Pending income tax issues: December 4, 2001. (Canada Customs and Revenue Agency).

On December 4, 2001, Tax Executives Institute held its annual liaison meeting with officials of the Canada Customs and Revenue Agency on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney of General Motors of Canada Limited. A full report on the meeting will be published in a future issue of The Tax Executive.

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Tax Executives Institute welcomes the opportunity to present the following comments and questions on pending income tax issues, which will be discussed with representatives of the Canada Customs and Revenue Agency (hereinafter, "CCRA" or "the Agency") during TEI's December 4, 2001, liaison meeting. If you have any questions about the agenda in advance of the meeting, please do not hesitate to call either Alan Wheable, TEI's Vice President for Canadian Affairs, at [phone] or David M. Penney, Chair of the Institute's Canadian Income Tax Committee, at [phone].

1. Audit Administration

A. General. At the 2000 liaison meeting, TEI requested CCRA's comments on establishing a single point of contact with final decision-making authority for all audit determinations where various specialists (e.g., Scientific Research & Experimental Development (SR&ED), Tax Avoidance, and International) are involved in the taxpayer's audit. In response, CCRA stated that under the Single-Window Focus:

   The Large File Case Manager (LFCM) is responsible. for managing the
   compliance relationship with the corporation (and its controlled entities)
   for all business lines by developing and maintaining open, cooperative and
   timely communication, and working to address all areas in a speedy and
   professional manner. The LFCM is a single point of contact for the
   corporation relating to all audit activities.

CCRA added:

   Each team member is responsible for developing and conducting specific
   audit procedures for their specialty area, establishing priorities and
   tentative completion dates with the LFCM, and communicating on their
   progress and findings on pre-established timelines. Requests for
   information and presentation of audit issues by the specialists are routed
   through the LFCM....

   Ultimately, and as a focal point, proposed adjustments are presented
   through the LFCM, as the Agency's reassessment position. Operational
   differences will have been resolved with the local functional managers and,
   where required, through Headquarters' assistance.

CCRA's increasing use of specialists in large-case file audits makes it more difficult for the LFCM to act as a the principal co-ordinator; hence, audit administration issues continue to provoke member concerns. Furthermore, members find that the LFCM does not necessarily act as the main point of contact even where the taxpayer requests that the audits be managed on that basis. We invite CCRA's comments and a discussion of what can be done to ensure that the message gets down to the field.

B. SR&ED Audits. At the May 2001 Ottawa Conference on SR&ED, CCRA confirmed that the SR&ED Directorate rather than the Audit Directorate will control the review of SR&ED claims. This new administrative process seems at odds with making the LFCM the focal point for all audit decisions. How will CCRA implement the SR&ED claim review process? Will the LFCM retain final authority to resolve SR&ED claims? If not, who will have that authority? If the LFCM retains final audit authority, how will the claim review process be coordinated with the audit?

2. Fines and Penalties

In many cases, auditors fail to take account of recent jurisprudence. For example, the Supreme Court decision in 65302 British Columbia Ltd. v. The Queen, 99 D.T.C. 5799, addressed the deductibility of fines and penalties, but few auditors seem aware of the decision or follow it unless TEI members bring the case to their attention. We invite CCRA's comments on its process for disseminating information about current jurisprudence to field staff in order to ensure that significant decisions are taken into account in audits that are underway when a case is decided.

3. George William Harris Litigation

George William Harris, et al., have been waging a relentless challenge in the courts seeking the discovery of information related to CCRA's administration of the advance rulings process. If Harris is successful, confidential taxpayer information may be subject to public disclosure. Has this litigation affected CCRA's current operations? We invite a discussion of CCRA's views of what the effect might be should the Harris group ultimately prevail in its quest.

4. Installment Interest--Corporations

In discussions with a Taxation Centre, members have been advised that the methodology for calculating installment interest on assessments and reassessments has been changed effective for taxation years ending in 2000 or later. For reassessments prior to 2000, CCRA will employ the old methodology only at the taxpayer's request. This change in the interpretation of the interest calculations has been effected without broad communication to taxpayers.

Subsection 157(1) of the Income Tax Act (hereinafter "the Act") provides that tax installments must be made in an amount equal to an amount that is the least of:

1. The current year tax liability;

2. The preceding year tax liability; or

3. One twelfth of the 2nd preceding year's tax liability for each of the first two months of the year, and, for each of the next ten installments, one tenth of the difference between the preceding year's tax liability and the first two months' installment payments.

Under the old methodology for installment interest, CCRA computed the required installments and related interest under all three methods and used the method that provided the least amount of installment interest. CCRA now interprets subsection 161(4.1} to mean that when the current year tax liability provides for the minimum total tax installment, the taxpayer must use option one in determining its monthly installments. To illustrate the results of applying the different methodologies, assume the following tax liabilities for each of the respective years for a calendar-year taxpayer:

1998   $0

1999   $100

2000   $99

Under the old methodology, a taxpayer could pay the following installments (based on option three above) on account of its year 2000 tax liability:

January and
February                 $0
(1/12 of the 2nd preceding year's tax liability of $0)

March to December        $10
($100-0)/10

The option three method is practical because the taxpayer cannot reasonably estimate its year 2000 tax liability by January 2000, nor would the taxpayer have finalized its estimate of its 1999 tax liability (which is usually prepared in time for the February make-up payment). As the year 2000 progresses and the 2000 tax liability approximates that of 1999, the taxpayer could switch methods and use option two (the 1999 tax liability) to bring certainty to its installments.

