TEI's Testimony before Canadian House of Commons Standing Committee on Finance on pre-budget consultations: September 6, 2005.

On September 6, 2005, Tax Executives Institute filed written comments with the Canadian House of Commons Standing Committee on Finance on the 2005 pre-budget consultations. The comments were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is David V. Daubaras of General Electric Canada.

Tax Executives Institute (TEI) commends the Standing Committee for holding pre-budget consultations again this year. The hearings provide an important avenue for the Committee to gather input from Canadians across the country. TEI is pleased to participate again this year to discuss a number of recommendations in respect of taxation measures to foster economic growth and job creation, promote a favourable business environment for investments in Canada, and ensure a high level of innovation and productivity. Implementation of our recommendations will spur economic efficiency and improve tax administration.

Background

Tax Executives Institute is the preeminent association of business tax professionals. TEI's 5,400 members work for 2,800 of the largest companies in Canada, the United States, Europe, and Asia. TEI's membership includes representatives from a broad cross-section of the business community, with members employed in all major industries and sectors of the economy. In that sense TEI is unique--we do not represent a particular group or industry. Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver. In addition, many non-Canadian members work for companies with substantial Canadian operations, investments, and employees.

Summary of Recommendations

The Institute urges the Standing Committee to adopt the following recommendations:

* Implement as soon as practicable the 2005 budget announcement calling for phased corporate income tax rate reductions as well as the elimination of the corporate surtax.

* Abandon or substantially narrow the Reasonable Expectation of Profit (REOP) test included in draft legislation clarifying the deductibility of interest and other expenses.

* Urge the Department of Finance to expeditiously negotiate and implement a new provision in the Income Tax Convention with the United States eliminating withholding on all dividends and interest for payments to both related and unrelated parties.

* Abandon draft legislation in respect of Foreign Investment Entities and Non-Resident Trusts; if perceived abuses of the Income Tax Act cannot be addressed by Canada Revenue Agency (CRA) under the current provisions of the Income Tax Act, adopt narrower, more targeted remedies than this draconian legislation.

* Adopt simpler and broader GST relief provisions for transfers of property among affiliated companies in connection with corporate restructurings and reorganizations.

* Implement a corporate loss transfer system or group loss relief mechanism

Implement the Corporate Income Tax Rate Reductions and Eliminate the Surtax

In its 2005 budget message, the Government announced proposals to (1) reduce the corporate income tax rate from 21 percent to 19 percent over a period of years through 2010 and (2) eliminate the corporate surtax by 2008. The proposals were removed, however, from the 2005 budget bill (Bill C-43) prior to Parliament's consideration. At the time of the budget's Royal Assent, Finance Minister Goodale reiterated the Government's commitment to introduce legislation at the earliest opportunity to follow through on its promise to eliminate the corporate surtax and reduce the corporate income tax rate. "These measures," he said, "will ... attract investment, generate economic growth, and create well-paying jobs for Canadians." TEI concurs and urges the Standing Committee to recommend prompt action to implement, as soon as practicable, the phased reduction of the corporate income tax rate and elimination of the surtax. As demonstrated by the income tax rate reductions implemented from 2001 through 2004, business tax reductions increase the attractiveness of Canada for both foreign and domestic investors. (1) Increased capital investment in Canada, in turn, spurs productivity, promotes employment, and enhances the prospects for sustainable economic growth.

Draft of Proposed Legislation Relating to Interest Deductibility and Other Expenses--Abandon the Statutory Reasonable Expectation of Profit Test

In October 2003, the Department of Finance released draft amendments that would add section 3.1 to the Act for the purpose of clarifying that (1) "income" for purposes of the Act is "net" income, in accordance with the generally accepted understanding of the Act before the Supreme Court of Canada's decision in Ludco Enterprises Ltd. v. Canada, (2) and (2) "net income" excludes "capital gains and losses." In addition, the Department of Finance said that draft subsection 3.1(1) should be introduced in order to institute a statutory "reasonable expectation of profit" (REOP) test.

