Pending income tax issues: December 8, 2004.

On December 8, 2004, Tax Executives Institute held its annual liaison meeting with officials of the Canadian Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is David V. Daubaras of General Electric Canada.

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 8, 2004, liaison meeting. If you have any questions about these comments, please do not hesitate to call either David M. Penney, TEI's Vice President for Canadian Affairs, at 905.644.3122, or David V. Daubaras, Chair of the Institute's Canadian Income Tax Committee, at 905.858.5309.

Background

Tax Executives Institute is an international organization of approximately 5,400 professionals who are responsible--in an executive, administrative, or managerial capacity for the tax affairs of the corporations and other businesses by which they are employed. TEI 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. Follow-Up Questions from Prior Years' Liaison Meetings

A. Regulation 105

During the 2003 liaison meeting, there was a discussion about the potential for either repealing Regulation 105 or making significant changes to the legislation or regulation in order to ease the administrative burden of obtaining waivers of withholding. The Department replied, as follows:

We have been pursuing this on three levels:

a. Assessing the revenue effect and cost to taxpayers--the revenue numbers are still not precise, and we need the best information possible in order to evaluate possible changes;

b. Improving our understanding of the US system, including their compliance experience; and

c. Developing potential models for replacement: for example, permitting non-residents from treaty countries with full mutual assistance agreement to pre-register with the CCRA and thereby exempting withholding tax from payments to those non-residents.

We know that this issue has been around for several years. We hope to be able to make recommendations to improve the rule.

Would the Department provide an update about the progress made in this area during the past year and discuss the actions it may take to resolve these concerns?

B. Contingent Interest

In response to Question 3 of the 2003 liaison meeting agenda, the Department stated:

It would appear that this suggestion follows from TEI's December 2002 questions regarding contingent interest to which the Department responded, in part, as follows:

   The prevailing view has been that, for accrual basis
   taxpayers, interest should be deductible in the
   year in which it accrues as this method most likely
   presents the "truest picture of income". However,
   allowing the deduction in the year that the contingent
   liability is satisfied as TEI suggests may
   advance the objective of administrative simplicity.
   We invite any further comments TEI may have on
   this matter.

The legislative suggestion made by TEI above suggests that TEI would favour allowing the deduction in the year the contingent liability is satisfied. We are continuing our review of the law, and policy considerations in this area and will note, in the course of that review, TEI's suggestion.

Have there been any developments with respect to TEI's suggestion?

C. Reimbursement of Arrears Interest

In response to Question 4 from the 2003 liaison meeting agenda, the Department said:

We are sympathetic to this request and we agree that refund interest received in respect of non-deductible interest levies related to Crown charges should be netted against non-deductible interest. Our initial reaction is to handle this matter through an amendment to Regulation 600. However, before concluding that Regulation 600 is the most appropriate avenue to address the concern, we would like to speak to the CCRA. Obviously, an alternative approach is to recommend an amendment to the Income Tax Act.

Has the Department approached Canada Revenue Agency (CRA) on this subject and decided on an approach to resolve this concern?

D. Surplus Entitlement Percentage

We note that the Department did not respond to Question 31 of the 2003 liaison meeting agenda relating to the Surplus Entitlement Percentage. For reference, a copy of the question is attached as Question 1 in the Appendix.

E. Publicly Traded Securities

In Question 14 of the 2003 liaison meeting agenda, TEI requested relief from certain provisions of the Act that require the issuer of certain interests to identify the residence of "all" holders of the units, shares, or interests of the issuer. We noted that publicly traded entities cannot always secure the required information for "all" holders. The Department's response indicated that it would be willing to discuss the matter but that more information was needed. The Department added, "As far as we know, mutual funds, which need to know the residence of their unit holders, have not had any problems with gathering the necessary information." Although true, mutual funds deal directly with their holders except where the funds are listed on an exchange. Other entities whose shares, units, or interests are publicly traded generally do not have access to information about a holder's residence.

The Department also said that TEI's 2003 proposal was unclear. We acknowledge that our recommendation could be improved and would like to work with the Department in order to gain a better understanding of the Department's policy concerns for requiring the identification of the residence of "all" holders of an entity. For example, TEI suggested adoption of a de minimis threshold whereby ownership of publicly traded partnership interests below, say, five percent total ownership of the entity need not be considered. TEI's proposal is intended to mitigate the "all or nothing" approach in the current legislation that publicly traded entities may not be able to comply with. We note that proposed subsections 131(5.2) and 132(5.2), relating to mutual fund trusts and corporations, in the September 2004 release of draft Legislation Relating to Income Tax adopt a five-percent de minimis concept that might serve as a useful reference for developing legislation.

