Pending income tax issues: December 4, 2002. (Canadian Department of Finance).

On December 4, 2002, Tax Executives Institute held its annual liaison meeting with officials of the Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared by 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 4, 2002, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Glenn G. Wickerson, TEI's Vice President for Canadian Affairs, at 403.233.1135, 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 5,300 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 number 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. Reorganizations

A. Expansion of Tax-Free Reorganization Provisions

During the past several liaison meetings, TEI has requested that the Department consider expanding the Canadian reorganization rules. In summary, we believe the provisions should be amended to permit the following:

* Tax-deferred wind-ups of wholly owned Canadian corporations into partnerships;

* Tax-deferred transfers of assets between Canadian partnerships;

* Tax-deferred transfers of assets from partnerships to trusts; and

* Tax-deferred transfers of assets from corporations to trusts.

Would the Department of Finance please advise whether consideration is being given to expanding the tax-free reorganization rules to include any of these additional forms of reorganizations?

B. Share-for-Share Exchanges

The October 2000 Economic Statement announced that a share-for-share exchange rollover rule would be developed in order to afford Canadian resident shareholders tax deferral where the only consideration received in exchange for the shares of a Canadian corporation are shares of a foreign corporation. Would the Department provide a status report on this measure? The announcement said the legislation would be drafted in consultation with the private sector. Has that consultation been completed, and would the Department be prepared to provide details of the draft legislation being considered? TEI recommends that the scope of this review and consultation be expanded to include not only this issue but the other areas noted in part A above.

C. Divisive Reorganizations

The rules governing divisive reorganizations confound practitioners and taxpayers. Hence, TEI suggests that the Department reconsider its approach to divisive reorganizations. Specifically, we urge the Department to provide a more specific regime that directly addresses such transactions rather than leaving them in their current form as an exception to an anti-avoidance rule. We believe that the lack of a comprehensive regime addressing these transactions causes Canadian-based businesses to be less efficient in their use of capital than their competitors headquartered in Canada's major trading partners.

2. Large Corporation Tax (LCT) Amendments

TEI believes that the Large Corporations Tax (LCT) is a profit-insensitive tax that increases the cost of capital and adversely affects investment, productivity, and, ultimately, employment in Canada. As a result, TEI recommends that the LCT be repealed immediately or phased out over a very short period of time. (1) This course of action will reduce Canada's overall tax burden and maintain or enhance the system's competitiveness with other OECD countries that are also implementing tax reductions. Until the LCT is eliminated, however, certain amendments are required.

A. Consequential LCT Amendments for Changes in Financial Accounting Methods

Where a taxpayer adopts a newly prescribed financial accounting reporting method, the new method can produce a significant change in its LCT liability when compared with the LCT computed under the old financial reporting method. Since most changes in financial accounting reporting methods are subject to extensive disclosure and a public review period prior to implementation, there is ample time to determine whether the government would obtain a capital tax windfall as a result of a change in method. Indeed, in order to mitigate the effect of financial accounting method changes on the computation of LCT liability, the Department should implement consequential amendments to section 181.2 with the same effective date as proposed changes in financial accounting standards. TEI recommends that the Department establish a process to review proposed changes in financial accounting methods and implement the necessary consequential amendments on a timely basis. TEI would be pleased to participate in such a process.

B. Hedged Debt

In question XXIII of the December 11, 1996, liaison meeting with the Department of Finance, TEI provided a detailed example relating to hedged debt and asked whether Finance would consider introducing an amendment to the Act in order to permit taxpayers to take hedge assets and liabilities into account in the calculation of taxable capital. Subsequent to the meeting, the Department of Finance indicated that it was prepared to recommend the introduction of such an amendment. To address deferred unrealized foreign exchange gains and losses generally, paragraphs 181.2(3)(b.1) and 181.2(3)(k) were added to the Act. Representatives from the Department have inquired whether the hedged-debt issue has been addressed by those amendments. Regrettably, TEI believes the answer to be, "no." (See Appendix I for additional detail.)

Would the Department of Finance provide a status report on the hedged-debt issue and advise when it anticipates introducing an amendment, with effect for taxation years commencing on or after January 1, 1996, that would ensure that hedge assets and liabilities are both taken into account in the calculation of taxable capital?

C. GAAP Reporting Effect on Rate-Regulated Industries

Rate-regulated entities have generally accounted for expenses such as income taxes, pension costs, and environmental liabilities on a pay-as-you-go (cash) basis. Increasingly, rate-regulated entities are giving balance sheet recognition to differences between the amounts reflected through the rate-setting process and the amount that would otherwise be recognized under generally accepted accounting principles (GAAP). For example, assume an entity establishes a liability under GAAP for estimated future expenditures to remediate contaminated land. Because such expenditures are recoverable through rates charged to customers, the entity will also establish a "regulatory asset." This method of financial statement presentation is optional under Canadian GAAP and required under U.S. GAAP. Recently, though, Canadian accounting standard-setting bodies have been moving in the direction of adopting U.S. balance sheet reporting models for such amounts.

