Revenue Canada liaison meeting on income tax issues.

On December 13, 1994, Tax Executives Institute held its annual liaison meeting on pending income tax issues with officials of Revenue Canada-Customs, Excise and taxation. (A separate liaison meeting was held on pending excise tax issues.) The meeting was arranged under the aegis of TEI's Canadian Income Tax Committee, whose chair is John J. Marczynski of Abitibi-Price Inc., and the Institute's delegation was chaired by C. Graham Kennedy of MacMillan Bloedel Limited, the Institute's Vice President-Region I. Reprinted below are the questions that the Institute submitted to Revenue Canada in advance of the liaison meeting.

Tax Executives Institute, Inc. welcomes the opportunity to present the following comments and questions on several pending tax issues, which will be discussed with representatives of Revenue Canada Customs, Excise and Taxation during TEI's December 13, 1994, liaison meeting. If you have any questions in advance of that meeting, please do not hesitate to call either C. Graham Kennedy, TEI's Vice President for Canadian Affairs, at [phone] or John J. Marczynski, chair of the Institute's Canadian Income Tax Committee, at [phone].

I. Financing Transactions

All businesses depend upon multiple, diverse sources of financing to maintain and expand their operations. In recent years, intense competition among domestic and foreign sources of business financing has led to the development of a substantial number of derivative financial instruments and arrangements, which have been designed to meet the complex and sundry needs of multinational borrowers. To remain competitive, Canadian businesses are under enormous pressure to cut costs. The reduction in borrowing and foreign currency costs achieved by participating in innovative derivative transactions, though often measurable in relatively small increments of basis points, permits Canadian businesses to remain competitive - especially where the incremental basis point savings are applied to huge sums.

Despite the proliferation of these complex instruments, the tax consequences of the various payments made pursuant to, or collateral to, the derivative financing transactions remain clouded by uncertainty. The uncertainty has been exacerbated by the following factors:

* the perpetual evolution, and chameleon-like nature, of derivative financial instruments;

* the confusing array of juris-prudential principles distinguishing the tax treatment of interest from capital and ordinary debt transactions, and the overall lack of precedent on the treatment of the more complex financial derivative transactions;

* the absence of clear administrative guidance, a deficiency exacerbated by -

* the cancellation of IT-114 on June 10, 1994, leaving no guidance on Revenue Canada's assessing practice in respect of discounts, premiums, and bonuses on debt obligations; and

* the possible revision of IT-233R, creating uncertainty about the circumstances under which Revenue will treat a leasing arrangement as an acquisition for tax purposes.

While it seems both imprudent and - indeed, impossible - to legislate detailed tax rules in respect of every type of financial instrument or transaction, the government should provide dance to enable taxpayers to structure their financing transactions and report the tax effects of those transactions properly. Costly litigation over unresolved issues is undesirable for both taxpayers and the government. Accordingly, we have recommended that the Department of Finance establish broad principles concerning the taxation of financing activities. Those principles would form the basis for further detailed administrative guidance from Revenue Canada on the taxation of various aspects of common financial instruments and arrangements including:

* leasing;

* asset securitization;

* discounts, premiums, and bonuses on financial instruments; and

* interest rate or foreign exchange swap and hedging transactions.

We recommend that Revenue Canada publicize, through interpretation bulletins and information circulars, its administrative position and assessing practice. The guidance should be updated to reflect developments attributable to new legislation, jurisprudence, or the evolution of financial instruments. We would be pleased to meet with officials from Revenue Canada to assist in the development of the requested guidance.

II. Revenue Canada

Audit Practice

Although some large-file auditors embrace taxpayer participation in the design of the audit plans and believe that a new paradigm of cooperation will lead to better tax administration, there remains a wide divergence in the conduct of large-file audits. For example:

* Some auditors do not inform taxpayers about the details of their audit plans. In addition, proposed audit adjustments are often not brought to the attention of the tax department on a timely basis thereby preventing resolution of an issue before a reassessment. Auditors often fail to provide updates on the progress of their audits and whether the information they have been supplied is sufficient.