F. Definition of Canadian Exploration Expense for Mines

In response to Question 20, Part 2 of the 2002 liaison meeting agenda, the Department advised that it would consult with CRA regarding its interpretation of paragraphs 66.1(6)(f) and (g) of the definition of Canadian Exploration Expenses (CEE). At the 2002 meeting, TEI expressed concern that CRA seems to believe that expenditures incurred prior to commercial production of a mine do not fit within paragraph (f) or (g) because the expenditures are incurred after the discovery of the resource but prior to a decision to commence construction of a mine. Please update TEI on the status of the Department's review with CRA and advise whether the Department is considering an amendment to the legislation to ensure that expenditures incurred prior to commercial production of a mine will be treated as CEE.

2. Series

If a sequence of events is determined to be part of a "series," the tax results arising from the events or transactions may differ radically from an identical set of facts and circumstances that is not considered part of a series. Regrettably, decisions in two Federal Court of Appeal cases--OSFC v. The Queen, 2001 FCA 260, and The Queen v. Canutilities Holdings Ltd., 2004 FCA 234--have spawned significant uncertainty and confusion for taxpayers and CRA in respect of the application of the definition of a series. Indeed, the cases can be read for the proposition that a series exists whenever a sequence of events is expected to take place and the events subsequently occur regardless of (i) how tenuous the connection is between the events or (ii) whether the events have independent purposes. Indeed, the test for a series seems to be reduced to whether there is a minimal connection between the events and whether, at the time subsequent events occur, the taxpayer has knowledge of the earlier events.

Concededly, the concept of a series is important in order to ensure that the tax results of a planned, interdependent sequence of events or transactions are determined by viewing the steps together as a whole. In light of the overbroad interpretation of series by the Federal Court of Appeal and the resulting confusion and uncertainty, however, we recommend that the Department narrow the current definition and provide guidance about the required degree of connection and interdependence of events in order to establish that a series exists. In TEI's view, when subsequent events have independent objectives or where subsequent events do not advance the objectives of earlier events, the events should not be considered to be part of a series. In addition, the Department should consider establishing a time-based safe harbour, available at the option of the taxpayer, in order to sever the relationship between earlier and later events for purposes of determining whether a series exists. We invite a discussion of TEI's suggestions and other ways to narrow the legislation and clarify that events will not be deemed to be a series simply because events follow one another.

3. Liability for Part XIII Tax--When Statute Barred?

Part I tax is generally first assessed within three to four months after the Part I income tax return is filed. That assessment is the starting point in determining the normal assessment period under Part I of the Act. The normal assessment period limits the period of time during which CRA may reassess taxpayers and thus provides certainty that tax liabilities will be final by a certain date.

Regrettably, there is no similar limitation period for Part XIII tax. As a result, a tax year is never closed for reassessment unless an audit is completed. Hence, taxpayers may be subject to Part XIII assessment for many years after the end of the normal assessment period for Part I tax. Would the Department of Finance consider drafting an amendment to the Act to provide a normal assessment period in respect of Part XIII tax? The operative provisions could be modeled after those establishing a normal assessment period for Part I tax. For example, the legislation might provide that the limitation period commences with the later of the filing date, the filing due date, or the date an assessment is received within the limitation period. Adoption of such a measure would close taxation years to assessment and thereby establish a date when taxpayers can be certain that their Part XIII tax liability is final.

4. Notices of Objection--Large Corporations

Subsection 165(1.11) of the Act sets forth rules governing notices of objection filed by large corporations. Under subsection 169(2.1), a large corporation is precluded from pursuing any issue in respect of which the taxpayer did not fully comply with the procedural requirements of subsection 165(1.11). Recently, in Potash Corp. of Saskatchewan, (1) the Federal Court of Appeal reviewed the Tax Court's decision to grant the taxpayer's motion for leave to amend its notice of objection and appeal. In upholding the Crown's appeal and refusing the taxpayer's request to amend its notice of objection and appeal, the Federal Court observed that the result was harsh but intended by Parliament.

Often, especially in tax disputes involving large corporations where the issues, facts, and amounts are substantial and complex, taxpayers attempt to obtain disclosure of the factual and legal basis of an assessment prior to filing their notice of objection. Regardless of whether the requested disclosure from CRA is sought pursuant to formal requests under the Access to Information legislation or pursuant to CRA's guidelines in the Administrative Appeals Renewal Initiative--Toward an Improved Dispute Resolution Process, the requested information is frequently not made available on a timely basis. Disclosure of the factual and legal basis supporting CRA's assessment is critical to a taxpayer's informed review, analysis, and understanding of an assessment and preparation of a notice of objection. Without complete and timely disclosure of the basis of the assessment prior to the due date for the notice of objection, large corporate taxpayers are arguably denied due process.

