Response of Canadian Department of Finance to questions posed at TEI liaison meeting on income tax issues.

On December 8, 1993, representatives of Tax Executives Institute met with officials of Canada's De to discuss pending income tax issues. (A separate meeting was held on issues related to the goods an liaison meeting, the Institute submitted a series of questions, which formed the agenda for the meet the responses TEI received from the Department of Finance. (The questions were reprinted in the Nove issue of The Tax Executive and should be reviewed in conjunction with these answers.

Benchmarking Canada's Tax System with the United States and Mexico

The 1992 suggestion from TEI, comparing North America to Europe, was deemed premature by the Department of Finance, since the European Community is attempting to form a union or commonwealth, whereas Canada and the United States are just creating a Free Trade zone. There was no acknowledgment that a similar "tax regime convergence" would inevitably be needed here, if North America is to avoid seeing one jurisdiction competing with another with ever-richer tax incentives for business.

TEI's specific 1993 suggestion for an annual benchmark report was rejected, but Department officials did agree that benchmarking already takes place informally. They recognize that the Canadian tax burden, at least for corporations, cannot get too far away from what it would be if a business relocated to the United States. They stated that numerous private studies were available, and those were reliable enough; the Department had no intention of commenting on those, let alone issuing a publicly available, formal benchmark-type analysis.

The Federal Government Role of Leadership and Harmonization with the Provinces

Although the Department of Finance agreed with all the issues raised by TEI [concerning the desirability of harmonizing the federal and provincial systems], the Department does not have the authority to compel the provinces to harmonize. A mechanism does exist, however, to review "irritants." Specifically, there is a committee at the Assistant Deputy Minister level that meets to discuss issues, though no meeting has been held recently. It is hoped that the committee start meeting again soon.

A formal body may not be any more effective. Department officials did identify, however, issues that they are currently seeking to resolve. These included provincial allocation, sales taxes, the provincial reclamation fund tax, personal tax, and the deductibility of payroll and capital taxes.

Part 1.3 -- Large Corporations Tax

A. Capital Taxes - Harmonization of Federal and Provincial Systems

Finance advised that, if the federal and provincial systems were harmonized, the provincial systems would likely be adapted to the federal system. It was suggested that TEI take a leadership role in advocating the benefits of harmonization to the provinces.

B. Investment Allowance - Debts Owed By One Partnership To Another

In principle, Finance would not object to tiered-partnership debts' qualifying for the investment allowance if there is an actual need. Department officials, however, are interested in finding out why two partnerships are required.

C. LCT Relief for Companies in Loss or Minimal Profit Position

Finance was not receptive to this recommendation. The LCT is regarded as a source of revenue by the government.

Deductibility of Provincial Business Taxes

The existing system provides an incentive for provinces to increase capital and payroll taxes at the expense of the Federal government. Action is required on this issue as those provinces which have not imposed significant payroll, business, and capital taxes are precluded from doing so by the current grandfathering provisions.

Expense Deductibility Relating to Real Estate

The current provisions in the Income Tax Act result in a matching of carrying costs of real property with the reporting of revenue derived from its sale. Consideration could be given to increasing the upper threshold level of interest expense deductible from the present $1 million times the prescribed rate to some higher level.

Non-Resident Withholding Taxes 

As a follow-up to the 1993 Budget when the government announced its intent to pursue reductions in the rates of withholding tax on intangibles, we were advised that this is currently being negotiated with the United States. Negotiations of other treaties/protocols are currently being pursued only in response to requests from other treaty partners.

TEI made the suggestion, that with the enactment of NAFTA, Canada and the United States should strive to achieve the European model of virtually no withholding taxes between member states.

TEI was advised that there is not a target date for renegotiation of either the U.S. or the U.K. treaty.

It was suggested that if the Institute were eager to see the Canada-U.S. treaty renegotiated, it could be in TEI's interest to pursue the issue with the government of the United States as well.

Butterfly Transactions

A. Refinancing Prior to a Divisive Corporate Reorganization

Finance officials observed that the types of transactions involving butterfly reorganizations is very broad. It would be impossible for Finance to identify in advance all of the potential transactions that it would like to restrict. In light of this and Revenue Canada's willingness to provide rulings on whether property has been acquired in contemplation of a butterfly, Finance does not intend to promulgate the regulations requested.

B. Certain Shares Deemed to be Capital Property

Finance is concerned about the potential use of butterflies to convert income to capital gains. Consequently, Finance is not prepared to make the requested change to section 54.2.

C. Proposed Amendment to Subsection 55(3.1)

Finance chose to use a broad rule due to the myriad ways butterflies can be structured. A number of concerns have been expressed regarding this proposal. These will be taken into account in Finance's broader review of divisive reorganizations. No changes will be made until that review is completed.

Recapture of Additional Allowance for Research and Development

Finance is sympathetic to TEI's position and will consider repealing section 37.1.