Under relevant federal and provincial tax legislation, such recorded liabilities are included in taxable capital as reserves (e.g., see paragraph 181(3)(b) for LCT purposes) and taxed accordingly. If a rate-regulated entity gives balance sheet recognition to both a regulatory asset and the GAAP liability in respect of a particular item, there will be an increase in capital tax because the recorded liability will not be offset by a reduction in retained earnings for an accrued expense or an investment allowance for the regulatory asset. Such tax increases are generally recovered from customers through higher utility rates.

Unregulated entities that follow accrual accounting for a similar environmental liability do not, under current (2) rules, record an asset; rather they charge such expenses on an accrual basis against earnings for the year. Since the increase in the GAAP liability is offset by a reduction in retained earnings, unregulated entities will not incur the additional capital tax cost. In contrast, rate-regulated enterprises will generally incur additional capital tax (all other things being equal) to the extent that the increase in the GAAP liability on an accrual basis exceeds the reduction to retained earnings (which, again, is on a cash basis for such companies). Because of the long-term nature of many liabilities, the increased capital tax is an ongoing, permanent annual cost that will be passed through to customers, adversely affecting their competitive position.

For rate-regulated entities that are required to establish regulatory assets or liabilities, TEI believes section 181.2 should be amended to permit the taxpayer to reflect the net difference between the GAAP liability and regulatory asset balance for purposes of computing LCT. Alternatively, rate-regulated entities should be permitted to establish an investment allowance for the regulatory asset. We invite a discussion of TEI's proposal.

3. "Misuse or Abuse" Test--Subsections 95(6) and 17(14)

Subsections 95(6) and 17(14) are anti-abuse provisions that apply in the foreign affiliate context. Although the purpose test and the tax benefit definition in each are virtually identical to the general anti-avoidance rule (GAAR) set forth in section 245, the subsections lack a "misuse or abuse" exception comparable to subsection 245(4). Under subsection 245(4), GAAR will not apply to a transaction where it may reasonably be considered that the transaction would not result in a "misuse or abuse" of the Act. Although certain foreign affiliate transactions would satisfy subsection 245(4) and would therefore not be subject to GAAR, the transactions might still be subject to subsections 95(6) and 17(14). In order to remedy this inconsistency, TEI recommends that the Department of Finance repeal subsections 95(6) and 17(4). Alternatively, TEI recommends that Finance add a "misuse or abuse" exception to those subsections.

4. Arbitration Procedures

Article 26 of the Canada-U.S. Treaty contains a Mutual Agreement Procedure that permits taxpayers to request competent authority assistance in order to resolve double taxation issues. As with many other Canadian treaties, the provision does not require that the Competent Authorities actually reach agreement; it only requires that they "endeavour" to reach agreement. Thus, there is no guarantee that taxpayers will avoid double taxation. Taxpayers, however, desire certainty that they will not suffer the inequity of double taxation and that difficult cases will be resolved on a timely basis.

Thus, TEI recommends adoption of a consensual arbitration procedure where, subject to taxpayer consent, the Competent Authorities would agree, if they are otherwise unable to resolve the matter, to submit a case for binding arbitration. Specifically, we recommend that, if the Competent Authorities cannot resolve a case within a fixed time frame of, say, 18 to 24 months, then an arbitration panel should be formed to issue a binding decision (again, within a stated time frame of, say, 12 months) that eliminates double taxation. The competent authorities should have discretion in the selection of arbitration methods, arbitrators, and procedures, but the taxpayer should be consulted about the process to be employed.

TEI believes that the inclusion of a binding arbitration article in all of Canada's treaties, including that with the United States, will facilitate timely case resolution. Even though such a provision may never be invoked, the presence of a binding arbitration clause will increase the likelihood that the Competent Authorities will reach a mutually agreed decision. Moreover, there are precedents for such provisions. The European Union (EU), for example, has instituted a mandatory binding arbitration procedure to settle transfer-pricing disputes between EU taxing authorities where the case cannot be resolved within two years of submission to Competent Authority. This mechanism is an important administrative tool for the effective and efficient resolution of disputes between EU treaty partners.

We invite a discussion of TEI's proposal.

5. Objections for Large Corporations

A. For large taxpayers, Canada Customs and Revenue Agency (CCRA) routinely conducts audits on certain specialist issues (e.g., GAAR, SR&ED, and International) on a different schedule and time frame from the general audit procedures. As a result, CCRA often issues multiple assessments for the same taxation year. While we recognize that CCRA cannot always coordinate the timing of its audits in a fashion that will facilitate the issuance of a single assessment, would the Department of Finance consider changing the objection deadline for large taxpayers in order to minimize the administrative burdens on taxpayers and the Appeals Division? Specifically, would the Department consider extending the time period for filing objections until 90 days after the normal reassessment period? Alternatively, would the Department consider clarifying the law so that taxpayers need not "re-object" to issues raised in Notices of Objections for previous assessments of the same year?

