Pending income tax issues: December 3, 2003.

On December 3, 2003, Tax Executives Institute held its annual liaison meeting with the officials of the Canadian Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Limited.

Tax Executives Institute welcomes the opportunity to present the following comments on income tax issues, which will be discussed with representatives of the Department of Finance during TEI's December 3, 2003, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Mario M. Tombari, TEI's Vice President for Canadian Affairs, at 514.932.6161, ext. 2943, or Monika M. Siegmund, Chair of the Institute's Canadian Income Tax Committee, at 403.691.3210.

Background

Tax Executives Institute is an international organization of approximately 5,400 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 2,800 of the leading corporations in Canada, the United States, and Europe.

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 eight geographic regions. In addition, a substantial member of our U.S. and European 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.

1. Non-Resident Withholding Taxes on Dividends and Interest

A. General. Studies, such as one prepared by the C.D. Howe Institute, have shown a strong link between the elimination of withholding tax on dividends and interest and increased foreign direct investment. The Howe Institute's study claims that elimination of withholding on all dividends and interest would result in an increase in capital investment in Canada of approximately $28 billion, and an increase in income of over $7.5 billion annually. The study also summarizes the detrimental effects that withholding taxes have on Canada, including restricting the free flow of capital, deterring foreign direct investment, and interfering with efficient global company operations. The study's conclusions are especially cogent in respect of the Canada-U.S. tax treaty because the United States is a key market for Canadian goods and services as well as key source of investment capital for Canadian enterprises.

Recently, the United States negotiated a nil withholding rate for dividends under the U.S.-U.K. tax treaty and under its protocols with Australia and Mexico. The United States and Japan have also announced that certain intercompany dividends will be exempt from withholding taxes under their new income tax treaty. TEI invites a discussion of the steps the Department of Finance is undertaking in respect of the Canada-U.S. treaty negotiations to ensure that Canadian residents can secure similar benefits and effectively compete with these jurisdictions for increased capital investments, exports, and jobs.

B. Effect of U.S. Tax Legislation. Under the Jobs and Growth Tax Reconciliation Act of 2003, dividends paid to U.S. individuals by most U.S. public companies and qualifying foreign corporations, including public Canadian companies whose shares are listed on U.S. stock exchanges, will be taxed at a maximum rate of either 15 or 5 percent. The same U.S. tax act also changed the U.S. foreign tax credit rules, reducing the foreign source income of dividends qualifying for the reduced tax rate to 15/[35.sup.ths] of the dividend amount. As a result, dividends paid by Canadian public companies to U.S. shareholders that are subject to the 15-percent Canadian withholding tax will be taxed at higher rates than a dividend from a U.S. corporation because, in many cases, the foreign tax credit for the Canadian withholding tax will not be fully available for U.S. individuals.

A number of Canadian members of TEI are concerned that the lower after-tax yield on dividends from Canadian public companies will lead U.S. investors to favour U.S. stocks. The potentially reduced demand for Canadian company shares could have a negative effect on stock prices and increase the cost of capital. We invite the Department's comments on the following questions.

1. Does the Department have a long-term strategy or objective to phase-out withholding taxes on interest and dividends for related and unrelated parties?

2. Does the Department agree that it would be desirable and appropriate to negotiate a nil withholding tax rate on dividends in the next protocol to the Canada-U.S. treaty? Such a step would make the Canada-U.S. treaty consistent with the recent U.S. treaties with the U.K. and Australia.

3. If a nil withholding tax on all dividends (from related and unrelated parties) cannot be achieved in the short term, would the Department consider negotiating a reduction of the withholding tax rate to no more than 10 percent on all dividends paid by Canadian public companies to individual U.S. shareholders? Such a reduction would mitigate the adverse effects of the changes in the U.S. tax rates and foreign tax credit rules. In addition, would the Department consider negotiating a nil withholding tax on dividends paid to a corporate shareholder that holds at least 10 percent of the voting shares of the Canadian company?

2. Regulation 105

Following a TEI submission on Regulation 105 in 2002, representatives from the Department of Finance met with TEI for an informative discussion about the issues arising from the requirement to withhold taxes on payments to non-resident service providers. Additional information was submitted after the meeting outlining the process for obtaining a waiver of withholding in the United States (Form W-8 BEN). What is the status of the Department's review of the potential for either repealing Regulation 105 or making significant changes to the legislation or regulation in order to ease the administrative burden for obtaining waivers of withholding?

3. Interest

A. The difference in the treatment of simple and compound interest under the Income Tax Act (hereinafter "the Act") seems anomalous and without a proper policy basis. Would the Department consider permitting compound interest to be deductible on an accrual basis?

B. Since the Act seemingly does not permit the deduction of interest that becomes due upon the occurrence of a contingent event if that event occurs in a taxation year subsequent to the year in which the interest would have accrued, issues frequently arise in respect of whether interest is considered to be contingent. Would the Department consider adding a clause to subsection 20(1), as follows:

   "an amount which would otherwise be deductible in
   a prior year except for paragraph 18(1)(e) and that
   has not been deducted and that would no longer be
   affected by paragraph 18(1)(e)"

4. Reimbursement of Arrears Interest

The Act does not specifically address the treatment of a refund of previously paid arrears interest. Section 161.1 permits a taxpayer to offset arrears interest payable against taxable refund interest through a reallocation of refunded amounts between taxation years. The purpose of the provision is clear: to ensure that timing differences (e.g., depreciation expense) reallocated between taxation years do not create non-deductible interest in one year and taxable refund interest in another year. In addition, paragraph 18(1)(t) addresses the non-deductibility of amounts paid or payable under the Act and provincial tax amounts are addressed under paragraph 18(1)(a). Paragraph 20(1)(11) provides a deduction for interest repaid by a taxpayer to a Government (whether Federal or provincial) "as was paid in the year and as can reasonably be considered to be a repayment of interest that was included in computing the taxpayer's income."