We recommend that Finance consider a legislative amendment that would permit large corporations to file an amended appeal or notice of objection within 30 days after CRA discloses the basis for an assessment or provides any requested information under a formal request made by the taxpayer within 60 days of an assessment. Such an amendment would ensure that large corporations are afforded due process through full disclosure of the factual and legal basis of an assessment in advance of the date by which they must file an appeal and notice of objection. We invite a discussion of the suggestion.

5. Elections and Designations in Prescribed Form

The Act and Income Tax Regulations include a number of provisions permitting taxpayers to exercise discretion by making elections, designations, or determinations. Where the Act affords taxpayers such discretion, a prescribed form with prescribed information must generally be filed within or at a specified time. In many cases, the rationale for the prescribed form is clear. For example, in the case of the joint election under subsection 85(1), the prescribed form is essential in order to bind different taxpayers to a consistent tax treatment. In other cases, the rationale for requiring a separate, prescribed form is unclear. Two examples are the elections under subsection 13(29) and subparagraph 59(1)(b)(ii) of the Act, respectively.

A. Subsection 13(29)

Under subsection 13(29) taxpayers may elect to use the "long term project rule." When the election is made, expenditures incurred in the course of a project are considered available for use prior to the project's completion. The election must be filed on Form T1031 with the taxpayer's return for the taxation year commencing more than 357 days after the end of the year in which the project commences. There is no procedure or opportunity for filing a late election. In order to accelerate capital cost allowance (CCA) claims, taxpayers will generally make this election.

B. Subparagraph 59(1)(b)(ii)

Subsection 59(1) addresses the disposition of a foreign resource property and requires the net proceeds from the disposition of a foreign resource property to be included in income. Where the property is a foreign resource property in respect of a country, subparagraph 59(1)(b)(ii) permits a taxpayer to designate an amount of proceeds to be applied to reduce the taxpayer's cumulative foreign resource expense in respect of the country pursuant to clause F of the definition of "cumulative foreign resource expense" in subsection 66.21(1). The designation must be in prescribed form (even though no form has yet been prescribed) and be filed within a prescribed period of time. Any credit balance created in the cumulative foreign resource expense pool is included in income pursuant to paragraph 59(3.2)(c.1). Since a taxpayer's cumulative foreign resource expense is only a 30-percent pool, taxpayers will generally make this designation. (2)

For a voluntary self assessment tax system to be effective, the legislation must be consistent and designed for ease of compliance and administration. Given the ever-increasing number of elections and designations that must be made, taxpayers may incur a substantial tax detriment by inadvertently failing to file the correct form within the required time period. Since the tax cost of failing to make proper elections or designations or to file them on the prescribed form within the proper period of time can be quite high, there should be clear and compelling administrative reasons for mandating the use of a prescribed form. Indeed, small and medium-sized enterprises that may not have the internal expertise or the resources to spend for expert tax advice stand to suffer significant harm for failure to make various elections, designation, and determinations. We would appreciate the Department outlining the criteria and considerations that are applied in determining whether an election, designation, or determination must be filed in prescribed form rather than simply permitting taxpayers to "elect or designate such amount as the taxpayer may determine" on their returns.

6. Calculating Currency

In previous liaison meeting agendas and submissions, TEI has noted that in certain circumstances it would be useful to permit taxpayers to use the Canadian dollar as a "calculating currency." The Department has averred that it is unaware of foreign tax regimes where the use of the Canadian dollar as the calculating currency would ease compliance burdens. At the 2004 International Fiscal Association's Canada Roundtable, CRA opined that, where countries such as Australia and Netherlands permit the use of a non-native currency as the functional currency for tax and other reporting purposes, the non-native currency is an appropriate calculating currency for surplus purposes. (See item 2 in the Appendix for details.) CRA's opinion leaves Canadian taxpayers in an odd position: Where a subsidiary of a Canadian parent uses the Canadian dollar as its functional currency, it may use Canadian dollars for all tax calculations except the calculation of Canadian taxes pursuant to Regulation 5907(6). Would the Department of Finance consider drafting an amendment to the Act to permit foreign affiliates to use the Canadian dollar as a calculating currency?

7. Qualifying Environmental Trusts (QET--Extend to Pipeline Reclamation

Pipeline owners are frequently required by law or contract to fund during the life of a pipeline the anticipated future reclamation expenditures for the pipeline. Currently the Qualified Environmental Trust (QET) rules permit a current deduction for funding of future reclamation expenditures in respect of mining operations, including waste-disposal sites and quarries. The QET rules do not extend, however, to pipeline reclamation expenditures even though they are similar to mining reclamation expenditures in nature, timing, amount, and environmental benefit. (Concededly, the life of a mainline pipeline can be appreciably longer than that of a typical mine and the costs incurred to reclaim a pipeline can be greater than the costs of mine reclamation.) In addition, in a regulated environment, these future costs are collected in current rates from today's customers, but the expenditures are not deductible under paragraphs 18(1)(a) and (e) until paid. As a result, there is a mismatch in the taxation of the revenues and expenditures, the tax cost of which may, in some cases, be recovered by a grossed-up charge to customers. Would the Department of Finance consider drafting legislation to extend the QET rules to funds contributed to a trust in order to fund future reclamation expenditures for long-lived mainline pipelines?

