TEI comments on proposed Canadian legislation restricting interest deductions.

On May 11,2007, Tax Executives Institute submitted the following letter to Canadian Minister of Finance James Flaherty, commenting on the 2007 Budget proposals restricting the deductibility of interest on indebtedness incurred to finance investments in foreign affiliates. TEI's comments were prepared under the aegis of its Canadian IncomeTax Committee, whose chair is David L. Penney of General Motors of Canada Limited. Contributing substantially to the development of TEI's comments was Julie Muirhead, also of General Motors of Canada Limited.

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On March 19, 2007, the government released its 2007 budget proposals. The accompanying message reported significant progress in the tax treaty negotiations between Canada and the United States to eliminate withholding taxes on interest. The message also announced the government's intention to introduce legislation eliminating withholding taxes on interest paid to arm's length non-residents of all countries. Tax Executives Institute applauds both measures.

Budget 2007 also includes a proposal to deny a deduction for interest and other costs incurred in respect of money borrowed to directly or indirectly acquire shares or indebtedness of a foreign affiliate (hereinafter "the Proposals"). On behalf of TEI, I am writing to express TEI's concerns about the Proposals.

Background

TEI is the preeminent international association of business tax executives. The Institute's 7,000 professionals manage the tax affairs of 3,000 of the leading companies in North America, Europe, and Asia. Canadians constitute 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 nine geographic regions, and must contend daily with the planning and compliance aspects of Canada's business tax laws. Many of our non-Canadian members (including those in Europe and Asia) work for companies with substantial activities in Canada. The comments set forth in this letter reflect the views of TEI as a whole, but more particularly those of our Canadian constituency.

TEI concerns itself with important issues of tax policy and administration and is dedicated to working with government agencies to reduce the costs and burdens of tax compliance and administration to our common benefit. In furtherance of this goal, TEI supports efforts to improve the tax laws and their administration at all levels of government. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the issues raised by the Proposals.

Longstanding Policy Undergirds the Current Rules

Since 1972, Canada has afforded Canadian taxpayers a deduction for interest on borrowings in Canada to finance investments in foreign affiliates. In addition, active business income earned by the foreign affiliates in designated treaty countries is considered "exempt surplus" and, to the extent dividends are paid by the affiliate to a Canadian taxpayer from such surplus, is not taxable. Consistent with international tax norms, the exemption reflects Canada's acknowledgement that (i) the foreign jurisdiction possesses the primary right to tax the active business income earned in that jurisdiction and (ii) taxing the income again in Canada would result in double taxation.

The deductibility of interest on borrowings to invest in foreign affiliates has been a cornerstone of Canadian tax policy that the Department of Finance has consistently and ardently defended. (1) The deduction promotes foreign investments by Canadian companies and enhances their ability to expand globally. Moreover, substantially all of Canada's major trading partners afford a comparable deduction to domestic enterprises for interest incurred on funds borrowed to invest in foreign affiliates. Some of those trading partners employ an exemption system similar to Canada's for dividends from foreign affiliates while others utilize a foreign tax credit system that mitigates double taxation of foreign profits. Accordingly, denying interest deductibility to Canadian companies will put Canadian companies at a substantial disadvantage compared with foreign competitors.

Competitive Disadvantage for Canadian Companies

A variety of studies, including a 1997 report submitted to the Technical Committee on Business Taxation (hereinafter "the Mintz Committee"), (2) have documented the economic benefits flowing to Canada from foreign expansion by Canadian companies. Such benefits include increasing the number of high-paying, high-skilled jobs in Canada to manage Canadian companies' global affairs and fostering the competitiveness of Canadian companies. Global expansion impels companies to compete more effectively and efficiently by operating closer to their global customers and suppliers, increasing their access to local markets, reducing transportation and other logistical costs, and diversifying foreign exchange and other business risks. The studies consistently confirm that it is in the best economic interests of Canada to have strong Canadian-based multinationals.

