Canadian pre-budget consultations.
Tax Executives Institute (TEI) commends the Standing Committee for holding pre-budget consultations again this year. The consultations provide an important avenue for the Committee to gather input from across the country. TEI is pleased to offer its recommendations to foster economic growth and job creation, promote a favourable business environment for investments in Canada, and ensure a high level of innovation and productivity. We believe the implementation of our recommendations will spur economic efficiency, improve tax administration, and enhance the competitiveness of Canada's business tax system.
Tax Executives Institute is the preeminent association of business tax professionals. TEI's 6,200 members work for 2,800 of the largest companies in Canada, the United States, Europe, and Asia. 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 Montreal, Toronto, Calgary, and Vancouver. In addition, many non-Canadian members work for companies with substantial Canadian operations, investments, and employees.
Summary of Recommendations
The Institute urges the Standing Committee to adopt the following recommendations in its next budget:
* Review the competitiveness of the Canadian corporate income tax structure, especially the tax rates, and encourage the provinces to follow suit with a review of their income, capital, and sales tax regimes; encourage the provinces to harmonize their sales tax systems with the GST, as well.
* Abandon altogether or substantially narrow the Reasonable Expectation of Profit (REOP) test included in draft legislation clarifying the deductibility of interest and other expenses.
* 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.
* Abandon 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.
* Implement a corporate loss transfer system or group loss relief mechanism.
Corporate Income Tax Rate Reductions, Elimination of the Surtax and Large Corporation Tax.
In budget legislation announced last May, the Government introduced proposals to (1) reduce the corporate income tax rate from 21 percent to 19 percent over a period of years through 2010 and (2) eliminate the corporate surtax by 2008. TEI commends the Government for implementing these measures because business tax reductions increase the attractiveness of Canada for both foreign and domestic investors. (1) Increased capital investment in Canada, in turn, spurs productivity, promotes employment, and enhances the prospects for sustainable economic growth. The implementation of the phased corporate income tax rate reductions and the elimination of the corporate surtax send a strong signal to the capital markets about the Government's commitment to maintaining and enhancing the competitiveness of the Canadian business tax system. Moreover, since the LCT is a job-killing tax on capital, the acceleration of its demise to January 1, 2006, has already improved the competitiveness of the Canadian business tax system.
Finance Minister James Flaherty said recently, "[Canada] must establish a meaningful, marginal effective tax rate advantage ... one that goes beyond the statutory tax rate itself and takes the overall impact of the business tax system on investment decisions into account." TEI concurs and notes that a recent study questions the competitiveness of Canada's business tax system, (2) calling for additional tax rate reductions by 2010. As a result, TEI recommends that the Standing Committee continue to review and monitor the competitiveness of the Canadian corporate income tax system, especially corporate tax rates, to ensure that Canada remains an attractive environment for business investments.
In addition, we recommend that the Standing Committee encourage the provincial governments to review their corporate income, sales, and capital tax systems and make corresponding rate reductions and tax base changes to ensure the competitiveness of Canada's tax environment. Finance Minister Flaherty observed recently that "Canada stands out as one of four OECD countries that still impose capital taxes and one of three that impose retail sales taxes on investment. If provincial governments eliminated these taxes and harmonized their sales taxes with the GST, Canada would actually have the lowest marginal effective tax rate among G7 nations." Tax Executives Institute has long supported elimination of capital taxes and the harmonization of the provincial and federal sales tax systems. (3) In order to be fully effective, harmonization of the federal and provincial sales tax systems would likely require that financial services be treated as zero-rated supplies by the provinces, just as they are treated under the Quebec sales tax regime. There are, of course, a number of technical and administrative issues that need to be addressed to achieve harmonization, and TEI would be pleased to submit additional comments to the Committee, the Department of Finance, and the provincial governments about crafting a workable, harmonized system.
