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Canadian foreign affiliate draft legislation.

On November 21, 1994, Tax Executives Institute filed the following comments with the Canadian Department of Finance in respect of the draft legislation concerning foreign affiliates. TEI's comments were prepared under the aegis of its Canadian Income Tax Committee, whose chair is John J. Marczynski of Abitibi-Price Inc. Contributing substantially to the development of TEI's comments was Hugh D. Berwick of Alcan Aluminium, Ltd.

Tax Executives Institute, Inc. is pleased to submit the following comments to the Department of Finance in respect of the February 22, 1994, budget proposals and the June 23, 1994, draft amendments to Canada's Income Tax Act relating to the taxation of foreign affiliates.

I. Background

The Institute is an international organization of approximately 5,000 professionals who are responsible--in an executive, administrative, or managerial capacity--for the tax affairs of the corporations and other businesses by which they are employed. TEI's members represent more than 2,800 of the leading corporations in Canada and the United States.

Canadians make up approximately 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. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

TEI has historically been concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as in an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government.

Among TEI's principal objectives are the gathering and dissemination of information on tax issues of wide concern and the development of responsible positions that reflect not only the diversity and professional training of our members but also an appreciation for the practical aspects of tax administration and business decisions. In addition, we strongly believe that tax legislation should be fully consistent with the goals of economic growth, clarity, and competitiveness.

II. Comments on Foreign Affiliate Proposals

A. Effective Date

The draft amendments to the Income Tax Act relating to foreign affiliates are generally proposed to be effective as of the end of the current taxation year (December 31, 1994, for calendar-year taxpayers). The proposed amendments are dauntingly complex and will prove difficult to understand and difficult to comply with. In addition, the proposed amendments will have substantial effects on ordinary day-to-day operating and investment decisions of multinational groups--effects entirely unrelated to the tax policy concerns motivating the adoption of the proposed amendments. As a result, companies will be compelled to reconsider their current methods of financing affiliate operations, sourcing inventory supplies for foreign purchasing and sales distribution companies, and insuring foreign operations generally. Indeed, the proposals will so profoundly affect the manner in which large, multinational groups conduct business that many will substantially restructure their business operations to mitigate their harsh and unintended effects.

For the foregoing reasons, we recommend that the effective date of the foreign affiliate legislation be delayed, at a minimum, for one year to permit taxpayers to comprehend its scope, and, if prudent, restructure their operations to avoid the unintended operating and administrative costs imposed by the legislation. The delay will also permit the Department to consider the comments of TEI and other interested parties on the various provisions.

B. Subsection 95(1): Definition of Income from an Active Business

The definition of income from an active business in the draft legislation includes income incident to the business but generally excludes income arising from property. Interpreted literally, any income from property of a company--including, for example, interest income from ordinary working-capital bank accounts--will be excluded from the protection of the active business income definition--even though the interest income is clearly incident to temporary investments and funding for that active business.

To comport better with the purposes of the foreign affiliate legislation, we recommend that the definition be modified to read, as follows:

Income from an active busi-

ness of a foreign affiliate of a

taxpayer for a taxation year

means the income of the af-

filiate for the year from an

active business of the affili-

ate. Active business income

shall not include income from

property except, and only to

the extent that, the income

pertains to, or is incident to,

the active business of the af-


C. Subsection 95(1): Definition of Investment Business

1. The "Only" and "Principal Business" Tests

Subparagraph 95(1)(a)(i) sets forth an important exception to the definition of "investment business," permitting certain types of activities ordinarily attributed to investment activities to be deemed from an active business. The exception, however, includes a significant restriction: a foreign affiliate's business income must consist only of income from one of the statutorily enumerated categories. In a similar vein, subparagraph 95(1)(a)(ii) sets forth another exception to "investment business," but includes a parallel restriction that an affiliate's principal business must be one or more of the statutorily enumerated businesses.