If implemented, the Proposals would significantly increase the cost of capital for Canadian companies, making it far more expensive to finance the start-up, acquisition, and growth of foreign businesses. For example, where a Canadian company and a foreign company are bidding to acquire the same foreign target, the foreign acquiring company would likely be able to deduct the interest cost of debt financing whereas the Canadian company would not. As a result, the foreign company would be able to offer a higher price for the target company or obtain financing more easily and at a lower after-tax cost. Similarly, in a bid for a Canadian company with foreign affiliates, a foreign acquirer would have a competitive advantage of a lower after-tax cost of debt financing. (3)

The proposed limitation on interest deductibility would also hinder the internal growth of Canadian foreign affiliates. In many cases, foreign affiliates are unable to borrow in foreign jurisdictions because of the instability or immaturity of capital markets in such jurisdictions, local regulatory restrictions, political or other risks in the foreign jurisdictions, or the foreign affiliate's lack of cash flow (especially during a business's start-up phase). In addition, a foreign affiliate may not be able to borrow at competitive rates abroad compared with the Canadian rates available to the Canadian parent. As a result, Canadian parent companies frequently finance the expansion and growth of their foreign affiliates through equity investments or inter-company loans. If the debt to finance the affiliates' business growth cannot be pushed down into the foreign entity or the interest (for a loan to, or equity investment in, a subsidiary) cannot be deducted in Canada because of the Proposals, the Canadian group will be at a competitive disadvantage vis-a-vis companies headquartered in other jurisdictions. (4)

Finally, the Proposals would make Canadian companies vulnerable to takeovers by foreign competitors. The increased cost of capital resulting from the Proposals would likely increase Canadian companies' effective tax rates, which will decrease their value (share price) and make them vulnerable to takeovers by foreign entities. Once acquired, it is likely that the high-wage, high-skill head-office jobs in Canada would be eliminated.

Existing Debt and Foreign Affiliate Structures

Businesses generally make investment decisions based on the after-tax returns. Since Canadian businesses have relied on the government's longstanding policy to structure their foreign investments and financing, denying a deduction for the associated interest expense would, in many cases, turn a currently profitable operation into a loss.

Moreover, the term of the debt financing for investments in foreign affiliates generally extends beyond the proposed effective date of the Proposals (December 31, 2008, for non-arm's length debt and December 31, 2009, for arm's length debt). Indeed, commercial debt obligations frequently have terms to maturity of 10 years or more. Consequently, Canadian companies will be compelled to choose between paying significant prepayment fees to terminate current debt arrangements prematurely in order to move the debt offshore (at potentially less favourable borrowing rates and terms) or continue existing arrangements and pay nondeductible interest. Either choice is economically inefficient and will hurt Canadian companies. (5) To avoid imposing significant refinancing costs on businesses, the grandfathering rules for current financial arrangements should be expanded or the transition period substantially lengthened. Broad grandfathering rules or a generous transition period for existing debt arrangements was a critical component of recommendations advanced in the Mintz Committee's Report. (6)

The Proposals Exacerbate Uncertainty and Create Significant Compliance Challenges for Taxpayers

The Proposals significantly exacerbate the current uncertainty about the tax treatment of outbound investments and interest costs. Specifically, the Department of Finance has released two substantial sets of draft legislation--on December 20, 2002, and February 27, 2004--revising the tax treatment of outbound investments. (7) In addition, on October 31, 2003, the Department released draft legislation revising the rules governing the deductibility of interest expense. Because of the retroactive effective dates, taxpayers must assume that the three sets of draft legislation will be finalized and file returns based on their best guess of the likely final rules even though the Department has acknowledged that substantial amendments to all three sets of proposed legislation are likely. By proposing yet another tax-pool account for each foreign affiliate (the disallowed interest pool), the 2007 Proposals compound the current uncertainty by adding another layer of technical complexity to rules already overburdened by complexity and the uncertainty of draft legislation. Consequently, the proposals create significant compliance challenges for taxpayers and pose significant audit and assessing challenges for Canada Revenue Agency.

Defer the Proposals Pending Additional Consultations

The 2007 Budget documents state that an advisory panel of tax experts will be created to undertake consultations in order to assess ways to improve the fairness of international taxation. TEI submits that these Proposals represent a dramatic and fundamental change in the taxation of foreign affiliates and the myriad ramifications may not have been fully considered prior to their announcement. (9) TEI believes the proposals represent a flawed tax policy that would have a deleterious effect on the competitiveness of Canadian businesses. Hence we recommend that the Proposals be withdrawn and reconsidered by the proposed Advisory Panel.