8. Payments from a Registered Pension Plan to a Corporate Plan Sponsor

Technical Interpretation 2002-0163535--Payments from RPP, Deferred Profit Sharing Plan or Supplementary Unemployment Benefit Plan (December 9, 2003)--provides that certain amounts paid from a registered pension plan (RPP) that are not in the nature of pension payments are nonetheless subject to withholding tax pursuant to paragraph 153(1)(b) of the Act. Payments by an RPP to a plan sponsor usually arise from (1) a return of overpayments made by the employer that are attributable to clerical or administrative errors, (2) a return of excess employer contributions in order to avoid revocation of the plan's registration, (3) a refund of plan administrative expenses paid by the employer, or (4) a payment of plan surplus that constitutes a superannuation or pension benefit received from the RPP.

The technical support for CRA's conclusion that the payment from the RPP is subject to withholding is, as follows:

* Regulation 100 defines an "employer" as "any person paying remuneration" and an "employee" as "any person receiving remuneration."

* The definition of "remuneration" in Regulation 100 includes a "superannuation or pension benefit."

* Section 248 defines a "superannuation or pension benefit" as including,

any amount received out of or under a superannuation or pension fund or plan and, without restricting the generality of the foregoing, includes any payment made to a beneficiary under the fund or plan or to an employer or former employer of the beneficiary thereunder

(a) in accordance with the terms of the fund or plan,

(b) resulting from an amendment to or modification of the fund or plan, or

(c) resulting from the termination of the fund or plan.

* Subsection 153(1) requires that tax be withheld at source from a "superannuation or pension benefit" payment.

Under CRA's interpretation, the employer sponsor of an RPP that receives a reimbursement of expenses is regarded as having received a "superannuation or pension benefit" that is subject to withholding tax in accordance with "prescribed rules." Thus, the interpretation creates the sole instance that TEI is aware of where a reimbursement of expenses is subject to withholding tax. (3) Just as curious, a consequence of the interpretation is that the employer sponsor becomes, in effect, the employee and the RPP becomes the employer. Thus, the amount of tax withheld from the sponsor is computed under regulations that apply to payments made by an employer or former employer to individuals.

TEI believes it is improper to subject reimbursements of expenses and other payments from an RPP to a withholding tax because corporations are required to remit tax instalments pursuant to subsection 157(1). We recommend that the Department consider introducing legislation to exempt such payments from the withholding tax that CRA seemingly believes is required by subsection 153(1).

9. Depreciation of the Capital Cost of the Right to Use Patented and Nonpatented Information

A. Background to Class 44: Capital Cost of Patents or Rights to Use Patented Information

In the April 26, 1993, Federal Budget, the government announced an amendment to the Income Tax Regulations to revise the capital cost allowance (CCA) that taxpayers may claim with respect to the capital cost of patents or the right to use patented information. The amendment created Class 44 of Schedule II and applies to "property that is a patent or a right to use patented information for a limited or unlimited period." The amendment applies to property acquired after April 26, 1993.

The effect of the amendment is to permit depreciation of qualified costs at a rate of 25 percent on a standard declining-balance basis, subject to the half-year rule. Prior to the amendment, patents and licences to use patents of a fixed period were depreciated over the life of the patent or licence as Class 14 property. Patents or licences to use patents of an indeterminate period were considered eligible capital property, with three-fourths of the cost written off for income tax purposes on a seven-percent, declining-balance basis.

In explaining the 1993 CCA amendment, the government stated:

   New technology is being rapidly developed and integrated
   into production and distribution systems.
   It is important for Canadian business to acquire
   new technologies in order to maintain their ability
   to compete in the global marketplace. An issue
   identified in the December 1992 Economic and
   Fiscal Statement was whether the tax system is
   impeding the ability of Canadian firms to access
   this new technology.

Thus, the government recognized that "an important factor that affects the after-tax cost of these patents or licences is the rate at which they are depreciated for tax purposes."

B. TEI Proposal in Respect of Capital Cost of Rights to Use Nonpatented Information

Canadian companies often obtain access to technology by purchasing the right to use special procedures, processes, recipes, or information concerning industrial, commercial, or scientific experience. The technology and know-how may or may not be covered by a patent. If a taxpayer acquires a licence to use nonpatented industrial information or know-how for an indefinite period, the capital cost of the licence does not fall under Class 44. Rather, the capital cost is treated as eligible capital property, the recovery of which is at a slower pace with a higher net, after-tax present-value cost. Specifically, 25 percent of the capital cost of such a licence will never be deductible for tax purposes and the remaining amount would be depreciated at the seven-percent declining-balance rate rather than the 25-percent declining-balance rate permitted for a Class 44 licence.