B. The current rules require large corporations to specify the dollar amount of requested adjustments in their Notices of Objection. Since the amounts stated in the Notice of Objection limit the maximum adjustment permitted on a successful appeal, companies will specify the largest possible dollar amount of relief. When CCRA sees large dollar amounts relating to the same issue in multiple Notices of Objections, CCRA will frequently raise an alarm about the potential revenue loss and request an amendment to the Act--sometimes with retroactive effect. Such requests are likely unwarranted because, in addition to making duplicative objections for multiple reassessments of the same issue, taxpayers may have simply overestimated the reported value of the amount in issue in order to protect their appeal rights. This is especially the case where taxpayers are not afforded sufficient time to evaluate an issue prior to the due date of the Notice of Objection. Would the Department consider eliminating the requirement that large corporations state the dollar amount of the item in dispute in their Notices of Objection? Alternatively, as long as the taxpayer makes a reasonable effort to identify the amounts in dispute, would the Department consider amending the rules so that the relief would not be limited to the amount stated in the Notice of Objection?

6. Term-Preferred Share Rules

The Term-Preferred Share rules have a market-distorting effect on equities and add significant complexity to ordinary business transactions. The scope of the rules is broad and, among other things, catches ordinary corporations with nominal financing activities or financing activities that are unrelated to the group's principal business. A key definition set forth in subsection 248(1) is that of a "specified financial institution," which deems each entity in a corporate group to be a "specified financial institution" if one member of the group is an insurance corporation or a corporation whose principal business is the lending of money to arm's-length persons. Hence, even though a particular member of the group carries on a business other than a financing business (e.g., manufacturing, mining, telecommunications, or oil exploration), and even though the primary business of the corporate group as a whole is not financing, the entire group can be characterized as a "specified financial institution" if one member carries on such activities. As a result, all group members are subject to the interest deeming rules should they make investments in Term-Preferred Shares.

The purpose of these rules is to curb tax-rate arbitrage and loss transfers. Tax-rate arbitrage opportunities, however, have been effectively addressed by the reduction in tax-rate differences among industries; loss transfers, moreover, have been limited by Part VII. As a result, TEI believes that the Term-Preferred Share rules should be repealed or their scope substantially narrowed. We invite a discussion of the potential for either course.

7. Application of the Foreign Affiliate Regime--Corporate Residence

In order to qualify for exempt surplus treatment a foreign affiliate must satisfy both the Canadian tax law judicial test of corporate residence and the relevant tax treaty's definition of residence. Tax practitioners have criticised the judicial test of corporate residence as both inefficient and ineffective in combatting tax avoidance. The principal criticisms are:

* Taxpayer Uncertainty--The traditional judicial test of determining corporate residence, i.e., central management and control, creates uncertainty. Small changes in facts and circumstances can cause a change in a foreign subsidiary's residence and a change in residence, in turn, produces material tax consequences.

* Discrimination Between Large and Small Companies--Other than the largest companies, most Canadian corporations cannot afford to maintain a large number of personnel abroad or delegate sufficient decision-making authority to foreign management.

* Ease of Manipulation--If taxpayers are prepared to devote sufficient resources, the concept of central management and control can be manipulated to achieve any result desired. Accordingly, the concept is more in the nature of a "trap for the unwary" than an effective tool to counter tax avoidance.

* Inefficient Allocation of Corporate Resources--New business ventures in foreign countries are often managed and controlled initially from within Canada. If the venture is successful (and many are not), the new businesses will grow to sustain an independent management. To avoid a potential change of corporate residence at a future date (and the material tax implications associated with that), taxpayers are compelled to incur the cost of establishing local management at the outset of new international business ventures regardless of whether the cost is justified. (3)

* Loss of Canadian Influence and Control--Many Canadian businesses prefer that their business culture and values pervade their operations throughout the world. The concept of corporate residence and the requirement to maintain and delegate substantial decision-making authority to local management limits the extent to which Canadian corporations are able to control and influence their foreign operations.

For the foregoing reasons, many tax practitioners have called for broad safe harbour legislation to replace the judicial residence test. TEI submits that, where a foreign affiliate (1) maintains bona-fide business operations in a treaty country that has tax rates comparable to Canada's, and (2) satisfies the definition of residence under the terms of the tax treaty in which the foreign affiliate operates, requiring the foreign affiliate to satisfy the judicial test of corporate residence is onerous and unnecessary. Would the Department consider introducing a legislative safe harbour rule deeming foreign subsidiaries of Canadian companies that are part of a bona-fide business operation abroad to be non-residents of Canada? Presumably the policy concerns of the Department would be satisfied if the safe-harbour rule were limited to countries with a tax treaty and tax rates comparable to those of Canada. A safe harbour rule would permit smaller companies to expand into countries like the United States, exporting goods and services without the complexities, costs, and uncertainty of the judicial test of corporate residence.

