Pending income tax issues: December 5, 2001. (Canadian Department of Finance).
Tax Executives Institute welcomes the opportunity to present the following comments on pending income tax issues, which will be discussed with representatives of the Department of Finance during TEI's December 5, 2001, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Alan Wheable, TEI's Vice President for Canadian Affairs, at 416.982.8003, or David M. Penney, Chair of the Institute's Canadian Income Tax Committee, at 905.644.3122.
Tax Executives Institute is an international organization of approximately 5,300 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, the United States, and Europe.
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 eight geographic regions. In addition, a substantial number of our U.S. and European 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.
1. Withholding Taxes: Canada--U.S. Treaty
TEI supports the elimination of withholding taxes through the negotiation of reciprocal tax treaties and many countries have entered into, or are actively considering, such agreements. For example, during the past year the United States announced modifications to its income tax conventions with the United Kingdom and Australia that will eliminate withholding taxes on most dividends and interest payments. In addition, in June 2001, the United States Assistant Treasury Secretary for Tax Policy released a letter to the Organization for International Investment that states "there are strong tax and economic policy reasons for the United States and Canada to eliminate withholding taxes" thereby reducing barriers to cross-border investments to the benefit of both countries. Moreover, the letter continues, the United States has "urged Canada to agree to modify the treaty to eliminate such withholding taxes." Would the Department please provide an update on the status of these discussions and specifically whether Canada, like Australia and the United Kingdom, will support an agreement with the United States to eliminate withholding taxes?
2. Large Corporations Tax
During last year's liaison meeting, TEI advocated the elimination of the Large Corporations Tax (LCT) levied under Part 1.3 of the Income Tax Act (hereinafter "the Act"). This recommendation is premised on the tax regime's insensitivity to profits and the disproportionate burden thereby imposed on capital-intensive companies and industries. Canada is currently implementing a number of significant reductions in the corporate income tax rate and modifications to the income tax base that will enhance the international competitiveness of the tax system. The LCT, however, discourages incremental capital investment by domestic and, especially, foreign businesses and investors because it is perceived as a direct tax on capital. This is at odds with the goal of making Canada a more attractive environment for global business investment.
In its response last year, the Department noted that provincial governments rely more heavily on corporate capital taxes than the federal government. Since that meeting, however, British Columbia has announced a phased elimination of its capital tax over a two-year period, Alberta has eliminated its only remaining capital tax (on financial institutions), and Ontario has increased its capital deduction. Clearly, the provinces are moving toward reducing the capital tax burden. In addition, we understand that the Conference Board of Canada is preparing a study, which may be released before the liaison meeting, that will advocate the elimination of taxes that are insensitive to profits. Taxes on capital have a negative effect on economic growth because of the increased cost of capital, which deters business investment--a key driver of productivity growth. TEI reiterates its recommendation that the Department of Finance should introduce legislation to repeal Part 1.3 of the Act. We invite the Department to discuss whether, in view of the continuing developments in the provinces and calls for repeal by other groups, it will reconsider its view on eliminating the LCT.
3. Payroll Cost Duplication
As a result of corporate reorganizations, employees often terminate employment with one legal entity and become employees of another, related legal entity. In many cases, the employees and the new employer must commence Employment Insurance and Canada Pension Plan premium payments anew without regard for the contributions previously made during the year. Excess premiums contributed by an employee are recoverable upon filing the individual's annual income tax return. The employer, however, is not entitled to obtain a similar recovery. At the Department of Finance's suggestion at last year's liaison meeting, TEI wrote to the Deputy Minister on July 25, 2001, outlining our concerns and urging amendments to the Act to permit employers to recover excess contributions. We would appreciate a status report on the Department's deliberations on this matter.
4. Disclosure of Comfort Letters issued to Taxpayers
Increasingly, the Department of Finance is issuing "private" "comfort letters" that acknowledge anomalies in the Income Tax Act and explain the technical changes under consideration to address them. Some of the letters are made available for publication in tax services (such as CCH, Carswell, etc.), whereas others are seemingly never released. TEI believes that, in an ever-changing tax environment, the letters represent an efficient way to rapidly communicate information about much-needed amendments to the Act. Hence, we wish to understand the policy and process the Department follows in determining which letters to release and when. More important, we encourage the Department to implement a formal and speedy process to make these letters available to the entire tax community as soon as they are issued (e.g., through a technical news update). We invite the Department's response.