Although the Department's goals are clear, circumscribed, and supportable in principle, the proposed amendment to add subsection 3.1(1) to the Act relating to limits on losses, is broader than necessary to achieve those goals. The emphasis of the proposed legislation on establishing a "cumulative profit" and requiring taxpayers to trace expenditures to a source of business or property income in order to ensure their deductibility raises a number of administrative and policy concerns. Specifically, the proposed changes would modify the longstanding treatment of interest and other commercial expenses that taxpayers and Canada Revenue Agency (CRA) have long considered fully deductible. For example, interest on borrowings to support investments in common shares of most companies would likely be disallowed, much to the surprise of most Canadian shareholders. Indeed, the proposals go substantially beyond restoring the Act to the pre-Ludco status quo for the treatment of such expenses. TEI believes the Supreme Court of Canada's decision in the Stewart' (4) case enunciates a clear and rational tax policy basis for distinguishing commercial, for-profit activities from personal and hobby-related expenditures.

Because the proposed legislation is broader than necessary to achieve the Department's goals, it poses a significant risk of confusing taxpayers and CRA auditors alike. (4) Moreover, the interaction of the REOP test with the source rule would impose an expensive and time-consuming burden on large commercial enterprises to trace expenditures to particular sources. (5) In addition, many overhead expenses incurred to comply with legal requirements or to provide management oversight may not be easily or directly traceable to a source and, thus, may not be deductible. As important, the "cumulative profit" prong of the REOP test ignores how business decisions are made. (6) In deciding whether to make an outlay, the key is whether the planned expenditure increases cash inflows or minimizes cash outflows. A "cumulative profit" is, of course, desired for any investment, but the recovery of past investments or expenditures incurred for the project or purpose (i.e., the recovery of cumulative sunk costs) is not considered when deciding whether to make a new, incremental payment or investment. (7) In addition, the proposed legislation's requirement of an annual evaluation of the prospect of a cumulative profit potentially penalizes high-risk, entrepreneurial activity as well as the misfortune of adverse business results or unanticipated changes in facts and circumstances. Finally, hindsight might be employed (i.e., consideration given to subsequent facts and circumstances not reasonably known by the taxpayer at the time of an investment) to second-guess a taxpayer's determination whether there is a "reasonable expectation of profit."

TEI submits that the disallowance of a business loss under any of the foregoing circumstances would be at odds with taxpayers' expectations under the Act and may also be at odds with the Department of Finance's intent. In The Budget Plan 2005, the Department of Finance acknowledged the concerns about the overbreadth of the REOP legislation expressed by TEI and others during the consultations and said that it will develop "a more modest legislative initiative that would respond to those concerns while still achieving the Government's objectives." (8) TEI will be pleased to consult further upon release of a revised proposal. In the interim, we urge the Standing Committee to recommend that the statutory REOP test be abandoned and that the revised legislative proposal be substantially narrowed and limited in scope.

Withholding Taxes--Canada-United States Income Tax Convention

In the Third Protocol to the Convention between Canada and the United States with Respect to Taxes on Income and Capital signed in 1995, the United States and Canada announced a general reduction in the withholding taxes on dividends, interest, and certain royalties. TEI applauded that development because we believe that withholding taxes constitute unnecessary friction on cross-border transactions, especially in geographic regions where the economies are highly integrated and dependent on the cross-border flow of goods, services, technology, and know-how. Within the European Union, for example, most cross-border transactions involving the payment of dividends, interest, and royalties within a corporate group are subject to nil withholding rates. A nil withholding rate ensures tax neutrality within the EU and, hence, promotes job-creating investments throughout the EU free-trade zone. Likewise, TEI believes that the full promise and benefits of the North American Free Trade Agreement (NAFTA) in creating a tax-neutral environment within North America for job-creating investments can only be realized by removing the friction of withholding taxes on cross-border payments between the United States and Canada. Hence, although we were pleased with the direction of the 1995 Protocol in reducing withholding taxes, the negotiations stopped short of the goal.

Studies, such as one by the C.D. Howe Institute, (9) have shown a strong link between the elimination of withholding taxes on dividends and interest and increased foreign direct investment. The C.D. Howe Institute's study found that the elimination of withholding taxes on all dividends and interest payments would result in an increase in capital investment in Canada of $28 billion, and an increase in income of $7.5 billion annually. Of the $7.5 billion increase in annual income, nearly $5.3 billion relates to the elimination of withholding taxes on interest. Moreover, only a small portion of the withholding tax revenues currently collected by Canada relates to withholding on interest.