Under the new methodology, CCRA has determined that subsection 161(4.1) limits the taxpayer to the installment methodology that requires the least total amount of tax installments. On the assumed facts, option one (current year tax) requires the payment of only $99 of tax and therefore the taxpayer is not entitled to use options two or three (which would require the payment of $100 of tax installments). As a result, CCRA will compute required monthly installments of $8.25. Since the taxpayer did not make any installments during months of January and February, the taxpayer would not have paid the required installments and installment interest will be calculated. Even though the taxpayer would correspondingly overpay its installments (vis-a-vis CCRA's calculations) for the months of March to December, there is insufficient time for the taxpayer to catch up on its installments. Hence, the taxpayer will be assessed installment interest even though it would have paid the minimum installments required under subparagraph 157(1)(a)(iii). Would CCRA please confirm the member's understanding and explain its revised interpretation of subsection 161(4.1)? Equally important, this is a fundamental change that affects the installment payments of every corporate taxpayer. TEI urges CCRA to issue a public announcement of the change as soon as possible.

5. Provisions of Service

Where payments are received in advance of the taxable period where services will be rendered or goods delivered, paragraph 12(1)(a) of the Act requires an income inclusion in the period when the payment is received. Unless the taxpayer can "reasonably anticipate" that goods or services will be provided after year-end, no reserve can be established under paragraph 20(1)(m) by a vendor. To avail itself of the reserve provision of paragraph 20(1)(m), a taxpayer generally must demonstrate that there is a contractual obligation to provide the goods or services.

Under most software maintenance agreements, the taxpayer can usually

demonstrate that software code fixes, updates, or upgrades will be provided; the only question is the timing of the service or upgrade. Similarly, most equipment maintenance agreements include a clause requiring the vendor to provide preventive or routine maintenance on a predetermined schedule in order to ensure that the customer's business operations continue in an uninterrupted fashion. Preventive maintenance schedules for equipment are generally based on the passage of time, level of usage, historical failure rates, or some combination of these variables, whereas most software maintenance agreements generally do not provide for scheduled releases of upgrades, updates, or code fixes. Rather, these services are provided on an "as required basis."

For both hardware and software agreements, a vendor receiving payment for an entire year of services near the end of its tax year must include the entire amount in income in the year of receipt. In addition, since few costs or expenses will have been incurred in respect of these contracts in the year of receipt, tax is payable on the entire amount of revenue with no deduction for costs or expenses to be incurred in providing the services. The tax prepayment, in turn, imposes a cash-flow burden on vendors thereby impairing their ability to fulfill their contractual obligations. In contrast with the tax treatment, Canadian GAAP requires the revenue to be deferred and included in income over the period of the contract. Would CCRA consider permitting the taxpayer to prorate the fees received, based on the length of the contract, and include in income only those fees that relate to the percentage of the contract period that pertains to the current taxation year?

6. Regulation 105

Companies increasingly are staffing projects based on global sourcing requirements and skills rather than looking solely to the resources available in their home jurisdiction. In many cases, staffing is provided by non-resident, related parties. In TEI's view, the current withholding requirements in Regulation 105 severely impede Canadian organizations in effectively competing for these global resources. In addition, administrative and compliance burdens are borne by the organization contracting for the services (in terms of withholding and reporting), the service provider (in terms of additional reporting requirements and cash flow), and CCRA in its administration of the program. One means of alleviating the compliance and administrative burdens would be to permit the issuance of a blanket waiver for any related party transactions in situations where the nonresident supplier, (1) does not have a permanent establishment in Canada or (2) will affirm that they will be responsible for filing appropriate tax returns with CCRA. Would CCRA consider implementing such a measure?

7. Withholding Tax Exemption

Paragraph 7 of IT 361R3 provides that a payment of interest made at the issuer's discretion does not disqualify an obligation from the withholding tax exemption set forth in subparagraph 212(1)(b)(vii) of the Act. There are, however, technical interpretation documents (1) that state that the presence of a conversion option that is exercisable by the issuer at its discretion will disqualify any payment under the obligation from the withholding exemption. Do these technical interpretations accurately state CCRA's position. If so, will CCRA please explain its position?

8. The GAAR Committee

In the interest of obtaining consistent and fair application of section 245 of the Act, the GAAR Committee was established in November 1988. One of the Committee's functions is to determine whether GAAR applies to specific transactions. We understand that the GAAR Committee is currently composed of senior members of the CCRA Rulings Directorate and representatives from the Departments of Finance and Justice. We have the following comments, questions, and concerns about the GAAR committee.

When conducting a review of specific taxpayer transactions, what is the role of the Department of Finance and under what statutory authority is taxpayer information provided to the Department of Finance? Subsection 241(1) of the Act generally prohibits disclosure of taxpayer information except for certain purposes and under specified circumstances. Subparagraph 241(4)(d)(i) states that taxpayer information may be provided "to an official of the Department of Finance solely for the purposes of the formulation or evaluation of fiscal policy." Would it be possible for the Committee to obtain input from the Department of Finance with respect to the policy and legislative intent of the Act on a "no names" basis for purposes of CCRA's administration and interpretation?

Similarly, what is the role of the representatives of the Department of Justice on the GAAR Committee? Are they legal advisers to the GAAR Committee or do they take an active part in the ruling decision itself?. Are communications between Department of Justice representatives and CCRA privileged, even if Department of Finance personnel are present? Is there a way for the CCRA to obtain legal advice from the Department of Justice that would then permit the GAAR Committee to maintain minutes of their considerations for release to the taxpayer?