* Some auditors emphasize adjusting timing issues, insisting, for example, on reductions in accruals established under generally accepted accounting principles where subsequent invoices show lower amounts. Both the auditor and taxpayer may expend inordinate amounts of time and resources on accounting estimates - issues that are largely timing in nature since a subsequent year's estimate will be increased or decreased to account for the variance from actual results.

* Some auditors propose adjustments unsupported by, or even contrary to, established precedent by, for example, disallowing capital losses on interest-free loans to foreign corporations despite the decision in Floyd Glass (92 DTC 1759), or disallowing the manufacturing and processing tax credit on interest income in disregard of the decision in Canadian Marconi (86 DTC 6526).

We understand that Revenue Canada, through liaison meetings with groups such as the Large Business Advisory Committee, is reviewing its procedures to improve the audit process. TEI supports these initiatives. To this end, we offer the following comments:

* Audits should focus on issues where there are a high probability of both improper treatment and adjustments of sufficient magnitude to be a material concern to Revenue Canada. Audit plans should generally not focus on areas requiring substantial taxpayer efforts to produce documentation where the potential revenue for the government is small.

* Auditors should rely more on analytical techniques (e.g., trend and ratio analysis, comparisons to prior years) to assess the risk of misstatements. Employing such techniques will assist auditors in targeting higher-risk, higher-value adjustments and simultaneously minimize the amount of time taxpayer's currently devote to providing documentation of routine business transactions.

* Auditors should be provided with incentives to discover all of the relevant facts to resolve issues with taxpayers before issuing a reassessment. Some auditors prefer to pass an issue to the appeals officer rather than expend the effort required to resolve it themselves.

We would welcome your feedback on these matters.

III. Exparte Requests

(Requirements) for

Information

In the interest of efficient tax administration, TEI encourages taxpayer cooperation with, and assistance to, the government. Indeed, cooperation is the hallmark of a voluntary self-assessed tax system, and our members' companies generally accede to proper requests for information. Nonetheless, we are concerned about recent requests for ex parte information that we believe exceed the bounds of legitimate government inquiry. Two examples are described.

The first request is directed to companies in the pulp and paper industry and relates ostensibly to potential assessments against other unnamed members of the industry. The information requested is neither directly related to the determination of tax liability of the company receiving the request nor does it concern transactions between the recipient of the information request and the taxpayer under scrutiny by Revenue Canada. Indeed, the companies receiving the data request often have no business relationship with the taxpayer under scrutiny.

The information sought by Revenue Canada generally relates to the structure of the companies' marketing strategies, distribution systems, and the terms of their relationships with their own agents and customers. This information is both sensitive and highly confidential. Given the stated purpose of using the information to assess other taxpayers, this information may well ultimately be disclosed in court. TEI believes that it is improper for Revenue Canada to request a company to provide confidential information, the disclosure of which may adversely affect its business, for the purpose of assessing another taxpayer.

The second request was issued to taxpayers in several different business sectors. The request seeks information concerning transactions with, and payments made to, suppliers. The purpose of the second request appears to be to identify potential non-filers and underreporting of income. In its decision in James Richardson & Sons Limited v. M.N.R. (84 DTC 6325), the Supreme Court of Canada found this type of inquiry to be improper. TEI urges Revenue Canada to withdraw these and any similar requests and to establish a general policy against such requests in the future.

IV. Third-Party Information

The policy on disclosure of taxpayer information is outlined in paragraph 48 of Information Circular No. 87-2. In the decision in Crestbrook Forest Industries (92 DTC 6187), the Federal Court of Appeals raised substantial questions about Revenue's ability to rely on confidential third-party information in assessing a taxpayer. Indeed, the government's ability to use third-party information that may or may not be available to the taxpayer in court proceedings on the assessment raises substantial and troubling questions. There is a careful need to balance the government's right to assess the proper amount of tax, the third party's right to protect its confidential information, and the assessed taxpayer's right to know the basis upon which an assessment is determined. What is Revenue Canada's current policy regarding reliance on, and disclosure of, third-party information?