A recent CCRA release (No. 2002-0164407, January 16, 2003), discusses reimbursements of non-deductible arrears (debit) interest previously paid by a taxpayer. The document addresses interest on Crown charges and states that subparagraph 12(1)(x)(iv) does not distinguish between a deductible and non-deductible expense. The view expressed is that a refund of previously paid non-deductible interest would be included in income absent an election under subsection 12(2.2).

TEI believes the interpretation of subparagraph 12(1)(x)(iv) enunciated in the release would impose a significant punitive financial burden on taxpayers where a refund of non-deductible interest is made. CCRA's previous administrative position of not taxing refunds of previously paid, non-deducted amounts provided an equitable application of the Act. The interpretation in the release would result in the government collecting a windfall even where all the issues reassessed are reversed on appeal.

Assuming that CCRA's interpretation is correct, TEI recommends that paragraph 12(1)(x) be amended to exclude from income amounts received "in respect of an outlay or expense" that were not deducted or deductible by the taxpayer at any time. TEI's recommendation essentially addresses the mirror image of paragraph 20(1)(ll). Alternatively, paragraph 12(1)(x) could be amended to exclude amounts that were not deductible because of paragraphs 18(1)(a) and (t). A third option would be to expand the list of elections that are eligible for late filing under subsection 220(3.2) and Regulation 600 in order to include the election under subsection 12(2.2).

5. Capital Cost Allowance System Review

In the 2003 Budget, the government announced its intention to review the Capital Cost Allowance (CCA) rates. Please advise on the status of this review. We would also appreciate a discussion of the principles and the processes that are being employed to determine whether the CCA rates are (1) economically appropriate for the asset classes and (2) competitive with the recently revised depreciation allowances in the United States. In addition, will taxpayers be consulted or otherwise permitted to provide input on this project?

6. Meaning of Term "has been wound up"

Subsections 88(1), 88(2), and 88(1.1) apply only where a Canadian corporation "has been wound up." The formal dissolution of a corporation, which has been wound-up in all other respects, will frequently be delayed for several years owing to potential claims or outstanding litigation. Once the wind-up is complete, the rules in subsection 88(1) or 88(2) will apply retroactively from the commencement of the wind-up to all transactions entered into during the coarse of the liquidation, including the distribution of assets.

The CCRA takes the position that a corporation has not been completely wound up until it ceases to exist and a corporation does not cease to exist until the date shown on a certificate of dissolution issued under applicable federal or provincial corporate law. (1) In addition, where a corporation is not dissolved in a particular year because of outstanding litigation claims, subsection 88(1) or 88(2) apply in that particular year as long as the corporation is formally dissolved within a reasonable time following the resolution of the outstanding litigation. (2)

In a recent technical interpretation, CCRA said that this administrative position does not extend to subsection 88(1.1). As a result, a parent corporation will generally be denied the use of a former subsidiary's losses until the year in which the subsidiary is formally dissolved. Once formally dissolved, the losses of the former subsidiary are available to the parent in any taxation year beginning after the commencement of the winding up. Since that may include a number of prior years, the CCRA has said that, following the formal dissolution of a subsidiary to which the provisions of subsection 88(1.1) apply, the parent can file amended returns claiming its subsidiary's losses for years after the commencement of the winding-up. (3) There are, however, a number of factors that make that approach impractical. For example, if the normal reassessment period for the parent corporation's taxation year expires before the subsidiary is officially dissolved, the CCRA will not reassess the parent's first taxation year after the commencement of the wind-up to permit a claim for its subsidiary's losses. In addition, the CCRA has said that in these circumstances there are technical difficulties under subparagraph 152(4)(a)(ii) associated with filing a waiver of the normal reassessment period for the year. (4)

We understand that the CCRA position on subsection 88(1.1) was developed in response to potentially abusive situations. (5) Nonetheless, TEI does not understand the policy basis for interpreting the term "has been wound up" for purposes of subsection 88(1.1) differently from the interpretation for applying subsections 88(1) and 88(2). To address CCRA's concerns about potential abuses, subsection 88(1.1) can be amended to specify that when losses have been transferred to a parent corporation as a result of the wind-up of a subsidiary, those losses can no longer be used by the subsidiary. As an additional safeguard, the provision might include a requirement that the parent and subsidiary file a joint election or certification to ensure that the same loss is not deducted twice. Assuming CCRA is prepared to extend its administrative position in respect of subsections 88(1) and 88(2) to subsection 88(1.1), there would be no need to define various terms such as "winding-up," "the time at which a corporation has been wound up," and "the time at which a winding-up has commenced." We invite the Department's comments on this issue and TEI's recommendation.

7. Large Corporation Audits, Objections, and Appeals

Under the New Directions initiative, CCRA is seeking to accelerate the audits of large corporations. TEI supports the New Directions initiative generally, including the accelerated audit approach because it would afford taxpayers finality and certainty in respect of their reported tax liabilities at an earlier date.

Regrettably, restrictions on large corporations' ability to file objections temper our enthusiasm for the acceleration of audits. Under the current rules, large corporations must identify all issues requiring adjustment, including affirmative claims, when filing a Notice of Objection. Once a taxpayer files an objection, it is precluded from raising new, affirmative issues. As a result, large corporations generally withhold their objections until the "audit" assessment, which, absent the initiative to accelerate audits, generally occurs near the end of the normal reassessment period. Hence, under current practices CCRA and large corporations have a generally fair and nearly equal opportunity to identify new matters.

Under the audit acceleration initiative, taxpayers would be required to identify all matters within a much shorter period of time. Even where the normal reassessment period remains open following the conclusion of the audit, taxpayers would be precluded from identifying or pursuing other matters. CCRA, on the other hand, would have until the end of the normal reassessment period to identify other matters and reassess as often as it wishes. As a result, CCRA would be able to change its position and reassess taxpayers based on new administrative interpretations or judicial decisions.

At the 2003 Canadian Tax Foundation Conference, CCRA Commissioner Nymark commented on the need for a "level playing field" for taxpayers and CCRA. We concur. Indeed, TEI's support for the audit acceleration initiative would be enhanced by an amendment to the Large Corporation Notice of Objection rules restoring a level playing field for post-return filing adjustments to a taxpayer's reported tax liabilities. To the extent a taxation year is open for reassessment by CCRA, taxpayers should have a reciprocal right to identify additional matters. Alternatively, a restriction on CCRA's ability to raise new issues after the conclusion of an audit (reciprocal to that imposed on large corporations to file a Notice of Objection) would also create a level playing field. (6) Either approach would be consistent with the spirit and tenor of the Taxpayer Bill of Rights. We invite the Department's comments.