Conclusion

TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments and recommendations. TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney. If you should have any questions about the submission or wish to discuss the issues raised above, please do not hesitate to contact Mr. Penney at 905.644.3122 (or [e-mail]) or Martina Krummen, TEI's Vice President for Canadian Affairs, at 514.422.7742 (or [e-mail]).

Appendix 1

Department of Finance Response to the 1992 Report of the Auditor General--Chapter 2, Pages 9 to 13 Department's response:

The audit note alleges a number of concerns with respect to the taxation of foreign affiliates and foreign source income. In particular, the Auditor General claims that hundreds of millions of dollars in tax revenue are being lost. This claim is unsubstantiated. The existing foreign affiliate regime accurately reflects the policy intention of Parliament and provides for the taxation of all income that is intended to be subject to Canadian income tax. Moreover, any theoretical revenue gains that might be realized by amending the Income Tax Act would be largely offset as a result of behavioral changes on the part of taxpayers. Specifically, any significant change in the existing rules would likely result in large numbers of businesses moving completely offshore. This would weaken the Canadian economy without generating any additional tax revenue.

Notwithstanding the fact that the foreign affiliate rules do not result in the revenue loss that the Auditor General claims, in many instances the concerns he raises are ones that are shared by the Department of Finance and that have been the subject of extensive analysis and remedial action over the last several years. This area is, however, one of the most complicated in the Income Tax Act and while it often appears to produce results that are questionable, these results are necessitated by fundamental policy considerations. Accordingly, before commenting specifically on the Auditor General's concerns, it is important to elaborate on some of the basic considerations that must be taken into account in designing a system for the taxation of foreign source income.

Background.

Canada has had to struggle with two conflicting goals. The goal of economic efficiency argues for a system which preserves capital export neutrality. This is achieved when foreign source income is subject to the same effective tax rate as domestic source income, leaving taxpayers indifferent, at least from a tax perspective, as to whether they invest inside or outside of Canada. Conversely, the goal of competitiveness argues for capital import neutrality. This requires that a Canadian investing in a foreign country be subject to tax at the same effective rate as a resident of that country. From a tax perspective, this ensures a level playing field between Canadian and non-Canadian businesses operating internationally.

In a world where countries maintain different tax systems, it is impossible to achieve both capital import and capital export neutrality. Accordingly, Canada has opted for a system that ensures capital export neutrality with respect to certain types of income and capital import neutrality with respect to other types of income. Specifically, in the case of passive income (i.e., investment income such as interest, dividends and rent) the tax policy concern is that taxpayers will attempt to shelter income in tax haven countries in order to defer the payment of Canadian tax. As a result of this concern, the Income Tax Act contains what are commonly referred to as the Foreign Accrual Property Income (FAPI) rules. The FAPI rules are intended to ensure that passive income earned by certain foreign affiliates is accrued and subject to Canadian tax on a current basis (i.e., annually), thereby eliminating the potential for deferral and hence the tax incentive to shift income offshore.

Conversely, in order to preserve the international competitiveness of Canadian businesses, active business income that is earned offshore by a foreign affiliate is not required to be accrued and is subject to tax only in the foreign jurisdiction. Furthermore, where such income is earned in a "listed country" (basically countries with which Canada has entered into a tax treaty) it may be repatriated (i.e., paid back as a dividend) to Canada on a tax-free basis. The ability to receive dividends from a foreign affiliate on a tax-free basis is intended, at least in part, as a proxy for the foreign tax credit that would have been available to the Canadian company if it had carried on its business through a foreign branch rather than a subsidiary. It also helps to ensure that there is no tax impediment to corporations re-investing their foreign earnings in their Canadian operations.