8. Debt Premiums and Discounts

In order to address the tax treatment of debt premiums and discounts, would Finance consider adding an elective tax regime similar to the following:

XX(1) (4) Premiums and bonuses--Where a taxpayer has:

(a) issued a debt obligation in the course of earning income from property or business at a premium or discount,

(b) has filed and not revoked an election under this subsection,

(c) regularly produces financial statements ("statements"), either individually or as part of consolidated financial statements, under generally accepted accounting principles, which in the ordinary course treat premiums and discounts as relevant to the determination of interest expense, and

(d) the premium or discount in respect of the debt obligation is relevant to the determination of interest expense in the statements,

then, for purposes of the Act,

(e) the premium or discount shall be deemed not to be a premium or discount,

(f) the debt obligation shall be deemed to be issued by the issuer and acquired by a taxpayer (other than a taxpayer for whom the debt obligation is a mark-to-market property) ("acquiring taxpayer") for an amount calculated as if such discount or premium did not exist,

(g) the premium or discount shall be deemed to be a financing cost adjustment over the term of the debt obligation to the issuer and the acquiring taxpayer and any subsequent holder of the debt obligation (other than a taxpayer for whom the debt obligation is a mark-to-market property),

(h) the amount of the annual premium financing cost adjustment required under paragraph (g) for a taxation year is the amortization amount on the statements for the first period and on a consistent basis thereafter, and

(i) the amount of the annual discount financing cost adjustment required under paragraph (g) for a taxation year is the amortization amount on the statements for the first period and on a consistent basis thereafter.

XX(2) A taxpayer may revoke an election at any time with the consent of the Minister.

In addition, the following conforming amendments would be necessary:

12(1)(c.1) the annual premium financing cost adjustment;

20(1)(f.1) the annual discount financing cost adjustment;

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

Canada may have one of the most generous SR&ED tax incentive programs among the industrialized countries of the world. The country also possesses geographic, demographic, and infrastructure advantages that should be attractive for SR&ED projects. Despite these advantages, Canada seems unable to attract the government's desired level of new SR&ED, especially from large multinationals. This may, in part, be attributable to fierce international competition for SR&ED investment. Indeed, since 1996 the number of OECD countries offering SR&ED tax credits has jumped from 10 to 16. Most recently, the United Kingdom and Norway have adopted incentives and Australia expanded its tax concession by offering an additional 175-percent incentive on incremental SR&ED expenditures.

Statistics Canada predicts that for the first time in 30 years spending on SR&ED by Canadian industries will decline this year. This creates a significant challenge for Canada, which ranks 15th in the world in SR&ED spending, to attain its announced goal of being 5th in the world in terms of SR&ED investments by 2010. The current SR&ED Program is an integral part of advancing toward that goal, but enhancements to existing programs and new approaches must also be examined if Canada is to achieve its long-term goal. To increase the attractiveness of Canada for SR&ED, we submit the following proposals for consideration and invite a discussion of whether Finance would adopt some or all of them.

A. Refundability

Small Canadian-based companies receive a refund of SR&ED credits irrespective of their profit or loss position. Large, established companies, however, can only utilize non-refundable SR&ED tax credits to lower their effective corporate tax rate when the company is profitable and pays current taxes. In an economic downturn, non-refundable tax credits have limited utility as an incentive to perform SR&ED in Canada. Universal refundability would increase the competitiveness of the SR&ED program by changing the timing of taxpayers' receipt of the benefit without changing the total revenue cost to the government. Under this scheme, refundable payments could be calculated in a manner similar to the current tax credit with a cap for the total refund claim. The refund could be tied to a percentage of salaries payable, for example, or another non-income-tax-based measurement that would demonstrate appropriate investment in Canada.

B. Offset Other Pretax Levy

A foreign investor that owns a Canadian company performing SR&ED can often claim a home country foreign tax credit for the Canadian taxes that were imposed on the earnings distributed from the Canadian company. The foreign tax credit is generally allowable to the extent the Canadian income tax payable does not exceed the foreign investor's local income tax payable on such income. As Canadian corporate income taxes decline under the scheduled rate reductions, the Canadian income tax paid will likely become fully creditable to the foreign investor. On the other hand, the SR&ED Investment Tax Credit (ITC) reduces the Canadian corporate income taxes payable, which reduces the local country foreign tax credits available to the foreign investor, and thereby increases the investor's local income tax liability. Since the SR&ED ITC provides no net benefit to foreign investors in determining total income taxes payable to all jurisdictions, many foreign-based parent companies ignore the value of the SR&ED credits in making decisions relating to incremental SR&ED investments in Canada.

To make the program more attractive to foreign investors, the investment tax credit might be used to reduce another government levy such as the employer portion of Employment Insurance (EI) premiums. This would increase Canadian corporate income taxes payable and decrease a pretax levy by a corresponding amount. (Internal governmental transfers between programs could ensure that the funding of the EI program (or other similar pretax levy) is not affected.) Since the Canadian corporate income tax payable is not reduced, the amount of foreign tax credit available to the foreign investor is unaffected by the ITC. This proposal, combined with a reduction in a pretax levy, would result in a meaningful cost reduction to the foreign investor.

10. Employee Objections

Last year TEI asked CCRA whether employers could, on behalf of their employees, address employee objections on a group basis. CCRA responded that, in the absence of specific statutory authority, it could not implement such a procedure. TEI believes that there are many circumstances where it would be better to permit employers to request relief on behalf of a group of affected employees than to require each employee to file a separate objection.