8. Loss Limitation on Disposition of a Share of a Foreign Affiliate

Contrary to taxpayer expectations, the December 20, 2002, Technical Bill failed to address numerous recommendations to amend or repeal subsection 93(2). Proponents of technical amendments have argued that losses on the disposition of a foreign affiliate share should not be reduced by exempt dividends where the loss is attributable to foreign exchange fluctuations. Others though have argued more broadly that subsection 93(2) should be repealed altogether since the targeted abuse will not arise in a foreign affiliate context because a dividend in excess of exempt and taxable surplus will reduce the cost basis thereby producing a capital loss. What is the status of the Department's study of this provision?

9. At-Risk Rules--Tiered Partnership

Where taxpayers employ a tiered-partnership structure, there seems an anomaly in the Act in respect of the treatment of limited partnership losses. To illustrate, consider the following:

   Partnership A, a general partnership, is a limited
   partner in Partnership B, a limited partnership, so
   losses incurred by Partnership B will flow through
   to Partnership A. Partnership A can deduct its
   share of the losses of Partnership B to the extent
   of Partnership A's at-risk amount. The share of
   the losses of Partnership B that can be deducted
   by Partnership A is then allocated to the members
   of Partnership A. A loss incurred by Partnership
   B that exceeds Partnership A's at-risk amount is
   deemed to be a limited partnership loss. Since
   subsection 102(2) of the Act deems Partnership A
   to be a taxpayer only for purposes of Part I, Division
   B, Subdivision j of the Act, the limited partnership
   loss cannot be claimed by Partnership A and will
   not be a limited partnership loss of the members of
   Partnership A. The result is that losses that exceed
   the at-risk amount in a particular year can never
   be deducted even where there is a sufficient at-risk
   amount in subsequent taxation years.

This is a harsh result for taxpayers that own limited partnership interests through a general partnership. Would the Department consider introducing legislation to allow the limited partnership losses of Partnership B to flow through to the members of Partnership A?

10. Canada-U.S Treaty--Continuance Provision

On September 18, 2000, the Department announced proposed changes to the Canada-U.S. treaty that would clarify the residence of corporations. The press release stated that a continuance provision would be added to the convention and explained that a company incorporated in one country that continues in the other will still be treated as a resident of the first country unless that country's internal law no longer treats it as such. What is the status of these changes?

11. Confidentiality of Taxpayer Information

The protection of confidential taxpayer information is the cornerstone of a voluntary compliance system. Without assurance that a taxpayer's information will be protected, confidence in the tax system and compliance will be seriously eroded. Thus, Parliament has enacted several provisions to protect taxpayers. Under subsection 239(2.2) of the Act, it is an offence for any person to contravene subsection 241(1) by improperly disclosing taxpayer information. Subsection 241(1) forbids any government official from disclosing or allowing any person unauthorized access to taxpayer information. The protection, of course, is not absolute, and a number of exceptions are set forth in subsection 241(4), including subparagraph (d)(i), which expressly authorises CCRA to provide taxpayer information to the Department of Finance for the purpose of the formulation or evaluation of fiscal policy.

Recently, outside legal counsel for one member received correspondence from the Department of Finance (DoF), the relevant contents of which are, as follows:

* DoF had received a request under the Access to Information Act (hereinafter, the "Access Act") for all documents and information pertaining to the introduction of a recently proposed change to the law.

* DoF retrieved from its files all documents that it believed were not exempt from the disclosure requirements under the Access Act. (Outside counsel for the company was provided with a copy of the documents that he had originated.)

* DoF expressed the view that none of the documents contained information described in section 20 of the Access Act (which exempts disclosure of certain types of confidential information received from third parties), and, accordingly, would release the documents pursuant to section 27 of the Access Act.

The purpose of the DoF correspondence was to afford the outside legal counsel an opportunity to make written representations objecting to the release of the documents. Counsel was instructed to submit an objection within 20 days of the date of the DoF correspondence and to frame an objection within the exemption provisions of either section 19 (dealing with personal information) or section 20 (dealing with confidential third-party information) of the Access Act.

Among the documents that the DoF intended to release was a lengthy, confidential submission prepared by the outside legal counsel and given to the CCRA Audit Division in response to a proposed audit adjustment (hereinafter, the "CCRA submission"). The issue addressed in the CCRA submission was relevant to the recently proposed change in the law.

Subsection 24(1) of the Access Act forbids the head of a government institution from disclosing any record that contains information the disclosure of which is restricted by any provision set out in Schedule II to the Access Act. Schedule II to the Access Act includes a cross reference to section 241 of the Income Tax Act. Surprisingly, there was no evidence in any of the documents provided by the DoF to outside counsel that indicated that DoF was aware that the CCRA submission was taxpayer information, the disclosure of which (1) was forbidden by subsection 241(1) of the Income Tax Act and subsection 24(1) of the Access Act and (2) constituted an offence under subsection 239(2.2) of the Income Tax Act.

Under the Access Act, the discretion to disclose the requested information rests with the "head of a government institution." In the example, the discretion seems to lie with the DoF, but the information was provided to the DoF by the CCRA pursuant to subparagraph 241(4)(d)(i) of the Income Tax Act. Hence, should CCRA have been the department to properly make the decision? At a minimum, should the CCRA have been consulted in the decision to release the requested information?

TEI is concerned that if no objection had been delivered to the DoF within the 20-day time limit, the DoF might have released taxpayer information pursuant to the Access request, and that in turn may have constituted an offence under the Income Tax Act. Would the Department of Finance explain the policies or procedures that it has established in order to protect the confidentiality of taxpayer information provided to it by the CCRA pursuant to subparagraph 241(4)(d)(i) of the Income Tax Act?