There are many reasons companies may not obtain patents in respect of their scientific information or know-how. (4) Nonetheless, nonpatented information is often as valuable as patented information. Moreover, in order to compete globally it is as critical for Canadian companies to obtain access to nonpatented scientific information and know-how as it is to obtain access to patented information. As important, Canadian companies should be able to recover the costs of nonpatented information as quickly as they recover the costs of patented information. Indeed, the economic useful life of nonpatented technical information is arguably shorter than that of patented information. In order to make the after-tax cost of obtaining licences for patented and nonpatented information comparable, TEI recommends that Class 44 be revised to apply, with respect to acquisitions after April 26, 1993, to:

Property that is a patent or a right to use patented or nonpatented industrial information or technical know-how for a limited or unlimited period.

In addition to making the costs of equally useful patented and nonpatented information comparable on an after-tax, net present-value basis, TEI's proposed revision will enhance the public policy objectives of removing impediments to the ability of Canadian firms to obtain access to new technologies and to make Canadian firms more competitive in the global marketplace. We invite a discussion of TEI's proposal.

10. Property Ineligible for Rollover Transfer under Subsections 85(1) and 97(2)

A. Subsection 97(2) of the Act permits a person to transfer certain types of property on a tax-deferred "rollover" basis to a partnership. Among the properties that qualify for rollover treatment are capital property and inventory. Certain securities and debt obligations used in the business of insurance or by money lenders are outside the definitions of both capital property and inventory. In addition, "specified debt obligations" of a financial institution are also ineligible. As a result, these assets do not qualify for rollover treatment upon a transfer to a partnership. Under analogous rollover rules for transfers to a corporation, however, paragraphs 85(1.1)(g) and (g. 1) specifically permit these assets to qualify for rollover treatment. TEI submits that there seems no compelling policy reason to preclude such assets from rollover treatment on a transfer to a partnership. Would the Department of Finance consider drafting an amendment to subsection 97(2) to add to the list of qualifying properties those assets currently covered by paragraphs 85(1.1)(g) and (g.1)?

B. In addition, seismic information, the cost of which constitutes either a Canadian exploration expense or a foreign resource expense, is seemingly ineligible for rollover treatment under either subsection 85(1) or 97(2). Specifically, since the cost of seismic information is neither "eligible property," as defined in subsection 85(1.1), nor capital property, Canadian resource property, foreign resource property, eligible capital property, or inventory, it is ineligible for rollover treatment under either provision. It is unclear, though, why seismic information should be excluded from the rollover provisions. Would the Department of Finance consider drafting amendments to subsections 85(1) and 97(2) to add seismic information to the list of property eligible for rollover treatment upon an otherwise qualifying transfer?

11. Silviculture Liabilities

CRA released technical interpretation 2003-0020445 (December 1, 2003) to address the tax issues arising from the pending takeback of timber tenures in British Columbia. The interpretation addressed, among other issues, the proper treatment of silviculture liabilities assumed by the Province as part of the takeback. CRA's position is, as follows:

Where a timber tenure holder is relieved from the obligation to incur accrued silviculture costs in connection with the reduction in a timber tenure pursuant to the provisions of the FRA, the value of the silviculture obligation from which the timber tenure holder is relieved will be included in its proceeds of disposition of the property or part thereof disposed of.

In a public forum for the Forest Industry following the release of this technical interpretation, CRA expanded on its comments by stating that, although the amount of assumed silviculture liabilities would be taxed as additional proceeds of disposition, no corresponding deduction would be permitted in respect of the silviculture liabilities because they had not been settled for tax purposes. CRA acknowledged that this would result in double tax on the amount of any silviculture liabilities assumed by the Province. Would the Department consider proposing a change to the Act in order to avoid double taxation to taxpayers on the assumption of a silviculture liability by the Province?

12. Section 17--Interaction with Section 15

Under section 17 of the Act, a corporation resident in Canada may make a loan to a non-resident person at market rates of interest. In the event the interest rate is less than a market rate and the loan is outstanding for more than a year, subsection 17(1) resets the interest earned by the Canadian entity to the prescribed interest rate unless the loan qualifies for one of the exceptions under section 17. Subsections 17(2) to 17(6) backstop section 17(1) to prevent taxpayers from circumventing subsection 17(1) through certain indirect loans or transfers.