5. Provincial Allocations
TEI understands that a committee consisting of federal and provincial officials is currently reviewing myriad issues related to the allocation of provincial income. TEI believes that any changes to the provincial allocation rules should be undertaken on a consultative basis and, as substantially affected parties, we would like to participate. Is this committee currently active? We invite the Department to provide an update on the status of the committee's deliberations and recommendations.
6. Partnership Information Returns T5013
Where a partnership has not filed a partnership information return, CCRA's position is that subsection 152(1.4) permits the Minister of Revenue to determine or redetermine the income or loss of the partnership at any time. (See CCRA Document Numbers 9726115 and 2000-0010935.) This is so even where a corporate partnership with fewer than five partners has availed itself of CCRA's published administrative position in Information Circular IC 89-5R, Partnership Information Return, and has not filed the partnership information return. TEI believes that CCRA's interpretation will ultimately result in significant additional administrative burden for both taxpayers and CCRA because taxpayers will be required to file additional partnership information returns (and related objections to CCRA re-assessments) simply to ensure that the corporate partner's taxation year becomes statute barred within the normal time period.
To minimize the additional compliance and attendant administrative burdens, would the Department of Finance consider making technical amendments to subsection 152(1.4) to exempt partnerships with five or fewer corporate partners from its application? Alternatively, would the Department consider amending subsection 152(1.4) to include (as a trigger for the beginning of the period for the determination of the statute-barred date) the day the income tax return for each partner is filed?
7. Consequential ITA Amendments to Reflect Tax Rate Changes
In last year's liaison meeting agenda, TEI requested that the Department review a number of areas where, because of pending changes to the income tax rates, appropriate amendments should be made to the Act because the amounts of certain deductions, credits, etc., are based notionally on the taxpayer's tax rate. Since the tax rate reductions have now been legislated, the consequential adjustments to the relevant amounts should also be made with effect from the date of the rate changes. We invite the Department's comments on the following examples of TEI-recommended adjustments.
A. Part VI.1 Tax
Under paragraph 110(1)(k) of the Act, a corporation is entitled to a deduction from income equal to 9/4 of the tax payable under Part VI.1. At the time this gross-up factor was enacted, it was based on a theoretical combined corporate income tax rate of 44 percent, representing federal and provincial tax rates of approximately 29 and 15 percent, respectively. This deduction effectively reduces the corporation's Part I tax by the approximate amount of Part VI.1 tax previously paid.
The technical notes accompanying the original enactment of the provision provided for a deduction equal to 2+ times the Part VI.1 tax and stated that the "purpose of this deduction is to permit an approximate offset of any Part VI.1 tax payable for a year against the corporate income tax payable." In 1990, the provision was amended to change the deduction to 2+ times the tax payable under Part VI.1. The 1990 technical notes explained that "[t]his amendment adjusts the amount of the offset to reflect prevailing corporate income tax rates more accurately by providing a deduction of 2+ times, rather than 2+ times, tax payable under Part VI.1." Since corporate federal tax rates are now approximately 22 percent (including the surtax) and since many provinces have also reduced their provincial tax rates, a deduction for 9/4 of the Part VI.1 tax will be substantially less than the amount of Part VI.1 tax paid. TEI urges the Department to introduce legislation to adjust the factor to reflect prevailing corporate income tax rates.
B. Subsections 95(1) and 113(1)--"Relevant Tax Factor"
The "relevant tax factor" is defined in subsection 95(1) as an amount equal to one divided by the general tax rate in subsection 123(1) (without taking into account either surtaxes or the general rate reduction percentage). When the relevant tax factor is applied to a dividend from a foreign affiliate in a non-treaty country, the deduction under paragraphs 113(1)(b) or (c) is inappropriately reduced. TEI requests that Finance consider amending the definition of "relevant tax factor" to be the effective tax rate after taking into account the surtax and the general tax rate reduction percentage.
C. Part VI Tax
Under subsection 190.1(3), a financial institution may reduce its Part VI tax payable by the total of its Part I tax liability for the year, plus such amount as it claims of its unused Part I tax credits and unused surtax credits. As a result of the legislated corporate tax rate reductions, the taxpayer's ability to offset Part VI tax against Part I tax has been diminished and the time required to recover the credits lengthened. TEI recommends that the tax payable rate prescribed under subsection 190.1(1) (currently 1.25 percent) be reduced proportionately with the reduction in the general corporate tax rate under Part I.