12. Transfer-Pricing Documentation

The contemporaneous documentation requirement set forth in subsection 247(4) should facilitate audits by CCRA and also reduce the number and scope of transfer-pricing controversies. In order to comply with the documentation requirements, taxpayers develop policies, procedures, and practices that are reasonable in respect of the arm's-length standard and take account of the costs and benefits of complying with subsection 247(4). CCRA, on the other hand, is not required to satisfy any standard in respect of the documentation it provides to taxpayers in support of its transfer-pricing assessments or reassessments (or any other assessment or reassessment). As a result, transfer-pricing assessments and reassessments frequently result in protracted and contentious disputes that are costly for both taxpayers and CCRA to resolve. To minimize the risk of an unfounded transfer-pricing reassessment and to facilitate the resolution of transfer-pricing disputes at an earlier stage, CCRA should be subject to a documentation standard for its assessments and its failure to satisfy that standard should have procedural consequences. For example, legislative language might be developed to implement the following conceptual proposal:

   Where a taxpayer satisfies the documentation standards
   set forth in subsection 247(4), CCRA shall
   prepare documentation in support of its reassessment
   to the same standard. Failure to provide the
   supporting documentation to the taxpayer being
   (re) assessed 60 days prior to the commencement
   of a (re) assessing action, will require the Minister
   to prove two conditions: (1) that the price the taxpayer
   reported was not reasonable in relation to the
   arm's length standard and (2) that the price that
   the minister used for (re) assessment purposes was
   reasonable in relation to the arm's length standard.
   Failure by the Minister to prove either condition
   shall result in the taxpayer's price being deemed
   to be the arm's length price and the return (re)
   assessed accordingly.

We invite the Department's comments on the proposal.

13. Paragraph 110(1)(d) of the Act and Paragraph 6204(1)(b) of the Regulations--Takeover Bid by a Specified Person

In computing taxable income, paragraph 110(1)(d) provides a deduction in the amount of one-half of any stock option benefit, provided (among other things) that the security issued under the stock option agreement is a "prescribed share" at the time of its issue. Paragraph 6204(1)(b) of the Regulations states that a share is not a prescribed share if it is reasonable to expect that it will be redeemed, acquired, or cancelled by the issuer or a specified person related to the issuer within two years of the date of issue.

In a typical takeover situation, A Co. will propose to acquire all the issued and outstanding shares of B Co., but the offer will not include outstanding stock options because the assignment or transfer of stock options is generally prohibited, either by the terms of the stock option plan or the stock exchange rules. As a result, holders of B Co. options generally exercise their options and tender those shares pursuant to the offer. If A Co's acquisition of B Co is successful, the B Co. option holders that exercised their options will be precluded from claiming a paragraph 110(1)(d) deduction. In order to accord that deduction to B Co. option holders, Regulation 6204(3)(a) includes an exception to the definition of "specified person," but the relief provision is frequently inapplicable. As examples, the relief will not apply where (1) the form of the transaction is not an "offer" or (2) the offeror is a specified person and the buy-out is a "going-private" transaction. We believe this unintended result occurs too frequently, especially where, immediately prior to the transaction, the shares of a public corporation would otherwise constitute prescribed shares.

We invite the Department's reaction to expanding the exception in Regulation 6204(3)(a) to include more situations where stock option holders exercise their options and sell their shares at the same time that public shareholders sell their shares. Several alternatives might be developed, including (1) incorporating a general exception in Regulation 6204(1)(b) for takeovers or (2) permitting option holders to test the shares for qualification for the paragraph 110(1)(d) deduction either at the time of the shares' issuance or disposition.

14. Publicly Traded Securities

Many provisions of the Act are drafted to address privately held entities, but the rules generally apply to publicly traded entities as well. For example, some provisions require that an entity be able to identify the residency of all holders of the entity's equitable interests. It will be impossible, however, for publicly traded partnerships to determine whether all of its partners are Canadian residents. As a result:

* The partnership may be treated as non-resident for purposes of the application of Part XIII withholding tax on payments to the partnership;

* All or a portion of payments for services made to the partnership may be subject to 15-percent withholding tax; and

* Certain transactions involving the partnership (such as the acquisition of property from its partners or a reorganization of the partnership into a joint venture or a company) cannot be undertaken on a tax deferred "rollover" basis.

Would the Department consider legislation to add a de minimis rule or a presumption to section 248 in respect of widely held public security holders whereby ownership interests below a certain threshold, say 5 percent, need not be considered?

15. Options for Limited Partnership Equity Interests

Increasingly, large corporate groups are using limited partnerships and other publicly traded entities within their corporate structures. In order to hire top quality management or these business units and provide remuneration that is competitive in the Canadian and American markets, many offer options on equity interests that are linked to the business unit's performance. The Act accords special tax treatment for securities issued by a corporation or a Canadian mutual fund to an employee, but is silent in respect of the treatment of options given to employees for equity interests issued by limited partnerships or other publicly traded entities.

To ensure neutral tax treatment of limited partnerships, other publicly traded entities, and their employees, would the Department consider standardizing the rules applicable to stock options and extending those rules to options for the acquisition of equity interests in these entities? Specifically, would the Department consider changing the definitions of "qualifying person" and "security" in order to permit options on the equity interests of these entities to benefit from the special tax treatment accorded to corporate stock options and mutual fund unit options?

16. Partnership Income Allocation

Draft paragraph 96(1.01)(a) "deems a taxpayer who is a former member of a partnership to be a member at the end of the fiscal period in which the taxpayer ceased to be a member, for the purpose of allocating partnership income or loss for that period.... The amount so allocated is relevant to certain calculations relating to partnership income or loss, including the calculation of the adjusted cost base of the former member of the partnership immediately before the taxpayer ceased to be [a] member." (7)

Draft subsection 96(1.01) attempts to address frequently recurring circumstances where the purchaser and the vendor of a partnership interest wish to allocate the taxable income based on the earnings of the partnership during their respective periods of ownership. The provision would also permit the taxable income allocated to a former partner to be added to the adjusted cost base of the former partner's partnership interest for purposes of calculating the taxable capital gain or loss on the sale. Prior to the introduction of the subsection, the only way to effect an allocation of income and an increase to the cost base of a transferred partnership interest was to declare a fiscal year end for the partnership (after obtaining approval from CCRA) immediately before the transfer date of the partnership interest.

