TEI testimony on pre-budget consultations before House of Commons Standing Committee on Finance: September 10, 2004.

On September 10, 2004, TEI filed a written statement with the House of Commons Standing Committee on Finance on the topics that it intends to testify about in connection with the Standing Committee's not-yet scheduled 2004 Pre-Budget Consultations. TEI will be represented at the hearing by its 2004-2005 Vice President for Canadian Affairs, David M. Penney of General Motors of Canada Limited, and by its 2004-2005 Chair of the Canadian Income Tax Committee, David V. Daubaras of General Electric Canada. Various members of TEI's Canadian Income Tax Committee contributed to the development of the written statement.

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 and TEI is pleased to have the opportunity to participate. TEI has a number of recommendations in respect of taxation measures that we believe will 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 tax policy and administrative 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, and Europe. 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 U.S. and European members work for companies with substantial Canadian operations.

Summary of Recommendations

The Institute urges the Standing Committee to incorporate the following recommendations in its report on the pre-budget consultations.

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

* Abandon the 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.

* Recommend that the Department of Finance 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.

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

On October 31, 2003, the Department of Finance released draft amendments to section 3.1 of the Act to clarify that (1) "income" for purposes of the Act is "net" income, in accordance with the generally accepted understanding of the Act prior to the Supreme Court of Canada's decision in Ludco Enterprises Ltd. v. Canada, (1) 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, replacing the common law REOP test. TEI is pleased to have participated in consultations with the Department of Finance on this proposed legislation and will continue to respond to requests for information. A copy of TEI's comments and recommendations to the Department of Finance is attached as Appendix 1.

Although the Department's goals are clear and seemingly circumscribed, the proposed amendment to subsection 3.1(1), relating to limits on losses, is far 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. Indeed, the proposals go substantially beyond restoring the Act to the pre-Ludco status quo for the treatment of such expenses. As important, TEI believes the Supreme Court of Canada's decision in Stewart enunciates a clear and rational tax policy basis for distinguishing commercial activities from personal and hobby-related expenditures. (2) Moreover, the generally accepted understanding of the Act pre-Ludco was that income is "net" income and that "net income" is synonymous with "profit" for determining a "source of income." Thus, TEI believes the draft legislation poses a substantial risk of (1) creating confusion and ambiguity for taxpayers and CRA auditors alike, (2) imposing unwarranted restrictions on the ability of commercial enterprises, especially large-file taxpayers, to deduct the costs of producing their "net" income, and (3) diverting limited CRA audit resources.

A. REOP Test Creates Significant Burdens for Commercial, For-Profit Enterprises.

The proposed legislation creates a continuing requirement to test--in respect of each source that is a business or property in each taxation year that the income source generates a loss--whether the taxpayer has a reasonable expectation of profit. Specifically, the deductibility of each expenditure must be evaluated from a narrow statutory tax perspective and even in isolation from the taxpayer's overarching business objectives and marketing strategy. The interaction of the REOP test with the source rule seemingly requires a microanalysis of business operations on at least an annual basis. It would be burdensome, expensive, and time-consuming for large commercial enterprises to annually trace each expenditure or investment to a particular "source." Moreover, the concept of "net income" has been a part of the Act for many years and is generally synonymous with "profit." Thus, large business taxpayers and CRA have rarely had disputes in respect of whether an expenditure has been incurred in pursuit of a profit. (3) In other words, the "source" to which deductions relate has been assumed to be for a commercial purpose and taxpayers have not been required to justify each business unit's profitability either on an annual or cumulative basis. Under the proposed legislation, however, the assumption would be upended and CRA would seemingly be required to review such questions. (4) TEI submits that the implementation of a statutory REOP test is unnecessary and is likely to spawn significant controversy and litigation about its scope and meaning.

B. "Cumulative Profit" Prong of the REOP Test is Unadministrable.

In taxation years in which a business source has a loss, the proposed rules require an evaluation of the expected cumulative profit for the entire period during which the taxpayer can reasonably be expected to carry on the business or hold the property. The cumulative profit test will introduce significant uncertainty for taxpayers and increase administrative and compliance costs for taxpayers and the CRA alike.

