TEI-Canadian Department of Finance liaison meeting (income tax issues).

Introduction

On December 11, 1996, a delegation from Tax Executives Institute met in Ottawa with representatives of the Canadian Department of Finance. The meeting was chaired by Len Farber of the Canadian Department of Finance and Alan Wheable, chair of Tax Executives Institute's Canadian Income Tax Committee. The Chairs introduced the participants. James Murray, President of TEI, expressed his appreciation of the close relationship between Finance Canada and TEI.

The participants discussed the items previously submitted. [Editor's Note: The Department's responses are summarized by the TEI members who participated in the meeting; the Department of Finance has reviewed and approved the summaries for distribution.]

Consolidated Tax Returns

In 1985, the Minister of Finance issued a White Paper on consolidated tax returns for affiliated groups of companies (which was referred to as the "corporate loss transfer system"). At that time, TEI supported a proposal to permit consolidation of wholly-owned, or nearly wholly-owned, group members, urging that Canada alter its unique position among major trading countries in not permitting consolidation. More than ten years later, little has changed; indeed, the rules governing corporate groups may be even less competitive now compared with the rest of Canada's trading partners. Notwithstanding that "loss transfer" mechanisms exist for federal income tax purposes, effectuating such transfers involves substantial transactional costs; moreover, the losses remain unavailable for provincial income tax purposes. In addition, the attendant compliance costs associated with filing separate returns for subsidiaries remains as high as ever. Recent reports by Professor Mintz's Technical Committee on Business Taxation and the Auditor General acknowledge these economic and tax policy inefficiencies. Hence, we urge the government to "just do it" and implement a regime to permit consolidated income tax return filing for corporate groups. We invite the Department's comments.

Finance response and discussion: There was general agreement that a form of group relief/consolidated return or loss transfer system would be appropriate for Canada. TEI emphasized that the Provincial and indeed Revenue loss concerns are not as significant as perhaps they were once thought to be. Even a federal-only system would be better than nothing.

Finance said that TEI should not expect to see this subject in the next Budget, but might see it in the medium term. There are "revenue" and provincial concerns. Finance is sympathetic to a loss transfer system.

Other issues that Finance said must be addressed before adopting a loss-transfer system:

* Should Finance adopt it with or without the provinces or certain provinces?

* How high should the ownership threshold be set to permit consolidation?

* What if there is a revenue loss for the provinces.

* How will a higher or lower percentage of ownership create other problems.

Finally, the subject of loss transfers is apparently being considered by the Mintz Commission.

Part I.3 Tax Deduction for

Surtax Credits

Under current rules, the capital deduction claimed in the computation of the Part I.3 Tax on Large Corporations must be allocated among associated companies. Would consideration be given to revising the rule to apply the excess surtax credits over Part I.3 tax to other corporations within the same associated group in respect of which the capital deduction allocation was made?

Finance response: The base issue here is loss transferability. The Department is not prepared to change this aspect of the legislation before changing the other.

TEI counter-response: An unfair result can occur where a company has high capital and a low return.

Finance counter-counter-response: Yes, this is understood.

Leasehold Improvements

Simplification Proposal

Determining the amount of the capital cost allowance (CCA) on Class 13 assets is excessively complicated. Each asset that forms a part of a leasehold improvement must be accounted for on a separate basis even though all the assets remain in a single class for purposes of the terminal loss and recapture rules. To simplify the system and permit both taxpayers and Revenue Canada to reduce the amount of resources devoted to the calculation and verification of CCA on such assets, we recommend that the Department of Finance adopt the same diminishing balance aggregate pool system for leasehold improvements as exists for most other assets. In addition, a transitional rule should be adopted permitting taxpayers to elect either to maintain the current rules for existing leasehold improvements or to transfer the balance into the new class of assets subject to the diminishing balance computation. We believe that the new rule and the transitional rule for existing leasehold improvements can be implemented in a revenue-neutral fashion. We would be willing to work with the Department to craft such a rule and invite the Department's views and comments on the topic.

Finance response: Finance stated that they were not previously aware of any Class 13 administrative problems. The Department is willing to consider a TEI brief on the subject. The brief should address a suggested rate; winners and losers; profile of a typical lease; lease term; and renewal period.

Harmonization

There is currently much discussion at the federal and provincial levels about simplifying the tax system and improving the efficiency of Canada's revenue administration. The Minister signaled his commitment to those goals with the announcement of the Canada Revenue Commission (hereinafter, "the Commission") in the last budget message.

One of the objectives of the Commission is to develop a closer partnership with provinces in revenue administration. TEI believes that the federal and provincial governments as well as business taxpayers have much to gain from the increasing trend toward harmonized tax bases where similar taxes are imposed by different jurisdictions. Consequently, we appreciate the active and substantial leadership of the federal government in developing a harmonized sales tax system across Canada. Regrettably, no government body has yet assumed the leadership mantle in respect of harmonizing capital taxes. Consequently, we believe the Commission would serve as a catalyst for promoting such an initiative because the capital tax is another area where harmonization will be beneficial. Once a common capital tax base is agreed upon, federal and provincial rates should be reviewed in order to maintain revenue neutrality for both taxpayers and the respective tax authorities. Harmonization of capital taxes would facilitate compliance by taxpayers, lower the risk of double taxation, minimize audit disputes, and thereby reduce compliance and administrative costs for taxpayers and tax authorities alike. We invite the Department's comments on our proposal to make capital tax harmonization a goal of the Commission.