Subsection 15(2) requires a shareholder of a company to include the amount of a loan or advance from the company in income unless, under the exception set forth in subsection 15(2.6), the loan or advance to the shareholder is repaid within a year after the taxation year in which the debt is incurred. In addition, under subsection 15(2.3), subsection 15(2) does not apply to debts that arise in the ordinary course of a creditor's trade or business or to a loan made in the course of a lender's ordinary business of lending money so long as bona-fide arrangements exist for repayment of the loan within a reasonable time.

Where a corporation resident in Canada has free cash available to invest and makes loans to a non-resident shareholder, the implicit policy of section 17 is that a company may lend money to its non-resident shareholders as long as a market rate of interest is charged. Section 17, however, does not specifically address a series of loans (or loan renewals) to non-resident shareholders. Where a company charges a market rate of interest on a loan--and thus satisfies the underlying policy of section 17--section 15 may convert a loan to a non-resident shareholder into income unless one of the "ordinary course of business" exceptions of subsection 15(2.3) are satisfied. Would the Department of Finance consider drafting an amendment to section 15 permitting loans that satisfy the requirements of subsection 17(1) to also qualify for an exception to section 15? Specifically, TEI recommends that, to the extent Canadian resident companies earn a market rate or a prescribed rate of interest income from non-resident shareholders, section 15 should not apply to the loan regardless of how long the loan is outstanding or whether loans are renewed. We invite a discussion of TEI's proposal.

13. Retroactivity

TEI has in several submissions and liaison agendas expressed concern about the introduction of retroactive legislation, especially where the legislation is not clearly remedial in nature. To allay taxpayer concerns about retroactive legislation, the government enunciated a number of guiding principles for retroactive legislation in its 1995 Comprehensive Response of the Government of Canada to the Seventh Report of the Standing Committee on Public Accounts. One of the principles is that retroactive legislation should rarely be employed. Regrettably, the practice of introducing retroactive legislation has become commonplace rather than rare. Indeed, under the Excise Tax Act, retroactive amendments have nearly become the norm and, under the Income Tax Act, the frequency of retroactive legislation is accelerating. Recent examples of retroactive legislation under the Income Tax Act include proposed changes to the limitations period, the treatment of trust capital distributions, and the interpretation of the general anti-avoidance rules and treaties. These retroactive changes were announced without reference to which, if any, of the principles enunciated in the Comprehensive Response of the Government of Canada to the Seventh Report of the Standing Committee on Public Accounts, justified the retroactive legislation. We invite the Department's comments in respect of the criteria it applies in determining whether legislation should be retroactive and, more important, clarifying how the examples referenced above satisfy those criteria.

14. Status of Proposed Amendments to the Income Tax Regulations

Currently, there is an expanding backlog of proposed amendments to the Income Tax Regulations. Some of the proposed regulations were introduced as many as ten years ago and have been relied upon by taxpayers in preparing returns and CRA in making assessments. For example, Part XC of the Income Tax Regulations was introduced as part of the June 1, 1995, draft regulations. Once enacted, these regulations will generally be applicable after February 22, 1994. Even though the proposed regulations have not been enacted, the Department of Finance published a series of comfort letters between 2000 and 2003 outlining the policy rationale for these regulations and in certain instances expressed a willingness to recommend amendments. Hence, the Department seemingly considers the proposed amendments to be part of the legislation as well.

Another example is proposed Regulation 5910. Introduced two years ago as part of the December 20, 2002, draft regulations, the proposed coming-into-force rule states that Regulation 5910 will apply to taxation years beginning after the later of December 31, 1994, and the date designated by the taxpayer, provided the taxpayer files its designation in writing on or before the due date for the taxpayer's first taxation year that ends after 2002. (5) Once enacted, Regulation 5910 will apply to most taxpayers for taxation years after December 31, 1994.

The long lag time between the dates regulations are proposed and finalized is causing serious corporate governance issues for taxpayers. The Sarbanes-Oxley Act of 2002 and related U.S. securities legislation as well as similar Canadian securities legislation have placed a heavy burden on financial statement issuers to ensure full and complete financial disclosure of their affairs as well as compliance with generally accepted accounting principles. A number of issues illustrating why it is important that extant proposed regulations be adopted promptly, follow.

A. With long lag times between the proposal and adoption of regulations as well as retroactive effective dates, taxpayers are compelled to decide between preparing their tax returns on the basis of what they believe the law is currently and what they believe the law will be once pending regulations with their myriad retroactive effective dates finally come into force. Since taxpayers may not be able to amend prior year's returns prior to the expiration of the statute of limitations for affected years, they often feel obliged to file their returns on the basis of what they believe the law will be upon adoption of pending legislation and regulations. In the current regulatory environment, however, corporate officers are reluctant to sign tax returns prepared on a basis that is inconsistent with the law at the time of signing.