The requirement that the income be from either the only or principal business of an affiliate in order to qualify for the investment business exceptions will discourage multinational groups from reducing the number of foreign affiliates, despite the groups' desires to right-size corporate structures and reduce substantial administrative costs. This is because the statutory restrictions practically require companies to establish separate financing subsidiaries in order to avoid the characterization of income arising from financing foreign affiliate customers as an investment business. Limiting the investment business exceptions to affiliates whose sole or principal business activity consists of financing customers' purchases (from, say, a separate trading company within the same or a different country) hence places an undue and unnecessary premium on incorporating the customer financing activities in a separate legal entity apart from the trading business. We submit that no sound tax policy impels the elevation of form (separate incorporation of a customer financing business) over the substance (separate trading and financing divisions) of foreign affiliates' business activities in these circumstances. To reduce needless comptiance and administrative costs for taxpayers--and to achieve a concomitant reduction in the burden on the minister's agents to audit numerous foreign affiliate legal entities--we recommend that the references to "only business" and "principal business" in subparagraphs (a)(i) and (ii), respectively, be eliminated.

2. More Than Five Full-Time Employees Test

One exception to the definition of "investment business" in subsection 95(1) includes a requirement that the foreign affiliate employ more than five persons whose full-time duties are devoted to the active conduct of the business. Some corporate groups have found that it is more efficient, in certain circumstances, to employ a management and service company within the group to perform certain duties and services for the companies in the group. In other cases, companies have contracted with third-party management and service companies to perform certain necessary functions. In addition, in order to minimize exposure to ordinary commercial liabilities, customary trade practice in many industries (especially the real estate industry) is to incorporate individual buildings and properties in separate corporate shells. Regrettably, draft paragraph (b) of the definition of "investment business" does not take proper account of any of these commercial realities.

What is more, subsection 125(7) of the Income Tax Act already sets forth a definition of "specified investment business" that includes a separate "more than five full-time employees" test. To reduce confusion (by permitting court and advance ruling interpretations of the "more than 5 full time employee" test to be consistent across the Income Tax Act), definitions of the same term in different parts of the Income Tax Act should be uniform. As a result, TEI recommends that the legislation be amended to incorporate by reference subsection 125(7)'s extant "more than five full time employees" test in the definition of "investment business." In addition, the Department should consider modifying the definitions to permit groups that contract with third-parties to perform the required work to meet the active business purpose of the test. Finally, the legislatin should provide an exception where a foreign affiliate, together with related companies carrying on the same or similar business in the same country, employs more than five full-time employees.

D. Subparagraph 95(2)(a)(i): Portfolio Income of a Captive Insurance


The technical notes to the draft amendments include an example explaining the application of the foreign accrual property income (FAPI) rules to a captive insurance company. In the example, the captive earns $150 of portfolio income on the foreign business net premiums and capital. The example states that the $150 will not be included in the FAPI of the foreign affiliate to the extent that proposed subparagraph 95(2)(a)(i) applies. Without clarification, however, it is difficult to reconcile the language of subparagraph 95(2)(a)(i) with the result in the example that the $150 of income is rendered active. In our view, the portfolio activities of the captive insurance company should not be attributed to the active business of another foreign affiliate.

TEI recognizes that, in proposing the draft amendments, the Department may have been concerned that some captive insurance companies are capitalized in excess of what is strictly necessary to conduct the offshore insurance activities and are thereby improperly sheltering investment income. If this concern is valid, we recommend that it be addressed directly rather than indirectly by deleting the terms "insurance premiums," "insurance corporation," and "insurance of risks" from the definition of "investment business," and by adding a specific paragraph to subsection 95(2) to treat investment income arising from excess capital as income from a business other the active conduct of an insurance business.(1)

E. Subparagraphs 95(2)(a)(i) & (ii): Use of the Term "Related"

Under the draft legislation released in June, income must be derived from or through a "related" foreign affiliate or nonresident company to qualify as active income to the recipient of the income. We believe this represents a drastic change from the February Budget proposals. More important, the draft amendments will adversely and unnecessarily restrict the provision of insurance to, and financing of, many foreign joint ventures where there are independent, arm's-length co-venturers. Specifically, where (i) as a result of arm's-length negotiations, one party holds a substantial, though less than 50 percent, interest in a foreign affiliate or (ii) a joint venture is organized in a country where local law prohibits a foreign company from owning a majority of the shares of an affiliate (e.g., natural resource companies), a Canadian-based joint venturer will be precluded from providing financing or insurance without being ensnared by the draft rule. Moreover, the draft rule will apply to existing, as well as future, joint venture arrangements.

