the investments are generally not considered to be "marketable" securities. This effectively prevents pooled fund trusts from investing in other pooled fund trusts and limits an RPP's ability to invest in some of the most cost-effective investment options. Is there an objection, from a tax policy standpoint, to the tiering of investments in pooled fund trusts? If so, please explain. If there is no policy impediment, will consideration be given to either amending the definition of pooled fund trusts to include units of other pooled fund trusts within the 80-percent limitation, or to revising the definition of marketable securities so that investments that are fully redeemable at the investor's option will qualify as marketable securities?

RRSP-RPP Integration

The reduction in the maximum contribution limit from $14,600 in 1996 to $13,600 in 1996 has exacerbated a problem faced by executives who change employers and cash out their Registered Pension Plan (RPP). For example, an employee who participates in a defined benefit plan and accumulates three years of service credit with an employer may receive a $10,000 lump-sum payment from the RPP on separation from service with the employer. The executive would be permitted to rollover this amount to a self-administered Registered Retirement Savings Plan (RRSP). Assuming that the maximum contribution that the employee could have made to his RRSP during the three-year employment period was $1,000 per year, the total tax assisted retirement savings permitted for this individual would have been $13,000, i.e., less than the maximum permitted for any one year. By changing employment, the employee has been disadvantaged and, regrettably, circumstances such as these are encountered too frequently. We recommend that consideration be given to reinstatement of provisions that permit contributions to RRSPs to be "made up" where employees belonging to an RPP cease to be participants in their plans.

$24,000 Cap On Automobiles

Regulation 7307 was adopted to restrict the amount and timing of deductions for costs associated with the ownership or leasing of so-called luxury automobiles. Prices for new automobiles, however, have increased significantly since Regulation 7307 was last amended nearly six years ago. Taxpayers now find that even moderately-equipped, mid-sized automobiles generally have a manufacturer's suggested retail price (MSRP) of more than $24,000 and, hence, are subject to the deduction limitations and administrative burdens associated with luxury vehicles (e.g., maintaining a separate Class 10.1 pool for each vehicle). Consequently, the restrictions are limiting deductions for the costs of standard fleet -- as opposed to "luxury" -- vehicles. Will the Department clarify the criteria or indicia to determine when adjustments to the amounts specified in Regulation 7307, subsections (1) and (2), will be made? Is it not time to revise the cap again? Will the Department consider revising the rule in order to permit taxpayers to use their actual purchase price (or, in the case of a leased vehicle, the equivalent capitalized lease capital cost) per vehicle in lieu of MSRP -- a notional amount that (i) does not necessarily reflect economic cost and (ii) is not routinely entered in the taxpayer's accounting for the purchase or lease?

Taxable Benefits

Over the years the audits of taxable fringe benefits have been a source of frustration for both Revenue Canada and taxpayers. This is particularly true in respect of the valuation of non-cash benefits granted as either a length-of-service or safety award. The United States Internal Revenue Code contains pragmatic rules that permit the cost of such awards to be deducted by the employer even as employees are permitted to exclude from income the entire amount of awards falling below specified thresholds. Specifically, where an item of tangible personal property with a cost of less than US$400 is awarded to an employee in recognition of either length of service or for a safety achievement, the employee may exclude the value from income and the employer may deduct the cost. TEI believes that taxpayers (employers as well as employees) and Revenue Canada alike would benefit from reduced compliance and audit burdens with the adoption of similar rules in Canada. Under what conditions would the Department of Finance support a similar rule in Canada?

Election for ECE-Related Inducements

Paragraph 12(1)(x) generally requires an income inclusion for inducements, reimbursements, and payments or benefits of a similar nature. On an elective basis, the recipient can reduce the amount of the income inclusion by reducing the capital cost of depreciable property (pursuant to subsection 13(7.4)) or offsetting outlays and expenses (other than the cost of property) incurred in the year or the year following receipt (pursuant to subsection 12(2.2)). A similar, though nonelective provision governs the offsetting of a reimbursement against the cost of an eligible capital expenditure (ECE) (for example, a perpetual technology licence). Under subsection 14(10), however, this latter exclusion applies solely to payments from a public authority and only to reimbursements (not inducements). Would the Department consider modifying and expanding the wording of subsection 14(10) to make it an elective provision and to permit a taxpayer to apply an inducement, reimbursement, or a similar form of assistance from either the public or private sector against the cost of an eligible capital expenditure that relates to the receipt of the inducement or reimbursement?