Finally, in formulating our policy with respect to the taxation of foreign source income, it was necessary to recognize that there are substantial costs inherent in implementing a system that deviates substantially from international norms. As is noted later, such international norms are largely responsible for the policy not to specifically restrict the deductibility of interest on money borrowed to invest in a foreign affiliate. Ultimately, Canada finds itself in the position of having to balance tax theory with the economic realities of the international marketplace. To a large degree, international norms limit the range of options available to the Canadian government and, in this context, the government's policy has generally been to favour competitiveness concerns over those of revenue generation. Nonetheless, the Department of Finance continues to study those rules relating to the taxation of foreign source income, both in Canada and in other countries, with a view to ensuring that the Income Tax Act produces results that are fair overall and maintain a reasonable balance between competing policy objectives.

Tax avoidance 

The audit note begins by making some general observations on the inappropriateness of tax avoidance, with the underlying implication that the problem of tax avoidance in the foreign affiliate area has not been properly addressed.

However, the note ignores the fact that numerous amendments to the foreign affiliate rules have been implemented over the last several years. As well, given the creativity of taxpayers in devising new avoidance transactions, it is frequently impossible either to anticipate a particular avoidance scheme or to specifically legislate against it. It was against this background that the General Anti-Avoidance Rule (GAAR) was introduced into the Income Tax Act--effective for 1988--in order to provide Revenue Canada with the legislative tool necessary to deal with unanticipated tax avoidance. While GAAR is still relatively new, it is anticipated that Revenue Canada will apply it on a regular basis in those cases which involve abusive tax avoidance. Rather than attempting to attack each avoidance scheme, a general anti-avoidance rule is a much more useful tool to deal with avoidance transactions. In the short time since its introduction the professional community has found it to be a matter that must be taken into consideration in any tax planning format.

Interest deductibility

The principal concern raised in the note is that a Canadian resident who borrows money in order to acquire shares in a foreign affiliate will, subject to the general rules regarding interest deductibility, be able to deduct the interest on the borrowed money as an expense, even though the income earned by the foreign affiliate may not be subject to Canadian tax on a current basis and, in many cases, may be repatriated to Canada tax-free.

While this clearly gives rise to a mismatching of income and expenses, it is important to note that, at least historically, it also represents the international norm. Departing from this norm (i.e., denying Canadians a deduction for interest when, in similar circumstances, other countries would permit an interest deduction for their residents) would have a significant impact on Canada's international competitiveness and, ultimately, could result in a considerable number of Canadian businesses either moving offshore or being forced out of foreign markets. Moreover, it is not always appropriate that the expenses related to a particular investment be deductible only against the income from that investment. For example, where an investment generates losses, such a narrow approach would have the effect of denying taxpayers a deduction for legitimate business expenses and would represent a significant disincentive for Canadians to invest in new ventures. Finally, the ability to repatriate certain income on a tax-free basis is intended both as a substitute for allowing a foreign tax credit in respect of the foreign source income and to eliminate any tax impediment to corporations reinvesting their foreign earnings in their Canadian operations.

Consequently, while the government continues to monitor developments in other countries, it has refrained from making changes that would have the potential to damage Canada's international competitiveness. As was indicated earlier, the exact balance to be struck between capital export and capital import neutrality is not easily achieved. In this regard, Canada--in keeping with most industrialized countries--has chosen to encourage international competitiveness at the expense of revenue generation. Where, however, technical anomalies with the existing rules are identified, they are dealt with on an ongoing basis.

Exempt dividends from foreign affiliates

The audit note criticizes the fact that dividends from Canadian corporations qualify for the dividend tax credit even when they are paid out of foreign source income that has not been subject to either Canadian or, in many cases, foreign income tax. The note also observes that although the ability to receive dividends on a tax-free basis ("exempt dividends") was intended as a substitute for a foreign tax credit system, exempt dividends may be received from a foreign affiliate even where the affiliate is based in a tax haven country and therefore is effectively not subject to any foreign tax. In this regard, the Auditor General has provided a number of examples of ostensibly abusive transactions and concludes that hundreds of millions of dollars in tax revenue are being lost.

The availability of the dividend tax credit is fundamental to the elimination of double taxation. This goal is equally appropriate in the context of Canadian as well as foreign source income. The ability of foreign affiliates to pay out exempt dividends also represents a strong incentive for other countries to enter into treaty negotiations with Canada, further contributing to the elimination of double taxation generally.