Notwithstanding the substantive goals that evolve for the Commission, we urge that the Government, in its efforts to harmonize business tax systems, adhere to certain key principles that we believe are fundamental to sound tax policy and administration. Among the core principles are revenue neutrality, simplification of the tax system, minimizing the burden of compliance, promoting common or uniform administration and tax regimes without material exceptions, fostering extensive taxpayer consultations, providing timely, prospective legislation and form release, and ensuring adequate transitional rules. With the announcement of such guiding principles, harmonization efforts would enlist the active participation of TEI.

Finance response: This issue has been raised at the Assistant Deputy Minister level, which meets with provincial counterparts twice a year, as well as at the "working" level on a more regular basis. Certain provinces have shown some interest. Owing to resource constraints, this has not been a priority. Certain provinces have moved their capital tax base closer to the LCT. Finance suggested that taxpayers (through TEI or others) try to give a higher priority of this issue at the provincial level so that the issue is on everybody's agenda the next time there is a meeting.

Provincial Allocations

-- Netting of Interest Charges

Where the taxpayer's provincial allocation is revised on audit, and assuming that the proper correlative adjustments are made in all other jurisdictions, the taxpayer will owe additional tax in some jurisdictions and be entitled to refunds in others. In addition, the taxpayer will be assessed interest on tax underpayments and be entitled to receive interest on overpayments. In total, the amount of tax and interest will likely entirely offset. The interest on the refund amounts, however, is taxable whereas interest charges on income taxes is not deductible. As an administrative concession, will the Department of Finance permit taxpayers to net the interest payable and refundable from all jurisdictions and only treat the net amount as either taxable (in the case of net refund interest) or nondeductible (in the case of net arrears interest)?

Discussion: This issue was withdrawn because Revenue Canada has indicated that it will permit the offset as an administrative accommodation.

Interest Charges and the

Competent Authority Process

The purpose of the competent authority process is to prevent double taxation in respect of cross-border transactions. Owing to the complexity of the issues involved, taxpayers must invest substantial time and resources to resolve competent authority issues. Even where the process ultimately results in the elimination of double taxation, the denial of a deduction for interest levied on tax deficiencies on one of the affected taxpayers will produce a result economically equivalent to double taxation where interest on the tax refund is taxable to the related party. Such a result is inconsistent with the overall thrust of the competent authority process. Consequently, we recommend that the Department permit a deduction for interest expense on Canadian tax deficiencies arising from competent authority issues, at least for the amount of interest accruing beyond the normal statute of limitations period. Would the Department support such a deduction?

Finance response: The Department indicated that it would place a higher priority on developing a system for netting Canadian tax refund interest against Canadian tax arrears interest (as suggested by TEI in earlier submissions) than on an offset rule in respect of Canadian versus foreign refund and arrears interest. The question was also raised whether relief in the latter context ought to be bilateral -- implying treaty changes or at least competent authority agreement.

TEI counter: It was suggested that this could be settled administratively and TEI would welcome any initiative in this area.

Regulation 105

Regulation 105 requires a Canadian taxpayer to withhold a 15-percent tax on all services performed in Canada by non-residents. Moreover, waiver of the withholding requirement (or the application of a reduced treaty rate) must be sought in advance on a contract-by-contract basis. Non-resident service suppliers will often refuse to perform work for a Canadian company unless the service recipient agrees to bear the cost of the withholding tax via a costly gross-up. Moreover, for smaller, non-resident service companies, the cost of hiring an accountant to file a Canadian tax return in order to obtain a refund of the tax is onerous and will likely reduce substantially, if not eliminate, the expected profit on the services rendered. Would the Department of Finance reconsider the application of Regulation 105, especially for non-resident U.S. companies?

Finance response and discussion: The Department indicated that it did not understand why this legislation should be a problem. The Department said that some have expressed the view that the rate should be increased from 15% to 25%. The Department said that the tax liability was the responsibility of the non-resident, not the Canadian payer. Where the nonresident is not taxable in Canada, it could receive a foreign tax credit or file for a refund.

TEI explained that a Canadian taxpayer was required to gross-up the payment in order to keep the nonresident whole.

The Department replied that exempting specific situations would be very difficult; they would have to consider all the facts relating to each specific situation. The Department believes that exempting all non-resident U.S. companies is too broad a suggestion; they are prepared to look at specific situations submitted by TEI. Finance said that consideration could be given to providing an exception where the recipient was not taxable on the receipt because of a bilateral tax treaty.

Non-resident Withholding

Unlike most filing and paying obligations under the Income Tax Act (hereinafter "the Act"), there is no effective limitation period for the obligation to withhold and remit tax under section 215 because no assessment is issued except in extraordinary situations. Would the Department support an amendment to the Act, perhaps by way of amendment to subsection 227(10), requiring the Minister to assess the filer's liability in respect of Part XIII, at least on an elective basis? If an elective provision is acceptable, could the proposal be implemented on the basis of a check-the-box feature on the appropriate filing forms?

Finance response: Finance agrees that it is desirable to establish a procedure whereby a taxpayer may request an assessment, but only on a transactional basis. They will need to talk to Revenue Canada about administrative issues before legislative amendments can be implemented.

Foreign Tax Credits

Last year TEI inquired about the Department's support for clarifying subsection 126(2) in order to permit taxpayers to claim foreign tax credits for certain amounts paid to foreign jurisdictions in connection with production-sharing agreements (PSAs). Many foreign countries permit exploration for, and production of, petroleum resources within their jurisdiction only on condition that (i) the state-owned oil company be part of a PSA and (ii) specified tax levies be imposed on production under the PSA. The liaison agenda submission requested that the Department consider whether ambiguity in the treatment of those tax levies promoted or impeded the Canadian petroleum industry's competitive position vis-a-vis companies operating in foreign jurisdictions that clearly permit tax credits for such payments. The Department's response invited the submission of additional information from both Revenue Canada and taxpayers.

