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Pending Canadian income tax issues.

Pending Canadian Income Tax Issues

I. BACKGROUND

Tax Executives Institute welcomes the opportunity to present the following comments on several pending tax issues, which will be discussed with representatives of the Department of Finance during TEI's November 19, 1990, liaison meeting. In the meantime, if you have any questions about these comments, please do not hesitate to call either Donald K. Cornborough, TEI's Vice President for Canadian Affairs, at (604) 372-2217 or Hugh D. Berwick, chair of the Institute's Canadian Income Tax Committee, at (514) 848-8235.

TEI is an international organization of approximately 4,500 professionals who are responsible -- in an executive, administrative, or managerial capacity -- for the tax affairs of the corporation and other businesses that employ them. TEI's members represent almost 2,000 of the leading corporations in Canada and the United States. (1)

II. INCOME TAX ISSUES

1. Deductibility of Interest

On November 24, 1989, a revised Notice of Ways and Means extended the application of the June 2, 1987, tax rules for deductibility of interest to all borrowings made before 1991. With less than two months left before 1991, taxpayers require certainty.

Has the Department of Finance completed its review of the rules concerning the deductibility of interest and other financing costs? Specifically, has the Department developed a position concerning the CBA/CICA Joint Committee Recommendations of August 20, 1990, including the proposal to broaden section 20(1)(c) to permit a deduction for all interest normally expensed in accordance with good commercial accounting practice? Will Finance be in a position to make its recommendations public before the end of the year?

2. Currency Swaps and Hedging

We understand that the Department of Finance and Revenue Canada have each been reviewing the government's policy regarding "swap and hedging" transactions. During the liaison meeting, we request a status report on the project, including some estimate of when any changes will be made known to the public.

3. Deductibility of Interest on

Income Taxes

The nondeductibility of interest on income tax underpayments is a significant issue for taxpayers because of high interest rates, new forms of tax, and the ever-increasing complexity of taxation legislation. The prohibition against an income tax deduction for interest paid on income tax underpayments operates as a penalty. Since the interest paid cannot be taken as a deduction for income tax purposes, the effective rate of interest paid is nearly double the prescribed rate; thus, today the rate is in the neighborhood of 27 percent for corporations with income not subject to the Small Business Deduction. At the same time, credit interest paid on refunds remains fully taxable.

This situation creates many distortions and anomalies. A most glaring anomaly is the not infrequent situation in which a taxpayer both receives credit interest and pays arrears or instalment interest relating to the same period of time.

The economic realities of this situation are that the government has a deposit on which it is paying interest, and at the same time, there is a liability of the same taxpayer on whic interest ins accruing; the actual amount due or refundable is the net of these positions. While the interest amounts may offest, the taxse payable on the non-deductible interest paid will exacerbate the burden of the interest expense.

The cause of arrears interest may ver well be out of the taxpayer's control. It may arise as a result of forecasting variances tht wer not foreseeable. Other causes may be administrative or interpretative or interpretative changes affecting legislation years after returns have been filed or simple, good faith errors or omissions. Some jurisdictions, such as Ontario, address this problem by not adjusting instalment requirements for subsequent reassessments.

The introduction of the Large Corporations Tax and the Federal Capital Tax, each with their own instalment and final payment requirements, have further complicated the administrative burden associated with the remittance of taxes.

TEI submits that existing penalties under the Income Tax Act are sufficient to deal with any abuses that might arise. There is no need for an "automatic" penalty by operation of the Act's interest provisions.

4. Low-or Non-Interest Bearing

Loans

Subparagraph 40(2)(g)(ii) of the Income Tax Act disallows recognition of a capital loss on debt unless the debt was acquired by the taxpayer for the purpose of gaining or producing income from business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer is dealing at arm's length.

In many cases, corporations invest in subsidiary companies by way of loans rather than capital stock for convenience rather than anything else. TEI submits that where a low-or non-interest bearing loans to a subsidiary forms part of the capitalization of the subsidiary, any loss incurred on the disposition of the debt should be recognized as a capital loss. We invite your response to this proposal.