From a tax policy perspective, TEI is concerned that there be consistent and fair application of GAAR with an open process. The affected taxpayers should be permitted to present their cases to the GAAR Committee or obtain copies of CCRA Audit submissions before the GAAR Committee has ruled on the issue. If the GAAR Committee considers an issue submitted by CCRA Audit and rules that GAAR should be applied to recharacterize the transaction, how does the Minister of National Revenue comply with subsection 165(3) of the Act to "reconsider" the assessment following a taxpayer's objection? Following a GAAR Committee decision, does an appeals officer have discretion to "reconsider" whether GAAR applies?

TEI has a number of questions regarding the composition of the Committee and serious concerns about the Committee's operation. The stature and influence of the Committee, the secrecy of its deliberations, and its unwillingness to hear directly from taxpayers undermines taxpayer confidence in CCRA's administration of the GAAR regime, including by officials in the Appeals Branch. TEI invites CCRA's response.

9. Interest Rate Swaps--Amortization of Premium Payments

Interest rate swaps are an essential element of financing transactions. Where two parties enter into a long-term interest rate swap, the premium received on entering into the contract seemingly should be included in income in its entirety upon receipt notwithstanding that the term of the swap extends over many years. Obversely, a premium paid is typically amortized over the term of the swap. As a result of the dynamic relationship between the notional interest rate for payments due under the swap and the market interest rates during the course of a long-term swap agreement, a taxpayer will in different periods sometimes pay and sometimes receive an amount under the swap agreement. The different tax treatment accorded the premium, depending on whether a payment is made or received under the contract, conflicts with the corporate treasury department's objective of amortizing all payments made or received over the life of the swap in order to properly reflect the financing cost of the debt. We request confirmation that a taxpayer that enters into an interest rate hedge as part of a financing transaction is permitted to amortize the swap premium paid or received over the term of the swap, provided this treatment is consistently followed by the taxpayer.

10. Reassessment Period

Paragraph 221(1)(d) of the Act empowers the Governor in Council to make regulations requiring any class of persons to file information returns. For partnerships, this requirement is reflected in Regulation 229. Under subsection 220(2.1) of the Act, the Minister can waive the requirement to file such returns but a person receiving the waiver must supply documentation or information whenever the Minister's requests. Paragraph 11 of Information Circular IC 89-5R, Partnership Information Return, specifically provides an administrative waiver for partnerships with fewer than five partners. In recent interpretations (specifically, Document Numbers 9726115 and 2000-0010935), the Department stated that the partners of a partnership that has not filed a partnership return may be assessed at any time in accordance with subsection 152(1.4). How does CCRA reconcile this position with the reassessment periods otherwise provided for the partners under subsection 152(4) of the Act? The interpretation effectively delays the statute-barred date indefinitely for corporate partners where the partnership is relying on the Minister's waiver of the obligation to file a return. If a corporate partner is requested to file the partnership information return after the corporation's taxation years are beyond the three-year limitation, how can CCRA effect any changes to the partnership income or carry forward balances in the partners' corporate tax returns?

11. Foreign Affiliate Rules--Interpretation

We invite the Department to consider the following hypothetical examples.

A. Canco has two foreign affiliates, FA1 and FA2. Canco has a "qualifying interest" in FA1 but does not have a qualifying interest in FA2. Both FA1 and FA2 are related to Canco. FA1 makes a loan to FA2, the interest on which is deductible from FA2's active business income. Will CCRA accept that clause 95(2)(a)(ii)(A) of the Act applies to recharacterize the interest income earned by FA1 as active business income notwithstanding that FA2 is a foreign affiliate of Canco?

B. Canco owns 100 percent of FA1. FA1 is an operating company that has excess cash that it invests in NR1, a related company that is not a foreign affiliate of Canco. NR1 performs a group treasury function whereby it obtains money from related, cash-rich companies and either deposits the cash with arm's-length financial institutions or lends it to related, cash-poor companies for use in their active businesses. The volume of NR1's borrowing and lending activity makes it impossible to track which portion of FA1's cash has been deposited with arm's-length financial institutions and which portion has been lent to related companies. Will CCRA permit taxpayers to use a "fungibility" approach to determine the amount of income recharacterized under clauses 95(2)(a)(ii)(A) and (B) as having been paid indirectly to FA1 by the cash-poor entities? For example, assume on average that 30 percent of NR1's cash is on deposit with arm's-length financial institutions and 70 percent is lent to related companies. Will CCRA consider that 70 percent of FA1's interest income is active business income?

12. Canadian Development Expense

Would CCRA please confirm that, where a taxpayer has acquired an oil-sands lease for the right to explore, drill, or mine for bituminous sands in Canada, the cost is included in the definition of Canadian Development Expense (CDE) pursuant to paragraph 66.2(5)(e)?

Would CCRA also confirm that the costs of drilling a development in-situ oil and gas well to extract bituminous sands are included in the definition of Canadian Development Expense pursuant to subparagraph 66.2(5)(a)(ii)? We understand that the 1996 legislative amendments are intended to ensure that, as long as the viscosity and density of the hydrocarbon specified in the bituminous sands definition of section 248 are met, these costs are CDE where a taxpayer acquires oil and gas leases in provinces that do not specifically issue oil-sands leases, even thought the right would technically fit both (a) and (b) of the definition of a Canadian Resource Property.