TEI applauds the Department for introducing the new subsection, but we believe it may need revisions, especially to take account of recent rulings issued by CCRA. Specifically, CCRA has stated that a partner cannot be allocated an income or loss component greater than the income or loss of the partnership at the fiscal year end. (8) As a result, problems may arise where the taxable income (or loss) for the period that the vendor owned the partnership interest is greater than the taxable income (or loss) of the entire partnership at the fiscal year end. Since the only equitable way for partners to transfer a partnership interest is to allocate taxable income based on actual operating income, plus or minus normal adjustments to taxable income, greater taxable income (or loss) should be allocated to the vendor partner up to the date of the transfer, with a correspondingly greater taxable loss (or income) allocated to the purchaser for the period after the transfer date. CCRA insists, however, that the allocation of taxable income to any partner must be based on taxable income as determined by the partnership at its fiscal year end.

Another administrative problem with proposed subsection 96(1.01) relates to its retroactive effect to 1995. CCRA is currently denying approvals for partnership fiscal year-end changes, saying that taxpayers will be treated in a manner consistent with the new proposed subsection 96(1.01). Moreover, CCRA reportedly will no longer consider an "allocation of income" for tax reporting purposes as a valid 'business" reason for approving a partnership fiscal year-end change. (9)

The inability to fully allocate taxable income or losses based on the actual operations of the partnership for the periods during which each partner owns the partnership interest is problematic for both parties unless the transfer is accomplished immediately after a regular fiscal year end. At any time during a fiscal year, the parties may be able to estimate what the taxable income or loss will be to the date of the transfer, but they will have for more difficulty estimating what the taxable income or loss of the partnership will be for the period after the transfer date in order to know whether the final total taxable income will be more or less than the estimated taxable income to date. This may cause frequent disputes between the purchaser and vendor. Indeed, where the operating income of the partnership is volatile, there may be situations where the parties cannot agree on a price until year end.

Would the Department consider introducing revisions to proposed subsection 96(1.01) in order to permit the partners to specifically allocate the income or loss on the same basis as if a fiscal year end of the partnership had been declared?

17. Withholding Tax on Interest

Given the sophisticated nature of many financial instruments, the scope of the postamble to paragraph 212(1)(b) is confusing. Would the Department consider narrowing the postamble to reflect the underlying tax policy of preventing the exportation of tax profits?

18. Section 86.1--Eligible Distribution in a Foreign Spin-Off

Assume the following: A foreign public corporation, Foreignco, has two classes of common shares, Classes A and B, listed on a prescribed stock exchange. Subco is a wholly-owned subsidiary of Foreignco. The Class A shares of Foreignco are linked to the performance of Subco, but on a reduction or redemption of the capital stock of Foreignco the Class A shareholders are not precluded from participating in the assets of Foreignco beyond the amount paid up on the Class A shares. Pursuant to a publicly filed prospectus, Foreignco solicits the approval of all shareholders to spin-off Subco. To effect the spin-off, Foreignco intends to distribute to its Class A shareholders one Subco common share in exchange for, and in redemption of, each outstanding Class A share. Fewer than five percent of all Foreingco shareholders are resident in Canada. Not all of the Foreignco shareholders own both classes of shares; indeed, only a small number of shareholders constituting a minority interest own shares of both classes.

Section 86.1 of the Act provides "rollover" treatment for Canadian resident shareholders of a foreign corporation that undergoes a spin-off of a wholly owned subsidiary. Section 86.1 is unclear, however, whether rollover treatment would be permitted where either (1) the foreign corporation has two classes of common shares listed on a prescribed stock exchange or (2) the "distribution" occurs as a redemption and exchange. Since many corporations have more than one class of common shares listed on a prescribed stock exchange (i.e., alphabet stock) for which a spin-off of a wholly-owned subsidiary would require a redemption of the "linked" common shares, would the Department consider amending section 86.1 to clarify that a rollover is available for such foreign spin-offs?

19. Foreign Affiliates

A. TEI believes that proposed paragraph 95(2)(g.3) provides a welcome clarification of the Act, but its application seems restricted to certain hedging transactions. Would the Department consider defining a broader class of transactions, including swaps, as foreign hedging agreements? Moreover, since hedging transactions are affected by other provisions in the Act, would the Department consider using the language in proposed paragraph 95(2)(g.3) (as expanded by TEI's proposal) on a consistent basis throughout the Act?

B. Proposed paragraph 95(2)(g.3) refers to "property." Paragraph 95(2)(g), however, also applies to liabilities and many hedges relate to liabilities rather than "property" or assets. Would the Department consider clarifying that the language applies to liability hedges as well?

C. Proposed clause 95(2)(b)(i)(C) will expand the scope of the FAPI regime, presumably in order to prevent the conversion of investment business income into services income. Many companies centralize the provision of services in key affiliates in order to serve different areas of the world. In order to avoid the unintended application of this provision to such companies, would the Department consider providing an exception to proposed clause 95(2)(b)(i)(C) where:

(a) services are provided by a company that is excepted from the investment business income definition, or

(b) the services provided are ancillary to the principal business?

20. Calculation of Foreign Affiliate Surplus

Subsection 5907(2) of the Income Tax Regulations is designed to restate the surplus of a foreign affiliate on an economic basis. The rules are detailed, but are not comprehensive and thus do not address many situations. For example, assume a foreign corporation incurs an expenditure in 1998 for which the local tax authorities require five-year amortization. The foreign corporation is acquired in 1999 by a Canadian corporation and the purchase price is reduced to reflect the full amount of the 1998 expenditure. The amortization expense is deducted from taxable income under local tax law and thus from "earnings from an active business" in each of the next four years. Although the amortization expense does not affect the foreign affiliate's economic position, no provision in subsection 5907(2) permits an addback. Rather than introduce additional specific rules in order to address this or other similar issues, would the Department consider introducing a general rule to address so-called "phantom income or expenses"?