In one situation reviewed by the Rulings Directorate of Revenue Canada, a PSA provided that the Canadian taxpayer and the PSA counterparty, the state-owned oil company in the foreign jurisdiction, would each receive a share of the production. As part of the consideration for its "agreed share" of production, the state-owned oil company agreed to make the taxpayer's tax payments to the state fiscal authorities. The agreement addressed the tax treatment of the taxpayer under the tax laws of the foreign jurisdiction and also protected the taxpayer from subsequent changes in the tax structure. In addition, the PSA clarified the manner in which the Canadian taxpayer's taxable income arising from its activities was to be determined. Notwithstanding the provisions in the PSA, the income tax was levied under the terms of the foreign jurisdiction's general taxing statutes. The Directorate ruled adversely to the taxpayer, concluding that the taxes imposed on the taxpayer do not constitute "income or profits" taxes that are creditable under subsection 126(2).

Given the prevalence of PSAs in a globalized and highly competitive petroleum industry, we renew our inquiry whether the Department will support policy or legislative changes to temper the relative disadvantage visited upon Canadian companies that are not permitted to credit such taxes. Canadian employment in the petroleum industry may be diminished should companies restructure their operations in order to avoid the adverse tax consequences of rulings such as the aforementioned one. Has Finance requested and received additional information from Revenue Canada in respect of Revenue's denial of credits for such foreign taxes, thereby permitting Finance to resolve this issue?

Finance response: Officials from Revenue Canada and the Department of Finance have met and discussed the issue. Officials in both Ministries have, in general, a much better understanding of the issue through the recent consultations that have been held with industry. A recommendation for possible changes to mitigate the problem will be made "in fairly short order" and almost certainly within the next year. However, it is too early to tell whether the changes will be legislative or administrative in nature.

Treaties

A. Withholding Taxes

The Government's policy of seeking reduced withholding tax rates in certain areas, such as dividends, interest, and computer royalties, has been implemented in only a few treaties. What progress can be reported in implementing the goal? In particular, the timing for review of further reductions in withholding taxes with our major NAFTA partner, the United States, would seem propitious. Can you provide a report on the prospects for such a review?

High withholding taxes are a significant disincentive to increasing the level of foreign investment in Canada. Moreover, reluctance to negotiate reciprocal reductions in withholding tax rates increases the tax burden for Canada's global corporations conducting business overseas. Hence, TEI urges the government to review the results of reducing various withholding tax rates in the Canada-U.S. protocol with a view to moving to the European and, indeed, the U.S. model with a zero rate as the target for intergroup dividends, interest, and royalties.

Finance response: The Department is not considering further reductions in withholding taxes with the United States. Finance is prepared to discuss the lower rates currently found in the revised U.S. treaty with other countries. Some countries have approached the Department to discuss reductions in withholding taxes with Canada.

TEI expressed concern with the delay in reducing all withholding taxes with our treaty partners in line with the recent U.S. protocol.

TEI was disappointed to learn that the Department has not yet started to review the adequacy of the withholding tax reductions in the U.S. Treaty with a view to further decreases. TEI considers that such reductions would bring Canada more in line with international norms and also enhance Canada's attractiveness for foreign direct investment.

B. Negotiation Update

We request that the Department provide a brief report on the status of its pending treaty negotiations with various countries worldwide. In particular, we understand that some European countries have expressed a desire to renegotiate expeditiously their treaties with Canada. Within the limits of government policy and inter-governmental confidentiality agreements, please comment on whether such requests have been made and will be accommodated.

Finance response: The Department provided the following comments on specific treaties:

Belgium: In 1992, Belgium was interested in lowering the withholding tax rate. Canada received an initial draft of the proposed changes. The change in Belgium's government has delayed further progress.

Denmark: Revision to this treaty began in the late 1970s. The revised treaty will likely be signed in 1997.

Germany: Canada had two discussions with Germany in 1995 regarding revisions to the treaty. Further progress has been delayed due to a lack of resources.

Ireland: Treaty revisions have been in discussion since 1973, with no success. The Department will attempt to re-activate the file in 1997.

Netherlands: The reduction in withholding taxes on dividends and on computer software royalties have been introduced in the 1992 Protocol. Discussions have been initiated in 1996 on an expansion of the coverage of the exemption for royalties.

Switzerland: The treaty will likely be signed in 1997.

U.K.: Negotiations began in September, 1995 and will continue into 1997. There are several outstanding issues under discussion. The Department expects that the protocol will be available in 1997.

Australia: There were negotiations in late November, 1996. The protocol should be issued in 1997.

Portugal: Negotiations began in 1973. The last meeting was in 1995.

Turkey: There is one outstanding issue. The Department expects that the treaty will be finalized in 1997.

Foreign Affiliates

"Investment Business"

A. Swaps and Other

Interest-rate

Management Products

As a result of 1994 amendments to the Act, in order for a controlled foreign affiliate's investment income to avoid generating foreign accrual property income (FAPI) to its Canadian resident shareholders, a business must be carried on principally at arm's length. Under subsection 95(2.1), "agreements that provide for the purchase, sale or exchange of currency" will, under certain circumstances, be considered to be arm's-length transactions for purposes of the investment business definition when concluded between a controlled foreign affiliate and a related Canadian financial institution. Specifically, to the extent that the relevant transactions consist of hedging operations ancillary to third-party business conducted by the controlled foreign affiliate, this is an appropriate result.