D. Part XI.3--Retirement Compensation Arrangements
The refundable tax imposed on a retirement compensation arrangement is currently 50 percent of contributions plus income less distributions and losses. Even though the tax is refundable, the time to recovery is so long and its present value so diminished that a substantial economic cost is imposed. Indeed, as the federal and provincial tax rates are reduced, the tax is more akin to a penalty on the use of the retirement compensation arrangement. TEI recommends that this refundable tax be based on the top individual marginal tax rate (actual federal tax rate plus an average of the provincial tax rates.) To compensate contributors for refundable taxes previously paid at a higher rate, the difference between the current 50 percent rate and the revised lower rate could be refunded immediately. The refund is an expedient solution that minimizes complexity and avoids a requirement to track previous payments.
8. No Part XIII Tax Where An Amount is Treaty Exempt
In question 12 of last year's liaison meeting agenda, TEI recommended that the Department amend Income Tax Application Rule 10(6) to eliminate the reference to required Part XIII tax withholding where a tax treaty provides an exemption for Part XIII withholding tax. In its response, the Department acknowledged that:
It does seem anomalous that if a tax treaty limits Canada's taxation of a cross-border payment to some specified rate, the Canadian-resident payer is statutorily allowed to withhold at that lower rate; while if the treaty prevents Canada from taxing the amount at all, the payer or the recipient must apply for administrative relief from the withholding obligation.
The Department said that it would discuss the issue with CCRA in order to determine whether a change would be appropriate. Has the Department consulted with CCRA and will it now consider amending the ITAR?
9. Triangular Amalgamations. Follow-Up to Previous Year
The hypothetical in question 18 of the 2000 liaison meeting agenda addressed whether the Department will consider extending the principles of paragraph 256(7)(b) to triangular amalgamations. (A copy of the question and the Department's response are included in the Appendix.) TEI believes that the exemption from an acquisition of control available under paragraph 256(7)(b) for a regular amalgamation should also be available where a transaction is structured as a triangular amalgamation. We invite the Department to comment on the proposal.
10. Withholding Tax Regulation 105
Companies increasingly are staffing projects based on global sourcing and skill requirements rather than looking solely to the resources available in their home jurisdiction. In TEI's view, the withholding requirements in Regulation 105 severely impede Canadian organizations in effectively competing for these global resources. Indeed, most nonresident suppliers pass the withholding tax cost on to Canadian companies by increasing the price of their services to cover the tax. In addition, administrative and compliance burdens are borne by the organization contracting for the services (in terms of withholding and reporting), the service provider (in terms of additional reporting requirements and cash flow), and CCRA in its administration of the program. Finally, few, if any, of Canada's major trading partners have similar rules. Would the Department please explain the continuing need for Regulation 105, and what steps it might consider to ease the effect the regulation has on the global competitiveness of Canadian organizations?
11. Determination of Certain Components of Foreign Accrual Property Income
Foreign customers of Canadian companies frequently require that Canadian manufacturing operations be moved closer to the customer sites in offshore locations. Many Canadian manufacturers believe these demands will escalate as more of their customers, who have historically been located in North America, expand into the European Union, South America, etc., to meet the challenge of globalization. Canadian companies expanding into these foreign jurisdictions are establishing controlled foreign affiliates" to carry out the manufacturing operations. In many cases, the Canadian companies are producing the fundamental or essential raw material or product and using the controlled foreign affiliate to finish the product for the end customer under a "contract manufacturer agreement" with the Canadian parent.
In a typical contract manufacturer agreement, the controlled foreign affiliate will charge the Canadian parent company an arm's-length fee for the processing or manufacturing services provided to the Canadian parent and the Canadian parent ultimately deducts the fees charged by the controlled foreign affiliates for the processing or manufacturing services provided. Paragraph 95(2)(b) requires that the arm's-length fees charged under a "contract manufacturer agreement" be included in the Canadian parent's Foreign Accrual Property Income (FAPI). Depending on the applicable income and withholding tax rates for the foreign jurisdiction, a FAPI inclusion may increase the consolidated tax cost to the Canadian parent company. Subsection 95(3) defines "services" for purposes of paragraph 95(2)(b) as excluding "services performed in connection with the purchase or sale of goods." Hence, it appears that paragraph 95(2)(b) was not intended to disadvantage Canadian companies carrying on an active business in a foreign jurisdiction for the sale of goods. We recommend that the Department of Finance expand the definition of "services" in subsection 95(3) to include services provided for the processing or manufacture of goods for resale. We invite the Department's response.