5. Interest Deductibility -- Interpretation

Bulletin It-445

TEI is also concerend that taxpayers who seemingly fall within Revenue Canada's policy for deductibility of interest may be denied the deduction. Such a result occured in David Scott v. MNR, 89 DTC 218, where an indvidual taxpayer borrowed funds at interest and then lent the funds interest-free to his company. The court declined to adopt the policy enunciated in Interpretation Bulletin IT-445 on the ground that the policy would permit an "undue tax advantage" to accrue to the taxpayer.

In respect of the situations outlined in Interpretation Bulletin IT-445, TEI recommends that the legislation be amended to take cognizance of REvenue Canada's stated policies and include a closely worded definition of what would not be regarded as an "undue" taxadvantage.

6. Prepaid Interest

Effective after 1984, proposed subsection 18(9.1) of the Income Tax Act requires that "prepaid interest" be deducted during the period over which a debt obligation would have remained outstanding. It appears, however, that the recipient of such "prepaid interest" will be taxable in the year of receipt. Please comment on the apparent discrepancy between the timing of when the payor claims a deduction and when the payee reports the income.

7. Large Corporation Capital Tax

Instalments

The separate instalment requirement outlined in the proposed section 181.7 of the Income Tax Act (as set forth in Bill C-28) may impose an unfair and unwarranted economic burden on taxpayers. For example, assume that a corporation makes equal but pffsetting overpayments and underpayments of Part 2 and Part I.3 tax, respectively. The corporation will accumulate contra interest income under Part 2, but without economic benefit since it cannot be applied against the Part I.3 tax. The interest expense for Part I.3 will not be offset and, furthermore, will be non-deductible.

In order to remedy this unfair and presumably uninted result, TEI has previously recommend that the requirements for Part I and Part I.3 tax instalments be combined in a manner similar to the requirement of combined income and capital tax instalments for Ontario and Quebec. In a letter to TEI dated August 13, 1989, the Minister of Finance acknowledge that the Institute's recommendation merited further study. We request a status report on this issue.

8. Payment Dates for Income Tax

Instalments

TEI understands that remittances of deductions at source are treated as being received on time when the payment due date falls on Saturday, Sunday, or holiday and the payment is received on the next business day. We note, however, that the date of receipt for instalment payments of income taxes when the due date falls on Saturday, Sunday, or a holiday is subject to the rules in the Interpretaion Act since the matter is not addressed in the Income Tax Act.

The Interpretation Act indicates that Saturday is a business day. therefore, Revenue Canada recognizes instalment payments "received on the next business day" as being on time only where the due date falls on a Sunday or holiday. This requires payment on a Saturday if the due date falls on a Saturday. This is a practical impossibility since Revenue Canada's offices are not open on Saturday to accept payments and payments made to a financial institution on Saturday are normally dated the following business day. Disparate treatment of payments required under the same Act leads to confusion and unwarranted interest penalties.

Paragraph 108(1.1)(b) of the regulations states that "all amounts deducted or witheld...made in a month in the particular year by the employer shall be remitted to the Receiver General on or before the 3rd day, not including a Saturday or a holiday, after the end of the following periods...." TEI recommends that all payments due under the Income Tax Act be treated in a similar fashion. Thus, when the due date falls on a Saturday, Sunday, or holiday, the payment should be treated as timely if made on the next business day.

9. Treatment of Capital Spare Parts

The income tax treatment of capital spare parts is a subject of confusion. Alternative treatments to date have varied, usually with the amounts involved and the accounting policy of the corporation, and typically have ranged from (i) expensing the amount; (ii) adding the amount to the Capital Cost Allowance pool to which the main asset belongs; or (iii) treating the spare parts as part of inventory.