As a recent example, an employer made an inadvertent error in reporting Pension Adjustments (PA) for a group of employees and, consequently, some of those employees over-contributed to their Registered Retirement Savings Plans (RRSPs). The employer provided CCRA with a list of the revised PAs as well as the names and social insurance numbers of the affected employees. The employer also requested and received CCRA's agreement for a waiver of interest charges arising from the disallowance of the employees' RRSP deductions. CCRA insisted, however, that each affected employee write and request relief individually rather than accept a collective request on behalf of all employees filed by the employer. TEI cannot envision any circumstance in which an employee in such a case would choose not to take advantage of the relief offered by CCRA. Another example where it would be beneficial to have an administrative procedure to accord relief to a group of affected employees is a reassessment of taxable parking benefits provided by the employer.

The Netherlands has addressed problems it encountered with mass employee objections by introducing legislation permitting the government to address the objections collectively. Concededly, the circumstances in the Netherlands that gave rise to the mass objections differ from those for which TEI is seeking a remedy, but the principle of streamlining the process to reduce the administrative burdens on the tax authority is similar. Would Finance consider adding a provision that would permit an employer to prepare an objection (or request relief) on behalf of a group of employees and represent those employees collectively rather than requiring each employee to make an identical objection or request?

11. Foreign Currency Reporting

With the increasing globalization of business more taxpayers are encountering foreign exchange issues. As important, with advances in the financial markets and products available to hedge foreign-exchange exposures, the issues arising under the Act are becoming more complex and challenging for taxpayers and CCRA to address. Would Finance consider permitting:

(a) Canadian companies to use Canadian dollars as their calculating currency for surplus calculations in respect of foreign affiliates that use Canadian dollars as their functional currency?

(b) Companies to elect to calculate their Canadian taxable income in a currency other than Canadian dollars? TEI notes that a number of other jurisdictions, including the UK, the Netherlands, and Hungary, permit taxpayers to employ such simplifying procedures.

12. Environmental Costs

The federal government has announced its intent to ratify the Kyoto Accord by the end of the year and has tabled the Climate Change Draft Plan describing the steps it is proposing as a means of satisfying its obligations under the Accord. Canadian companies are currently studying the Plan to determine its effects on their operations as well as the attendant risks and costs of implementing the various measures. In implementing the measures, a key concern will be maintaining international competitiveness.

To ensure that the government's environmental policy objectives are satisfied, TEI recommends that the Department of Finance provide clarification of the tax treatment of the many expenditures that companies will be called upon to incur under the Plan. Clarification of the tax treatment of the costs would help inform the public debate about the economic effect of the Plan and permit Canadian businesses to assess alternative options based on the lowest overall cost.

Among the expenditures for which clarification of the tax treatment should be provided are: investments to reduce emissions from operations; the cost of the purchase of emission credits; the cost of the acquisition of "offsets" (such as tree planting or investments in international energy efficiency projects) or through community investments; contributions to government-sponsored industry joint venture funds to satisfy environmental emission obligations or to develop and demonstrate new technology; and site cleaning and restoration costs incurred at, or prior to, abandonment of a project.

For many of these costs the treatment under the Act is unclear. For those costs where the tax treatment is clear, there is considerable inconsistency. For example, some costs will clearly be operating expenses while others are capital. For expenditures that are capitalized, the recovery periods can vary substantially. Hence, the after-tax costs of the various expenditures and their effect on taxpayers will vary widely. More important, where the tax treatment of an expenditure is unclear, disputes will arise between CCRA and taxpayers. Indeed, the controversy will likely center on whether the costs are currently deductible as an operating expense or should be capitalized and depreciated (or amortized) over a period of time. To ensure that the government's environmental Plan is implemented as quickly as possible, TEI recommends that the Department consider introducing legislation to clarify and, more important, provide consistent tax treatment for the costs taxpayers will incur to implement the Kyoto Accord. Specifically, we recommend that the Act be amended to treat all such expenditures as Class 12 assets with no half-year rule. We invite a discussion of TEI's proposal.

13. Consultation Process

TEI recommends that the Department of Finance review the benefits and costs of the current procedures and processes relating to the development of proposed amendments to the Income Tax Act and Regulations. Occasionally, the current procedures engender relatively detailed concepts, or even draft legislation, without the benefit of timely consultation with industry or public or private practitioners familiar with the subject area of the proposed amendments. Early and open consultation will mitigate the need for significant conceptual restructuring and redrafting after a proposed amendment is introduced and before the legislation is enacted or regulation is adopted. Although the Department has been receptive to many changes recommended during the consultation process (including TEI's), we believe that better legislation would likely be produced faster if the consultation process were streamlined and started before proposed amendments become too detailed. We encourage the Department to solicit advice on technical matters from industry and professional groups at an earlier stage than has occurred in the past several years. We invite a discussion of ways to facilitate earlier involvement of trade and professional groups in the development of legislation.