12. Paragraph 95(2)(g)--Exclusion for Currency Fluctuation
A proposed amendment to paragraph 95(2)(g) will deem certain foreign exchange gains and losses of a foreign affiliate to be nil regardless of whether realized on shares or on debt and regardless of whether the foreign exchange gains or losses are realized on income or capital account. Paragraph 95(2)(g) seemingly will not apply, however, to a very common capital gain or loss of a foreign affiliate arising from foreign exchange: a gain or loss on a non-Canadian dollar debt of a foreign affiliate denominated in a currency other than the reporting currency of the foreign affiliate. TEI understands that the Department is studying the issue and recommends that the Department consider expanding the scope of paragraph 95(2)(g) so that it clearly applies to capital gains and losses realized in respect of foreign-to-foreign currency fluctuations. We submit that this proposal would be consistent with the purpose of paragraph 95(2)(g).
13. Practical Application of Section 17
There is considerable uncertainty about the potential application of subsection 17(2) because of the ambiguity of the phrase "it is reasonable to conclude that the particular person entered into the transaction ... because (i) a corporation resident in Canada made a loan or transfer of property." Where a Canadian resident subsidiary of a large multinational corporation transfers property, the indirect implications of the transfer cannot always be identified. Thus, it is conceivable that, because of a transfer of property by the Canadian corporation, a loan is indirectly made or indirectly remains outstanding somewhere in the global organization. In many multinational organizations, the Canadian subsidiary is so small that it is impossible for the Canadian corporate tax officers to recognize the indirect implications of every transfer of property. In addition, the Agency cannot possibly audit compliance with the provision without reviewing the operations of the entire global entity. TEI recommends that the Department of Finance consult with tax practitioners from industry and private practice to formulate a new provision that will achieve the policy objectives of section 17 without imposing undue burdens on either taxpayers or the CCRA.
14. Capital Distributions by Foreign Corporations
Generally, the amount of the paid-up capital of a share can be returned to a shareholder without being treated as a dividend or as a benefit under subsection 15(1). The computation of the "paid-up capital" of a class of shares is defined as "the paid-up capital in respect of that class of shares at the particular time, computed without reference to the provisions of this Act." This definition is generally considered to refer to the "stated capital" of the class of shares, as determined under the governing corporate law.
For foreign corporations, CCRA consistently takes the position that foreign corporate law is determinative in analyzing the Canadian tax results of capital distributions by foreign corporations. Corporate laws in certain foreign jurisdictions, however, do not permit returns of 'stated capital." Instead, they permit amounts to be trsnsferred out of capital into surplus and then distributed from surplus. Since these distributions are not paid directly from the "stated capital" of the corporation, anomalies may arise under the ITA. In previous technical interpretations, CCRA has stated that distributions after June 1988 on a reduction of paid-in capital or contributed surplus under U.S. corporate law would be income pursuant to subsection 15(1). (1) Also, capital distributions under Delaware corporate law (made from the surplus account) are regarded as dividends and not as returns of capital. (2)
TEI recommends amending subsection 15(1) to ensure that, regardless of foreign corporate law, any subscription amount paid for the issuance of shares of a non-resident corporation will be treated as "paid-up capital" for purposes of subsection 15(1) so that returns of capital are treated as statutory reductions of capital for Canadian tax purposes (reducing tax basis in the shares) rather than as dividends or as amounts subject to subsection 15(1). For example, the definition of paid-up capital under subsection 89(1) could be modified by adding the following after subparagraph (iii):
... except that where the corporation is a resident of a foreign jurisdiction and is governed by a foreign jurisdiction's corporate laws, a) Any contributed surplus or other surplus arising on the issuance of shares of that class of shares shall be deemed to be paid-up capital in respect of that class of shares, at the particular time; or b) Where the corporation converts an amount of the paid-up capital of that class of shares (including amounts deemed to be paid-up capital pursuant to the preceding paragraph (a)) to any surplus accounts (hereafter the "conversion amount") solely for the purpose of allowing the distribution to shareholders of an amount of the paid-up capital of that class of shares, such conversion amount shall be deemed to be paid-up capital in respect of that class of shares, at the particular time.
In addition, the definition of "dividend" in subsection 248(1) should be amended to add the following:
... but does not include an amount paid on a reduction of paid-up capital.
We invite the Department's response to the proposal.
15. Hedged Debt and Part 1.3 Tax on Large Corporations
During TEI's December 11, 1996, liaison meeting with the Department of Finance, there was a discussion of a counter-intuitive LCT result for hedged debt that arises from the introduction of section 3860 to the Canadian Institute of Chartered Accountants (CICA) Handbook. (Copies of item XXIII from the 1996 meeting agenda and the member-prepared and Department-approved summary of the discussion are attached in the Appendix. Also, a similar discussion occurred at that year's liaison meeting with Revenue Canada. (3)) Although some participants in the meeting understood that the Department of Finance would introduce amendments in a technical bill to correct this counter-intuitive result, nearly five years have passed without any action. Would the Department of Finance indicate whether such amendments will be introduced and confirm that such amendments will be with effect for taxation years beginning on or after January 1, 1996, the date section 3860 of the CICA Handbook became effective?