Paragraph 10(5)(a) of the Income Tax Act includes in its definition of inventory "[p]roperty (other than capital property) of a taxpayer that is work-in-progree of a business that is a profession, advertising or packaging material, parts or supplies..." This broad definition has recently been used by Revenue Canada to include within its ambit spare parts of capital assets. A consequence of this treatment has been to reduce the investment tax credit claims of corporations in certain circumstances. In addition, the recent decision of Stearns Catalytic Ltd. and Air Products Canada Ltd. v. The Queen, 90 DTC 6286 (FCTD), held that capital spare parts should be included in Class 8.

TEI submits that it is neither fair nor realistic to treat as inventory a substantial piece of custom-made equipment that has been specifically identified for internal use in business operations. Moreover, the cause of even and equitable treatment of capital spare parts is not well served by decisions such as Stearns Catalytic since they result in spare arts' not being classified in the same way as the main piece of equipment.

TEI recommends that capital spare parts be treated, for fax purposes, as depreciable property and be classified in the same way as the property for which they are spare parts.

10. Contractors' Holdbacks -- Capital

Cost Allowance

The recent decision in the case of Newfoundland Light & Power Co. Ltd. v. The Queen, 90 DTC 6166(FCA), held that contractors' holdbacks were contigent liabilities and as such cannot be treated as "part of the capital cost...of property" under paragraph 20(1)(a) of the Act and Part XI of the regulations for purposes of capital cost allowance (the "capital holdbacks").

TEI is concerned that this decision will impair the international competitiveness of capital intensive industries that have experienced dramatic reductions in their capital cost allowance claims as a result of the tax reform -- i.e., the "available for use" rule and the change in the write-off for manufacturing and processing equipment from three years under Class 29 to more than 10 years under Class 39. TEI notes that the recent study of the Conference Board f Canada, captioned "Canada - U.S. Tax competetitiveness in Manufacturing Industries," found that the Canadian manufacturing tax system is not competitive with that of the United States.

TEI recommends that the Income Tax Act and regulations be amended to allow capital holdbacks as a capital expenditure for purposes of capital cost allowance.

11. Subparagraph 20(1)(a), et seq.

Certification Requirements

Class 34 requires certification by the Minister of Energy, Mines and Resources of certain energy projects cost eligibility for accelerated capital cost allowance. Where a certificate is not issued or where the certificate is issued for a lesser amount than applied for by a taxpayer, there are no procedures for a taxpayer appeal.

TEI recommends that a taxpayer be allowed to appeal an unfavourable decision of the Minister of Energy, Mines and Resources. This could be done by having the certification constitute a definitive affirmation that the property meets the conditions for Class 34 rather than be one of the conditions. Thus, where a certification is not fortcoming, the taxpayer could nevertheless take the position that the property falls within Class 34 and, if necessary, pursue a favorable result by way of objection or further appeal.

12. Late-Filed Section 85 Elections

Subsection 85(7) permits late-filed elections for a three-year period. Some of the circumstances that would necessitate a late-filed election, however, would not be identified until after the expiration of the three-year period -- for example, during the course of a Revenue Canada audit.

TEI recommends that subsection 85(7) be amended to permit late-filed elections within the normal reassessment period in subsection 152(4), rather than confining such elections to a rigid three-year time frame.

13. Amended Section 85 Elections

Subsection 85(7.1) permits amended or late filed section 85 elections in circumstances where it is just and equitable in the opinion of the Minister of National Revenue.

Such administrative discretion creates considerable uncertainty for taxpayers. While Revenue Canada has outlined circumstances where an amended election will generally be accepted in Infomation Circular IC 76-19R2, the uncertainty remains. The wording of subsection 85(7.1) effectively denies taxpayers any right to appeal from an adverse decision of the Minister.

TEI recommends that subsection 85(7.1) be amended to delete the requirement to obtain the Minister's approval for amended elections. The need for ministerial approval should be retained only for amended elections or late electins filed beyond the normal reassessment period in subsection 152(4).

14. Amended Tax Returns

At present, a taxpayer generally has no statutiry right to file an amended income tax return where an error in the preparation of the initial return is discovered. The only recourse a taxpayer has is to object to an assessment within 90 days following the date of issuance by Revenue Canada. By administrative practice, however, Revenue Canada will in certain circumstances permit a taxpayer to amend an initial return (see Information Circular IC 84-1).