21. Services as Non-Active Business Income

During its 2002 Liaison Meeting with CCRA, TEI posed the following question (Question 14) and received the CCRA response set forth below:

   TEI Question:

   In Technical Interpretation 9622935 (November
   25, 1996), CCRA seemingly indicates that, in
   certain non-arm's-length situations, paragraph
   95(2)(b) will not apply. Consider the following
   circumstances:

      Canco, a Canadian corporation, is a
      wholly owned subsidiary of ParentCo.
      ParentCo is a large Canadian Financial
      Institution. Canco is licensed to provide
      discretionary investment management
      and custodial services to Canadian resident
      clients (e.g., pension plans). Canco
      is not licensed to carry on investment
      management services in a jurisdiction
      other than Canada. Subject to Canadian
      securities regulations, Canco may appoint
      investment sub-advisers to manage, with
      discretionary authority, all or a portion of
      the assets in its clients' accounts.

      ForeignCo is a controlled foreign affiliate
      of ParentCo. ForeignCo is licensed under
      foreign securities laws and regulations to
      carry on an independent business with its
      own employees that provide discretionary
      investment management and custodial
      services to third-party clients. ForeignCo
      is not licensed in Canada, however, to
      provide discretionary management services
      directly to Canadian residents; it
      is permitted to act as a sub-adviser to a
      licensed Canadian adviser.

      Canco appoints ForeignCo as a sub-adviser
      for non-Canadian securities and enters
      into a bona fide subcontract, comparable to
      that which ForeignCo would enter into in
      providing services to arm's-length parties.
      pursuant to the subcontract arrangement
      Canco pays a fee to ForeignCo.

Does paragraph 95(2)(b) apply to the subcontract fee paid to ForeignCo? Would CCRA elaborate on the factors to be considered in determining whether paragraph 95(2)(b) applies?

   CCRA's REPLY:

   The fact pattern described above would clearly fall within
   the scope of paragraph 95(2)(b) because the business of
   Canco is carried on in Canada and the fee is deductible
   in computing the income of Canco from that business.
   However, there may be circumstances where a taxpayer
   carries on more than one business and one of such businesses
   is carried on entirely outside Canada. In such
   case, fees paid by the taxpayer to a controlled foreign
   affiliate which are deductible in computing the income
   from the business which is not carried on in Canada
   would not be subject to paragraph 95(2)(b).

   * As a result of our review, it is our opinion that the
   comments in Technical Interpretation 9622935 are
   misleading and the interpretation will be rescinded.

Would the Department of Finance consider expanding the exemptions to include the provision of services by foreign affiliates whose principal business is the provision of such services, directly or indirectly, to third-party foreign persons?

22. Foreign Tax Credit Limits

In computing the Business Foreign Tax Credit (FTC) limit in subsection 126(2), the Canadian Tax Otherwise Payable threshold determined in subsection 126(2.1) can be summarized by the following formula:

Tax Otherwise Payable   X   Net qualifying income
                            (i.e.. foreign income)
                            Adjusted Net Income

In arriving at Adjusted Net Income, dividends, net capital losses, and certain other deductions are allowed, but several other deductions are not, including charitable donations and deductions under paragraph 110(1)(k). By excluding charitable donations and paragraph 110(1)(k) deductions from the definition of Adjusted Net Income, the FTC limit is reduced.

A. Charitable Donations:

As a taxpayer's donations increase, the taxpayer's FTC entitlement decreases. Is this inverse correlation intended? Would the Department consider introducing legislation to amend the provision in order to support corporate charitable donations?

B. Part VI.1 Offset:

With respect to the paragraph 110(1)(k) deductions, the underlying policy rationale for offsets to Part VI.1 tax liability is to ensure tax neutrality for profitable taxable Canadian corporations. In the context of the FTC limit, however, neutrality is eroded. Was the inverse correlation between the FTC Limit and the Part VI.1 offset intended? Would the Department consider introducing an amendment to remedy this deficiency?

23. Prepayment of Assessments by Large Corporations 225.1(7)

Under subsection 225.1(7) of the Act, CCRA may commence collection proceedings against "large" corporations for 50 percent of assessed amounts despite a formal appeal of the assessments. TEI submits that the discriminatory treatment of large corporations under subsection 225.1(7) is inappropriate and unwarranted and urges that the rule be repealed. Requiring companies to deposit taxes in order to seek an administrative or judicial appeal imposes a substantial financial burden especially since the assessment may be resolved in whole or in part in the taxpayers' favour. The "pay to play" provision is especially onerous where the assessments involve double taxation flowing from disputes among two or more taxing jurisdictions (e.g., transfer pricing). Resolving such disputes is a time-consuming process. We also believe the provision is contrary to fairness policies, taxpayer rights, and CCRA's Future Directions initiative. We invite a discussion of the prospects for repeal of subsection 225.1(7).

24. Stock Appreciation Rights

Stock Appreciation Rights (SARs) are commonly used by public companies as a means of providing long-term incentives for employees. SARs can generally be issued in conjunction with stock options (hereinafter, "tandem SARs") or on a stand-alone basis ("stand-alone SARs"). Tandem SARs are effectively the same as standard employee stock options where the terms of the stock option afford the employee a "cash-in-lieu" right. As a result, most tandem SARs are subject to tax under the rules in section 7 of the Act, (10) which provides much-needed certainty of treatment. On the other hand, stand-alone SARs are not stock options per se, so they can be distributed more widely in a corporation. In addition, since there is no agreement to issue shares and no corresponding opportunity for a paragraph 110(1)(d) deduction or capital gains treatment, stand-alone SARs are not taxed under section 7 and are subject to taxation at full rates.

CCRA has suggested that, once a right to stand-alone SARs becomes exercisable, the stand-alone SARs are potentially subject to the rules relating to salary deferral arrangements (SDA) if one of the main purposes of the arrangement is to postpone tax. Indeed, CCRA reportedly will not rule on whether such plans constitute SDAs after stand-alone SARs become exercisable because it is generally not possible to determine whether the principal purpose for the creation of the right was to postpone tax otherwise payable. CCRA's position, however, seemingly ignores the market risk to which holders are subject, a risk that can cause the appreciation in the SARs to disappear quickly. The potential application of the SDA rules results in significant uncertainty that is causing companies to reconsider whether to issue these rights.