Furthermore, the dividend tax credit is as much an inducement to invest in the equity of Canadian companies as it is a credit for taxes paid at the corporate level. Given this, the precise composition of a corporation's income is irrelevant. Under the Canadian tax system, earnings are not segregated by source. Rather, funds are co-mingled and the dividend tax credit is available in respect of all earnings, regardless of the amount of underlying tax which may have been paid by the corporation. On a practical level eliminating the dividend tax credit for dividends paid out of foreign source earnings would simply result in corporations paying dividends only out of their Canadian source earnings. Moreover, based on the examples in the note, there is no indication of the extent, if any, to which exempt dividends received from foreign affiliates are flowed out to Canadian taxpayers, who are eligible for the dividend tax credit. Accordingly, there is no evidence that the availability of the dividend tax credit in respect of foreign source income represents a serious problem.

With respect to the ability of corporations to receive exempt dividends from foreign affiliates based in "designated countries" that are tax havens, historically Canada's policy was to designate countries once we had entered into tax treaty negotiations with them. In some instances, although negotiations were commenced, no treaty was ratified. Notwithstanding this, certain countries continued to be designated in the expectation that a tax treaty would be entered into at a future date. Since the early 1980s, however, Canada has had a general policy of neither designating, nor entering into tax treaties with, countries that are considered to be tax havens. Difficulties arise, however, where a country introduces tax preferences into its law only after it has concluded a treaty with Canada. In this respect many countries that introduce such tax preferences are really no different from Canada, which also offers limited tax preferences in order to stimulate certain sectors of the economy.

The Department of Finance is, however, currently considering a number of proposals to address these issues. In particular, the list of designated countries is continually under review as a result of changes to our treaty network, with a view to adding new countries with which tax treaties have been entered into and removing countries with which tax treaties are not in effect. In addition to this, the Income Tax Act and Regulations contain several provisions to ensure that income earned in tax haven countries cannot generally be brought back to Canada tax-free. Where there is a concern that a foreign affiliate based in a tax haven country has attempted to circumvent these rules, the arrangement should be attacked by Revenue Canada on the basis of either the specific rules in the Income Tax Act or GAAR.

Taxable dividends from foreign affiliates

The audit note observes that even where a foreign affiliate is not able to pay exempt dividends, an incentive may exist to defer distributing income in order to postpone paying Canadian tax. The note also provides a number of examples of instances in which the foreign affiliate rules may have been circumvented.

Once again, the appropriate policy response to the issue of deferral necessitates weighing the desirability of capital export neutrality against that of capital import neutrality. Thus, in those situations where it is reasonable to conclude that the principal reason for earning or retaining income in a foreign affiliate is to avoid Canadian tax, the FAPI rules are intended to ensure that the income is accrued and subject to tax on a current basis in Canada. Where, however, there are legitimate business reasons for the income being earned or retained offshore, competitiveness concerns dictate that it should be taxed only when it is brought back to Canada.

Other related problems

The FAPI rules, which are designed to prevent taxpayers from sheltering investment income offshore, drive off the distinction between active and passive income (with only the latter being subject to tax on an accrual basis). The audit note criticizes the lack of any definition as to what constitutes active and passive income. The audit note also puts forth a list of examples to demonstrate the apparent ease with which tax avoidance occurs.

Although the Income Tax Act does not define active and passive income, the policy underlying these concepts is well understood by the business community. The terms have also been commented on extensively by the courts and the principles underlying their characterization are well established. Given this, there is little foundation for the Auditor General's comment that "there is no reasonable assurance that the rules will apply in circumstances where they should".

The examples cited by the note are misleading. In many instances the income involved would appear to constitute FAPI and, as such, would be accrued and subject to tax in Canada on a current basis. In addition to this, many of these examples would also seem to involve transactions which could be attacked by Revenue Canada, under either the specific anti-avoidance provisions of the Income Tax Act or GAAR. Consequently, the claim that hundreds of millions of dollars in tax revenue are being lost is not supported by the examples and is unfounded.