The C.D. Howe Institute's study also categorized the detrimental effects of withholding taxes on Canada, including restricting the free flow of capital, deterring direct foreign investment, and interfering with efficient global company operations. The study's conclusions are especially cogent in respect of the Canada-U.S. income tax convention because the United States is a key market for Canadian goods, services, and investments by Canadians, as well as a key source of investment capital for Canadian enterprises. Since the withholding tax rates between the United States and Canada were last revisited in 1995, (10) the United States has negotiated a nil withholding rate for most cross-border interest payments and all non-portfolio dividends under its tax treaty with the United Kingdom. Similarly, the United States and Japan have implemented a revised tax treaty exempting most interest payments and certain intercompany dividends from withholding taxes. In addition, the United States has implemented a nil withholding rate for specified intercompany dividends under its protocols with Australia and Mexico and reached agreement with the Netherlands to exempt certain intercompany dividends from withholding taxes following approval and implementation of the revised treaty.

Although negotiations over a new treaty between the countries have been stalled for an extended period, Finance Minister Goodale's announcement on July 8 that Canada and the United States will work toward completing negotiations by the end of the year makes this an especially propitious year for action. Thus, TEI urges the Standing Committee to recommend expeditious negotiation and implementation of a new provision in the Income Tax Convention with the United States eliminating withholding taxes on all dividends and interest for payments to both related and unrelated parties. We believe steps should be taken immediately to ensure that Canadian residents can secure benefits similar to those enjoyed by residents of other treaty partners of the United States and effectively compete with those jurisdictions for increased capital investments, exports, and jobs.

Draft of Proposed Legislation in Respect of Foreign Investment Entities and Non-Resident Trusts

Through the interaction of complex, overlapping rules, Canada's current foreign affiliate regime balances multiple, competing policy goals and is consistent with the Government's foremost objective of fostering the international competitiveness of Canadian businesses. As a result, Canada has become a more attractive environment for foreign and domestic investments.

TEI is concerned that proposed legislation to implement a new regime for taxing Foreign Investment Entities (FIEs) and Non-Resident Trusts (NRTs) would upset the careful policy balance that has been struck by the current foreign affiliate rules. The proposed FIE and NRT legislation was originally released in June 2000, revised in August 2001, revised substantially in the October 2002 and 2003 Notices of Ways and Means Motions, and revised yet again in July 2005.

TEI is pleased to have participated in consultations with the Department of Finance on the legislation. Moreover, TEI fully supports the Department's efforts to strengthen the integrity of the tax system while ensuring that amendments to the Act are targeted, sustainable, and administrable. We regret to say that, despite the Department's latest efforts to fine tune the proposed legislation in its July 2005 release, the proposed legislation remains overbroad, extraordinarily complex, confusing, and, in the case of the proposed FIE rules, continues to overlap and conflict with the entire foreign affiliate regime, including section 17 in respect of loans to non-residents. In addition, the proposed FIE rules simply do not mesh well with the proposed NRT rules.

Fundamentally, we believe the draft legislation is unworkable and again--as we did in our 2002, 2003, and 2004 pre-budget consultation statements--urge the Government to withdraw it because it:

* would apply to numerous, compliant taxpayers that are not attempting to avoid Canadian tax by "transferring funds to offshore trusts or accounts."

* is overbroad, overlaps the foreign affiliate regime as well as section 17, and applies to many legitimate commercial transactions, and potentially applies to organizations that likely are not targeted by the proposed legislation. (11)

* would impose myriad compliance and reporting requirements (as well as create relieving provisions and elections) where the information necessary to comply and report (or to take advantage of the relieving provisions or elections) is either (1) unavailable generally or (2) likely unavailable to a Canadian taxpayer where, as will generally be the case, the taxpayer is a minority investor and lacks sufficient control of the entity to enable the taxpayer to obtain the requisite information.

As important, TEI believes that, once an entity is trapped in the labyrinth of the FIE or NRT rules, compliance may prove impossible. Moreover, we question whether CRA will, any more than taxpayers, have the resources to properly administer these rules.