V. Tax Consequences of

Foreign Trade Actions

The vitality and the prosperity of the Canadian economy depends largely on the ability of Canadian industry to compete internationally. As a result of local economic or political pressures exerted by competitors in some foreign markets, Canadian companies occasionally face protectionist levies in the form of dumping duties, countervailing duties, and "other" import surcharges. These levies generally must be paid to the customs authority by the importer or the manufacturer prior to or at the time the goods enter the foreign country. Furthermore, although many countries provide judicial or administrative procedures permitting importing companies to appeal the imposition of such levies, experience demonstrates that recovering even a portion of the levies can be an exercise in futility. Consequently, Canadian businesses that incur such costs generally treat them as an operating cost related to doing business in the levying country. Indeed, under generally accepted accounting principles the trade levies must be treated as current expenses and charged to income - usually at the time the goods subject to the additional import duty are sold.

Many of the principal Canadian exporting industries have been working with the federal Departments of Industries, Foreign Affairs, and International Trade to dissuade foreign governments from imposing these additional countervailing duties. The joint efforts of the public and private sectors have been directed to securing a level-playing field for Canadian business to improve its competitive position in foreign markets. As a result, Canadian industry finds itself frustrated when the Canadian tax authority takes a position that is at odds with the policies and positions advanced by the other federal departments.

To illustrate the problem specifically, consider the position taken by Revenue Canada with respect to countervailing duties imposed on softwood lumber exported to the United States. Revenue Canada, in a recent letter addressed to the Canadian Forest Industries Council, expressed the view that countervailing duties, though paid, are not deductible until the taxpayer exhausts its rights of judicial and administrative appeals in the foreign jurisdiction. The taxpayer's right to appeal to recover the countervailing duty is more theoretical than real since few companies ever prevail in trade levy disputes in foreign tribunals. TEI submits that, where recovery of an amount is highly speculative, the proper tax treatment, consistent with the generally accepted accounting principle of matching current expenses with current income, is to permit a current deduction for the levied charge. Should the contingent claim ultimately be honored, the taxpayer should, of course, include the recovered amount in income.

Although the countervailing duty problem (and, hence, Revenue Canada's constricted view) is confined currently to the forest industry, trade disputes could easily arise in other industries with significant exports. As a result, TEI requests that Revenue Canada reverse its position. We believe that there must be strong technical and policy justifications for its position denying a deduction (i) in the face of strong evidence that the duty amount is unlikely ever to be recovered and (ii) contrary to the sound accounting practice. We would appreciate receiving a briefing of the legal analysis that Revenue Canada believes supports a contrary view.

In view of the deleterious effect that Revenue Canada's position will have on Canadian industries' competitive trade position, TEI wonders whether Revenue would support an amendment (should one be offered by the Department of Finance) clarifying that amounts incurred as countervailing duties are deductible in the year during which the goods subject to the levy are ultimately sold? We invite your views on the issue generally and our recommendation for administrative or legislative reversal of the current position.

VI. Distress Preferred Shares 

Assume that a corporation issues preferred shares that would otherwise qualify as "short-term preferred shares," "taxable preferred shares," or "term-preferred shares," and the shares were issued under circumstances that also meet the definition of distress preferred shares in subparagraph 248(1)(e)(iii). In the event that the circumstances under which the "distress" shares were issued change, or upon the expiration of the five-year period during which the shares are deemed "distress preferred shares," does the status of the distress shares change to some other category of shares? If so, what are the shares deemed to be?

VII. Investment Allowance

- Investments in Mutual

Fund Trusts

Paragraph 181.2(4)(c) permits a taxpayer to establish an investment allowance in respect of bonds, debentures, notes, mortgages, and similar obligations of another corporation other than a financial institution. Assume that a taxpayer purchases units of a mutual fund trust. Will Revenue Canada permit taxpayers to look through the trust to the nature of the underlying investments to determine whether some portion of the mutual fund investment qualifies for the investment allowance? (For purposes of the Ontario Capital Tax, the Ontario Ministry of Finance will permit taxpayers to look through the trust.)