Preferred Dividend Tax

Section 191.2 of the Act sets forth detailed rules for filing elections that affect the rate of tax imposed under Part VI.1 when taxable dividends are paid. An election under section 191.2 must be filed within certain prescribed time periods, which are determined according to the taxation year in which the class of shares is issued or first characterized as a taxable preferred share. The time limits permit the election to be filed within six months after various stages of the appeals process for assessments with respect to that year. In some cases, however, no dividends will be paid during the taxation year during which the shares are first issued or are first deemed to be taxable preferred shares; hence, the first assessment of Part VI.1 and Part IV.1 tax with respect to dividends on the shares will be imposed in a subsequent year.

Where the taxpayer is uncertain about the status of the shares as taxable preferred shares, it faces a dilemma in respect of a section 191.2 election because the election cannot be filed (and would be unnecessary) if the shares are not taxable preferred shares. Would the Department consider amending paragraph 191.2(1)(a) to read "not later than. . .the taxation year in which dividends are first paid on that class of shares, or shares of that class are first issued or first become taxable preferred shares; or"? The proposed change would permit a taxpayer to make its election after a final determination is made that the shares are indeed taxable preferred shares.

Subsection 87(11)

Draft subsection 87(11) introduced on June 20, 1996, will permit a bump of the cost of non-depreciable capital property following the amalgamation of a parent company and one or more of its wholly-owned subsidiary corporations. The result is similar to the so-called "88(1)(d)" bump. There is, however, a significant difference in that draft subsection 87(11) will only apply where the parent company owns all the issued share capital of the subsidiary (except for director's qualifying shares). The bump under paragraph 88(1)(d) is permitted where the parent company owns 90 percent of the issued shares of each class of the capital stock of the subsidiary.

TEI believes that requiring the ownership of 100 percent of the capital stock of a subsidiary is an unduly restrictive condition. Being able to combine corporations through an amalgamation rather than by way a subsidiary wind-up is very often desirable for business reasons since the procedures are far simpler and the transaction much less expensive to consummate. Hence, would the Department consider amending draft subsection 87(11) to permit the bump where the 90-percent ownership threshold similar to section 88 is met? If not, will the Department please explain the policy rationale for differentiating between two transactions with identical tax results.

Paragraph 85(1)(e.2) Issues

A. Cross-Ownership of Subsidiaries

Consider the following situation. Company A owns 75 percent of the issued and outstanding share capital of Company B and 80 percent of the issued and outstanding share capital of Company C. Company C owns the remaining 25 percent of the share capital of Company B. Company B owns the remaining 20 percent of the issued and outstanding share capital of Company C.

Company A transfers to Company B a capital property in exchange for Company B common shares. The fair market value of the capital property of $1 million significantly exceeds the ACB of $100. Company A and B intend that the property be transferred at fair value. Hence, a valuation of Company B is undertaken to determine the proper number of shares to issue to A in the exchange. Moreover, the asset transfer agreement between A and B includes a provision requiring an adjustment of the number of shares to be issued to A should the fair value of the contributed property vary significantly (up or down) from the appraised value determined by A and B. Company A and B jointly elect to have the provisions of subsection 85(1) of the Act apply to the transfer. The agreed amount of the joint election is the adjusted cost base of the property at the time of the transfer.

Please comment on the following questions concerning the transaction:

1. Does the Department of Finance consider Company B to be a "wholly-owned corporation" of Company A so that paragraph 85(1)(e.2) will not apply? If not, what is the policy rationale that underlies the Department's position?

2. Would the Department consider expanding the definition of a "wholly-owned corporation" to include corporations with circular cross-ownership as described?

B. Different Parties Hold Common and Preferred

Consider a different situation. Company A and Company B are both large, public companies. Company A owns 100 percent of the voting common shares of Company B. Company B also has a class of non-voting, fixed return, preferred shares held entirely by third-party shareholders. Company B is financially solvent and capable of discharging its obligation to the preferred shareholders.

Company A transfers to Company B a capital property in exchange for Company B common shares. The fair market value of the capital property of $1 million significantly exceeds the adjusted cost base of $100. Company A and B intend that the property be transferred at fair value. Hence, a valuation of Company B is undertaken to determine the proper number of shares to issue to A in the exchange. In addition, a valuation of the capital property is undertaken as well. Company A and B jointly elect to have the provisions of subsection 85(1) of the Act apply to the transfer. The agreed amount of the joint election is the ACB of the property at the time of the transfer. Since Company B is not a "wholly-owned corporation" of Company A within the meaning of subsection 85(1.3) of the Act, and even though reasonable effort has been made to ensure that no benefit is conferred on a related person by establishing a fair value for the transferred property, there is no certainty that Revenue Canada will not apply paragraph 85(1)(e.2) to the transfer. Moreover, since the preferred shares are non-voting and have a fixed return, any benefit accruing from the transfer of the capital property will accrue to Company B directly and Company A indirectly. Consequently, the result is arguably no different from where Company A owns 100 percent of the shares of Company B.