16. Scientific Research & Experimental Development (SR&ED) Credit Utilization
Pursuant to subsection 127(9), a taxpayer is required to file Form T2038 within 12 months of the due date for filing its return in order to identify and claim investment tax credits (ITC). Moreover, the amount set forth on the form sets a permanent ceiling on the amount of ITC a taxpayer is entitled to claim for the taxation year. There are a number of administrative and procedural issues that arise from these requirements, as follows:
* Any audit adjustment that would increase the amount of ITC available to the taxpayer is not eligible for ITC to the extent the audit adjustment would cause the total ITC for the year to exceed the amount identified on Form T2038.
* Where a taxpayer files the T2038 information form after filing its tax return but within the prescribed time limit and CCRA disagrees with the taxpayer's position on the claim form, the taxpayer does not have any appeal rights unless CCRA issues an assessment. In the case of large corporations, the ability to object to the denial of an ITC claim is subject to other limitations. Specifically, if the company has already filed objections to an assessment, it is precluded from raising new objections except to the extent that CCRA raises an issue in a subsequent assessment. There are means available to the taxpayer to challenge the disallowance of the ITC claim in a subsequent year, but it would more effective and efficient for the tax system if the issues were addressed in the year a claim arises.
* The 12-month period for filing an ITC claim is arbitrary.
The results in items 1 and 2 are inimical to the government's policy of encouraging investment in SR&ED. TEI recommends that the Department amend the ITC claim procedures to permit an increase in the amount of eligible ITC where the increase arises as a result of CCRA assessments. Moreover, taxpayers should be accorded a separate appeal right if the claim form is filed outside of the regular tax return filing. Finally, in respect of item 3, we recommend eliminating the requirement to file the form within 12 months of the regular filing date. Taxpayers should be permitted to file a claim at any time within the normal reassessment period.
17. Available For Use and Other Rules Affecting Depreciation
The available-for-use, rolling-start, and long-term project rules in subsections 15(26) to 18(29) apply to depreciable property acquired after 1989. The purpose of the rules is to delay the inception of tax depreciation until property is put in use (available for use) or two years elapse following its acquisition (Rolling Start). Under the current rules, a taxpayer must also file a one-time election in order to come within the long-term project provision. An untimely election will preclude eligibility for the long-term project provision.
We request that the Department review the requirements of these complex provisions that diminish the attractiveness of capital investments in Canada. We recommend specifically that the Department eliminate the requirement to file an election under 13(29) for long-term project benefits because the administrative purposes served by filing the election are unclear. In addition, other technical issues associated with the long-term project provisions would become moot by eliminating the requirement to file an election.
18. Funding Limitation for Pension Plans
In 1976, the maximum pension payable under a defined benefit (DB) registered pension plan (RPP) was $1,715 per year of service. The limit was nominally increased to its current level of $1,722 per year of service in 1990. In effect, the limit has been frozen for 25 years. During the same period, however, there have been significant increases in other pension limits. For example, defined contribution (DC) plans have been increased by 90 percent, RRSP limits by 130 percent, and Canada Pension Plan limits by 400 percent. Moreover, Canadian DB limits are not even, close to those permitted in the United States.
As a result of the stringent limitations (as well as the substantial rise in the cost of living during the past 25 years), private pension benefits are inadequate. While a number of Canadian companies have established Supplemental Employee Retirement Plans (SERPs) in addition to RPPs in order to deliver more competitive pension benefits, many plans are unfunded because of the limitations of the Act. TEI does not believe that employees who participate in a DB plan should be at risk in order to have an adequate pension. Hence, we recommend that the Department consider increasing the DB plan funding and benefit limits.
19. Arbitration Procedures
Paragraph 6 of Article XXVI of the Canada-United States Income Tax Convention (1980) provides for an arbitration procedure. Implementation of the procedure, however, is subject to a further exchange of notes between Canada and the United States. Question VI of the 1999 liaison meeting agenda urged the Department to initiate discussions on this matter in order to establish a working arbitration procedure. Despite the Department's expressed preference "to follow a passive approach and adjust to international developments," TEI believes that effective and efficient tax administration would be well served by instituting such a procedure and again urges the Department to move forward to establish an arbitration procedure in the treaty. TEI would appreciate the Department's current view on this.