B. In order to preserve the government's fiscal interest (especially in years that may become statute barred), CRA must either secure a taxpayer's waiver or consider assessing or reassessing a taxpayer on the basis of existing law even though the assessment or reassessment will be mooted by enactment of a pending law or regulation. If assessed or reassessed, large corporations must, in turn, formally object and pay half of any resulting tax that is "in dispute." This imposes an onerous financing burden on companies for taxes that they may never incur.

C. Under U.S. generally accepted accounting principles, the financial statements and footnotes must be prepared on the basis of existing law regardless of how advanced pending changes to the law might be. Under Canadian GAAP, pending changes to the law may be recognised provided the changes are sufficiently "well advanced." This leads to potentially complex differences between Canadian and U.S. GAAP in respect of reported tax liabilities and expense that must be disclosed in external financial reports.

D. The status of Regulation 5910 is a significant factor in determining the amount of foreign oil and gas reserves a taxpayer can recognise under GAAP. The amount of reported reserves, in turn, materially affects the determination of the earnings that taxpayers report in external financial statements. In addition, the delay in enacting Regulation 5910 has caused some taxpayers to delay repatriating foreign oil and gas profits to Canada. The delay in enacting the regulation has also been cited as among the reasons for abandoning otherwise attractive foreign business opportunities.

We would appreciate the Department providing an update on the status of the proposed amendments to the income tax regulations, especially those discussed above. We also invite a discussion of whether there is anything TEI or taxpayers can do to expedite the enactment of key amendments.

15. Scientific Research & Experimental Development (SR&ED)

Corporate research and development (R&D) activities generally create high-skilled, high-wage jobs, facilitate knowledge transfer, and enhance the prospects for commercialization and sale of products and services by the company performing the R&D. Is the Department considering any changes to the SR&ED program in order to facilitate achieving the federal government's goal of making Canada one of the top-five centres in the world for performing R&D? One means of increasing investment in Canadian-based R&D would be to modify the SR&ED credit mechanism to make it more attractive to foreign investors on an after-tax basis, taking account of the foreign investor's home country tax laws. Moreover, we believe the goal can be achieved without reducing the government's net tax revenues. We submit the following proposal and discussion.

Where a foreign investor owns a Canadian company performing R&D activities, the foreign investor in many countries (e.g., the United States, the U.K, and Japan) is generally able to recover Canadian corporate income tax payable as a foreign tax credit offset against the local tax otherwise payable on the distributed earnings of the Canadian company. Recovery of the tax is generally permitted to the extent that the Canadian income tax payable does not exceed the foreign investor's home country income tax payable. Indeed, with the Canadian corporate income tax rate slated to decline under the legislated rate reductions, it is more likely the Canadian income tax paid will be fully recoverable by foreign investors. On the other hand, since the SR&ED investment tax credit reduces the Canadian corporate income tax payable, the foreign tax credits that would otherwise be available to the foreign investor are correspondingly reduced, thereby increasing the local income tax liability. Consequently, the current investment tax credit regime provides little or no net benefit to the foreign investor in determining its total worldwide income taxes payable. Thus, when making decisions relating to incremental investments in R&D activities in Canada, the value of the SR&ED credits is frequently discounted by a foreign parent company.

TEI believes that if the SR&ED credit were applied as an offset against a different, non-income tax Canadian levy, the SR&ED credit would be a more powerful incentive for foreign investors. The Canadian corporate income tax payable would not be reduced by the SR&ED credit and the amount of foreign tax credit available to the foreign investor in its home country would be correspondingly higher. To ensure that funding of a government program supported by the levy is not reduced, an internal transfer of additional Canadian corporate tax could be made to the program to the extent the non-income tax levy is reduced by an SR&ED credit. Moreover, to ensure that overall government revenues are not reduced, the non-income tax levy that is offset by the SR&ED could be limited to taxpayers qualifying for the SR&ED credit that are net income tax payers. To ensure its effectiveness as a tax incentive, the legislation should include mandatory ordering rules for applying the SR&ED credit. Specifically, the credit should be applied first to the non-income tax levy, then to the large corporations tax (so long as it remains in existence), then to the corporate income tax. TEI believes that the adoption of its proposal would create a significant incremental cost advantage for Canadian-based R&D activities thereby enhancing Canada's ability to attract corporate investments in R&D. We invite a discussion of the proposal.

16. Service Maintenance Agreements

Paragraph 12(1)(a) requires that payments for services or goods that will be rendered or delivered in a future period be included in income when received. Unless it can be "reasonably anticipated" that goods or services will be provided after year end, a vendor cannot avail itself of paragraph 20(1)(m) of the Act in order to establish a reserve for the related expenses. Generally, taxpayers must demonstrate there is a contractual obligation to provide the goods or services in order to avail themselves of the paragraph 20(1)(m) reserve.