VIII. Electronic Filing

Requirement for Large

Corporate Taxpayers

Ontario has announced that all large corporations will be required to file their corporate returns electronically for 1996 and thereafter. Does Revenue Canada anticipate issuing a similar mandate in respect of either the federal T2 income tax return or the GST return? If the Department is considering such a plan, we request a status report as well as the opportunity for continuing consultation during the planning and implementation phases.

IX. Direct Appeal of Issues to

the Tax Court under

Subsection 173(1)

Under section 173(1), a question of law, fact, or mixed questions of law and fact in respect of any assessment, proposed assessment, determination, or proposed determination may be referred to the Tax Court of Canada upon agreement between the Minister and the taxpayer. Employing this provision may enable more timely resolution of disputed issues, to the benefit of both taxpayers and Revenue Canada. Recently, however, the Minister refused to consent to a taxpayer's request to refer a substantial question of law to the Tax Court of Canada. Has Revenue Canada ever consented to refer issues to the Tax Court under subsection 173(1)? If so, what departmental guidelines exist on the selection of cases for referral? Are there guidelines and procedures that taxpayers may consult to prepare submissions to obtain the requisite consent for a subsection 173(1) referral?

X. Foreign Tax Credit

In determining its allowable foreign tax credit under section 126 of the Act, a taxpayer must first compute its adjusted net income (ANI) in accordance with the instructions for Box A of Schedule T2S(21). In determining ANI, is a taxpayer permitted, pursuant to paragraph 110(1)(K) of the Act, to deduct the amount of its Part VI.1 tax?

XI. Penalties - Late-Filed

Subsection 93(1) Election

Does the penalty for late-filed subsection 93(1) elections (subsection 93(6)) still apply where (i) an election prepared with reasonable care is initially filed timely, but the election is subsequently revised as a result of changes made to the amount of exempt surplus (most likely in connection with adjustments pursuant to an audit), and (ii) it is evident that the corporation intended to make the election on the basis of the full amount of its exempt surplus and is not attempting to obtain an undue tax advantage through the subsequent revision? TEI believes that, in the circumstances described, no penalty should be assessed.

XII. Research & Development

New subsection 127(11.4) in Bill C-27 issued on May 5, 1994, states that subsection 127(9)(c) will not apply where the Minister reclassifies an expenditure on an assessment. The explanatory notes to subsection 127(11.1) state that 127(11.4) only applies to expenses reclassified by the Minister in the course of an audit initiated by Revenue Canada and that no reclassification will be made for taxpayer-requested adjustments. During an audit, though, taxpayers will supply vast amounts of information in direct response to requests from the auditor, and hence - in the context of the continuous exchange of information between the taxpayer and the auditor that constitutes an audit - the line between a "taxpayer-requested adjustment" and a reclassification initiated by the auditor becomes very murky. As a result, we invite your comments whether Revenue Canada will reclassify the identified expenses as R&D pursuant to subsection 127(11.4) in either of the following alternative circumstances:

(a) During an audit, the taxpayer provides documentation to an auditor for an R&D project. The documentation and identification were not submitted by the due dates provided in subsection 127(9)(c).

(b) During an audit, the taxpayer provides documentation to an auditor for an R&D expense related to an R&D project that was submitted by the due date prescribed in 127(9)(c), but the expense amount was discovered late and omitted from the original documentation.

XIII. Allocation of Taxable

Income to a Province

For purposes of allocating taxable income to a province or a country, Regulation 402(4) prescribes rules for determining gross revenues attributable to a permanent establishment in a province or country. Regulation 402(4)(a) sets forth the "destination" rule, which provides that gross revenue is deemed to be derived in the province to which merchandise is delivered. Ontario's view (and assessing practice) in respect of the destination rule is that the destination of a shipment of merchandise to a customer is the ultimate destination of the merchandise without regard to the location where title to, possession of, and risk of loss in relation to the merchandise passes to the customer. What is Revenue Canada's position with respect to Ontario's interpretation of the term destination?

XIV. Flexible Pension Plans

In November 1993, Revenue Canada released a draft of procedures setting forth conditions for registration or approval of amendments relating to "flexible pension plans." What is the status of the draft of the procedures and when do you anticipate its final release?