Following enactment of the new rules, Revenue Canada has taken the position that interest-rate swaps do not involve a "purchase, sale or exchange of currency" within the meaning of subsection 95(2.1) of the Act, notwithstanding explicit references to swaps and other interest-rate management products in paragraph 95(2.1)(b). Revenue Canada's interpretation causes interest rate swaps entered into between a Canadian financial institution and its related offshore affiliates to be considered as non-arm's-length transactions for purposes of the FAPI rules. This improperly disadvantages taxpayers where such transactions are no more than tools for managing interest-rate risk arising from the foreign financial institution's third-party business.

Since Revenue Canada has interpreted the Act in a fashion that undermines the legislative intent, will the Department of Finance make necessary technical amendments on a retroactive basis? A retroactive amendment is likely required because the consolidated integration of worldwide treasury operations in financial groups inevitably results in significant levels of on-balance-sheet intragroup assets and liabilities, which under current rules count as non-arm's length.

The submission requests that the Department provide a clarifying amendment to ensure that interest rate swaps are covered by the phrase in subsection 95(2.1) - "agreements that provide for the purchase, sale or exchange of currency."

Finance response: Finance indicated that it was not inclined to recommend an amendment but was in agreement that the intent is that interest-rate swaps would be covered by the existing wording. Accordingly, Finance and Revenue Canada have consulted together on this matter and have agreed that Revenue will interpret the phrase to include both interest rate swaps and currency swaps. [A taxpayer's representative has] since contacted Revenue Canada and a representative of the Legislation & Interpretations Branch has confirmed the desired interpretation. Thus, the problem is solved without the need for an amendment. A written confirmation is forthcoming from Revenue.

B. Request for New

Deeming Rule

In order for the business of a controlled foreign affiliate that earns interest, dividends, or other property-type income to avoid generating FAPI to its Canadian shareholders, an "investment business" of the subsidiary must adhere to certain conditions under subsection 95(1), including a requirement that "throughout the period in the year during which the business was carried on" it be carried on principally with persons with whom the affiliate deals at arm's length. In Interpretation Bulletins IT-290 and IT-371, Revenue Canada ruled that the issue whether a business is carried on principally at arm's length is determined with reference to the revenues and assets of the affiliate.

The arm's-length requirement applies regardless of whether a related party revenue stream or asset position is deemed under subsection 95(2) to be from an active business (subject to an exception for certain qualifying non-arm's-length derivative transactions entered into by a controlled foreign affiliate and a related Canadian financial institution, provided for in subsection 95(2.1) of the Act). Thus, even where the related-party revenue stream or asset position is generated by underlying third-party assets or revenues of the related-party payer, the intra-group position will count as non-arm's length for purposes of the test in the "investment business" definition.

The foreign business of a multinational financial group will often result in the balance sheets of related foreign financial institutions reflecting high levels of intra-group assets and liabilities. For example, the treasury services for a group of related companies operating in a particular foreign jurisdiction or geographic sector will typically be provided by a single (usually the largest) institution within the group. Centralization of the treasury functions permits the group to achieve efficiencies and economies of scale by minimizing the costs for staff and investments in costly trading rooms in every location where financial services are offered to the public. Thus, liquidity arising from, for example, customer deposits at a particular foreign branch will often be loaned to the treasury unit of the corporate operating group business unit.

The need to manage a foreign group's liquidity and interest-rate and currency risks in a centralized manner exposes many of the group's companies to the hazard that their businesses will be deemed to be carried on principally with persons with whom they are not at arm's length. The difficulty is not so much with their related-party asset positions and revenue streams (which will normally give rise to deemed active business income under special rules) as with the income derived directly from third-party borrowers, which may be taxable in Canada as non-excepted investment business income.

As the statute is currently drafted, the arm's-length test must seemingly be met at all times throughout the taxation year of the controlled foreign affiliate. TEI submits that the costs of monitoring compliance with the arm's-length requirement on a continuous basis combined with the likelihood of errors by employees unfamiliar with, or occasionally forgetful of, detailed Canadian tax rules exposes Canadian financial institutions to exacting even unreasonable standards. A simple and elegant solution to this problem would be to deem intra-group assets and revenue streams that generate deemed active business under the various provisions of subsection 95(2) to count as arm's length for purposes of meeting the requirements of an investment business. In order for income to qualify as deemed active business income, it must arise from an active business of a related company, i.e., a business that is carried on principally with persons with whom the affiliate deals at arm's length. If adopted, the requested change would extend the existing policy without penalizing intra-group transactions that relate to the underlying third-party active business of the group.

Finance response: The submission requested a new deeming rule to treat intra-group assets and revenue streams at arm's length in those cases where they are deemed to generate active business income. This would ensure that such assets would not inadvertently tip the balance in favour of a majority of non-arm's length assets or revenues thus causing otherwise qualifying third party income to be treated as FAPI.

Finance is not receptive to an amendment of this type due to a concern that such a new deeming rule might actually convert some truly passive income that should be FAPI into qualifying active business income. It was suggested that an alternative approach that would not carry this risk might consist of ignoring or excluding the intra-group assets and revenues that generate deemed active business income rather than deeming them to be arm's length.

TEI looks forward to exploring this alternative further with Finance perhaps at the May Conference.