There are only a few exceptions where the right to file amendments is provided for in the Act, such as subsection 49(4) and the right to file prescribed forms to carry back losses, investment tax credits, and foreign tax credits. In contrast, the Minister may reassess a taxpayer for any aspect related to a tax return of a particular year within the reassessment period in subsection 152(4).

TEI recommends that a taxpayer be permitted to file amended returns any time within the reassessment period in respect of items that have not been the subject of an assessment or reassessment for a particular taxation year.

15. Part VI.I Tax: Preferred Share

Dividends

In tabling a Notice of Ways and Means Motion in June 1987 proposing a special tax on dividends payable on preferred shares, the Department of Finance stated:

[C]orporations that have earnings subject to [the regular corporate] tax and therefore gain no advantage from the after-tax financing, will be unaffected by [this] new Tax .... The new tax is designed to ensure that tax has been paid with respect to dividends on preferred shares when relief is given at the shareholder level. As such it will affect dividends paid by non-taxpaying corporations and will have no impact on taxpaying corporations issuing preferred shares.

This assurance notwithstanding, the Part VI.I tax has adeversely affected taxpaying corporations. This is because the deduction permitted -- currently, 9/4 of the tax paid [2] -- equates to a combined tax rate of 44.44 percent. Any corporation with a lower effective tax rate (such as a Quebec-based company or one in the manufacturing and processing sector) will be penalized by this tax.

During last year's liaison meeting, Finance representatives suggested that the tax rate of the purchaser of the shares should be considered in judging the adequacy and merits of the 9/4 deductions. We continue to disagree. Differentials in tax rate always affect pricing. On a debenture, for example, a tax deduction in a debtor company with a 38-percent tax rate will not "match" interest income in a lender company with a 44-percent rate. The two parties will incorporate this factor in their pricing negotiations, along with all other relevant factors, such as security, term, and comparable borrowing rates.

Accordingly, we reiterate our view that the deduction mechanism requires adjustment in order to accomplish the Minister's stated goal. Specifically, TEI recommends that the 9/4 fraction be replaced by a non-refundable tax credit applicable against income taxes otherwise payable.

III. PENSION REFORM ISSUES

16. Tax Assisted Retirement Savings

The goal underlying the government's December 1989 release of proposals to reform the rules governing tax assistance for pension and retirement savings was to provide for a more equitable and consistent system. With respect to defined benefit plans, however, the proposal can actually produce inequitable results. Specifically, the "factor of nine" [3] that is used in determining the pension adjustment (PA) is unrealistically high and consequently generates an insufficient PA. Furthermore, the elimination of the Pension Adjustment Reversal (PAR) adversely affects individuals who terminate their employment well before age 65 or who switch employers without their pensions being portable.

TEI recommends that (i) the adjustment factor of nine be reduced, and (ii) more than one factor be used depending on the age of the individual.

17. Rollovers of Retirement Payments

Because of the level of inflation since 1981 when paragraph 60(j.1) came into force, TEI recommends that there be an increase in the RRSP rollover provisions (currently $2,000 a year) relating to retirement payments. increase would allow individuals a greater opportunity to provide for independent retirement.

18. Maximum Pension Benefits

In prior submissions, TEI has argued that the prsent limitation of $60,025 for tax-assisted pensions is unrealistically low. The limitation's not being indexed until 1994 exacerbates the inequity by preventing pensions from keeping pace with salary increases.

TEI recommends that the limitation on pension benefits be increased immediately to reflect salary increases from the time that the limitation was imposed; the revised limitation should then be indexed annually.

IV. OTHER ISSUES

19. Application of Subsection 59(3.3)

in the Case of a Partnership

We understand that Revenue Canada believes that subsection 59(3.3) should be applied at the partnership level and not at the partner level. Therefore, if subsection 59(3.3) is applicable, that amount would be added to the income of the partnership.