XV. Foreign Affiliate - Taxation

Year

Foreign accrual property income (FAPI) calculations are determined pursuant to section 91 of the Act. Earnings from an active business of a foreign affiliate are computed pursuant to the rules laid down in Regulation 5907(1)(a)(i), which provides generally that the active income will be deemed to arise where the business of the foreign affiliate is carried on. Subsection 95(2) deems certain income from services that would otherwise be active business income to be income from a business other than an active business. In the following circumstances, what is the taxation year that Revenue Canada will apply in calculating the section 95(2)(b)(i) income from services of the controlled foreign affiliate?

Canadian parent taxpayer has a June 30 taxation year-end and owns a controlled foreign affiliate that is incorporated and resident in Singapore. For commercial accounting purposes, the foreign affiliate maintains a September 30 year-end. Under Singapore law, a corporation incorporated in Singapore must employ a December 31 year-end for taxation purposes. Singapore law also states that, where a corporation maintains an accounting year-end that differs from the deemed year for income tax purposes, the corporation must calculate its "business income" in accordance with its accounting year (September 30 basis) and all other income (e.g., investment income) is calculated as at December 31. As a result, the December 31 Singapore tax year return for the affiliate reflects active business income calculated on the basis of the October-to-September year, and the passive investment income calculated on the basis of a January-to-December year.

In computing the Canadian taxpayer's FAPI for its June 30, 1994, taxation year, will the Canadian company include its percentage of the income of its controlled foreign affiliate in Singapore on the basis of the July 1993 to June 1994 year, or - pursuant to the accounting year-end of its controlled foreign affiliate - on the basis of an October 1992 to September 1993 year? The latter calculation will reflect the income included in computing the foreign affiliate's income in Singapore at the end of the affiliate's 1993 Singapore taxation year-end.

XVI. Lease Cancellation

Payments

Revenue Canada's policy regarding lease cancellation payments made by a tenant to a landlord is set forth in Interpretation Bulletin No. IT-359R2. Paragraph 4 of the IT states that "amounts a landlord receives from a tenant for cancelling a lease or sublease always constitute income to the landlord." Paragraph 15 states that "an amount a tenant pays to cancel a lease or sublease is deductible by the tenant in computing income from a business or property provided that the rent is so deductible." Assuming a rent payment is otherwise deductible in accordance with paragraph 15, is a lease cancellation payment deductible in full for tax purposes in the year paid where the tenant chooses for accounting purposes to amortize a lease cancellation payment to income over the remaining lease term?

XVII. SR&ED Tax Credit -

Taxable Benefits

Where a taxpayer elects to use the proxy method to determine qualifying research and development (R&D) expenses, the portion of the salary or wages of employees directly engaged in R&D that reasonably relates to time spent on R&D activity qualifies as a subsection 37(1) expense and is also included as a qualified expenditure for purposes of computing the amount of investment credit. Since taxable benefits are included in the definition of salary or wages in the Act, please confirm that such benefits are also included as qualified R&D expenditures and that these benefits are not considered prescribed expenditures (and, therefore, ineligible) under Regulation 2902. Reducing the investment credit base for taxable benefits would penalize unfairly corporations that offer such benefits in lieu of a higher base salary.

XVIII. Payments Made on

Behalf of a Subsidiary

To protect its business reputation in the community or to preserve customer, supplier, or banking relationships generally, a corporate taxpayer may intervene to resolve a dispute between a subsidiary and the subsidiary's clients or employees. Often, the parent will make a payment on behalf of its subsidiary to resolve the dispute out of court. Under certain circumstances, the subsidiary will be unable to reimburse the parent for the payment (e.g., where the subsidiary is insolvent or would be made substantially insolvent by the payment or where the subsidiary is being wound-up.)

Interpretation Bulletin No. IT-467R expresses the government's position with respect to the tax treatment of out-of-court payments to settle disputes where a taxpayer is discharging its own liabilities. Do the views expressed in IT-467R apply where a corporate parent makes settlement payments on behalf of an insolvent or potentially insolvent subsidiary or where the subsidiary is in the process of being wound up?