The related company test should be designed to ensure that the foreign affiliate's payments qualify for active income treatment to the recipient where (i) the payor-affiliate's income is primarily from active sources of business income and (ii) a minimum quantum of ownership of the foreign affiliate exists within the recipient Canadian group. With respect to the latter requirement, we believe that present subsection 95(6) provides the Department with the proper indicia of ownership to measure whether payments from related parties constitute active business income. In the event that the Department believes that a separate test is necessary for purposes of the foreign affiliate rules, the ownership requirements should be modified to reduce the threshold ownership requirement for the "look through" treatment to ten percent of share value and ten percent of the share voting control. The combined ten-percent "vote" and "value" tests will ensure that there is a sufficient nexus between the foreign affiliate and the Canadian group.(2)

F. Subclause 95(2)(a)(ii)(B): Excluded Property Requirement

This subclause contains a test that excludes from the scope of the draft rules certain foreign affiliates whose shares constitute "excluded property." The subclause seemingly requires that shares of the foreign affiliate be "excluded property" at all times throughout the taxable year. While this requirement may seem facially reasonable, it will be practically impossible for taxpayers to prove that shares were at all times "excluded property." For example, immediately following the receipt of a dividend or other significant cash distribution, the shares of a foreign affiliate may be temporarily disqualified from "excluded property" status. To address this problem, we recommend that the word "generally" be inserted before the phrase "throughout the year excluded property."

G. Subclause 95(2)(a)(ii)(A): Grammar

This subclause could be read to apply only where the nonresident corporation is not a foreign affiliate. The concern arises from the wording of the phrase "...if the foreign affiliate was a foreign affiliate..." (emphasis added). Some commentators have expressed the view that the phrasing amounts to a hypothetical condition and that the clause as a whole will apply only when the nonresident corporation is not a foreign affiliate. This clearly is not the intended result as illustrated by example 1 in the Technical Notes. Other commentators have said that the condition is a factual condition precedent because the subjunctive mood is not used. Should the intended relationship indeed be a factual prerequisite, the phrase should be stated in the present tense (rather than the past) to be consistent with the correlative phrase "a nonresident corporation to which the particular affiliate is related." We recommend that the subclause be clarified by changing was to is.

H. Paragraphs 95(2)(a.1), (a.2), and (a.3): Meaning (or Translation) of

the Term "Gross Income"

In paragraphs 95(2)(a.1) and (a.3), the 90-percent test refers, in the French text, to "90 percent du revenu brut" and in paragraph 95(2)(a.2), the test refers to "90 percent du revenu tire des primes." The English version of the comparable provisions refer, however, to "gross income" and "gross premium income" (emphasis added).

We wonder whether the English version is a mistranslation of a French text? Otherwise, the term "gross income" introduces a new concept--the meaning of which is unclear. We recommend that the English version be corrected to refer to "90 percent of the gross revenue" and "90 percent of the gross premium revenue" respectively. Alternatively, if the Department intends that the phrase "gross premium income" refer to gross premium revenues less the costs of reinsurance premiums, the statute should be clarified to eliminate the existing ambiguity.

I. Paragraph 95(2)(a.1): Meaning of "Agency"

Proposed paragraph 95(2)(a.1) would include as income from the sale of property a foreign affiliate's commission income earned as an agent in respect of the purchase or sale of property. The parenthetical exception in subparagraph 95(2)(a.1)(i), however, does not take into account property that was subsequently sold to nonresidents through the services of the foreign affiliate as an agent. TEI believes that the relief provided in the parenthetical exception in subparagraph 95(2)(a.1)(i) should be expanded to include property that was sold to a non-resident through the activities of the foreign affiliate as an agent as well as property purchased by the foreign affiliate and resold to a nonresident.