14. Foreign Affiliates--Underlying Foreign Tax Paid Pursuant to Production-Sharing Contracts

The Department of Finance has indicated that it is favourably disposed to introduce amendments to the Act governing the treatment of the underlying foreign tax paid by foreign affiliates pursuant to production-sharing contracts. We understand that the new rules would parallel the recent foreign tax credit amendments in subsection 126(5) of the Act dealing with foreign oil and gas levies. Would the Department comment on the status and content of the proposed amendments?

15. Withholding Taxes

Studies, such as one recently prepared by the C.D. Howe Institute, demonstrate a strong correlation between the elimination of withholding tax on interest and dividends and increased foreign direct investment. The report summarizes the adverse effects of withholding taxes, which include deterring capital investment, diminishing the free flow of capital, and impairing the efficiency of global business operations. The Howe study concludes that eliminating withholding on dividends and interest payments would produce approximately $28 billion of new capital investment in Canada and increase annual income more than $7.5 billion.

TEI has consistently urged the Department of Finance to implement a nil withholding rate on interest and dividends. Is the Department developing a long-term strategy to phase out withholding taxes on interest and dividends (both arm's-length and non-arm's-length) in Canada's tax treaties? We are especially interested in hearing about progress toward this goal in treaty negotiations with the United States.

16. Tax Refunds Attributable to Wound-Up Companies

Recently, a TEI member received a letter from CCRA indicating that the Agency is unable to issue a refund to the shareholder (and former parent) of a corporation that has been dissolved or wound up. TEI acknowledges that the government should be cautious in issuing refunds to third parties, but wholly owned subsidiary corporations are routinely wound up into the parent company shareholder. Would the Department consider adding an enabling provision (with appropriate safeguards) that would permit CCRA to issue a refund that is attributable to the taxes paid by a wound-up company to, and in the name of, the former parent and shareholder?

17. Subsection 93(2)

To the extent that exempt dividends have been received from a foreign affiliate, subsection 93(2) will reduce a loss on a disposition of shares of the foreign affiliate. A taxpayer that acquires stock denominated in a foreign currency that is redeemable or retractable at specific dates may decide to enter into a contract to hedge the currency fluctuation associated with the future redemption or retraction. Where a taxpayer hedges its exchange risks, gain on the disposition of the stock will be appropriately offset by a loss on the hedge contract under subsection 93(2). If the foreign currency depreciates, however, the gain on the hedge contract may not offset the stock loss because subsection 93(2) will reduce the loss on the stock to the extent of exempt dividends. TEI recommends that Finance consider amending the Act so that the portion of a loss on the disposition of a share in a foreign affiliate that is attributable to a foreign exchange fluctuation is not subject to the reduction contemplated by subsection 93(2). We invite the Department's view of the proposal.

18. Contingent Interest Expense

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 after the year in which the interest would have otherwise accrued. In previous liaison meetings with the Department of Finance, TEI has raised questions about the proper treatment of contingent interest expense, but owing to uncertainty about CCRA's interpretative position, the Department provided no clear response. We have confirmed that CCRA is of the view that no deduction is available for contingent interest. On one hand, CCRA will deny a deduction for contingent interest because of the restrictions of paragraph 18(1)(e). (In CCRA's view, there is no expense to accrue and deduct until the contingency occurs.) On the other hand, after the contingency occurs and the interest is exigible, CCRA will disallow the deduction of some or all of the interest because the amount is not considered payable in respect of the year. Would the Department consider amending the Act to provide specifically that contingent interest expense is fully deductible in the year the contingency occurs or is satisfied?

19. Available for Use

Paragraph 13(27)(f) provides that a property will be considered to be "available for use" in the taxation year of a public corporation--

   for which depreciation in respect of the property
   is first deducted in computing the earnings of a
   corporation in accordance with generally accepted
   accounting principles and for the purpose of
   the financial statements of the corporation for the
   year presented to its shareholders.

The provision includes property owned by "a subsidiary wholly-owned corporation" of such public corporations. Would the Department consider expanding this provision to include property owned by partnerships where the partnership's earnings are included in a public corporation's financial statements that are prepared in accordance with GAAP?

20. Resource Taxation Issues

A number of audit issues have arisen as a result of uncertainties in the interpretation of provisions of the Act governing resources. The uncertainties have engendered unnecessary disputes between taxpayers and CCRA and, correspondingly, increased administrative burdens for both. Examples of current issues that would benefit from legislative changes include:

1. Business Interruption Insurance Premiums and Claims--CCRA takes the position that premiums paid for business interruption insurance are expenses that are deducted in determining resource income. On the other hand, CCRA also takes the position that proceeds from business interruption insurance claims are not included in resource income. Would the Department of Finance consider introducing a clarifying amendment to ensure that business interruption insurance premiums and proceeds from claims are treated consistently for purposes of computing resource income?

2. Definition of Canadian Exploration Expense (CEE) in Subsection 66.1(6)--Paragraphs (f) and (g) of the definition of CEE set forth the types of expenditures that qualify as CEE for new mines "coming into production," including those for mining bituminous sands. CCRA takes the position on audit that expenditures that are incurred after the discovery of the existence of the resource but before a firm decision is made to commence construction of a mine do not fall within either paragraph (f) or (g) of the definition of CEE. This seems to be contrary to the purpose of providing that costs incurred prior to commercial production should be considered CEE. Would the Department of Finance consider amending the Act to clarify that there is no "gap" between expenditures that qualify as CEE under paragraph (f) and those that qualify under paragraph (g)?