Draft of Proposed Legislation Relating to Interest Deductibility and Other Expenses--Abandon the Statutory Reasonable Expectation of Profit Test
In October 2003, the Department of Finance released draft amendments that would add section 3.1 to the Act for the purpose of clarifying that (1) "income" for purposes of the Act is "net" income, in accordance with the generally accepted understanding of the Act before the Supreme Court of Canada's decision in Ludco Enterprises Ltd. v. Canada, (4) 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.
Although the Department's goals are supportable in principle, the proposed limits on losses are far broader than necessary. 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 to ensure their deductibility raises a number of administrative and policy concerns. Specifically, the proposed changes go substantially beyond restoring the Act to the pre- Ludco status quo and would modify the longstanding treatment of interest and other commercial expenses that taxpayers and Canada Revenue Agency (CRA) have long considered fully deductible. For example, interest on borrowings to support investments in common shares of most companies would likely be disallowed, much to the surprise of most Canadian shareholders. TEI believes the Supreme Court of Canada's decision in the Stewart (5) case enunciates a clear and rational tax policy basis for distinguishing commercial, for-profit activities from personal and hobby-related expenditures.
Because the proposed legislation is broader than necessary to achieve the Department's goals, it poses a significant risk of confusing taxpayers and CRA auditors alike. (6) Moreover, the interaction of the REOP test with the source rule would impose an expensive and time-consuming burden on large commercial enterprises to trace expenditures to particular sources. (7) In addition, many overhead expenses incurred to comply with legal requirements or to provide management oversight may not be easily or directly traceable to a source and, thus, may not be deductible. As important, the "cumulative profit" prong of the REOP test ignores how business decisions are made. (8) In deciding whether to make an outlay, the key is whether the planned expenditure increases cash inflows or minimizes cash outflows. A "cumulative profit" is, of course, desired for any investment, but the recovery of past investments or expenditures incurred for the project or purpose (i.e., the recovery of cumulative sunk costs) is not considered when deciding whether to make a new, incremental payment or investment. (9) In addition, t he proposed legislation's requirement of an annual evaluation of the prospect of a cumulative profit potentially penalizes high-risk, entrepreneurial activity as well as the misfortune of adverse business results or unanticipated changes in facts and circumstances. Finally, hindsight might be employed (i.e., consideration given to subsequent facts and circumstances not reasonably known by the taxpayer at the time of an investment) to second-guess a taxpayer's determination whether there is a "reasonable expectation of profit."
TEI submits that the disallowance of a business loss under any of the foregoing circumstances would be at odds with taxpayers' expectations under the Act and may also be at odds with the Department of Finance's intent. In The Budget Plan 2005, the Department of Finance acknowledged the concerns about the overbreadth of the REOP legislation and said that it will develop "a more modest legislative initiative that would respond to those concerns while still achieving the Government's objectives." (10) In the interim, we urge the Standing Committee to recommend that the statutory REOP test be abandoned and that the revised legislative proposal be substantially narrowed and limited in scope.
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. Thus, we are disappointed that negotiations on the Canada--U.S. treaty fall short of the goal.
Studies, such as one by the C.D. Howe Institute, (11) have shown a strong link between the elimination of withholding taxes on dividends and interest and increased foreign direct investment. The C.D. Howe Institute's study predicted 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 C.D. Howe Institute's study also categorized 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 especially resonate in respect of Canada-U.S. policy because the United 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. Since the Canada-U.S. Protocol was negotiated in 1995, the United States has 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, and 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 withholding taxes following approval and implementation of the revised treaty.
TEI believes 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. Hence, we urge the Standing Committee to recommend that the Department of Finance expeditiously negotiate and implement a new protocol with the United States that eliminates withholding taxes on all dividends and interest for payments to both related and unrelated parties.
Draft of Proposed Legislation in Respect of Foreign Investment Entities and Non-Resident Trusts
Through the interaction of complex, overlapping rules, Canada's current foreign affiliate regime balances multiple, competing policy goals and is consistent with the Government's foremost objective of fostering the international competitiveness of Canadian businesses. As a result, Canada has become a more attractive environment for foreign and domestic investments.