XIX. Unrealized Foreign

Exchange Gains

& Losses

The Financial Industries Division of Revenue Canada issued a Technical Interpretation (TI) on July 8, 1991, concerning the proper treatment of unrealized foreign exchange gains and losses in the calculation of the large corporation tax (LCT). Under the TI, unrealized foreign exchange gains arising from long-term (i.e., items outstanding for more than one year) foreign currency denominated monetary items are, for LCT purposes, a "reserve" under subsection 181(1) and, hence, included in the calculation of taxable capital.(1) Unrealized foreign exchange losses, on the other hand, are not permitted to reduce taxable capital and, furthermore - while they are treated as though assets on the balance sheet - they are not permitted to be included in the calculation of an allowable investment allowance.

We believe that the treatment prescribed in the TI is inequitable, leading to anomalous results in some circumstances. Consider, for example, a foreign currency denominated long-term loan between two affiliated companies controlled by a common parent. A change in the exchange rates affecting the loan amount will cause an unrealized exchange gain for one company and an unrealized exchange loss for the other. The company experiencing the unrealized gain will be required to increase its taxable capital for LCT purposes, but the sister company with the unrealized loss will not, under the TI, be permitted to decrease its taxable capital by a like amount. As a result, the combined LCT paid by the two companies will be higher than if the loan transaction had been structured in Canadian dollars.

The result in our example arises, of course, only where the foreign currency denominated long-term loans remain outstanding at year-end. If the loans in the example were instead prepaid by year-end, the foreign exchange gain or loss of the respective companies would be realized and reflected as part of retained earnings at year-end. Thus, under the altered circumstances the company with the foreign exchange gain would have had a higher taxable capital (as in the example), but the taxable capital of its sister company would have been reduced in like amount by the realized exchange loss.

If the facts in the example are again altered slightly, such that the loans between the affiliates consist of term loans with a duration of less than one year, the unrealized exchange gains and losses also will increase or reduce the taxable capital of the subsidiaries in like, but offsetting, amounts. Under the circumstances, the TI seemingly places substantial reliance on the term of the loan and whether it is prepaid before the end of the taxation year.

Will Revenue Canada consider amending the TI to eliminate these anomalous results?

XX. Canada-U.S. Income

Tax Treaty Protocol

Article 7 of the Protocol amends Article XII of the 1980 Canada-U.S. Tax Convention to remove the withholding tax on computer software payments, payments for the use of or the right to use patent and certain information concerning industrial, commercial, and scientific experience. TEI agrees that the changes to the treaty are proper and commends both taxation authorities for undertaking this initiative.

We are concerned, however, that some taxpayers will have difficulty in complying with certain changes where the royalty payment entitles the Canadian taxpayer to a "bundle of rights" - some of which are for purposes that are exempt from withholding while payments in respect of others may remain subject to withholding tax. In particular, we believe that royalty payments in connection with rights to (i) the use of trademarks, (ii) the use of certain patents, (iii) access to scientific information, (iv) market new products, (v) obtain training and manuals for employees, and (vi) strategic marketing support may remain problematic.

As an ancillary result of the potential for withholding tax in respect of cross-border payments for "mixed" rights, valuation issues will also become a difficult administrative and compliance problem since taxpayers may be compelled to unbundle the components and value the payment stream with respect to the separate rights.

We would appreciate your views on the following questions. Will guidelines be provided to assist taxpayers in computing the correct withholding tax where the royalty payment entitles the payer to a "bundle of rights?" If so, what documentation will be required to support the unbundling of the royalty payment? Will valuations be required? If so, how will taxpayers obtain proper arm's-length information?

XXII. Conclusion

Tax Executives Institute appreciates this opportunity to provide its comments and questions. We look forward to discussing our views with you during our December 13, 1994, liaison meeting.

(1) For self-sustaining operations, generally accepted accounting principles treat unrealized foreign exchange gains and losses alike as deferred items, reflected as a separate component of shareholders' equity.