Most maintenance agreements for high-tech equipment incorporate a preventative or scheduled maintenance. Under such agreements, there is generally no question whether the services will be provided; the question is when the services will be provided. Modern information technology permeates business operations--whether in desktop PCs, large-scale information systems, or equipment used in manufacturing, transportation, or natural resource extraction. Indeed, technology is so pervasive that critical business operations may cease if a company's technology infrastructure is not available. To ensure that business operations can be carried out in an uninterrupted fashion, preventative maintenance services are a routine part of most contracts for the sale or lease of high-tech equipment.

Preventative maintenance routines are based on the passage of time, level of usage, historical failure rates, or some combination of such variables. Although most vendor agreements state that preventative maintenance will be provided, no set schedule for performing the activities is generally included in the contract. Where payments are received for an entire year of services near the end of the tax year, the vendor must include the entire amount in income but few costs or expenses will have been incurred. As a result, tax is payable on the entire amount with no offsetting deductions for the costs or expenses that will be incurred in providing the services. This imposes a cash flow hardship on the vendor since the taxes must be prepaid before the contractual obligations are fulfilled. Would the Department consider drafting an amendment to the legislation to permit taxpayers to prorate the fees received based on the term of the contract, and include in income only the fees that relate to the percentage of the contract period that pertains to the current taxation year?

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 8, 2004, liaison meeting.

APPEDIX

1. Background for Question 1 (e) of the 2004 Liaison Meeting Agenda--Question 31 from the agenda for the 2003 Liaison Meeting with the Department of Finance relating to surplus entitlement percentage.

Surplus Entitlement Percentage

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

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

* FA2 is wound up and dissolved into FA1.

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

Analysis:

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

This result penalizes Canadian multinationals that, because of various factors (e.g., legal liability, regulatory requirements, and tax purposes), split the ownership of foreign affiliates among two or more related Canadian corporations. TEI submits that a "related party" concept should be introduced into the definition of surplus entitlement percentage in order to address this inequity. The introduction of a related-party test would be consistent with other provisions in the Act that address foreign affiliates, including proposed paragraph 95(2)(n) and subsection 17(13). Would the Department introduce an amendment to address this surplus entitlement percentage issue?

2. Background material for Question 6 of the 2004 Liaison Meeting Agenda, relating to calculating currency.

Income Tax Rulings Directorate Jim Wilson Manager, International Section, Income Tax Rulings Directorate

Question #4 2004 International Fiscal Association Canada Roundtable Denomination of Foreign Affiliate Surplus Accounts

Recently a number of countries have amended their tax legislation to allow taxpayers to choose a functional currency for tax return purposes that differs from the local currency. This is the case notably in Australia and the Netherlands. Assume that in the past, the surplus accounts of a foreign affiliate (FA) resident and carrying on business in Australia were kept in Australian dollars and that the FA decides to use the US Dollar as its functional currency for financial statement and tax return purposes. From an economic and policy perspective, keeping the surplus accounts in US dollars would be appropriate on a go-forward basis. Applying such an approach is not fundamentally different from the one that was used for European companies which moved from their respective legacy currencies to the Euro. Due to the requirement in Regulation 5907(6) that consistency be maintained, it is not clear that the functional currency of FA can be changed from the Australian dollar to the US dollar.

Where the business of FA is transacted in a foreign currency other than the currency of the country in which FA is resident and in which the business is carried on, and such foreign currency is used by FA for financial statement and tax return purposes in that foreign country, it would in our view be reasonable in those circumstances that FA's surplus accounts be maintained in that same foreign currency. Therefore, provided that the adoption of the new foreign currency for financial statement and tax return purposes is carried out when such option first becomes available under the foreign tax law, the CRA would generally consider a conversion of FA's surplus accounts to the new foreign currency to be in compliance with Regulation 5907(6). Conversions carried out at another time would be considered on a case-by-case basis.

(1) [2004] 2 C.T.C. 91 (FCA), leave to appeal to Supreme Court of Canada denied.

(2) The one exception is that pursuant to subsection 66(4), taxpayers are entitled to deduct their unclaimed foreign exploration and development expenses to the extent of income included under subsection 59(1). Unclaimed foreign exploration and development expenses, however, are not deductible to the extent of income included under paragraph 59(3.2)(c.1).

(3) Even regulation 105 does not subject expense reimbursements to withholding.

(4) In some cases, technological obsolescence may render the life of the information too short to be worth the time and cost of prosecuting a patent application. In other cases, a company may believe that the information can be better protected as a proprietary trade secret if the information is not patented.

(5) Since Regulation 5910 has not yet been enacted, there is no basis for taxpayers to make the written designation noted above. Further more, the time limit for making the written designation has now expired. Would the Department please confirm that, upon the enactment of Regulation 5910, the coming-into-force rule will be revised in order to permit taxpayers to file their designations within a certain time after the date of enactment and to have those designations deemed timely made?