Would the Department consider amending Regulation 6801 to make stand-alone SARs a "prescribed plan or arrangement" in order to provide certainty in respect of the taxation of these securities? Note that, owing to the operation of subsection 78(4), the employer cannot deduct the payment any earlier than the year prior to the exercise of the SARs.

25. Waivers Beyond Normal Assessment Period

Under subparagraph 152(4)(a)(ii), a taxpayer may extend the normal assessment period in respect of a taxation year by filing a waiver with the Minister of National Revenue. The waiver is valid only if filed within the normal assessment period for the taxpayer in respect of the taxation year. The normal assessment period for corporations, other than Canadian Controlled Private Corporations (CCPCs), is four years from the date of the mailing of the original notice of assessment, but there are circumstances, which are described in paragraph 152(4)(b), where the assessment period is extended by an additional three years. One example is for assessments of transactions between the taxpayer and a non-arm's length non-resident.

In many circumstances, the seven-year assessment period creates a procedural trap for taxpayers, especially large-case taxpayers that must pay 50 percent of the reassessed tax in order to appeal a reassessment. Specifically, assume that in Year 6 CCRA proposes, under the seven-year assessment period of paragraph 152(4)(b), an adjustment to a dividend received in Year 1 from a taxpayer's foreign affiliate and reassesses the taxpayer's Year 1 return. The taxpayer disagrees with the reassessment, pays 50 percent of the tax (even though it believes it will win the issue in its entirety), and appeals the case to the courts. In the meantime, in Year 7 CCRA begins an examination of the taxpayer's returns for Years 2 and 3 and identifies a similar adjustment for dividends from foreign affiliates in Years 2 and 3. In respect of Year 3, the taxpayer may be able to file a waiver of assessment. In respect of Year 2, however, the "normal assessment" period has passed so the taxpayer is precluded from filing a waiver of assessment even though both CCRA and the taxpayer accept that the proper treatment of the Year 2 (and Year 3) dividend will be determined by the court's resolution of the issue in Year 1. As a result, CCRA must issue a formal reassessment and the taxpayer must pay 50 percent of the tax in order to pursue an appeal of the identical issue in Year 2 that is already pending for Year 1. Since there is no harm to the government's interest in the revenue, we believe it would be far more efficient to permit the taxpayer to provide a waiver in respect of both Years 2 and 3.

Would the Department explain why waivers in respect of an issue are not possible where the normal assessment period has passed? Would the Department consider a legislative change in order to permit a waiver to be filed beyond the normal assessment period? As in the example, there are many circumstances where a waiver given by the taxpayer after the normal assessment period would be beneficial for both the taxpayer and CCRA.

26. Proposed Clause 248(16)(a)(i)(B)

Proposed clause 248(16)(a)(i)(B) provides that a GST input tax credit will be deemed to be government assistance received at the earlier of the time that the GST was paid or became payable if,

(a) The taxpayer's threshold amount for the fiscal year is greater than $500,000, and

(b) The taxpayer claimed the input tax credit at least 120 days before the end of the taxpayer's normal reassessment period, as determined under subsection 152(3.1) for the year.

Large corporations enter into thousands (if not hundreds of thousands) of transactions on which GST is paid and for which they are entitled to receive input tax credits. Given the volume of transactions, it would not be unusual for errors to occur that result in the GST input tax credits being understated. The proposed amendment deems the missed input tax credits to have been received during the period in which the GST was paid or payable. Accordingly, the taxpayer's taxable income for the earlier period will be affected, possibly resulting in interest and penalties being assessed against the taxpayer. Although this result may be proper in certain circumstances, it is not proper if it simply reflects computational errors or adjustments. TEI recommends that the Department consider legislation to establish a de minimis input tax credit amount of say, $500,000, before taxpayers would be required to adjust their prior year income tax returns for purposes of this provision.

27. Reorganization of Foreign Affiliates

The Act permits tax-free reorganizations of foreign affiliates and of a Canadian controlled group. Would the Department consider permitting tax-free reorganizations of Canadian corporations where there are intermediate controlled foreign affiliates?

28. Part VI Tax and Related Deductions in Computing Taxable Income

During the last two liaison meetings, TEI has recommended that a number of consequential amendments be made to the Act in order to take account of the reduction of the corporate income tax rate. We are pleased that some of the recommendations were incorporated in the December 20, 2002, Technical Bill. TEI's recommended adjustment to the Part VI tax rate, however, was not included. (11) We invite the Department to explain why the Technical Bill omitted amendments to the Part VI tax rate. As an alternative to reducing the Part VI tax rate, other solutions, such as extending the carryover period or permitting the tax to be transferred within a corporate group, can be fashioned.

29. Overseas Employment Tax Credit--December 20, 2002, Technical Bill

The December 20, 2002, Technical Bill adds paragraph 122.3(1.1)(b) to the Act to restrict the benefit of the overseas employment tax credit. Under this proposal, an individual would be denied the benefit of the credit if at any time in the "qualifying period" the individual's services are rendered to an entity with which the employer does not deal at arm's length and less than 10 percent of the fair market value of all interests in the entity are held by persons resident in Canada.

Canadian companies often carry on their foreign operations through foreign affiliates or foreign partnerships that are owned indirectly by an individual's Canadian resident employer. The proposed amendment seemingly requires the Canadian resident employer to have a direct 10-percent ownership interest in the entity to which the individual's services are provided. Would the Department consider revising proposed subparagraph 122.3(1.1)(b)(ii) to limit its application to situations where less than 10 percent of the fair market value of all interests in the entity are held "directly or indirectly" by persons resident in Canada?

30. Double Tax for Controlled Foreign Affiliates

Scenario A: Assume the following initial ownership structure for a corporate group:

[ILLUSTRATION OMITTED]

* CANCO Parent and CANCO Sub are resident in Canada.