Deferral of Capital Gain on Replaced Debts

Finance appreciates TEI's concern, is aware of the problem, and is reviewing it. It may be addressed in the interest deductibility study currently begin done. Finance did not, however, agree with the problem being similar to the replacement property rules. The policy under those rules is different from rolling over a gain on debt. The real gain and how to deal with it on a rollover is a debt/ interest issue, which is more complex than the replacement property rules. It involves the matching principle and how to deal with it effectively. Foreign exchange gains on debt create several issues that are currently being reviewed.

Automobile Operating Cost Benefit

The 12 cents-per-kilometre provision was introduced in response to taxpayer requests for simplification of these rules. Finance will not consider allowing the optional use of this rule since one, uniformly applied rule is easier to administer.

Carryback of Investment Tax Credit of Amalgamated Corporation

Although Finance agrees it would be logical to extend the carryback provision to investment tax credits (ITCs), the Department is not prepared to look at that credit in isolation. A commitment was made to review sections 87 and 88 with the intent to bring the two systems closer together.

Update on Proposed Interest Deductibility Legislation

Finance reported that the interest deductibility proposal released in December 1991 would not be enacted in 1993. The interest study is ongoing and complex, but the Department is making steady progress. It is likely that revised proposals will be issued in draft form.

Retroactive Legislation

The general policy of the government is not to make enactments retroactive, but to make them prospective--that is, effective when announced. It is considered important to be able to make the legislation effective when announced--

* because of the revenue loss

that would otherwise arise,

* to make incentives available

immediately, and

* to close loopholes.

As for the example given by TEI of the proposed amendments that may require recalculation of employee benefits back to January 1, 1993, history has been that proposals are generally enacted.

Pension Reform

The review of pension reform to be undertaken after three years was suggested by the House Standing Committee on Finance, not the Department of Finance. Consequently, if such a review is to take place, the initiative will have to come from the Committee. The three-year period does not run out until 1995.

The Department will engage outside consultants to conduct its own ongoing studies. These studies will focus on economic issues such as how pension reform has affected the level of retirement savings and on compliance issues. The Department will consult with industry with respect to the latter.

There are no plans at this time to reintroduce the Pension Adjustment Reversal (PAR). This is an issue TEI may want to raise with the House Standing Committee on Finance if it undertakes the above-mentioned review.

Business Foreign Tax Credit Versus Non-Capital Loss Carryforward 

The Department disagreed with TEI's analysis, stating that the result obtained in our example was indeed intended when Parliament created the legislation. The reason is that non-capital losses are not segregated into the portion that is domestic and the portion that is foreign. The tax credit formula requires a specific calculation of the net foreign income each year, but the result of the calculation is not carried forward separately if it shows that there was a net foreign loss. For this reason, the formula applies any non-capital losses ratably against domestic and foreign income.

Applying losses ratably will produce a smaller foreign tax credit (FTC) than streaming foreign-source losses against foreign-source income where, as in TEI's example, the loss is domestic. The ratable allocation of a foreign-source loss, however, leaves a larger FTC than it would under a system that streamed losses.

Changing these rules would certainly add complexity. From Finance's perspective, there seems to be no reason to attempt to change them. If the taxpayer eventually gets to use the carryforward losses, tax will have been paid sooner, but there is no permanent increase in taxes paid.

Foreign Sales Corporations 

TEI had asked the Department to consider providing export incentives to business similar to the foreign sales corporation tax incentive provided in the United States -- to make Canada more competitive with the United States under the Free Trade Agreement. The Department's response was not encouraging. The government preferred to assess the competitiveness of the Canadian tax system rather than specific components.

The Conference Board of Canada had reviewed the competitiveness of the Canadian tax system vis-a-vis the United States and concluded that the systems were more or less equal. Mention was made of the manufacturing incentives introduced to counter the Domestic International Sales Corporation in the early 1970s. TEI pointed out that those manufacturing and processing incentives had been substantially eroded since they were first introduced as a package in 1973-1974. The investment tax credit had been eliminated and the two-year write-off had been watered down by the half-year rule, and TEI suggested that the matter should be reviewed, particularly with the signing of the Free Trade Agreement. The Department said that they preferred Canada's current system which is generally viewed as competitive with the United States.

Finance will continue to monitor the competitiveness of the Canadian tax system.

Master Trusts

A. Proportional Holding Election

The history of the pooled fund trust arrangements dates back to pre-1972. Section 259 governing foreign property rules and registered pension plans was introduced in 1981 and modified in 1985. The master trust rules were introduced in 1987 as an accommodation for trusts that were pooling arrangements of pension plans. The borrowing restrictions under the qualified trust definition were developed largely to prevent RRSPs and DPSPs from borrowing indirectly through a trust.

A "pooled fund trust," as defined in the regulations, is also unable to borrow long-term and hold deposits, if it is to be a "qualified trust" under section 259. The master trust definition and the qualified trust rules reflect the current policy of Finance. If a change is made, it would not delete these two restrictions from the qualified trust definition, but would include them in the "pooled fund trust" definition.

B. Foreign Property Rules

The master trust rules currently reflect Finance's position that there should be no doubling up on foreign property. At the present time, the pooled fund trust rules have a foreign property doubling up opportunity that may or may not be eliminated.