(a) Subsection 59(3.3) was intended to require a taxpayer to recapture depletion deductions previously claimed or to reduce the balance in its depletion base with the sale proceeds of an asset only in a situation where the purchase price of that asset was added to its, or a non-arm's length taxpayer's, depletion base. By applying this provision at the partnership level, Revenue Canada will adversely affect taxpayers who have become partners after the assets qualifying for the depletion base were purchased and have never enjoyed any benefit from the depletion incentives.

(b) If Revenue Canada insists on applying subsection 59(3.3) at the partnership level, will Finance amend the provisions in Regulation 1201(a)(ii), so that the partner can claim a deduction from his earned depletion pool equal to his allocated portion of the recaptured depletion which has been included in the partnership's income under subsection 59(3.3)?

20. Oil and Gas Successor Rules

A question exists concerning the deductibility of "Successor Pools" where more than a single entity is acquired or assets are acquired from more than a single entity, and there was common control of the target entities or assets.

At present, the Income Tax Act (including the amendments proposed in the July 13, 1990, draft legislation) segregates tax pools of each acquired company along with the properties held at the time control is acquired and describes them as if they had been purchased from an "original owner." Each separate acquisition is treated as if there were a separate "original owner." Where there are a number of acquisitions from unrelated vendors, it may be appropriate to segregate the pools and properties. Recognizing the importance of the concept of the "controlled group" throughout the Income Tax Act, we submit that it would also be appropriate to aggregate acquisitions from a controlled group (occurring during a specified period of time) into a single purchase. We not that the same result could be effected by the vendor's combining the properties and pools before the arm's lenghth sale.

Thus, TEI recommends that where there has been an acquisition of control of a number of related entities within a 90-day period and the successsor rules apply to deem there to be an "original owner," that owner should be deemed to be the same original owner for the purpose of successor resource deduction claims.

21. Withholding Tax on Leasing

Transactions

The Canadian withholding tax on rental payments often operates either to increase costs to Canadian businesses or to prevent leasing transactions from occurring. This is because the Canadian lessee usually must agree to hold the foreign lessor harmless from Canadian withholding tax.

Leasing is a common mode of financing often similar in nature to long-term debt. Given the significant constriction of the domestic leasing business, access to international sources of lease financing is critical. TEI recommends that withholding tax on equipment rentals should not apply to leasing agreements having a term of five years or more. Such a rule would be analogous to the sub-paragraph 212(1)(b)(vii) exemption for interest payments on long-term debt.

22. Goods and Services Tax and

Taxable Benefits

By virtue of section 173 of the Excise Tax Act, an employer who makes available certain property for which an employee benefit is determined under section 6 or section 15 of the Income Tax Act is deemed to have made a taxable supply equal to the taxable benefit. The benefit is therefore subject to the seven-percent Goods and Services Tax (GST), which will be paid by the employer. By virtue of a new paragraph 6(1)(e.i) of the Income Tax Act, this amount will be included in the employee's income as a taxable benefit.

There are no transitional rules for property purchases made by the employer prior to 1991 and made available to the employee after 1990. For instance, a car purchased in 1989 will include the 13.5-percent Federal Sales Tax in the computation of the minimum standby charge. Paragraph 6(1)(e.i) of the Income Tax Act wil increase the standby charge by seven percent -- a patently inequitable result. TEI has recommended to Revenue Canada that appropriate administrative guidelines be issued to ameliorate this harsh, double-taxation result. If it is not feasible for Revenue Canada to do so because of the wording of the law, TEI recommends that the legislation be amended to introduce appropriate transitional rules.

23. Consolidated Tax Returns

TEI has addressed the issue of consolidated tax returns several times. A detailed submission was filed with the Minister of Finance on November 6, 1985, and we again discussed the issue in our submission to Finance dated November 28, 1988.

In our meeting with the Department of Finance in January 1990, we raised the matter again. In response to TEI's comments, representatives of Finance stated that the Minister continued to support a consolidation mechanism, but that there were strong objections to the plan by certain provinces. These provinces predicted that there would be unacceptable shifts of income among provinces if a consolidated return suystem were adopted.