Finally, we note that the Government has been fine-tuning the proposed legislation for more than five years. Given its mind-numbing complexity (and the myriad revisions to the draft legislation), taxpayers will need time to digest and understand the legislation and, after determining whether the information is available, modify company information systems to capture and report the additional required information. Thus, the proposed January 1, 2003 coming-into-force date for the legislation is unreasonable. In order to give compliant taxpayers the opportunity to understand the provisions and ensure that their legitimate business operations are not inadvertently caught by this legislation, the coming-into-force date should be no earlier than taxation years beginning after December 31, 2006.

Broaden the GST Relief Provisions of the Excise Tax Act for Transfers of Property or Activities among Companies Undertaking Corporate Restructurings

Sections 221(2), 167, 167.1, and 156 in the GST provisions of the Excise Tax Act afford taxpayers relief from the obligation to collect and remit GST in connection with certain reorganization transactions, but require taxpayers to satisfy a range of highly technical requirements. (12) TEI believes the technical requirements establish thresholds for relief that are too stringent to address many corporate reorganizations. (13) As a result, an entity transferring property in a reorganization transaction must collect and remit GST while affiliates receiving the property must file administrative claims to recover that GST. Even though no net revenue will ultimately be collected by the government, taxpayers must incur compliance costs and CRA must expend scarce administrative resources reviewing the transactions. Moreover, corporate groups undergoing reorganizations will most likely have to borrow money and incur interest expense in order to fund a temporary payment of taxes --which in substance is a loan--to the government.

TEI urges the Standing Committee to recommend that the GST relief rules be simplified and expanded in order to eliminate the imposition of GST on transfers of property among affiliates in connection with reorganizations of corporate groups. Specifically, (1) the closely related group rule of section 156 should be broadened to permit the use of newly formed companies, (2) section 221(2) should be broadened to include significant asset transfers when in the course of commercial activities, and (3) rules should be introduced to address tax-free divisive reorganizations (i.e., butterfly transactions). In addition, the relief provisions should permit registered non-resident corporations participating in reorganization transactions to receive property on a GST-free basis. TEI would be pleased to work with the Department of Finance and the Standing Committee in developing legislative language to effect these changes.

Implement a Loss Transfer System or Group Loss Relief Mechanism

In comparing the competitiveness of the Canadian tax system with other jurisdictions, the Government has focused on aligning Canada's tax rate structure and capital recovery provisions with other countries' rules. To fully assess the competitiveness of the Canadian tax system and its relative tax burden, the government should take a broader view and consider all aspects of the tax system. Specifically, TEI believes the Canadian system for tax loss utilization within corporate groups is far too restrictive, subject to significant administrative uncertainty, and imposes unnecessary costs on taxpayers seeking to avail themselves of CRA's administrative concessions. (14)

The government eliminated the previous loss consolidation system in 1952 and a policy debate, which continues to this day, ensued about developing and implementing a replacement system. In 1985, the Department of Finance joined the debate by proposing a system to allow transfers of losses between subsidiaries and their parents or between subsidiaries within a group. We believe the time for debate has ended and the time for action has come. To be globally competitive, Canada should implement a formal Loss-Transfer System--or otherwise provide for group tax loss relief. (15) The adoption of a formal loss-sharing mechanism in the Income Tax Act would complement the current administrative concessions and provide much needed clarity, certainty of result, and greater stability in the law.

On several occasions TEI has urged the Department of Finance to review its 1985 proposal, revise and update it as necessary, and release draft legislation to implement such a system. Similarly, we urge the Standing Committee to recommend that a formal system be introduced to permit the sharing and utilization of tax losses and other tax attributes among groups of related corporations. The introduction of a formal loss-sharing system would bring the Canadian tax system in line with that of most other countries in the world.

Conclusion

Tax Executives Institute appreciates the opportunity to participate in the 2005 pre-budget consultations by the House of Commons Standing Committee on Finance. TEI's representatives at the hearing will be pleased to respond to your questions as well as follow up in writing on any item addressed.

(1.) For resource income, the rate reductions are not fully implemented.

(2.) Ludco Enterprises Ltd. v. The Queen, 2001 S.C.C. 62.

(3.) Brian J. Stewart v. The Queen, 2002 S.C.C 46.