TEI is concerned that proposed legislation to implement a new regime for taxing Foreign Investment Entities (FIEs) and Non-Resident Trusts (NRTs) would upset the careful policy balance that has been struck by the current foreign affiliate rules. The proposed FIE and NRT legislation was originally released in June 2000 and has been revised four times since. The most recent revisions were announced in July 2005.
TEI fully supports the Department of Finance's efforts to strengthen the integrity of the tax system while ensuring that amendments to the Act are targeted, sustainable, and administrable. We regret, however, that, despite the incorporation of many helpful changes since 2000, the proposed legislation remains overbroad, extraordinarily complex, and confusing.
Fundamentally, we believe the draft legislation is unworkable and reiterate our recommendation that it be withdrawn because it:
* would apply to numerous, compliant taxpayers that are not attempting to avoid Canadian tax by "transferring funds to offshore trusts or accounts."
* is overbroad, overlaps section 17, applies to many legitimate commercial transactions, and potentially applies to organizations that likely are not targeted by the proposed legislation. (13)
* impedes foreign investment by Canadian companies and impairs their global competitiveness.
* would impose myriad compliance and reporting requirements (as well as create relieving provisions and elections) where the information necessary to comply and report (or to take advantage 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, the taxpayer is a minority investor and lacks sufficient control of the entity to enable the taxpayer to obtain the requisite information.
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, any more than taxpayers, have the resources to properly administer these rules.
Finally, taxpayers are suffering from "draft legislation fatigue" with respect to the proposed rules. The multiple revisions have succeeded in confusing taxpayers about the likely scope and operation of the "final" legislation. Given its mind-numbing complexity (and the myriad revisions to the draft legislation), taxpayers will also need time to digest and understand the legislation and, after determining whether the information is available and obtainable, modify company information systems to capture and report the additional required information. Thus, the proposed January 1, 2003, coming-into-force date for the legislation is unreasonable. In order to give compliant taxpayers the opportunity to understand the provisions and ensure that their legitimate business operations are not inadvertently caught by this legislation, the coming-into-force date should be no earlier than taxation years beginning after December 31, 2006.
Implement a Loss Transfer System or Group Loss Relief Mechanism
In comparing the competitiveness of the Canadian tax system with other jurisdictions, the Government has focused on aligning Canada's tax rate structure and capital recovery provisions with other countries' rules. To fully assess the competitiveness of the Canadian tax system and its relative tax burden, the Government should take a broader view and consider all aspects of the tax system. Specifically, TEI believes the Canadian system for tax loss utilization within corporate groups is far too restrictive, subject to significant administrative uncertainty, and imposes unnecessary costs on taxpayers seeking to avail themselves of CRA's administrative concessions. (14
Companies frequently establish multiple entities within a corporate group in order to manage their businesses better and more efficiently. A loss-transfer system helps to minimize the tax inefficiency of multi-entity corporate structures by permitting the expenses and net losses of one or more entities within the group to offset the taxable profits of other members of a corporate group. Without a loss transfer system, the corporate group is subject to a higher overall tax burden because the losses are otherwise trapped in unprofitable entities. In today's competitive global environment, where investment capital and labour are highly mobile, TEI submits that the goal of achieving a tax-efficient corporate structure should not be at odds with a management-efficient or business-driven corporate structure.
The Government eliminated the previous loss consolidation system in 1952 and a policy debate, which continues to this day, ensued about developing and implementing a replacement system. In 1985, the Department of Finance joined the debate by proposing a system to allow transfers of losses between subsidiaries and their parents or between subsidiaries within a group. We believe the time for debate has ended and the time for action has come. To be globally competitive, Canada should implement a formal Loss-Transfer System--or otherwise provide for group tax loss relief. (15) The adoption of a formal loss-sharing mechanism in the Income Tax Act would complement the current administrative concessions and provide much needed clarity, certainty of result, and greater stability in the law.