* FA1 is a non-resident of Canada and is resident in a low-tax jurisdiction.

* FA1 carries on an investment business as defined in subsection 95(1) and thus CANCO Parent includes the FAPI of FA1 in computing its income. CANCO Parent's adjusted cost base in FA1 is increased pursuant to section 92. The FAPI is added to FA1's taxable surplus pool.

CANCO Parent then transfers its shares of FA1 to CANCO Sub under section 85 in exchange for additional common shares of CANCO Sub, resulting in the following ownership structure:

[ILLUSTRATION OMITTED]

Following the transfer of shares, FA1 pays a dividend to CANCO Sub out of taxable surplus.

Analysis of Scenario A results:

Pursuant to subsections 91(5) and 91(6), CANCO Sub can deduct from its income the amount of the dividend received from FA1. CANCO Sub's adjusted cost base in the shares of FA1 is reduced by a corresponding amount pursuant to section 92. This result is reasonable because it prevents the income earned by FA1 from being subject to double taxation in Canada.

Scenario B: Assume the following alternative structure:

[ILLUSTRATION OMITTED]

* CANCO Parent owns 100 percent of the common shares of FA1 and FA2.

* CANCO Parent is resident in Canada.

* FA1 and FA2 are non-residents of Canada and both are resident in a low-tax jurisdiction.

* FA1 carries on an investment business as defined in subsection 95(1) and thus CANCO Parent includes the FAPI of FA1 in computing its income. CANCO Parent's adjusted cost base in FA1 is increased pursuant to section 92. The FAPI is added to FA1's taxable surplus pool.

* FA2 is a holding company and has no surplus balances.

CANCO Parent then transfers its shares of FA1 to FA2 under subsection 85.1(3) in exchange for additional common shares of FA2.

[ILLUSTRATION OMITTED]

Following the transfer of FA1 to FA2, FA1 pays a dividend to FA2 out of taxable surplus. FA2 pays a corresponding dividend to CANCO Parent.

Analysis of Scenario B results:

The dividend received by CANCO Parent is subject to tax in Canada even though the earnings that funded the dividend payment (i.e., the earnings of FA1) have already been subject to tax in Canada as FAPI. The adjustments provided by subsections 91(5) and 91(6) in Scenario A are not available here. There is no mechanism to prevent the earnings of FA1 from being subject to double taxation in Canada.

Because of various business and economic factors (e.g., legal liability, regulatory requirements, and tax reasons), Canadian multinationals often reorganize the ownership structure of their controlled foreign affiliates. In order to prevent income of a controlled foreign affiliate from being subject to double taxation where the ownership in a controlled foreign affiliate is transferred from a Canadian tax resident to another controlled foreign affiliate of the Canadian tax resident, TEI recommends that the Department of Finance introduce an adjustment mechanism similar to that provided in subsections 91(5) and 91(6). Would the Department introduce an amendment to address this issue?

31. Surplus Entitlement Percentage

Assume the following:

[ILLUSTRATION OMITTED]

* FA1 carries on an active business as defined in subsection 95(1).

* FA2 carries on an investment business as defined in subsection 95(1) and owns capital property (non-excluded property) that has appreciated in value.

* FA2 is wound up and dissolved into FA1.

* No gain or loss is recognized for U.S. tax purposes in the course of the liquidation and dissolution of FA2 into FA1.

Analysis:

Upon the liquidation and dissolution of FA2 into FA1, CANCO Parent can avail itself of the rollover provisions in paragraph 95(2)(e.1) in order to avoid the realization of FAPI. On the other hand, CANCO Sub cannot rely on the rollover provisions in paragraph 95(2)(e.1) because its surplus entitlement percentage in FA2 is less than 90 percent. As a result, CANCO Sub will be required to pick up its pro-rata share of FAPI that results from the deemed disposition of FA2's assets.

This result penalizes Canadian multinationals that, because of various factors (e.g., legal liability, regulatory requirements, and tax purposes), split the ownership of foreign affiliates among two or more related Canadian corporations. TEI submits that a "related party" concept should be introduced into 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). Would the Department introduce an amendment to address this surplus entitlement percentage issue?

32. Employee Objections

At the 2002 liaison meeting with the Department, TEI queried whether the Act could be amended to permit employers to directly appeal the assessments of employee remuneration, especially where the assessment affects multiple employees or is attributable to the employer's compensation and taxable benefit reporting practices. Currently, the only way an employer may pursue an appeal of an employee assessment is to request that each employee appeal his or her assessment and assign the appeal to the employer corporation. The individual's assessment including applicable assessment interest must also generally be paid, which the employee often recovers from the corporation. An employee that is tax protected, thus, has no incentive to help the corporation in the appeal. The net result is that the employer corporation often bears the costs of the assessment and appeal without a direct right of appeal.

The Department said that the cumbersome appeal procedure is necessary in order to protect the confidential information of the individual employees. TEI acknowledges the Department's concern, but submits that employers should be in a position to manage their affairs. One solution might be to create a new provision in Act modeled on subsection 173(1). This would protect individual privacy while also affording employers an opportunity to protect their financial position. To focus the discussion, we suggest the following draft language:

Where the Minister and a taxpayer are aware that employees of the taxpayer have been assessed or are proposed to be assessed for a matter related to remuneration from the employer and it is reasonable to conclude that the taxpayer will ultimately bear the costs related to the assessments or proposed assessments to the taxpayer's employees, the taxpayer may raise a question of law, fact, or mixed law and fact arising under this Act to the Tax Court of Canada in respect of any assessment, proposed assessment, determination, or proposed determination and that question shall be determined by that Court.

We invite the Department's views on the proposal and request an update on the Department's position.

33. Partnership Foreign Tax Credit Follow Up

In its response to question 21 from the 2002 liaison meeting agenda (a copy of which is attached as item number two in the appendix), the Department said that it would review CCRA's interpretation and consider their concerns. The Department said that, if CCRA maintained its position, it would consider introducing a legislative amendment. Would the Department provide an update on this issue?

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 3, 2003, liaison meeting.