20. Scientific Research & Experimental Development (SR&ED) Incentives
At the May 2001 SR&ED Conference in Ottawa, government representatives stated that Canada currently ranks fifteenth among all countries in the world in terms of research and development activities performed. The government's goal is to rank in the top five. In light of this objective, what initiatives are currently underway in the Department of Finance to modify the SR&ED program to enhance the incentives? Has consideration been given to broadening the definition of eligible SR&ED activities?
21. SR&ED--Proxy Method
When the proxy method is elected, companies are precluded from claiming energy costs as eligible expenditures "as they are not items composing the body of a thing at some point in time in the SR&ED process." Thus, where energy costs are a significant component of the research and experimentation process, companies are effectively precluded from using the proxy method and must rely on the traditional approach to compute overhead costs. Assume, for example, a large multi-division corporation has two divisions that conduct SR&ED. One division is a mixed-use facility (combining SR&ED and non-SR&ED activities) and another is a dedicated SR&ED facility that conducts SR&ED projects as its primary focus. Assume further that the projects at the dedicated SR&ED facility require a tremendous amount of energy, as opposed to labour costs, in connection with the SR&ED process. Both facilities are conducting extensive SR&ED in Canada. In the mixed-use facility, the proxy method is more efficient to use because it is difficult to quantify the incremental overhead expenditure for energy and other costs. At the dedicated SR&ED facility, the energy expended during the SR&ED process is clearly evident and constitutes the bulk of the expenditures for the facility in a given year. Under these circumstances, the company is compelled to choose between the proxy method, which simplifies its claim process and precludes claiming substantial energy costs, or not electing the proxy method and undertaking the task of quantifying the incremental cost of overhead expenditures at the mixed-use facility. Will the Department of Finance consider amending the SR&ED prevision to permit a company to claim identifiable energy expenditures, which are clearly incremental to non-labour SR&ED activities, as materials when claiming the proxy method?
22. Dividend Deductions
TEI is concerned that new subparagraph 93.1(2)(d)(i) may result in a reduced section 113 dividend deduction amount for a partner in a partnership that is less than the partner's share of the gross dividends actually received from a foreign affiliate by the partnership. Subparagraph 93.1(2)(d)(i) limits the deduction to the amount of the dividend included in income pursuant to subsection 96(1), which, in turn, operates on a "net" basis to include income from a source. Such a result seemingly puts partners investing in foreign affiliates at a disadvantage vis-a-vis direct investors because there is no similar restriction on the level of dividends deducted by direct investors. Would the Department please clarify whether this is the intent of subparagraph 93.1(2)(d)(i) and, if so, explain its logic?
23. In-Situ Projects--Definitions
The 1996 Budget amended the Act to provide that "tangible capital expenditures for oil sands in-situ projects be treated in the same manner as tangible capital expenditures for oil sands mining projects." The intent of these rules is to provide equitable treatment to all producers of comparable hydrocarbons in all provinces. Unlike the treatment of oil sands mines, paragraph 1104(7)(c) provides that all wells of a taxpayer that the Minister determines constitute one project are deemed to be one mine. Such a determination will affect (1) the costs that qualify for accelerated capital cost allowances (CCA) for purposes of determining the five-percent revenue threshold in paragraph (a.1) of Class 41 and (2) the computation of "income from the mine" for computing the allowable claim. The process for obtaining a determination from the Minister on the scope of a project is onerous, unclear, and subjective. Limited taxpayer personnel resources, as well as the cost and difficulty providing the required information in advance of drilling the wells for the project, make it infeasible for the taxpayer to provide the requested information, especially for small in-situ projects (such as those in Saskatchewan). To provide equitable treatment to all producers of similar hydrocarbons in all provinces, would the Department consider establishing more practical guidelines for in-situ oil sands wells? The current rules, which are designed to reflect issues related to hard-rock mine operations, are impractical to apply to in-situ oil sands wells. Making the guidelines for the determination of a project more practical would afford taxpayers better access to the accelerated CCA rules generally and especially for smaller in-situ projects.
24. Employer Appeal Rights
Currently, an employer is not permitted to appeal an assessment on behalf of an employee unless the employer obtains authorization from the employee. This is a cumbersome requirement where the employer wishes to appeal an issue affecting multiple employees (e.g., the taxability of an employment benefit). Will the Department consider adopting a process whereby for transactions between the employer and its employees the employer can elect to be jointly assessed with all of its affected employees? In such case, the tax would be calculated based on the income inclusion to the individual employees, but the employer could elect to be assessed for the total amount of tax. Adopting such a rule would permit the employer to file a notice of objection and thereby appeal the issue to its conclusion. (An objection filed by the employer, however, should not preclude an individual employee from filing his or her own objection and appeal.) Should the company's appeal ultimately prove unsuccessful, this process would also permit the employer to pay on behalf of the employees the amount of tax owing.