Foreign Group of Companies

Subclause 95(2)(a)(ii)(D)(v) requires that the interaffiliate interest payments be relevant for purposes of computing the liability for income taxes of the members of a group of corporations composed of the second affiliate and one or more other foreign affiliates of the taxpayer (the shares of which are excluded property). Most taxpayers and tax professionals interpret subclause (v) as providing that only foreign affiliates whose shares are excluded property are to be considered as part of the group in applying the test in subclause (v). At the 1996 Canadian Tax Foundation's Corporate Management Tax Conference Roundtable, however, representatives from Revenue Canada, in commenting on the application of subclause (v) to interaffiliate payments involving a U. S. consolidated group, said that foreign tax laws determine the composition of the group rather than Canadian tax law. Will the Department of Finance confirm whether the intended meaning for subclause (v) is that only foreign affiliates whose shares are excluded property are to be considered? If the Department agrees with taxpayers' interpretations, will the Department support an amendment to clarify the interpretation?

Finance response: Revenue Canada expressed the view at the 1996 Corporate Management Tax Conference that foreign tax laws will determine the composition of a group of corporations for purposes of subclause 95(2)(a)(ii)(D)(v). Finance agreed that the Revenue Canada interpretation is correct. Apparently, the rationale for this position is that taxpayers filing consolidated returns wanted a passthrough for interest payments between the affiliates. Therefore, since the foreign tax laws determine which corporations qualify for inclusion in consolidated tax returns, the foreign tax laws will apply to determine the group of corporations for purposes of subclause 95(2)(a)(ii)(v).

Stop-loss Rule

-- Subsection 93(2)

Subsection 93(2) of the Act reduces the amount of permitted deduction for a loss arising from the disposition of a share of a foreign affiliate by the amount of any dividends received on the share that are deductible under paragraph 113(a), (b), or (c). In certain cases where the disposition is to an affiliated corporation, any loss on the disposition of the share would be deemed nil by virtue of proposed paragraph 40(3.6)(a) and, under proposed paragraphs 40(3.6)(b) and 53(l)(f.2), the disallowed loss would be added to the adjusted cost base (ACB) of any remaining shares. Where the loss is disallowed by subsection 93(2) rather than subsection 40(3.6), however, there would be no corresponding increase in the ACB of the remaining shares of the foreign affiliate.

There is a notable distinction between the situations to which subsections 93(2) and 112(3) apply. The latter section will apply to a loss on a share of a subsidiary that paid a dividend from earnings realized prior to the parent's acquisition of the subsidiary shares. In such a case, the dividend will not reduce the ACB of the share. In the case of foreign affiliates, however, dividends paid from pre-acquisition surplus automatically reduce the ACB of the shares. In the subsection 93(2) situation, the dividends that are considered are those that have already borne the appropriate foreign tax. It therefore seems appropriate to increase the ACB of other shares where subsection 93(2) applies. TEI recommends that an amendment be introduced to adjust ACB in circumstances where a loss was denied by virtue of subsection 93(2). We invite the Department's comments.

Finance response: The intention is that exempt dividends which Canadian corporations receive from foreign affiliates reduce any subsequent loss on the sale of the shares of the foreign affiliate. The point was raised that subsection 93(2) may not apply to reduce the loss since the subsection refers to the loss as calculated without reference to this subsection. Therefore, if the loss is otherwise reduced to nil by clause 40(3.6)(a), it appears that subsection 93(2) would not apply. Finance disagrees with this analysis, stating that it holds the view that subsection 93(2) will apply before subsection 40(3.6), and that if there is any doubt about this, the subsection will be amended to reflect the correct view.

Pooled Fund Trusts

Section 206 imposes a tax on "foreign property" held by Registered Pension Plans (RPP) in excess of prescribed limits. Except as set forth in regulations, an interest in a trust can be considered to be foreign property. One exception excludes an interest in a pooled fund trust from the definition of foreign property. In order to qualify as a pooled fund trust, at least 80 percent of the trust's assets must consist of shares, bonds, mortgages, marketable securities, life insurance policies in Canada, and certain annuities. Many of the investment pools marketed for investments by RPPs are pooled fund trusts. These funds are fully redeemable at the option of the investor, but are not themselves publicly traded. As a result, the investments are generally not considered to be "marketable" securities. This effectively prevents pooled fund trusts from investing in other pooled fund trusts and limits an RPP's ability to invest in some of the most cost-effective investment options. Is there an objection, from a tax policy standpoint, to the tiering of investments in pooled fund trusts? If so, please explain. If there is no policy impediment, will consideration be given to either amending the definition of pooled fund trusts to include units of other pooled fund trusts within the 80-percent limitation, or to revising the definition of marketable securities so that investments that are fully redeemable at the investor's option will qualify as marketable securities?

Finance response: The proposed change could allow RPPs an additional mechanism to avoid the 20% foreign property limit. Thus, the proposal is not supported by Finance.

RRSP-RPP Integration

The reduction in the maximum contribution limit from $14,500 in 1995 to $13,500 in 1996 has exacerbated a problem faced by executives who change employers and cash out their Registered Pension Plan (RPP). For example, an employee who participates in a defined benefit plan and accumulates three years of service credit with an employer may receive a $10,000 lump-sum payment from the RPP on separation from service with the employer. The executive would be permitted to rollover this amount to a self-administered Registered Retirement Savings Plan (RRSP). Assuming that the maximum contribution that the employee could have made to his RRSP during the three-year employment period was $1,000 per year, the total tax assisted retirement savings permitted for this individual would have been $13,000, i.e., less than the maximum permitted for any one year. By changing employment, the employee has been disadvantaged. Circumstances such as these are encountered too frequently. We recommend that consideration be given to reinstatement of provisions that permit contributions to RRSPs to be "made up" where employees belonging to an RPP cease to be participants.