(4.) The proposed statutory formulation of the REOP test is no more precise than common law tax requirements because it depends on all the facts and circumstances of a taxpayer's case. The scope of the proposed statutory test though is far broader than the common law rule and will apply to all ordinary commercial transactions and investments, including those of large taxpayers for which there can be little doubt about the for-profit purpose of an expenditure or investment.

(5.) In addition, in any year a loss is incurred, the REOP test requires a taxpayer to prove its expectation of profit many years after the initial investment by providing records for the entire holding period for the source. Thus, there is seemingly no statute of limitations in respect of the records that taxpayers would be required to retain in order to comply with the REOP test. In effect, the cumulative profit test compels taxpayers to retain all of their annual accounting records permanently for each source. In addition, the taxpayer's reasonable expectation of profit can be challenged anew each and every year a loss is incurred regardless of whether or how the issue was resolved in a prior year's audit. Expending taxpayer and CRA resources to resolve the identical issue in a recurring dispute over the same source of income without a final resolution is unproductive and wasteful for the Government and taxpayers alike.

(6.) For example, a company may make strategic investments in a losing enterprise in order to (1) pre-empt competitors from offering a product or service or from entering a particular geographic market; (2) provide a full range of products or services to customers; (3) comply with regulatory requirements; or (4) minimize the overall cost of producing the goods or services.

(7.) In addition, a taxpayer may, after incurring several years of losses, conclude that a business venture is unlikely to produce a cumulative net profit. If the taxpayer's variable costs of production are less than the selling price of the goods or services, however, the taxpayer may continue the business because the absorption of fixed overhead expenses borne by that business may result in a marginal contribution to overall net profit. In other words, other product lines or businesses may be marginally more profitable because fixed overhead costs are allocated to and absorbed by a business that is cash-flow positive but produces accounting losses.

(8.) The Budget Plan 2005, Annex 8 Tax Measures: Supplementary Information and Notices of Ways and Means Motions, Department of Finance Canada (February 23, 2005), at 410.

(9.) Mintz, Jack M. Withholding Taxes on Income Paid to Nonresidents: Removing a Canadian-U.S. Border Irritant, C.D. Howe Institute Backgrounder, (March 5, 2001).

(10.) When the Third Protocol to the Convention between the Canada and the United States with Respect to Taxes on Income and Capital was signed in 1995, Canada and the United States agreed to consult within three years on further reductions in withholding taxes. Finance Minister Goodale announced on July 8, 2005, that the two countries would work toward finalizing the negotiations on a new protocol by the end of the year. We have urged and continue to urge both countries to implement nil withholding rates on cross-border payments between the two countries to the maximum extent feasible.

(11.) For example, a close examination of these very complex and convoluted rules suggest that dues paid to a non-resident international labor union may well be considered investments in foreign investment entities. There would likely be little or no imputed income, however, if the union dues were deducted by an individual member when computing taxable income. This is but one example of the many, likely unintended, consequences that these overbroad rules will produce.

(12.) For example, sections 167 and 167.1 (in respect of the transfer of assets and goodwill, respectively) provide for a tax-free transfer of (i) a business or part of a business by the supplier and (ii) 90 percent or more of the assets necessary for the purchaser to carry on the business are transferred. As another example, section 156 accords an election to taxpayers to treat a transfer of assets as made for nil consideration where both the supplier and the purchaser qualify as members of a closely related group.

(13.) The relief provisions may not apply for various reasons, including (1) the assets sold at arm's length do not constitute the sale of a business; (2) the group may not be able to determine whether 90 percent or more of the assets necessary to carry on the business has been transferred; (3) the assets are transferred to or through a new company (which may be ineligible for relief unless it has commenced operations); or (4) the assets transferred to or through a new company within a group do not constitute a business.

(14.) Even though CRA permits related parties to transfer losses through various techniques, the tax result in any particular case depends upon the agency's exercise of administrative discretion and that engenders a degree of uncertainty for taxpayers.

(15.) Of 30 OECD countries surveyed in 2001, Canada was one of only four countries that did not provide group tax loss relief directly through its legislation. See Donnelly & Young, Policy Options for Tax Loss Treatment, 50 CANADIAN TAX JOURNAL 429 (2002).