13. Exemption from Withholding on Transfer of Bonus to RRSP

New regulation 100(3) allows for the deduction, from the amount on which deductions at source must be calculated, of an amount that is a premium under a registered retirement savings plan (RRSP). The new regulation replaces the problematic $10,000 threshold of now repealed regulation 100(3.2) with the employee's RRSP deduction limit. Specifically, to the extent that "the employer believes on reasonable grounds" that a premium is deductible in computing the employee's income for the taxation year in which a payment of remuneration is made, the deduction is permitted. TEI welcomes this change, but to be effective the regulation depends on proper administration of the phrase "that the employer believes on reasonable grounds." To clarify the regulation, we submit the following question and recommendation:

A. Assuming a bonus is paid in January 2002, is the relevant RRSP deduction limit the one available for 2001 (as calculated by CCRA based on the year 2000 figures) or the one for 2002 (computed with reference to the 2001 earned income)?

B. TEI recommends that an employer be permitted to establish that it "believes on reasonable grounds" that the deduction is permitted by obtaining a letter from {he employee that states the amount of his or her RRSP deduction limit. Please comment on the recommendation.

14. Crown Forest Interpretation

Many TEI members are surprised by CCRA's interpretation of Crown Forest Industries v. Canada, 95 D.T.C. 5389 (S.C.C.), that CCRA believes Crown Forest requires that, to be considered a resident under a treaty for Canadian tax purposes, the taxpayer must be subject to the most comprehensive worldwide tax system within the treaty country. The shipping company (Norsk) in Crown Forest, however, was exempt from United States tax under the explicit terms of the U.S. tax legislation. If the issue before the Supreme Court of Canada had been whether a domestic tax exemption applied, the Court could have addressed the issue in a much simpler way. More important, the Internal Revenue Service in Revenue Ruling 2000-59 (2000-52 I.R.B. 543) has taken a position that appears at odds with the CCRA interpretation of Crown Forest. Specifically, Rev. Rul. 2000-59 (holding number one), which is attached as an Appendix, states that the phrase "liable to tax" in the determination of residence under a treaty with a country imposing worldwide taxation does not require actual taxation of the entity or person, which is contrary to CCRA's position. As a result, could you please advise whether there is a dispute with the United States on the coverage of what is arguably Canada's most important treaty?

15. Assessments Contrary to Published Administrative Positions

In Lerric Investments Corp. v. The Queen, 2001 D.T.C. 5169, the Federal Court of Appeal held that a taxpayer cannot count its proportional share of full-time employees employed by a joint venture in which it participates in order to satisfy the 'more than five full-time employees" test in subsection 125(7) of the Act. The court's ruling was surprising because the taxpayer's position was based on CCRA's published guidance. Specifically, paragraph 16 of IT-73R5 states that, in order to determine the number of full-time employees employed by a corporation participating in a joint venture or other co-ownership arrangement, "the total number of full-time employees who work jointly for all the co-owners must be allocated to each co-owner in accordance with the co-owner's percentage of interest in the property." In effect, CCRA's assessment and litigation position was diametrically opposite its published guidance.

Regrettably, this is not the first instance where a taxpayer has been assessed on a basis different from a published administrative policy. In a self-assessment tax system, it is important for taxpayers to perceive that they will be treated equitably and can rely on the government's published administrative positions. Without such assurance, the credibility of the tax system is undermined. As important, without such a constraint, tax auditors may be emboldened to assert assessing positions contrary to the government's published policy. Hence, TEI is puzzled that the government would assert an assessment and litigation position contrary to its official published position. The government may, of course, reconsider its position on specific issues, but if it does so, published guidance should be changed prospectively with taxpayers afforded protection from retroactive application of the new position.

To frame the discussion at the meeting, we are interested in understanding what internal "quality control" processes are employed to prevent auditors from asserting a position contrary to a published administrative position (whether an interpretation bulletin, technical interpretation, or other document)? In addition, since cases can take years to wind their way through the system, we strongly recommend that the Agency publish an early "warning" as soon as possible in order to inform the public that an administrative position has changed, is under review, or may no longer be relied upon. We invite CCRA's comments on an early warning system for revised administrative positions.

16. Assessments and Litigation Contrary to Tax Policy

In Royal Trust v. The Queen, 2001 D.T.C. 52, the Minister assessed the taxpayer for purposes of calculating the Part I.3 liability for amounts representing its interest in direct financing leases. The position of the Minister was that the amounts were related to "tangible property used in Canada" by the taxpayer. The taxpayer, however, won the case because financing for the leases was part of the taxpayer's ordinary business of providing loans and financing for customers.

Regrettably, the Minister's assessment position was seemingly based on a misapprehension not only of the policy underlying the specific provisions of the Part I.3 tax but of many other interrelated policies in the Act. Specifically, the items included in the taxable capital of a financial institution are more limited than for other corporations because the balance sheet consists largely of financial assets on both sides of the ledger. As a result, the items included in the taxable capital of a bank for purposes of Part I.3 are "pure" capital items (i.e., long-term debt and shareholders' equity) that support the financial intermediary operations of the institution. When the capital tax provisions were enacted, however, the government recognized that capital assets acquired by a financial institution for its own use (as is the case with most non-financial corporations) are very likely financed (or should be deemed financed) by long term or "permanent" capital. Since it is administratively difficult for a financial institution--and even more so a tax auditor--to allocate debt financing to specific assets, the government created a fiction and deemed the tangible property held by a bank for its own use to be financed by "capital" and included the deemed amount on the balance sheet for purposes of computing the taxable capital under Part I.3. The government's intention to distinguish assets relating to, or resulting from, its financial intermediary operations from those used in operations is also clear under paragraph 181.3(1)(a), which excludes from tangible property assets that are acquired by a financial institution as a consequence of another person's default-in respect of a debt owed to the institution. Clearly, direct leases that result from the financial intermediary operations should not be included in the taxable capital of a bank if the intention and policy of the government is to be respected. That the Minister chose to litigate the issue is disturbing and prompts several questions:

1. Where an issue rests on an interpretation of tax policy and the underlying intent of legislation, does CCRA consult with the Department of Finance to ascertain that intention before issuing an assessment? How much weight is assigned to the advisory opinion of the Department of Finance in determining what the legislative intent of various provisions are?

2. What consideration does CCRA give to the government's intention and underlying tax policy before proceeding to court?

3. What is the role of the Justice Department in advising the Minister, especially in ascertaining the underlying intent and policy of tax legislation?

17. Audit Management

The Agency has employed statistical sampling as an audit tool for a number of years. The decision rendered by the Tax Court of Canada in Huyen v. The Queen, 1997 G.S.T.C. 37 (T.C.C.), however, casts doubt on whether this audit methodology should continue to be used. What are the Agency's views with respect to this decision? Will the decision affect the Agency's continued use of statistical sampling? Please explain.

18. Voluntary Disclosure

We have four questions relating to Information Circular 00-1, Voluntary Disclosures Program.

1. If a taxpayer makes a voluntary disclosure on a "no names" basis through a third party (e.g., legal counsel), will the conditions in the information circular apply?

2. Under what circumstances may a taxpayer under audit, especially a large-case file that is generally under continuing audit, make use of the Voluntary Disclosure Program?

3. Is it necessary in a large case file matter that the disclosure be complete across all CCRA administered program lines? In large companies, errors can regrettably occur in various areas. The requirement to determine whether there are any other unrelated areas where errors may have occurred will inhibit the free flow of disclosures and related information. In addition, some errors can be more effectively addressed with the large case file manager at the time of audit.

4. Finally, where an error is unintentional, does CCRA agree that corrections should be limited to open tax periods that are not statute-barred? The IC would be improved by explicit recognition of the policy underlying the statute of limitations.

19. Employer Requesting Relief for Employees

CCRA has indicated that under certain circumstances it will waive interest (and sometimes penalties) that might otherwise apply to individual employees where an adjustment to tax is a result of incorrect information supplied by the employer to the employee. Each affected employee must apply separately for interest and penalty relief. Where an adjustment to employee income arises from an audit of the employer or from a correction of an error by the employer and the employer provides all the necessary details for the adjustment, will CCRA permit the employer to request tax relief on behalf of all affected employees without requiring that each employee authorize the employer to act on his or her behalf? Such a process would expedite the correction of the affected employees's returns and increase administrative efficiency for the benefit of the employer, employees, and CCRA.

20. Taxable Benefits

TEI commends the government for adopting the recent changes that will permit employers to provide up to two non-cash awards and two non-cash prizes per year to employees. These changes provide welcome relief to employers from the administrative burden of valuing, tracking, and recording de minimis benefits for purposes of reporting taxable benefits.

Large organizations have numerous service, safety, and recognition award programs for their employees and it is extremely difficult to track and value all the awards. Indeed, it is often far more efficient

for the employer to record the costs of these awards in a single account and forgo deductibility of that account than to allocate the costs and taxable benefit to the employees. Will CCRA consider affording employers the option to exclude from taxable benefits those awards that are "cash or near cash" (such as gift certificates) where an individual employee receives more than two such awards in a year? To limit the effect, this option could be limited to award programs that are widely available, the value of the award is not deducted in computing taxable income, and each individual award does not exceed $500 in value. We invite CCRA's comment on TEI's proposal.

21. Subsection 85(1.11)

The recently enacted exception to the definition of eligible property in subsection 85(1.11) provides that subsection 85(1) cannot be used in a transfer of a foreign resource property held by a taxpayer (hereinafter the "transferor") to a non-arm's length Canadian subsidiary (hereinafter the "transferee") where "it is reasonable to conclude that one of the purposes of the disposition ... is to increase the extent to which any person may claim a deduction under section 126" (e.g., a foreign tax credit claim (FTC)). (Emphasis added.) The technical notes to Bill C-22 indicate that this provision is "intended" to counter the avoidance of income-based limits on the foreign tax credit in section 126 that might be achieved through the sale of direct or indirect interests in foreign resource property at less than fair market value."

The roll-down of tax paying foreign oil and gas assets to a transferee within the same Canadian corporate group will almost always results in an increase in the FTC claim of the transferee because, for example, it may not have previously owned any foreign tax paying properties. Hence, for purposes of subsection 85(1.11), the roll-down will almost always increase the extent to which at least one person (the transferee) may claim a deduction under section 126. Accordingly, on each transfer of a foreign resource property in a transaction otherwise qualifying under subsection 85(1), it will be necessary to determine whether it is reasonable to conclude that the increase to the transferee's (or any other person's) FTC was one of the purposes of the disposition.