Finance response: Individuals who change employment may be disadvantaged by cashing out of the RPP. A recommendation was made that consideration be given to reinstatement of provisions that would permit the lost RRSP contribution room to be restored in such situations. Finance responded that the Minister had announced in the 1995 Budget that this problem would be reviewed. A study has been commissioned to survey employers. There is some sympathy at Finance to support such a change.

$24,000 Cap on Automobiles

Regulation 7307 was adopted to restrict the amount and timing of deductions for costs associated with the ownership or leasing of so-called luxury automobiles. Prices for new automobiles, however, have increased significantly since Regulation 7307 was last amended nearly six years ago. Taxpayers now find that even moderately-equipped, mid-sized automobiles generally have a manufacturer's suggested retail price (MSRP) of more than $24,000 and, hence, are subject to the deduction limitations and administrative burdens associated with luxury vehicles (e.g., maintaining a separate Class 10.1 pool for each vehicle). Consequently, the restrictions are limiting deductions for the costs of standard fleet as opposed to "luxury" vehicles. Will the Department clarify the criteria or indicia to determine when adjustments to the amounts specified in Regulation 7307, subsections (1) and (2), will be made? Is it not time to revise the cap again? Will the Department consider revising the rule in order to permit taxpayers to use their actual purchase price (or, in the case of a leased vehicle, the equivalent capitalized lease capital cost) per vehicle in lieu of MSRP a notional amount that (i) does not necessarily reflect economic cost and (ii) is not routinely entered in the taxpayer's accounting for the purchase or lease?

Finance response: Finance advised that a Business Income Tax Division composed of economists prepares a report each fall which recommends whether or not to change the limit. We now know that the limit for 1997 was increased marginally to $25,000. Finance think that the 0.85 factor in the formula in paragraph 67.3(d) is sufficient to deal with the difference that may exist between the list price of a leased vehicle and the capital cost inherent in the lease. There was no commitment to reveal how the recommended limit is determined.

Taxable Benefits

Over the years the audits of taxable fringe benefits have been a source of frustration for both Revenue Canada and taxpayers. This is particularly true in respect of the valuation of non-cash benefits granted as either a length-of-service or safety award. The United States Internal Revenue Code contains pragmatic rules that permit the cost of such awards to be deducted by the employer even as employees are permitted to exclude from income the entire amount of awards falling below specified thresholds. Specifically, where an item of tangible personal property with a cost of less than US$400 is awarded to an employee in recognition of either length of service or for a safety achievement, the employee may exclude the value from income and the employer may deduct the cost. TEI believes that taxpayers (employers as well as employees) and Revenue Canada alike would benefit from reduced compliance and audit burdens with the adoption of similar rules in Canada. Under what conditions would the Department of Finance support a similar rule in Canada?

Finance response: Finance currently does not support a rule in Canada, similar to the US$400 tax exemption for tangible personal property awards which recognize either length of service or safety achievements. The maximum administrative relief continues to be the $100 exemption described in paragraph 9 of IT-4047OR Employee's Fringe Benefits for gifts to employees.

Election for ECE-Related

Inducements

Paragraph 12(1)(x) generally requires an income inclusion for inducements, reimbursements, and payments or benefits of a similar nature. On an elective basis, the recipient can reduce the amount of the income inclusion by reducing the capital cost of depreciable property (pursuant to subsection 13(7.4)) or offsetting outlays and expenses (other than the cost of property) incurred in the year or the year following receipt (pursuant to subsection 12(2.2)). A similar though non-elective provision governs the offsetting of a reimbursement against the cost of an eligible capital expenditure (ECE) (for example, a perpetual technology licence). Under subsection 14(10), however, this latter exclusion applies solely to payments from a public authority and only to reimbursements (not inducements). Would the Department consider modifying and expanding the wording of subsection 14(10) to make it an elective provision and to permit a taxpayer to apply an inducement, reimbursement, or a similar form of assistance from either the public or private sector against the cost of an eligible capital expenditure that relates to the receipt of the inducement or reimbursement?

Finance response: This issue asks for the same treatment for assistance received in relation to the acquisition of ECE as is already provided for assistance related to the acquisition of depreciable property and other capital property. In other words, to permit via an election of the assistance from income and its treatment as a reduction in the unamortized ECE pool.

The Department pointed out that GAAP will operate to treat the assistance as a reduction of the ECE cost where the assistance is very clearly related to the ECE acquired. In such cases, it follows that an election is not required and the offset would be acceptable for tax based on general principles of profit measurement under section 9. At this stage, the Department is reluctant to make a specific amendment -- since that would mean accommodating circumstances where there may not be as close a linkage between the assistance and the ECE asset. The Department is concerned that perhaps too many forms of receipts/assistance could arguably be described as being related to the acquisition of assets as intangible and mushy in their identification as some ECEs (such as goodwill). Accordingly, Finance said, there is a possibility that sums that should otherwise be income would be deferred and amortized over time in the ECE pool. The Department would be very upset if this happened and therefore does not agree with this proposed amendment.