On several occasions TEI has urged the Department of Finance to review its 1985 proposal, revise and update it as necessary, and release draft legislation to implement such a system. Similarly, we urge the Standing Committee to recommend that a formal system be introduced to permit the sharing and utilization of tax losses and other tax attributes among groups of related corporations. The introduction of a formal loss-sharing system would bring the Canadian tax system in line with that of most other countries in the world.
Tax Executives Institute appreciates the opportunity to participate in the fall 2006 pre-budget consultations by the House of Commons Standing Committee on Finance. If you should have any questions about TEI's written statement, we shall be pleased to respond. Please contact either Martina Krummen, TEI's Vice President for Canadian Affairs at 514.422.7742 (or martina.krummen@ aircanada.ca) or David M. Penney, Chair of TEI's Canadian Income Tax Committee at 905.644.3122 (or email@example.com).
(1.) For resource income, the rate reductions are not fully implemented.
(2.) Mintz, The 2006 Tax Competitiveness Report: Proposals for Pro-Growth Tax Reform, C.D. Howe Institute Commentary No. 239 (September 2006), available at http://www.cdhowe.org/pdf/commentary_239.pdf.
(3.) As early as 1989, TEI expressed regret that the federal sales tax reform did not encompass the provincial sales tax systems. In addition, on January 20, 1997, Tax Executives Institute testified in support of proposed legislation harmonizing the federal GST and provincial sales tax systems in the Maritime Provinces. In addition, TEI wrote to the Finance Ministers of the non-harmonizing provinces to encourage them to consider harmonizing their sales tax systems so that Canada could have the benefit of a single national consumption tax with a single rate, identical base, and a unified administration. Finally, TEI's previous pre-budget consultation statements to this Committee have consistently emphasized the need to eliminate direct taxes on capital.
(4.) Ludco Enterprises Ltd. v. The Queen, 2001 S.C.C. 62.
(5.) Brian J. Stewart v. The Queen, 2002 S.C.C 46.
(6.) The proposed statutory formulation of the REOP test is no more precise than common law tax requirements because it 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 can be little doubt about the for-profit purpose of an expenditure or investment.
(7.) In addition, 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.
(8.) For example, a company may make strategic investments in a losing enterprise in order to (1) preempt 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.
(9.) In addition, a taxpayer may, after incurring several years of losses, conclude that a business venture is unlikely to produce a cumulative net profit. If the taxpayer's variable costs of production are less than the selling price of the goods or services, however, 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.
(10.) The Budget Plan 2005, Annex 8 Tax Measures: Supplementary Information and Notices of Ways and Means Motions, Department of Finance Canada (February 23, 2005), at 410.
(11.) Mintz, Withholding Taxes on Income Paid to Nonresidents: Removing a Canadian-U.S. Border Irritant, C.D. Howe Institute Backgrounder, (March 5, 2001).
(12.) 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 three years on further reductions in withholding taxes. Since then, we have urged both countries to implement nil withholding rates on cross-border payments between the two countries to the maximum extent feasible.
(13.) For example, a close examination of these very complex and convoluted rules suggest that dues paid to a non-resident international labor union may well be considered investments in foreign investment entities. There would likely be little or no imputed income, however, if the union dues were deducted by an individual member when computing taxable income. This is but one example of the many, likely unintended, consequences that these overbroad rules will produce.
(14.) Even though CRA permits related parties to transfer losses through various techniques, the tax result in any particular case depends upon the agency's exercise of administrative discretion and that engenders a degree of uncertainty for taxpayers.
(15.) Of 30 OECD countries surveyed in 2001, Canada was one of only four countries that did not provide group tax loss relief directly through its legislation. See Donnelly & Young, Policy Options for Tax Loss Treatment, 50 CANADIAN TAX JOURNAL 429 (2002).
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|Date:||Nov 1, 2006|
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