TEI is concerned that CCRA could almost always assert that the "purpose test' in subsection 85(1.11) is satisfied, which would extend the reach of the statute far beyond the stated reason for introducing subsection 85(1.11). At a minimum, the "purpose test" creates uncertainty. One of the principal reasons Canadian oil and gas companies transfer foreign branches to Canadian subsidiaries is to limit exposure to the additional legal liabilities that can arise when a foreign operation moves from the exploration stage to development and production. Another non-tax reason to transfer the assets is to ease compliance with various obligations arising under foreign operating agreements. Inappropriate or uncertain tax results arising from the application of the "purpose test" may well inhibit, or even preclude, Canadian oil and gas companies from continuing to employ this traditional and prudent form of financial management.

In order to minimize ambiguity and uncertainty from the administration of subsection 85(1.11), TEI recommends that, where the elected amount pursuant to subsection 85(1) is not less than the lesser of the fair market value of the transferred property and the aggregate of unamortized Foreign Exploration and Development Expense and unamortized Cumulative Foreign Resource Expense that is reasonably allocable to the transferred property, subsection 85(1.11) should not be applied. We believe this represents a reasonable interpretation of the policy underlying the subsection and invite the Agency to comment on whether adoption of the recommendation would improve the administration of the provision.

22. Expatriate Returns

Many TEI member companies are part of large multinational organizations and as such they have many expatriate and "inpatriate" employees. Such employees are frequently highly paid, qualify for benefit and compensation arrangements that take account of their status, and hence have complex financial and tax situations. The most common situation is a U.S. citizen resident in Canada who files an income tax return in the United States based on citizenship and in Canada based on residency. In most cases, employers will provide professional tax assistance to the affected employees and the returns are prepared by competent tax preparers who are familiar with the subtleties and complexities of taxpayers' becoming resident or non-resident, the claiming of foreign tax credits, etc. Regrettably, taxpayers and their tax advisers are compelled to explain fundamental, but commonly recurring, issues that arise on these returns. For example:

* Taxpayers or their advisers frequently receive requests for detailed supporting information for return items even though the requested information was included with the original filing.

* The taxpayers receive requests to complete routine questionnaires about residency status even though the return preparers are highly knowledgeable about the rules for the determination of residency and may have completed an internal checklist in connection with the return preparation process.

* The assessment of these returns is frequently delayed, with assessments requiring more than a year to process.

Would CCRA consider establishing within the International Tax Services Office an internal service team that would be devoted to processing expatriate and inpatriate tax returns and responding to taxpayer and tax adviser questions? Establishing a central point of contact and concentrating CCRA's expertise for issues normally found on such complex returns would likely expedite the processing of these returns.

23. Scientific Research and Experimental Development (SR&ED)

Where expenditures are intended to qualify for SR&ED treatment, taxpayers must submit, and CCRA must review, annual claim forms describing each SR&ED project. Frequently, small projects will be commenced near the end of the tax year and completed shortly after the beginning of the subsequent year. Hence, the annual write-up process can create a profusion of duplicate project claims because the same project is submitted for review in each of two succeeding years. For large corporations with hundreds of project claims, a general administrative policy concession that permits companies to aggregate de minimis claims would be mutually beneficial for taxpayers and CCRA. In order to minimize the burden of taxpayers' claim preparation processes and to minimize CCRA's review of redundant claims, TEI recommends that CCRA permit taxpayers to aggregate numerous small projects with total expected SR&ED expenditures of up to say, $10,000 on a single, combined project write-up. We are aware of at least one taxpayer that was afforded this administrative relief and we invite CCRA to comment on adopting the concession as a general practice.

24. Schedule 80--Industry Canada Annual Return

Industry Canada and CCRA entered into an agreement that, beginning in 1999, calls for the Industry Canada Annual Return and filing fee to be filed with the annual corporation tax return. CCRA schedules 80 and 81 gather the information formerly submitted on Industry Canada Form 22. Recently, CCRA advised a TEI member that under standard operating procedures the information and filing fee are transmitted to Industry Canada within two to five days following receipt of the tax return. Members, however, have reported receiving default notices from Industry Canada several months after the tax returns were timely filed. Despite the standard operating procedure, neither the Industry Canada information

nor the filing fee had been forwarded by CCRA. The default notices were attributed to a "system" problem at the CCRA processing centres. In other words, new computer programs installed by CCRA were rejecting returns, delaying refunds and assessments, etc. When inquiries were made, CCRA personnel indicated that they were aware of a problem, but no relief has been offered to companies affected by the failure to transmit the data to Industry Canada. CCRA representatives explained that all "tombstone" information is being transferred to the new programs and until these files are free of errors, the taxpayer's file is essentially "put on hold." To frame the discussion at the liaison meeting we invite CCRA to respond to the following questions. Have the "system" problems been resolved and are the problems affecting more than the transmittal of the information to Industry Canada? Has CCRA explained the source of the delays to Industry Canada? What steps are CCRA and Industry Canada taking to ensure that companies are not erroneously placed in default for failure to file the Industry Canada returns?

25. SR&ED Administration

The SR&ED Action Steering Committee has focused its efforts to date on the technical aspects of the program's administration. What are the plans and target dates for reviewing the financial aspects of the program? For example, will the Committee issue a Guide to Conducting an SR&ED Review--Part 2: Financial Aspects? If so, when?

26. SR&ED Eligibility Criteria

The three criteria for determining whether activities undertaken by a taxpayer qualify as SR&ED are set forth in Information Circular IC 86-4. Since the IC was first published in 1986, there has been a substantial amount of technological change but the criteria have not been updated. In addition, the criteria set forth in the IC are vague and often difficult to apply to commercial research activities, especially to projects involving experimental development. We believe that CCRA should broaden the eligibility of projects qualifying as experimental development by relaxing the application of the three criteria in the IC. We invite a discussion of the three criteria and the Department's views on updating them.