Preferred Dividend Tax

Section 191.2 of the Act sets forth detailed rules for filing elections that affect the rate of tax imposed under Part VI.1 when taxable dividends are paid. An election under section 191.2 must be filed within certain prescribed time periods, which are determined according to the taxation year in which the class of shares is issued or first characterized as a taxable preferred share. The time limits permit the election to be filed within six months after various stages of the appeals process for assessments with respect to that year In some cases, however, no dividends will be paid during the taxation year during which the shares are first issued or are first deemed to be taxable preferred shares; hence, the first assessment of Part VI.1 and Part IV.1 tax with respect to dividendson the shares will be imposed in a subsequent year.

Where the taxpayer is uncertain about the status of the shares as taxable preferred shares, it faces a dilemma in respect of a section 191.2 election because the election cannot be filed (and would be unnecessary) if the shares are not taxable preferred shares. Would the Department consider amending paragraph 191.2(l)(a) to read "not later than ... the taxation year in which dividends are first paid on that class of shares, or shares of that class are first issued or first become taxable preferred shares; or"? The proposed change would permit a taxpayer to make its election after a final determination is made that the shares are indeed taxable preferred shares.

Finance response and discussion: The Department believed the suggested wording changes may be somewhat limited; the wording must be expanded to consider other equally deserving situations (e.g., where dividends were paid in prior years, but total dividends in those earlier years was below the issuer's dividend allowance.) The Department, in theory, generally agrees that the current wording may be restrictive but believes the taxpayer has a certain responsibility to determine what the status of the shares may be at time of issue -- and be prepared to accept changes with certain modification. The Department questioned when this section would become a particular problem; TEI indicated it was a particular problem with new issues at the end of a year. The Department questioned whether this problem was a significant issue or just something that would be "nice" to have; TEI indicated it did not believe it was a significant issue and agreed to the Department's suggestion to put it at the "bottom of the list" of priorities.

Subsection 87(11)

Draft subsection 87(11) introduced on June 20, 1996, will permit a bump of the cost of non-depreciable capital property following the amalgamation of a parent company and one or more of its wholly-owned subsidiary corporations. The result is similar to the so-called "88(1)(d)" bump. There is, however, a significant difference in that draft subsection 87(11) will only apply where the parent company owns all the issued share capital of the subsidiary (except for director's qualifying shares). The bump under paragraph 88(l)(d) is permitted where the parent company owns 90 percent of the issued shares of each class of the capital stock of the subsidiary.

TEI believes that requiring the ownership of 100 percent of the capital stock of a subsidiary is an unduly restrictive condition. Being able to combine corporations through an amalgamation rather than by way of a subsidiary wind-up is very often desirable for business reasons since the procedures are far simpler and the transaction much less expensive to consummate. Accordingly, would the Department consider amending draft subsection 87(11) to permit the bump where the 90-percent ownership threshold -- similar to section 88 -- is met? If not, will the Department please explain the policy rationale for differentiating between these two transactions that engender identical tax results.

Finance response: Finance indicated that they had provided what had been requested. While they were willing to discuss aligning the sections, they wondered whether this item had a particularly high priority with TEI given the other matters requested. TEI acknowledged that this was a fair comment.

Paragraph 85(l)(e.2) Issues

A. Cross-Ownership

of Subsidiaries

Consider the following situation. Company A owns 75 percent of the issued and outstanding share capital of Company B and 80 percent of the issued and outstanding share capital of Company C. Company C owns the remaining 25 percent of the share capital of Company B. Company B owns the remaining 20 percent of the issued and outstanding share capital of Company C.

Company A transfers to Company B a capital property in exchange for Company B common shares. The fair market value of the capital property of $1 million significantly exceeds the ACB of $100. Company A and B intend that the property be transferred at fair value. Hence, a valuation of Company B is undertaken to determine the proper number of shares to issue to A in the exchange. Moreover, the asset transfer agreement between A and B includes a provision requiring an adjustment of the number of shares to be issued to A should the fair value of the contributed property vary significantly (up or down) from the appraised value determined by A and B. Company A and B jointly elect to have the provisions of subsection 85(1) of the Act apply to the transfer. The agreed amount of the joint election is the adjusted cost base of the property at the time of the transfer.

Please comment on the following questions concerning the transaction: 1. Does the Department of Finance consider Company B to be a "wholly-owned corporation" of Company A so that paragraph 85(1)(e.2) will not apply? If not, what is the policy rationale that underlies the Department's position? 2. Would the Department consider expanding the definition of a "wholly-owned corporation" to include corporations with circular cross-ownership as described?

B. Different Parties Hold

Common and Preferred

Consider a different situation. Company A and Company B are both large, public companies. Company A owns 100 percent of the voting common shares of Company B. Company B also has a class of non-voting, fixed return, preferred shares held entirely by third-party shareholders. Company B is financially solvent and capable of discharging its obligation to the preferred shareholders.

Company A transfers to Company B a capital property in exchange for Company B common shares. The fair market value of the capital property of $1 million significantly exceeds the adjusted cost base of $100. Company A and B intend that the property be transferred at fair value. Hence, a valuation of Company B is undertaken to determine the proper number of shares to issue to A in the exchange. In addition, a valuation of the capital property is undertaken as well. Company A and B jointly elect to have the provisions of subsection 85(l) of the Act apply to the transfer. The agreed amount of the joint election is the ACB of the property at the time of the transfer. Since Company B is not a "wholly-owned corporation" of Company A within the meaning of subsection 85(1.3) of the Act, and even though reasonable effort has been made to ensure that no benefit is conferred on a related person by establishing a fair value for the transferred property, there is no certainty that Revenue Canada will not apply paragraph 85(1)(e.2) to the transfer. Moreover, since the preferred shares are non-voting and have a fixed return, any benefit accruing from the transfer of the capital property will accrue to Company B directly and Company A indirectly. Consequently, the result is arguably no different from where Company A owns 100 percent of the shares of Company B.