25. Non-Arm's-Length Exemption with Respect to Carved-Out Income in Part XII.1
TEI recommends that the Department consider expanding the definition of "carved-out property" in paragraph 209(1)(f) to exclude all carved-out property acquired in non-arm's-length transactions. Permitting transfers of carved-out property among non-arm's-length parties would afford a group of companies another means to effect a practical tax consolidation. TEI is unaware of any tax policy concerns that might inhibit the recommended amendment. We invite the Department to comment on the proposal.
26. Effective Tax Rates
In the February 28, 2000, Federal Budget, the Minister of Finance proposed phasing in significant corporate tax rate reductions by 2004. Some types of income, however, were excluded from the proposed reductions with the explanation that the "effective tax rate" in respect of the excluded types of income was lower, even without the benefit of the proposed reduced rates, than the "effective tax rate" in respect of other types of income. TEI questions the relevance of "effective tax rates" in formulating federal tax policies because an "effective tax rate" is based on financial statement reporting of the operations of an entity. Moreover, "effective tax rates" are a function of various items such as capital cost amortization policies of taxpayers, capital cost versus operating cost policies, liability exposure recognition, and other accounting concepts and policies. In addition, "effective tax rates" are a function of capital expenditures, which increase and decrease depending on many variables. TEI believes that tax policies should be developed with attention to the tax applicable to incremental expenditures and incomes. This marginal tax rate concept is the most relevant to business in making strategic decisions.
Would the Department of Finance please comment with respect to the Department's emphasis on "effective tax rates" when developing tax policy? In the process of developing the 2000 Budget message, what method did the Department use to compute the "effective tax rates" of various industries? To what extent are other factors considered in developing tax policy related to a particular segment of corporations? What are the other factors and how are they analyzed to determine their appropriateness in setting tax policy? What processes are followed by the Department of Finance to test the validity of the data sources used?
27. Stock Option Benefits
Recent amendments affecting the taxation of stock option benefits will permit Canadian companies to compete more effectively in hiring employees. For many international enterprises, however, the inconsistent tax treatment of stock options among various jurisdictions impedes the companies' ability to transfer employees. Specifically, where an option is granted while an employee is resident in one country and exercised while resident in a second country, both countries may assert the right to tax some or all of the gain on the exercise. Moreover, in many cases, the foreign tax credit mechanism will not afford full relief from double taxation. (4) For example, assume that a Canadian-based employee receives a stock option grant and then, pursuant to a transfer, becomes resident in the United States. After a number of years pass following the transfer, the employee exercises the option while working in the United States. For U.S. purposes, all or nearly all of the stock option benefit will likely be sourced as U.S. income. As such, it will qualify for little or no foreign tax credit because the United States does not consider the stock option benefit to be Canadian-source income. The new tax treaty between the United States and the United Kingdom specifically addresses this issue by providing that the stock option benefit will be allocated for taxation in the two countries based on the period of time that the employee was resident in each country. (5)
Will the Department of Finance consider:
1. Amending the Act to allocate the stock option benefit based on the period of time during which an employee was resident in Canada? For example, the income could be allocated to Canada by multiplying the entire stock option benefit by a fraction, the numerator of which is the number of days between the grant date and exercise date that the employee was resident in Canada and the denominator of which is the total number of days between the grant and exercise dates.
2. Providing in future treaties and treaty amendments a clause comparable to the diplomatic notes in the new US-UK tax treaty? (See footnote 5.)
28. Change of Control
At the time of an acquisition of control of a corporation, subsection 111(4) of the Act requires that all unrealized capital losses with respect to non-depreciable capital property be recognized and added to other capital losses available to the corporation. All such losses expire upon the acquisition of control. Pursuant to paragraph 111(4)(e), a corporation can ameliorate some of the adverse consequences of the rule by electing a deemed sale of nondepreciable capital property (or depreciable property subject to recapture) and offsetting both the realized and deemed losses with built-in unrealized gains. If the taxpayer does not avail itself of the deemed sale provision to create capital gains, the realized and deemed capital losses of the corporation that exist at the time of acquisition of control will likely expire unused.