3. Definition of Canadian Field Processing in Subsection 248(1)--Would the Department consider adding a de minimis provision to paragraph (h) of subsection 248(1) where the production of ethane at a gas plant is an insignificant byproduct of the processes at the gas plant?

21. Partnership Foreign Tax Credit

For purposes of the Act, a partnership is not a taxpayer. Rather, the income or loss of the partnership is taxed in the hands of the partners. Where the fiscal year of the partnership and the tax year of a partner do not coincide, the partner's pro-rata share of the partnership's income for a particular year is included in the partner's income for his taxation year in which the partnership's fiscal year ends. These rules can lead to situations where the taxes paid by a foreign partnership relate to a year that differs from the year in which a Canadian partner is required to include in income his share of the foreign partnership's income.

In response to a taxpayer letter (Document number 2000-0029575, December 14, 2000), CCRA indicated that:

   [i]n interpreting the term "for the year" as it is
   used in subsections 126(1) and 126(2), as well as
   in the definitions of "business income-tax" and
   "non business-income tax" in subsection 126(7) of
   the Act, that term relates to the year for which
   the foreign income or profit tax is exigible (i.e.,
   liable to be paid). In other words, it relates to the
   year for which the taxpayer is liable to pay tax to
   the foreign jurisdiction for the income which is
   considered to have been earned under the tax law
   of the foreign jurisdiction (the "taxable year").

The CCRA letter continues, stating that

   subject to the relevant carryover provisions for
   business-income tax, such tax is eligible to be
   claimed as a foreign tax credit, for Canadian tax
   purposes, for a taxation year if such taxation
   year for which the person is making the claim
   coincides with the taxable year.

Given the anomalous result that CCRA's interpretation creates, would the Department of Finance indicate whether this result is intended? If CCRA's interpretation is correct, would the Department amend the applicable provisions to clarify that in the circumstances described above the foreign income or profit tax may be claimed as a foreign tax credit in the taxation year in which the Canadian resident includes the foreign income in his income?

22. Payments of Tax in Dispute

In general, section 225.1 limits CCRA's power to commence collection proceedings where formal appeals from assessments are outstanding. Under subsection 225.1(7), however, CCRA may commence collection proceedings against "large" corporations for 50 percent of the 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. The requirement that large corporations immediately pay 50 percent of taxes in dispute is especially egregious where the related assessments involve double taxation flowing from disputes among two or more taxing jurisdictions. For example, international transfer-pricing disputes involve two or more taxing jurisdictions asserting the right to tax the same income. Such disputes are generally resolved through competent authority proceedings and take years to settle. Depending on the assessment and collection laws in the relevant jurisdictions, taxpayers may be compelled to pay tax on the same dollar of income to two or more jurisdictions until the competing jurisdictions resolve the matter. Similar delays in resolving cases arise within Canada where two or more provinces assert the right to tax the same dollar of income. Would the Department of Finance consider repealing subsection 225.1(7)? Alternatively, would the Department of Finance consider introducing appropriate exceptions to the application of subsection 225.1(7)? TEI believes, for example, that an exception to subsection 225.1(7) is warranted where the tax in dispute pertains to matters that are under review by Competent Authority pursuant to a tax treaty. We invite a discussion of the prospect of repeal or significant amendment to subsection 225.1(7).

23. Reserves

A. 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 in payment is received. Unless it can be "reasonably anticipated" that goods or services will be provided after year-end, the vendor cannot establish a reserve under paragraph 20(1)(m). To avail itself of the reserve provisions in paragraph 20(1)(m), taxpayers generally must demonstrate a contractual obligation to deliver future goods or render future services at specified times.

Computers are an integral part of business today and many day-to-day operations will immediately grind to a halt if critical software or hardware is not available for use. As a result, software and equipment vendors adopt a proactive approach to providing the maintenance needed to keep customers' systems up and running. Under most software maintenance agreements, code fixes, software updates, and software upgrades are invariably provided. It is not a question of whether the additional software will be provided, but when it will be provided. Similarly, most hardware maintenance agreements provide for preventative maintenance to be provided according to a predetermined schedule in order to ensure that the customers' business operations continue in an uninterrupted fashion. Indeed, equipment manufacturers outside of the computer industry also employ preventative maintenance service schedules in their sales agreements to ensure smooth operation of mission-critical equipment. Where equipment manufacturers use such agreements (whether in- or outside the computer industry), the maintenance schedules are based on predictable patterns such as the passage of time, level of usage, historical failure rates, or some combination of the three variables.

Regrettably, most software maintenance agreements do not provide for scheduled releases of upgrades, updates, or code fixes. Although vendors can demonstrate, based on historical practices, that these releases are provided on a predictable, periodic basis, the agreements likely state only that they will be provided on an "as required" basis. Similarly, although most equipment maintenance agreements state that preventative maintenance will be provided, there is often no set schedule within the contract that specifies predetermined dates when the maintenance activities will be carried out.