Please comment on the following questions concerning the transaction:

1. Would the Department consider expanding the definition of "wholly-owned corporation" in subsection 85(1.3) to include a situation similar to that described, i.e., where 100 percent of the voting and fully-participating common is held by one corporation and fixed-return preferred shares are held by arm's-length parties?

2. If the answer to question 1 is no, please explain the policy rationale for the Department's position.

Finance response: The definition of a "wholly owned corporation" in subsection 85(l.3) was intended to be very narrow. Subsection 85(1)(e.2) could apply in both situations, as the transferee would not be a wholly owned corporation of the transferor. Finance expressed the view that broadening the definition of "wholly owned corporation" would require extensive legislative change, and that taxpayers should be satisfied to protect themselves from uncertainties with price adjustment clauses and other similar mechanisms. There is no plan to broaden the definition.

Large Corporation Tax -- Hedged

Debt

Section 3860 of the Canadian Institute of Chartered Accountants (CICA) Handbook summarizes the financial statement presentation and disclosure for financial instruments, including corporate debt denominated in a foreign currency that is hedged or otherwise combined with a foreign currency swap or forward contract. The net result of the guidance in the Handbook (subsection 3860.34, paragraph 3860.41(a), subsection 3860.09, and paragraphs 3860.05(a), (b), and (c)) is that, where there is no legal right of offset, foreign denominated debt must, for fiscal years beginning on or after January 1, 1996, be translated at the foreign exchange rate in effect as at the date of the balance sheet. In addition, the "net principal value' of the currency swap or forward contract must be reflected as an asset or liability (referred to below as a "hedge asset" or "hedge liability) at the presentation date. Prior to 1996, the net principal value of the foreign currency swap or forward contract was netted against (or combined with) the debt.

Example 1 illustrates the financial statement presentation under the new rules.

Under the rules that were in effect until 1995, the financial statements would have reflected a net debt of $130 M every year. We posed the following question to Revenue Canada: What is Revenue Canada's position on the treatment of the amounts presented as a hedge asset and a hedge liability in the example above for the purpose of computing taxable capital under section 181.2 of the Act?

Assuming that the answer from Revenue Canada results in a different treatment from what would have applied prior to 1996, will the Department of Finance introduce an amendment applicable to taxation years commencing on or after January 1, 1996, in order to take into account the hedge asset and hedge liability in the calculation of taxable capital?

Finance response: Finance agrees that it is counter-intuitive that hedging activity designed to remove a market exposure should result in a change in the amount of taxable capital arising from a borrowing. The Department's response to the situation will depend on the finalization of certain changes to Handbook recommendations, which the Department understands that the CICA is currently considering.

Eliminate Requirement to

Issue T5s to Corporations

Regulation 201 requires T5 slips to be filed by all persons making payments to residents of Canada, including corporations, as, or on account of a dividend, interest, or royalty. The T5 information return must be prepared on the basis of cash payments made during a calendar-year reporting period. In as much as the calendar-year information reporting period often does not coincide with the fiscal year end of corporate recipients, and inasmuch as corporate taxpayers are required to report taxable income based on amounts accrued rather than cash amounts received, the T5 slips are used neither to record a corporate recipient's income nor to prepare the corporate income tax return. Moreover, Revenue Canada auditors rarely, if ever, resort to the information reported on T5s as a basis for auditing corporate tax returns, even for calendar-year taxpayers. In our view, the requirement to issue T5 slips to corporations is an unnecessary reporting burden. Has consideration been given to amending Regulation 201 to eliminate the requirement to file information returns with respect to payments made to corporations? We believe that such a revision would significantly reduce the compliance costs for issuers as well as the storage and handling costs for the recipients. We urge the Department to consider making the change.

Finance response: Regulation 201 requires that T5 slips be distributed by all persons making payments of interest, dividends and royalty to residents of Canada. Amounts reported on these T5 slips must be computed on a cash basis for each calendar year. Given that corporations must report income on an accrual basis for their fiscal period, there is little relevance of the information reported on the T5 slip to the income inclusion by the corporation on its tax return. As a result, TEI recommended the elimination of the requirement to complete the T5 information slip when the recipient is a corporation.

The Department of Finance indicated that consultations on the subject with Revenue Canada indicated that T5 slips are useful in the income tax audit process and suggested that TEI discuss the matter directly with Revenue Canada, to determine if T5 information slips can be replaced by electronic data files.

Conclusion

The meeting adjourned.

Example 1

On January 1, 1996, Canco issues a US$100 M denominated debt when the exchange rate is Us$l = CAN$1.30. The debt matures on January 1, 1999. On the same date, Canco enters a currency swap transaction ("the hedge") under which it agrees to exchange its US$100 M liability for a CAN$130 M liability to be reexchanged on the maturity date.

1. On December 31, 1996, the exchange rate is Us$l = CAN$1.40.
The financial statement presentation at that date is:

   Asset                      Liability
   Hedge asset        $10 M   Debt        $140 M
2. On December 31, 1997, the exchange rate US$1 = CAN$1.20.
   The financial statement presentation at that date is:

   Asset   Liability
           Debt              $120 M
           Hedge liability    $10 M
3. On December 31, 1998, the exchange rate is US$l = CAN $1.30.
The financial statement presentation at that date is:

Asset   Liability
        Debt        $130 M