Conclusion

While the Auditor General has identified a number of concerns with respect to the operation of the foreign affiliate rules, he has failed to indicate that most of these concerns are the result of conscious policy decisions on the part of the government and reflect a desire to promote the goal of international competitiveness. Moreover, he has also overstated the impact of the rules on revenue collection while understating the degree to which any problems have already been addressed by existing legislation. It would not be prudent to implement a system for the taxation of foreign source income which deviates substantially from international norms and fails to properly address the issue of competitiveness. In this regard, the economic costs inherent in amending the income tax legislation to accommodate the Auditor General's ostensible concerns would far exceed any marginal revenue gains that might be realized thereby.

Appendix 2

2002 Report of the Auditor General of Canada--December Chapter 11--Other Audit Observations, Pages 18 to 20.

11.110 Ten years have passed since we first expressed concern that tax arrangements for foreign affiliates cost hundreds of millions of dollars in reduced tax revenues. In response to our Report, the House of Commons Standing Committee on Public Accounts held hearings and made recommendations to the Department of Finance in 1993. The Minister of Finance's Technical Committee on Business Taxation also examined the issues and reported on them in 1997.

11.111 We observed that in the three transactions shown in Exhibit 11.4, foreign-owned Canadian companies incurred $2.1 billion of debt to finance investments in third countries. In addition, the Canada Customs and Revenue Agency is pursuing a number of cases involving foreign-owned Canadian companies that borrowed money to finance foreign investments. Twelve of these case involved $1.1 billion of debt. The Minister of Finance's Technical Committee on Business Taxation also noted that Canada's rules have allowed foreign-owned multinational businesses to shift debt into Canada and have encouraged tax-planning mechanisms that erode Canadian tax revenues.

11.112 We also observed that in a transaction shown in Exhibit 11.6, a foreign affiliate of a foreign-owned Canadian corporation was used to move $500 million of capital gains from Canada to Barbados tax-free. Information provided to us by the Canada Customs and Revenue Agency shows that in 2000, Canadian companies received $1.5 billion of virtually tax-free dividend income from their affiliates in Barbados (compared with $400 million in 1990). In paragraph 11.108 we showed how the foreign accrual property income rules continue to be exploited.

11.113 In our view, tax arrangements for foreign affiliates have eroded Canadian tax revenues of hundreds of millions of dollars over the last 10 years.

11.114 Recommendation. To protect the integrity of the tax base, the Department of Finance should obtain and analyze current information to reassess the tax revenue impact and the rationale of

allowing foreign-owned Canadian corporations to deduct interest on borrowed funds related directly or indirectly to investments in foreign affiliates, and allowing tax-privileged entities in treaty countries to bring income into Canada tax-free.

11.115 Recommendation. The Department of Finance should reassess the rules related to foreign accrual property income and taxable dividends in order to protect the integrity of the tax base.

Department of Finance's Response

The Auditor General, in her December 2002 Report, expresses a number of observations with respect to Canada's system of taxation of foreign source income and foreign affiliates. These observations, which follow similar observations made in the Auditor General's 1992 Report, are of two types. First, the Auditor General raises issues regarding the policy underlying some of the most significant aspects of the current system. Second, the Auditor General expresses concerns that certain tax arrangements entered into by Canadian taxpayers may contravene the policy intention of the current system.

With respect to the policy issues raised regarding Canada's system for taxing foreign source income and foreign affiliates, the Department expressed the general view in response to the 1992 Report that "the existing foreign affiliate regime accurately reflects the policy intention of Parliament and provides for the taxation of all income that is intended to be subject to Canadian income tax." Since 1992, the government has enacted several amendments to the law, which specifically address a number of issues raised by the 1992 Report of the Auditor General. In particular, these amendments have strengthened and clarified the foreign accrual property income or FAPI rules, which prevent the use of controlled foreign affiliates to avoid Canadian tax. In broad terms, the current Canadian income tax system provides for the exemption of certain types of foreign source income from taxation, the deferral of taxation for other types of foreign source income until repatriated to Canada, and the taxation on an accrual basis of certain passive foreign source income whether repatriated or not. This system is complex and necessarily involves making distinctions in the definition of the different types of income and their respective tax treatment. As a result, the system is continually under review by the Department in order to ensure that it continues to achieve a reasonable balance of policy objectives.

