TEI comments on repeal of term preferred share rules.

March 11, 9004

On March 11, 2004, Tax Executives Institute submitted the following letter urging the Canadian Department of Finance to introduce legislation repealing the Term Preferred Share provisions of the Canadian Income Tax Act. The letter was prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Limited. Contributing to the development of TEI's comments were Julie Muirhead and David M. Penney of General Motors of Canada Limited.

During a Department of Finance--Tax Executives Institute (TEI) Liaison Meeting, the merits of eliminating the Term Preferred Share (TPS) and related rules (such as the guaranteed preference and collateral preference rules) from the Income Tax Act (the "Act") were discussed. On behalf of TEI, I am pleased to follow-up on those discussions by submitting the following comments and recommendations for your consideration.

Background

Tax Executives Institute is the preeminent international association of business tax executives. The Institute's 5,400 professionals manage the tax affairs of 2,800 of the leading companies in Canada, the United States, and Europe. 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 eight geographic regions, and must contend daily with the planning and compliance aspects of Canada's business tax laws. Our non-Canadian members (including those in Europe) work for companies with substantial activities in Canada. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Recommendation

The Term Preferred Share (TPS) rules impose significant restrictions on the design of Canadian equity instruments and reduce the depth and vibrancy of Canada's capital markets. Moreover, the TPS rules are redundant with other rules in the Act affecting preferred shares, increase the cost of preferred-share financing over debt financing, and add significant complexity to ordinary business transactions. Consequently, TEI recommends that the TPS rules be repealed.

Discussion

Businesses that need financing must choose between two fundamental options: debt or equity. Where a company is unable to borrow additional funds or issue new debt securities--whether because of concerns over the effect on credit ratings, debt covenant restrictions, or regulatory requirements--and does not wish to dilute earnings per share by issuing additional common shares, a preferred share issuance is the only viable course. Because of the potential double tax burden under the Act, however, preferred shares are an expensive--even a last resort--means of raising capital in Canada.

Subsections 112(2.1) through (2.6) and 258(3) through (5) of the Act are the principal charging provisions for the TPS rules and convert what would otherwise be tax-exempt dividends into taxable dividends. The provisions were aimed originally at restricting financial institutions from acquiring financial instruments that were structured legally as equity but were in substance debt. The issuers and banks were, in effect, arbitraging their respective tax rates and tax positions by converting fully taxable interest income into tax-exempt dividends. In a typical case, the "debtor" issuing the instruments would be a tax-indifferent party that would not be paying taxes currently, owing either to its status as a tax-exempt entity or, in the case of a commercial enterprise, to large tax loss carryforwards. In either case, the preferred share issuer would forgo interest deductions in exchange for a reduced "interest rate" paid in the form of a fixed return on preferred shares. Both the tax-indifferent debtor and the tax-paying creditor would benefit from the preferred share financing compared to the tax treatment of a traditional loan arrangement.

Dividends on preferred shares are also subject to the Part IV.1 and Part VIA taxable preferred share rules. Under these rules, the recipient is denied the intercorporate dividend deduction and the Part VI.I tax is payable by the dividend payer. Thus, dividends on preferred shares are generally subject to two separate but redundant regimes under the Act.

When the taxable preferred share rules were first introduced in June 1987, shares subject to the taxable preferred share regime were excluded from the TPS rules. The Department, however, reversed its position in December 1987 and introduced legislation subjecting preference shares to both regimes. The rationale for maintaining both the TPS rules and the taxable preferred share rules was a concern that financial institutions would build a portfolio of preferred shares that were really disguised loans in order to avail themselves of the $500,000 dividend allowance for taxable preferred shares.

TEI acknowledges the concern but submits that the overlap between the term preferred share rules and the taxable preferred share rules and the double tax burden on shares falling under both regimes is unjustified and excessive. If the $500,000 dividend allowance poses a risk of a material revenue loss, it would be more appropriate to address that issue directly rather than through a draconian double-tax regime that inhibits the use of preferred share financing. Accordingly, we urge the Department to introduce legislation to repeal the term preferred share regime and, if necessary, make adjustments to the dividend allowance rules in section 191.1 in order to mitigate potential abuses of the $500,000 dividend allowance.

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 Monika M. Siegmund. If you should have any questions about the submission, please do not hesitate to call Ms. Siegmund at 403.691.3210, or Mario M. Tombari, TEI's Vice President for Canadian Affairs, at 514.932.6161, ext. 2943.