27. General Index of Financial Information (GIFI)

TEI is concerned that impelling large-case file taxpayers to comply with the General Index of Financial Information (GIFI) system imposes an unnecessary burden. Specifically, we question whether the standardized GIFI chart produces useful data across diverse industry groups. More important, CCRA field auditors have informed TEI members that GIFI data is unlikely to be used in audits. We invite CCRA's comments on the utility of GIFI, especially on whether the information will be used either in the initial assessment or during field examinations of large-case file taxpayers. If the data collected through GIFI is intended primarily for statistical analysis purposes, we invite a discussion of whether other means are available--and more appropriate--through which Statistics Canada can gather the requisite information directly rather than piggyback on the tax return process.

28. Staffing CCRA

Recently there has been an exodus of some of the more talented and senior CCRA employees. Often these individuals are seasoned professionals who are comfortable exercising judgment and making reasoned decisions based on a wealth of knowledge and experience. TEI believe it is in the best interests of the Agency to retain a professional, experienced work force. In the face of competitive market pressures, TEI will support the Agency's efforts in achieving that goal. We invite the Agency's comments.

Conclusion

Tax Executives Institute appreciates this opportunity to present its comments and questions. We look forward to discussing our views with you during our December 4, 2001, liaison meeting.

Appendix 1

TEI-CCRA Liaison Meeting Agenda

December 4, 2001

Background

Rev. Rul. 2000-59, 2000-52 I.R.B. 593 (12/26/2000) Section 894(a)--Income Affected by Treaty 26 CFR 1.894-1(a): Income affected by treaty. (Also sections 894(c); 894(d))

"Liable to Tax" treaty residence standard. Guidance is provided on the "liable to tax" standard for residence under U.S. income tax treaties.

Rev. Rul. 2000-59

This revenue ruling provides guidance on whether certain entities will be considered liable to tax under the laws of a foreign country for purposes of determining if such entities are residents within the meaning of the relevant Treaty. In order to obtain treaty benefits, a person must be a resident of the applicable treaty jurisdiction and must meet all other applicable requirements for obtaining treaty benefits, including any applicable limitation on benefits provision and, in the case of an entity that is fiscally transparent under the laws of the United States or the entity's jurisdiction, the requirement that the entity derive the item of income for which treaty benefits are sought within the meaning of the Treas. Reg. Section 1.894-1(d).

FACTS:

Situation 1

Entity A is a business organization in Country X, which has an income tax treaty in effect with the United States that is identical to the 1996 United States Model Income Tax Treaty (1996 U.S. Model). Under the laws of Country X, Entity A is an investment company taxable on income from all sources at the entity level by reason of being incorporated in Country X. Similar to other domestic corporations, distributions from a Country X investment company are generally treated as dividends and do not retain the character or source of the underlying income. However, net capital gains, and in some cases, tax exempt interest, retain their character when they are distributed to the investment company's interest holders. Further, a Country X investment company may deduct distributions of current income to its interest holders in computing taxable income. Entity A distributes its net income and capital gains on a current basis to its interest holders so that it will not actually bear a tax. Country X imposes a withholding tax on Entity A's dividend distribution to its foreign interest holders regardless of the source of Entity A's underlying income. If Entity A did not distribute such amounts, Entity A would be taxed by Country X on such amounts. Entity A receives dividend income from the United States. Country X has not announced by public notice that investment companies such as Entity A are not residents of Country X, and there is no competent authority agreement providing that such entities are not residents of Country X. Further, the U.S. competent authority has not issued a public notice indicating that treaty benefits to such entities are being denied because, and to the extent that, Country X will not grant treaty benefits to similar U.S. entities.

Situation 2

Entity B is an investment company organized in Country Y, which has an income tax treaty in effect with the United States that is identical to the 1996 U.S. Model. Under the laws of Country Y, corporations organized in Country Y are generally taxable on income from all sources at the entity level by reason of being incorporated in Country Y. A specific provision in Country Y law, however, exempts the income of investment companies such as Entity B from taxation. Under Country Y law, the character and source of distributions from Entity B to al its interest holders are determined based on the distributions themselves rather than on the character and source of Entity B's underlying income. Further, Country Y imposes a withholding tax on distributions to its foreign interest holders regardless of the source of the underlying income. Entity B receives dividend income from the United States.

Country Y has not announced by public notice that investment companies such as Entity B are not residents of Country Y, and there is no competent authority agreement providing that such entities are not residents of Country Y. Further, the U.S. competent authority has not issued a public notice indicating that treaty benefits to such entities are being denied because, and to the extent that, Country Y will not grant treaty benefits to similar U.S. entities.

Situation 3

Entity C is a trust established and administered in Country Z, which has an income tax treaty with the United States identical to the 1981 U.S. Model Income Tax treaty (1981 U.S. Model). The trust exclusively provides pension benefits. Entity C's trustee is a resident of Country Z. Under the laws of Country Z, because Entity C's trustee is a resident of Country Z, Entity C is treated as a resident trust taxable at the entity level. However, because Entity C is established and operated exclusively to provide pension benefits, a provision of Country Z law exempts Entity C from Country Z income tax. Entity C receives dividend income from the United States. Country Z has not announced by public notice that entities such as Entity C are not residents of Country Z, and there is no competent authority agreement providing that such entities are not residents of Country Z. Further, the U.S. competent authority has not issued a public notice indicating that treaty benefits to such entities are being denied because, and to the extent that, Country Z will not grant treaty benefits to similar U.S. entities.