It is also important to note that there is an interaction between this system of taxation of foreign source income and the taxation of Canadian source income. The government has made significant changes to the general structure of the income tax system since 1992 that are relevant to issues raised by the Auditor General, but that are not referred to in this chapter. In particular, the government has implemented a five-year tax reduction plan that will significantly lower the federal corporate statutory income tax rate. Also, a number of provinces are making significant reductions in provincial corporate income tax rates. The net result of these changes will be that Canada will have on average a five percentage-point lower corporate tax rate (including capital taxes) than the United States by 2006.

This significant reduction of corporate tax rates will change the tax effects of placing debt financing in Canada. This is a reversal of the situation underlying the studies referred to in this chapter. As a result of this change, Canada will become a relatively less attractive jurisdiction for multinationals to locate their debt financing and interest expenses.

With respect to specific tax arrangements entered into by Canadian taxpayers as discussed in this chapter, it is important to note that the use by taxpayers of international tax arrangements evolves with changing circumstances and is thus the subject of continuous monitoring by both the Department and the Canada Customs and Revenue Agency. When specific issues are identified, analysis is performed and amendments are recommended in order to curtail abuse of the law and its intent. This process usually involves consultation with interested stakeholders. This helps to ensure that such amendments are properly targeted, sustainable over time, in keeping with international norms, and not inappropriately detrimental to the international competitiveness of Canadian multinationals.

As a result of this process, several amendments to Canada's Income Tax Act have been implemented since 1992 that strengthen the existing anti-avoidance measures in the legislation or provide new legislative tools to challenge abusive arrangements. As noted in this chapter, the FAPI rules, which deal with the shifting of passive income to foreign jurisdictions by Canadian residents, were the subject of substantial modifications in 1995 and have continued to be reviewed and improved since that time. The effect of these changes to the legislation has been to make the FAPI rules more effective in protecting the Canadian tax base by more precisely defining passive income that is subject to Canadian taxation as it is earned, active business income that may be subject to taxation on its repatriation to Canada by way of dividends paid to Canadian residents, and the situations under which such passive income arises. As also noted in this chapter, Canada's Income Tax Act has recently been amended in order to restrict the inappropriate channelling of funds through Canadian subsidiaries to third countries. The effect of these modifications to the legislation has been to make these rules more effective by ensuring that they apply in cases where funds are transferred to subsidiaries in third countries through the use of back-to-back transfer arrangements and the use of special types of entities such as partnerships and trusts.

Furthermore, the government has taken action in four areas that, although not noted in this chapter, are important in reducing the detrimental impact on the Canadian tax base of tax arrangements using tax havens. First, new foreign reporting requirements were implemented in 1996 requiring Canadian taxpayers to provide detailed information regarding their foreign sources of income and their use of foreign entities in earning such income. These new reporting requirements have already provided the Canada Customs and Revenue Agency with important information in relation to non-resident trusts, foreign affiliates, and FAPI. The Canada Customs and Revenue Agency has indicated that this information has improved its ability to manage compliance by allowing it to scrutinize substantial foreign investments held by Canadian taxpayers.

Second, improved transfer-pricing rules were enacted in 1997 to counter the potential for cross-border shifting of income through the manipulation of transfer prices in transactions between related companies. Transfer-pricing provisions of the income tax system are of increasing importance in a world where corporate tax planning strategies also have become globalized. As a result of these changes, Canada's transfer pricing legislation is fully in line with international standards and helps ensure that an appropriate amount of profit is reported and taxed in Canada.

Third, revised proposals first included in the 1999 federal budget would, if implemented by Parliament, strengthen the rules applicable with respect to non-resident trusts and foreign investment entities in which Canadian residents have an interest. The proposed modifications to these rules, the details of which were set out in draft legislation released on 11 October 2002, are intended to make the income tax system fairer and prevent tax avoidance by taxpayers that invest in or otherwise transfer property to foreign trusts or investment funds. These provisions support the FAPI system and better protect the tax base by ensuring that passive income earned outside of Canada by Canadian residents is taxed in Canada as earned.