Please comment on the following questions concerning the transaction:

Would the Department consider expanding the definition of "wholly-owned corporation" in subsection 85(1.3) to include a situation similar to that described, i.e., where 100 percent of the voting and fully-participating common is held by one corporation and fixed-return preferred shares are held by arm's-length parties?

2. If the answer to question 1 is no, please explain the policy rationale for the Department's position.

Large Corporation Tax -- Hedged Debt

Section 3860 of the Canadian Institute of Chartered Accountants (CICA) Handbook summarizes the financial statement presentation and disclosure for financial instruments, including corporate debt denominated in a foreign currency that is hedged or otherwise combined with a foreign currency swap or forward contract. The net result of the guidance in the Handbook (subsection 3860.34, paragraph 3860.41(a), subsection 3860.09, and paragraphs 3860.05(a), (b), and (c)) is that, where there is no legal right of offset, foreign denominated debt must, for fiscal years beginning on or after January 1, 1996, be translated at the foreign exchange rate in effect as at the date of the balance sheet. In addition, the "net principal value" of the currency swap or forward contract must be reflected as an asset or liability (referred to below as a "hedge asset" or "hedge liability") at the presentation date. Prior to 1996, the net principal value of the foreign currency swap or forward contract was netted against (or combined with) the debt.

Example 1 illustrates the financial statement presentation under the new rules.

Under the rules in effect until 1995, the financial statements would have reflected a net debt of $130 M every year. We posed the following question to Revenue Canada: What is Revenue Canada's position on the treatment of the amounts presented as a hedge asset and a hedge liability in the example above for the purpose of computing taxable capital under section 181.2 of the Act?

Assuming that the answer from Revenue Canada results in a different treatment from what would have applied prior to 1996, will the Department of Finance introduce an amendment applicable to taxation years commencing on or after January 1, 1996, in order to take into account the hedge asset and hedge liability in the calculation of taxable capital?

Eliminate Requirement to Issue T5s to Corporations

Regulation 201 requires T5 slips to be filed by all persons making payments to residents of Canada, including corporations, as, or on account of, a dividend, interest, or royalty. The T5 information return must be prepared on the basis of cash payments made during a calendar-year reporting period. Inasmuch as the calendar-year information reporting period often does not coincide with the fiscal year end of corporate recipients, and inasmuch as corporate taxpayers are required to report taxable income based on amounts accrued rather than cash amounts received, the T5 slips are used neither to record a corporate recipient's income nor to prepare the corporate income tax return. Moreover, Revenue Canada auditors rarely, if ever, resort to the information reported on T5s as a basis for auditing corporate tax returns, even for calendar-year taxpayers. In our view, the requirement to issue T5 slips to corporations is an unnecessary reporting burden. Has consideration been given to amending Regulation 201 to eliminate the requirement to file information returns with respect to payments made to corporations? We believe that such a revision would significantly reduce the compliance costs for issuers as well as the storage and handling costs for the recipients. We urge the Department to consider making the change.

Conclusion

Tax Executives Institute appreciates the opportunity to present its comments in respect of pending income tax issues. We look forward to discussing our views with you during the Institute's December 11, 1996, liaison meeting.

RELATED ARTICLE: Example 1

On January 1, 1996, Canco issues a US$100 M denominated debt when the exchange rate is US$1 = CAN$1.30. The debt matures on January 1, 1999. On the same date, Canco enters a currency swap transaction ("the hedge") under which it agrees to exchange its US$100 M liability for a CAN$130 M liability to be reexchanged on the maturity date.

1. On December 31. 1996, the exchange rate is US$1 = CAN$140. The financial statement presentation at that date is:

   Asset                  Liability
   Hedge asset   $10 M    Debt              $140 M

2. On December 31, 1997, the exchange rate US$1 = CAN$1.2(). The
financial statement presentation at that date is:

   Asset             Liability
   Debt             $120 M
   Hedge liability    $10 M

3. On December 31, 1998. the exchange rate is US$1. = CAN $1.30. The
financial statement presentation at that date is:

   Asset                  Liability
                          Debt              $130 M