1. The provision interferes with rational, incremental business decisionmaking. The "cumulative profit" test ignores the principle that sunk costs (i.e., the costs of previous investment decisions) are generally ignored when a new decision is required. Since most business decisions are made "at the margin," or in respect of incremental changes to, or effects on, the business, the generation of prospective, incremental cash inflows (or minimization of incremental cash outflows) is the driving factor in a decision rather than whether a "cumulative profit," including the recovery of sunk costs, will be engendered by a particular business activity. (5) The denial of a loss deduction in such cases is harsh where the taxpayer continues the business for a period of time in an effort to generate incremental cash flows that recoup prior losses. The test thus potentially encourages commercial enterprises to make decisions based on the tax law rather than sound business practices. (6)

2. The requirement to evaluate the prospect of realizing a cumulative profit potentially restricts the deductibility of losses arising from adverse, unanticipated events. The cumulative profit test must be applied each year. Thus, even though a taxpayer and CRA may conclude that a business or property produces a deductible loss in one year, a loss arising from that same business or property in a later year may subsequently be disallowed even if the change in the prospects for a cumulative profit is attributable to circumstances beyond the taxpayer's control. For example, a business might, after a string of loss years from ordinary business operations, incur an extraordinary or catastrophic, uninsured loss (e.g., as a result of an explosion or a toxic emission) that eliminates all possibility of a cumulative profit. The extraordinary loss (and all subsequent losses incurred to remedy the situation) may be nondeductible under the REOP test and, thus, inconsistent with the current tax result.

3. The requirement of an annual evaluation of the prospect of a cumulative profit potentially penalizes entrepreneurial activity as well as poor business results. Many new ventures incur start-up losses. Management continually evaluates the prospects of start-up businesses against long and short-range business plans and trends. After operating a start-up business at a loss for several years, management may conclude that its initial decisions were based on faulty information or flawed analysis. Alternatively, changes in technology or in the market for the product or service may render the initial decisions questionable. If a decision is made to discontinue the business, a loss for that year, for subsequent years until the business or property is sold or wound up, and for years prior to the decision to discontinue the business that are open for audit may be disallowed even though the taxpayer had a reasonable expectation of profit at the time it started the business. The disallowance of a business loss as a result of a decision to discontinue a business would clearly be at odds with taxpayers' expectations under the prevailing understanding of the Act prior to the Ludco decision.

4. The requirement to evaluate the expectation of a cumulative profit on a property-by-property and business-by-business basis will place undue emphasis on the allocation of expenses among business units of a multi-business operation or among different activities that are part of a single, integrated business. The proposed REOP test ultimately depends on a source-by-source allocation of expenses, but the requirement to allocate expenses, such as general corporate overhead or research expenditures that benefit multiple business product lines, to each business and property source will engender new and significant disputes between taxpayers and the CRA because auditors may attempt to reallocate expenses in order to produce or increase nondeductible losses. Finally, requiring taxpayers to fully allocate all costs to each business source will impose a significant burden on taxpayers to implement and refine their cost and financial accounting systems.

For the foregoing reasons, TEI urges the Standing Committee to recommend that the REOP test included in draft legislation affecting the deductibility of interest and other expenses be abandoned or substantially narrowed.

Foreign Affiliate Regime and Draft Legislation in Respect of Foreign Investment Entitites and Non-Resident Trusts

In Chapter 11 of her December 2002 report on Canada Revenue Agency and Canadian tax administration, the Auditor General made a number of observations about the policies underlying the taxation of foreign source income and foreign affiliates. She also noted that some Canadian taxpayers have entered into transactions with foreign affiliates that erode the tax base and recommended that the Department of Finance reassess the rules relating to interest deductibility, foreign accrual property income, and taxable dividends.

In its response to the Auditor General's report, Department of Finance stated 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." (7) The Department also pointed to the steps undertaken by the Government since the Auditor General's 1992 Report in order to curb tax avoidance transactions. Although we support the Auditor General's efforts to identify arrangements that might contravene tax policy, TEI is concerned about the implication that the underlying tax policies are unsound. The current rules provide for exemption of certain foreign source income, taxation upon repatriation to Canada of other income, and current taxation of certain passive income on an accrual basis without regard to repatriation. Through the interaction of complex, overlapping rules, the foreign affiliate regime balances multiple, competing policy goals. Most important among these, the current rules are consistent with the Government's objective of promoting the international competitiveness of Canadian businesses. Moreover, the policies underlying the taxation of foreign source income cannot be divorced from the taxation of Canadian source income and, with the ongoing phased reduction in corporate income tax rates at the federal level, Canada has become a more competitive environment for attracting foreign and domestic investments.