Fourth, the Department also participates actively in the work of the Organisation for Economic Co-operation and Development (OECD) to enhance co-operation with other jurisdictions to secure the integrity of our respective tax systems. For example, the OECD reviews and updates on an ongoing basis its Model Tax Convention (which Canada uses as a model to negotiate its own bilateral tax treaties) and its Transfer Pricing Guidelines (which define the standards used for calculating an appropriate amount of income in each jurisdiction in respect of cross-border related-party transactions). The OECD also has a project ongoing that is intended to address some of the issues raised by harmful tax practices with respect to mobile activities that erode tax bases of other countries and distort the location of capital and services.

With respect to the recommendations made in this chapter, the Department of Finance will continue to assess the rationale and operation (including revenue impact) of Canada's system for taxing foreign affiliates and foreign source income, as well as the treatment of expenses incurred to make investments in those affiliates. This analysis will incorporate the most recent information available for this purpose. As part of this process, the Department of Finance will continue to consider appropriate improvements to Canada's system of taxation of foreign source income and foreign affiliates, recognizing that the system serves a number of policy goals, including supporting the international competitiveness of Canadian businesses.

(1.) See Appendices I and 2, respectively, for the Department of Finance's responses to the 1992 and 2002 Auditor General Reports criticizing the rules governing the taxation of foreign affiliates and permitting the deductibility of interest in Canada for loans financing investments in those affiliates.

(2.) Brean, Donald J.S., Policy Perspectives on Canadian Tax Treatment of the Foreign Source Income of Canadian-based Multinational Enterprises (August 11, 1997).

(3.) Although the Proposals would permit an interest deduction in Canada where the Canadian company loans borrowed funds to a foreign acquiring company, the interest would likely be nondeductible in the foreign jurisdiction unless the acquiring and acquired companies can be merged or the foreign jurisdiction permits the acquiring and acquired companies to file a consolidated tax return.

(4.) In some cases, the form of a foreign investment may prevent the foreign affiliate from incurring the acquisition indebtedness. For instance, a Canadian company may attempt to take over a U.S. public company where the only way to structure the transaction is a direct purchase of shares by the Canadian company from the target's public shareholders. As another example, a foreign joint venture may be structured in a fashion that requires each investor to secure its own financing outside of the joint venture. Where the debt cannot be pushed into the foreign entity and the interest cannot be deducted in Canada because of the Proposals, Canadian investors will be at a competitive disadvantage because of the higher after-tax cost of debt financing and would likely reassess the viability of the foreign investment.

(5.) The Proposals' requirement that taxpayers trace the use of their borrowings would also adversely affect current debt arrangements. Since there is no tracing requirement under current rules, documentation may no longer be available that would permit taxpayers to determine whether a bond issuance or bank loan relates to a particular foreign investment. Consequently, taxpayers in economically equivalent financing positions may have different interest deductions under the Proposals.

(6.) See Report of Technical Committee on Business Taxation, at 6.18 (December 1997). "Indebtedness incurred or committed to under existing rules should be exempted from the new regime or be eligible for a generous transition period. Grandfathering or transitional provisions are particularly significant in this area, having regard to the fact that taxpayers have made significant borrowing and investment commitments based upon existing rules."

(7.) In addition to draft legislation revising the tax treatment of foreign affiliates, the government has also tabled a Notice of Ways and Means Motion to implement proposed Foreign Investment Entity rules, an entirely new regime that would--with or without the proposed revisions noted in the text--substantially overlap the foreign affiliate rules.

(8.) The Proposals have been defended as recommendations of the Mintz Committee. Assuming the Mintz Committee would make the same recommendations today as it did 10 years ago, there are two critical differences that TEI believes make the current Proposals untenable. First, the Mintz Committee recommended that the Canadian corporate tax rate be reduced in order to create a competitive rate advantage in Canada. Although the government has announced reductions to the corporate income tax rate over the past several years, the reductions have not created an advantage for Canada or Canadian-based companies because other jurisdictions have lowered their corporate rates more quickly and substantially. Second, the Mintz Committee recommended that existing debt be exempted from the new rules or that generous transition relief be afforded to taxpayers to permit them to restructure their affairs. The proposed one- and two-year transition rules for related and unrelated debt, respectively, are insufficient.