For either software or equipment maintenance 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. Since the vendor will have incurred few costs in respect of these contracts in the year of receipt of payment, tax is payable on the entire amount received with no deduction for costs or expenses that will be incurred in providing these services. The mismatch between the timing of the income and deduction imposes a cash-flow burden on the vendors to make, in effect, a prepayment of taxes.

Would the Department consider amending the legislation to prorate the fees received for a maintenance agreement over the length of the contract and include in income only the portion of the fees that relate to the percentage of the contract period pertaining to the current taxation year?

B. Similarly, subsection 20(24), which affords a taxpayer a deduction for amounts paid to another party as consideration for that party undertaking a taxpayer's future obligations, is available to the payer only where it has included an amount in income under paragraph 12(1)(a). TEI submits that subsection 20(24) should not be limited to amounts included in income under paragraph 12(1)(a) and recommends that subsection 20(24) be amended to apply to any payments made to another party in consideration for that party undertaking a taxpayer's future obligations.

We invite the Department's comments on the proposals in parts A and B.

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 4, 2002, liaison meeting.

Appendix I

Hedged Debt and Paragraphs 181.2(3)(b.1) and (k) of the Act

After January 1, 1996, Canadian GAAP required companies to translate foreign-denominated debt hedged by a currency swap or forward contract at the foreign exchange rate in effect as at the balance sheet date. The offsetting debit or credit for any adjustment to the carrying value of the debt at the balance sheet date is treated as a deferred unrealized foreign exchange gain or loss. * GAAP also requires that the "net principal value" of the currency swap or forward contract hedging a debt be reflected as an asset or liability (the "hedge asset" or "hedge liability") in a corporation's financial statements based on the foreign exchange rate in effect as at the date of the balance sheet. For fiscal years commencing between January 1, 1996, and December 31, 2001, the offsetting debit or credit for establishing or adjusting the "net principal value" was also treated as a deferred unrealized foreign exchange gain or loss. ** Since the offsetting debit or credit for the hedge transaction and the debt amount are equal but opposite, the respective deferred unrealized foreign exchange gain or loss amounts cancel each other out.

By way of illustration, we restate example I from Question XXIII of the 1996 agenda. (The example ignores transactions costs.)

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

   1. On December 31, 1996, the exchange rate is US$1 = CAN$1.40
   The financial statement presentation at that date is:

   Asset                Liability

   Hedge asset   $10 M    Debt   $140 M

   [Parts 2 and 3 of the example in question XXIII are omitted.]

The $US100 M debt issued by Canco on January 1, 1996, when the exchange rate was US$1 = CAN$1.30, has a carrying value of $140 M on December 31, 1996, when the spot exchange rate was US $1 = CAN $1.40. The accounting entry to reflect the increase in the value of the debt is:

DR Deferred unrealized foreign exchange gain or loss   CAN$10 M
CR Debt                                                         CAN$10 M

The entry to reflect the hedge asset created as a result of the difference between the foreign exchange rate under the currency swap transaction and the spot rate on December 31, 1996, is:

DR Hedge Asset                                         CAN$10 M
CR Deferred unrealized foreign exchange gain or loss            CAN$10 M

The offsetting debit and credit to the deferred unrealized foreign exchange gain or loss account produce a nil balance. Thus, in TEI's view, paragraphs 181.2(3)(b.1) and 181.2(3)(k) of the Act do not resolve the issue raised in item XXIII of the 1996 agenda. TEI submits that, on the foregoing facts, the amount that should be included in taxable capital is CAN$130 M, consisting of the liability of CAN$140, offset by a deduction for the hedge asset of CAN$10. Does Finance agree and would it consider introducing legislation to clarify that this is the proper result?

* For fiscal years commencing on or after January 1, 2002, the offsetting debit or credit will be reflected in a corporation's statement of operations. Any unamortized deferred unrealized foreign exchange gain or loss remaining on the balance sheet at the beginning of the first fiscal year beginning on or after January 1, 2002, will be eliminated by an adjustment to retained earnings.

** As described in footnote 5, the treatment will change for fiscal years beginning on or after January 1, 2002.

(1) Most recently, TEI testified before the House of Commons Standing Committee on Finance on November 6, 2002, and recommended repeal of the LCT.

(2) If a proposed statement of accounting standards in respect of asset-retirement obligations is adopted, unregulated entities will face a comparable increase in LCT because the accrued liability will be included in the computation of the LCT without an offset for the corresponding asset (debit) increase. Hence, if the proposed financial accounting method is adopted, the Department of Finance should introduce legislation permitting companies to reflect the net difference between the asset and liability in the computation of LCT. Alternatively, companies should be permitted to establish an investment allowance for the asset.

(3) In addition, after the September 11, 2001, terrorist attacks, executives are more hesitant to travel because of the potentially increased security risk. Thus, many companies would prefer to limit the amount of travel necessary to hold meetings that will establish corporate residence.

(4) We adopt the "XX" convention to designate a new section of the Act