In addition, the Department of Finance, through consultations with, and the review of statistical reports from, Canada Revenue Agency, continually monitors taxpayers' compliance with the foreign affiliate regime. Where specific abuses are identified, the Department analyzes the situation and, where appropriate, proposes amendments to the Act to curtail the abuses. Generally, the process involves consultations with stakeholders to ensure that the amendments are targeted, sustainable, consistent with international norms, and not detrimental to the competitiveness of Canadian multinationals. For example, draft legislation released on February 27, 2004, includes a number of technical amendments tightening the foreign affiliate rules and curbing certain transactions. TEI is analyzing that legislation and will provide its comments to the Department very soon. We fully support the Department's efforts to strengthen the integrity of the tax system and strive to provide comments that not only ensure that amendments to the Act are targeted and sustainable, but also administrable.

To that end--providing comments to ensure that legislation is administrable--TEI is concerned about proposed legislation that would implement a new regime for taxing Foreign Investment Entities (FIEs) and Non-Resident Trusts (NRTs). The proposed legislation was originally released in June 2000, revised in August 2001, and revised again when released in an October 2002 Notice of the Ways and Means Motion. TEI is pleased to have participated in consultations with the Department of Finance on this proposed legislation. A copy of TEI's most recent comments and recommendations to the Department of Finance is attached as Appendix 2.

Briefly stated, TEI believes that 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. As a result, the provisions will interfere with legitimate business operations. In addition, the proposed FIE rules simply do not mesh well with the proposed NRT rules. 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, anymore than taxpayers, have the resources to properly administer these rules.

Fundamentally, we believe the draft legislation is unworkable and we again--as we did in our 2002 and 2003 written statements on the pre-budget consultations--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."

* The proposed legislation is overbroad, overlaps the foreign affiliate regime as well as section 17, and catches many legitimate commercial transactions.

* The information necessary to comply with the proposed legislation's myriad reporting requirements or to take advantage of one or more 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, it is a minority investor and lacks the requisite control of the entity in order to obtain the necessary information.

Finally, we note that the Government has been fine-tuning the proposed legislation for more than four 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, where possible, modify company information systems to capture and report the additional required information. Thus, the proposed January 1, 2003, effective date for the proposed legislation is unreasonable. If the legislation is not withdrawn, the effective date must be postponed substantially in order to give compliant taxpayers the opportunity to understand the provisions and ensure that their legitimate business operations are not inadvertently caught in the maw of this legislation.

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, (8) have shown a strong link between the elimination of withholding taxes on dividends and interest and increased foreign direct investment. The Howe Institute's study claims 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 Howe Institute's study also summarizes 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 Unites 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. As important, since the withholding tax rates between the United Sates and Canada were last revisited in 1995, (9) the United States has subsequently 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 with-holding taxes following approval and implementation of the revised treaty.

TEI urges the Standing Committee to recommend that the Department of Finance expeditiously negotiate and implement 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.

Conclusion

Tax Executives Institute appreciates the opportunity to participate in the 2004 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.) Ludco Enterprises Ltd. v. The Queen, 2001 S.C.C. 62.

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

(3.) The proposed statutory formulation of the REOP test is no more precise than the common law test enunciated by Canadian courts because the test 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 is can be little doubt about the for-profit purpose of an expenditure or investment.

(4.) Moreover, 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.

(5.) For example, a taxpayer may, after incurring several years of losses, conclude that a business venture is unlikely to produce a cumulative net profit. Nonetheless, if the taxpayer's variable costs of production are less than the selling price of the goods or services, 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.

(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.) Office of the Auditor General, December 2002 Report, section 11.115.

(8.) 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).

(9.) 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 a three-year period with respect to further reductions in withholding taxes. The two countries commenced consultations some time ago, but have not yet reached agreement. 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.