J. Subparagraph 95(2)(a.1) (ii): Definition of "Relevant Country,"

"Country in Which Business is Principally Carried On"

1. For sales income to be deemed active, draft subparagraph 95(2)(a.1)(ii) requires that the income arise from property manufactured, produced, grown, extracted, or processed in the country under whose laws the affiliate was formed or organized. The current foreign affiliate regulations recognize that the country of incorporation is irrelevant in determining whether active business income is taxable or exempt. We believe that the current rule should be retained and the proposed grafting of "a country of incorporation" test in subparagraph 95(2)(a.1)(ii) be deleted.

2. Proposed subparagraph 95(2)(a.1)(ii) also requires that, in order for income from the sale of property to be classified as active business income, the property must be "Manufactured, produced, [etc.] the country ... in which the affiliate's business is principally carried on." Many foreign affiliates use branches to conduct business in one or more other countries. In an era where minimizing administrative costs is paramount to maintaining international competitiveness, TEI believes that there will be a stronger move to branch operations wherever possible. The result, however, for foreign affiliates carrying on otherwise active business sales from branches in more than one country will be to create FAPI.

TEI urges the Department to consider redrafting subparagraph 95(2)(a.1)(ii) to refer to "a country in which the affiliate's business is carried on."

K. Hedging and Excluded Property

The Department is reportedly aware of a serious glitch in the new foreign affiliate rules, namely, a rule characterizing as FAPI the hedging gain or loss realized on the disposal of excluded property. TEI believes that hedging gain or loss should be categorized consistently with the corresponding (and offsetting) loss or gain arising from disposition of the hedged property or position. As a result, gain or loss arising from hedges of excluded property should be characterized consistently with the corresponding (and offsetting) loss or gain from dispositions of excluded property. TEI urges the Department to correct this unintended result and exempt from the FAPI rules the hedging gain or loss from hedges of excluded property.

L. Regulation 5907(1)(b)(iv) (B)(III)

Interest income deemed to be paid from an active business is, under regulation 5907(1)(b)(iv)(B)(III), added to exempt earnings as long as "the second affiliate and the third affiliate and each other corporation relevant for the purpose of determining whether the shares of the third affiliate are excluded property" are resident in a designated treaty country. Should a small investment exist in a company resident in a non-treaty country, the entire transaction may be deemed offside. TEI recommends that the requirement that "each other corporation" be resident in a designated treaty country be amended to require that a certain percentage of the shares (say, 90 percent) of "the aggregate value of the shares of all such corporations" be shares of corporations resident in a designated treaty country.

III. Conclusion

TEI is pleased to have the opportunity to present its views on the draft amendments affecting the taxation of foreign affiliates. Should you have any questions on our comments, please call either C. Graham Kennedy, TEI's Vice President for Canadian Affairs, at (604) 661-8549 or John J. Marczynski, Chair of our Canadian Income Tax Committee, at (416) 369-6821.

(1)We refrain from supplying a further definition of "excess capital" because the amount of capital necessary for the insurance business is dependent upon the type of insurance offered, the specific risks underwritten, and the level of reinsurance sought by the company or available in the insurance market. As a result, the facts and circumstances of the captive insurance companies should determine, in part, whether the capital is excessive.

(2)Grandfathering present joint-venture structures, by itself, will be inadequate. Hence, the rules should be amended to not inhibit the forms of ownership structures that Canadian taxpayers may employ in structuring investments in foreign enterprises--especially in countries with restrictions on the level of foreign ownership.
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Title Annotation:Tax Executives Institute
Publication:Tax Executive
Date:Nov 1, 1994
Previous Article:Provincial sales tax and GST harmonization.
Next Article:A Lawyer's Life Deep in the Heart of Taxes.

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