LAW AND ANALYSIS

Article 4 of the 1996 U.S. Model provides in relevant part:

1. Except as provided in this paragraph, for the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.

a) the term "resident of a Contracting State" does not include any person who is liable to tax in that state in respect only of income from sources in that State or of profits attributable to a permanent establishment.

b) A legal person organized under the laws of a Contracting State and that is generally exempt from tax in that State and is established and maintained in that State either:

i) exclusively for a religious, charitable, educational, scientific, or other similar purpose; or

ii) to provide pension to other similar benefits to employees pursuant to a plan is to be treated as a resident of the Contracting State where it is established.

The analogue portion of Article 4 of the 1981 U.S. Model provides:

1. For purposes of this Convention, the term "resident of a Contracting State" means any person who under the laws of the State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature, provided, however, that

a) this term does not include any person who is liable to tax in that State in respect only of income form sources within that State or capital situated therein;

The phrase "liable to tax" as used in the above articles does not require actual taxation. Thus, the fact that a person is only nominally taxable does not preclude that person from meeting the applicable "liable to tax" standard of these residence articles. This is consistent with the position taken in the 1996 U.S. Model Technical Explanation to Article 4(1), which provides: "certain entities that are nominally subject to tax but that in practice rarely pay tax also would generally be treated as residents and therefore accorded treaty benefits. For example, RIC's REIT's and REMIC's, are all residents of the United States for purposes of the treaty". For purposes of these residence articles, whether a person will be liable to tax in. and thus a resident of a jurisdiction depends on the facts and circumstances. However, in the context of a bilateral income tax treaty, a person will not be considered a resident of a contracting state if (1) the treaty partner has announced by public notice that such persons are not residents of that state; (2) there is a competent authority agreement or separate specific treaty provision providing that such persons are not separate specific treaty provisions providing that such persons are not residents of the state; or (3) the treaty partner would not treat similar U.S. persons as residents of the United States, and the Internal Revenue Service has issued a public notice indicating that treaty benefits to such entities are consequently being denied. Conversely, a person may be treated as a resident of a contracting state if there is a competent authority agreement or separate specific treaty provision providing that such persons are residents of that state. The Internal Revenue Service shall announce the terms of any relevant competent authority agreement or treaty partner's position.

Situation 1

Under the facts of Situation 1, notwithstanding that Entity A is only nominally taxable in Country X, Entity A is "liable to tax in (Country X) by reason of its place of incorporation, "within the meaning of the U.S. --Country X treaty, because of the following factors. First, as a corporation incorporated in Country X, Entity A may be taxed by Country X on its worldwide income. Second, but for the deduction regime, Country X would have imposed a tax on Entity A as it would any corporation incorporated in Country X. Third, the character and source of certain distributions by Entity A are determined independent of the character and source of Entity A's income, and Country X imposes a withholding tax on such distributions by Entity A to its foreign interest holders regardless of the source of Entity As underlying income.

Finally, Country X has not announced by public notice that persons such s Entity A are not residents of Country X; there is no competent authority agreement providing that such persons are not residents of Country X; and the U.S. competent authority has not issued a public notice indicating that treaty benefits to such persons are being denied because Country X will not grant treaty benefits to similar U.S. persons.

Accordingly, Entity A is liable to tax in Country X by reason of its place of incorporation within the meaning of Article 4 (1) of the U.S.--Country X treaty, and thus is a resident of Country X for purposes of the U.S--Country X treaty. In order to obtain treaty benefits, however, Entity A must still meet all other applicable requirements for such benefits, including the applicable limitation on benefits provision and, if Entity A is viewed as fiscally transparent under the laws of either the United States or Country X, those provisions of Treas. Reg. Section 1.894(d).

Situation 2

Under the facts of Situation 2, notwithstanding that Entity B is only nominally liable to tax in Country Y, Entity B is liable to tax by reason of its place of incorporation, within the meaning of the U.S.--Country Y treaty, because of the following factors. First, as a corporation incorporated in Country Y, Entity B may be taxed by Country Y on its worldwide income. Second, but for the specific exemption in Country Y law, Country Y would have imposed a tax on Entity B as it would any corporation incorporated in Country Y. Third, the character and source of distributions by Entity B are determined independent of the character and source of the Entity B's underlying income, and Country Y imposes a withholding tax on distributions by Entity B to its foreign interest holders regardless of the source of Entity B's underlying income.

Finally, Country Y has not announced by public notice that persons such as Entity A are not residents of Country Y; there is no competent authority agreement providing that such persons are not residents of Country Y; and the U.S. competent authority has not issued a public notice indicating that treaty benefits to such persons are being denied because Country Y will not grant treaty benefits to similar U.S. persons.

Accordingly, Entity B is liable to tax in Country Y by reason of its place of incorporation within the meaning of Article 4(1) of the U.S.--Country Y treaty, and thus B is a resident of Country Y for purposes of the U.S.--Country Y treaty. In order to obtain treaty benefits, however, Entity B must still meet all other applicable requirements for such benefits, including the applicable limitation on benefits provision and, if Entity B is viewed as fiscally transparent under the laws of either the United States or Country Y, those provisions of Treas. Reg. Section 1.894-1(d).