At TEI's 1988 Annual Conference, David A. Dodge, then-Assistant Deputy Minister, Finance predicted that post-Tax Reform statistics would disprove theprovinces' concerns; that is to say, the data would demonstrate that tax reform's broadening of the tax base foreclosed the possibility of unacceptable income shifts. Do the statistics support Mr. Dodge's statement, and have any further discussions been held with the provinces on this subject?

In our previous discussions, the Department expressed the view that a "federal only" consolidation would not work. We ask that you reconsider this position. TEI believes that consolidation of federal taxable income without provincial participation would be preferable to further delay. For Quebec, Ontario and Alberta, the mechanism to "deconsolidate" for provincial tax purposes would not be difficult. (4) WE believe that every province would eventually accept the consolidation.

The Department has previously also expressed concern that the adoption of consolidated returns, combined with the "overhang" of loss carryforwards, would reduce federal tax revenues. There are two ways to address this concerns:

* Adoption of the concept of "Single Return Limitation Year" (SRLY), such as that used in the United States. The SRLY limitation operates so that after a change of control (or upon the adoption in Canada of the consolidated) existing losses would be deductible only by that particular corporation; i.e., they would not be grouped with the income of related corporations.

* Adoption of a group relief limitation mechanism (such as that used in the United Kingdom), whereby relief is provided only on a year-by-year basis; prior losses are used only by the particular corporation that incurred them.

These recommendations are offered to support our belief that, if the decision is made to proceed with a consolidation system, the Department will be able to address any of its concerns and those of the provinces. We reiterate our recommendation that the Department proceed expeditiously to implement a consolidation system.

24. Creditability of Large

Corporations Tax

Despite TEI's earlier recommendations to Finance and Revenue, under current draft legislation the Large Corporations Tax is creditable against the federal suftax instead of the other way round. Thus, the LCT wil be viewed as a capital tax instead of an income tax, and hence will not be a creditable tax for U.S. tax purposes. This unfavourable tax result could negatively affect investment by U.S. corporations in their Canadian subsidiaries or branches, and this burden will increase with the rise in the LCT rate to 0.2 percent on January 1, 1991.

What, if any, justification remains for crediting LCT against the surtax rather than crediting the surtax against the LCT? Are any steps being taken to address this issue by way of treaty negotiations?

25. Capital Gain/Loss Offset

At TEI's May 1990 Canadian Tax Conference, we questioned why capital losses cannot be applied to reduce capital gains unless there is taxable income in the year in which the gain occurred. The wording of subsection 111(1) requires that non-capital losses in the year be reduced by taxable capital gains before net capital losses can be carried forward or back to offset those gains. The result does not seem fundamentally reasonable. Generally, a taxpayer will preferr to offset capital gains with capital losses.

TEI continues to recommend that the taxpayer be afforded the opportunity to apply allowable capital loss carryforwards or carrybacks against taxable capital gains before being required to offset taxable capital gains witn non-capital losses. What is the status of this proposal?

V. CONCLUSION

Tax Executives Institute appreciates this opportunity to present its comments on pending tax issues. WE look forward to discussing our views with you during the Institute's November 19, 1990, liaison meeting.

(1) 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, or are otherwise affiliated with, companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distribution, wholesaling, and retailing; real estate; transportation; financial; and resource (including mining, pulp and paper, and petroleum). These comments reflect the views of the Institute as a whole but more particularly those of our Canadian constituency, which is principally responsible for their preparation.

(2) Befor being reduced to 9/4 as part of the April 26, 1989. Budget the deduction was equal to 5/2 of the Part VI.1 tax paid.

(3) The pension adjustment is determined by translating the benefits earned in the year into contribution terms using the standard contiribution-to-pensions ratio 9:1.

(4) We note that, in the United States, some states do not permit consolidated returns.
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Author:Berwick, Hugh D.
Publication:Tax Executive
Date:Nov 1, 1990
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