These rules were developed many years ago in order to prevent loss trading, but they produce harsh and inequitable consequences to taxpayers that are subject to an acquisition of control when the value of their capital assets is temporarily depressed. In addition, we believe the Department should reconsider these provisions because they adversely affect acquisitions that are made for valid business reasons and not for purposes of acquiring tax losses. TEI recommends the Department consider modernizing the rules, as follows:
1. Permit capital losses that exist at the time control of a corporation is acquired to be deducted to the extent of capital gains realized after the acquisition of control in respect of any capital property held at the time of acquisition of control. Responsibility should rest with the taxpayer for tracking these assets. These capital losses should not expire nor should they be permitted to offset capital gains realized with respect to capital assets outside of the historic business assets of the acquired company.
2. Allow capital losses arising from foreign currency transactions under subsection 39(2) that were realized prior to the change of control to form a separate capital loss pool available to offset any capital gains that arise after the change of control. These foreign exchange capital losses should not expire nor should they be required to be allocated to other capital assets.
We believe that the foregoing proposal would prevent loss trading but accord more equitable treatment to taxpayers that are subject to a change in control. We invite the Department's comments.
29. Reporting Requirement for Pensioners
The elimination of the exemption for the first $25,000 of life insurance for purposes of determining the taxable benefit amount attributable to group term life insurance premiums has increased employers' administrative burdens, especially in respect of retired employees. The change requires employers to issue T4As to each pensioner for a small taxable benefit of $200 to $400 per pensioner. Previously, benefits payable to many pensioners were under the threshold and, as a result, no T4As were required. To minimize the additional reporting requirements and attendant costs on employers (and CCRA's corresponding cost of auditing such amounts), would the Department consider reinstating the threshold amount for retirees or other former employees of the employer?
30. Double Tax and Totalization Agreements
In view of the highly mobile, competitive, global workforce and compensation issues that multinational companies must consider and address, TEI encourages the Department to assign a higher priority in its treaty and totalization agreement negotiations to provisions relating to the taxation of pensions and the related employer contributions to pensions, social insurance, and superannunation funds. Currently, Canada's tax treaties and totalization agreements generally address the double taxation of an individual's pension income. Rarely, however, are the costs imposed on employers for contributions to pension plans or superannuation or social insurance funds considered. In addition, exemptions are rarely negotiated to eliminate the requirement to contribute to such funds for foreign expatriates. Finally, when foreign-service employees depart from a host country to the home country, there is little or no ability to withdraw contributions to such funds or permit inter-country transfers in order to ensure that income and tax credits are matched. Without proper matching of the income and credits, the company's tax equalization payments are increased. As Canadian companies become more global, these costs are increasing and are a barrier to competing effectively with companies operating out of lower tax jurisdictions with offshore pension funds. We invite the Department's continents.
31. ITC Utilization
The current ITC rules in subsection 127(5) require a taxpayer to fully offset the current year federal tax payable with ITCs before any ITC may be carried back. The effect of the rule is to generate a nil assessment for the year to which the ITC is applied and the nil assessment precludes a taxpayer from appealing any issues that arise in that return. As a result, a taxpayer must either defer utilization of ITCs until a final assessment for the taxation year or forgo its appeal rights in years affected by the ITC utilization. This creates significant administrative complexity and diminishes the value of the ITC. Hence, TEI recommends that the Department consider amending the Act to state that, for purposes of determining whether an assessment has been made, the amount of tax payable shall be the tax shown on the return before the application of ITC. Such a provision would result in a valid assessment or reassessment that, in turn, would permit taxpayers to appeal any issues in the return. Alternatively, taxpayers should be permitted to elect the amount of ITC to use, up to the amount of tax payable, and be permitted to carry back the excess regardless of whether the current year tax is fully offset. For example, a taxpayer could elect to use say, $90 of $110 of ITC generated in the year in order to offset $100 of current year tax payable and carry back the balance of unused ITC. We invite the Department's views of the proposal.
32. Resource Allowance
In Cominco Ltd. v. The Queen, (84 DTC 6535), the court concluded that the calculation of resource profits does not include business interruption insurance proceeds. Logically, the premiums paid for business interruption insurance proceeds should correspondingly not reduce resource profits because the expenditure is deducted in computing income from a source other than resource profits. Regrettably, CCRA auditors interpret certain 1996 amendments to the Act as requiring a reduction in resource profits for business interruption insurance premiums.6 Taxpayers, however, take the position that the premium cost is related to the insurance revenue source because this expense is not "ancillary to, in support of, for the purpose of, or as a consequence of production or processing of" the resources. TEI recommends that the Department clarify the treatment of such costs by amending Regulation 1204(1.1)(a)(iv) to specifically exclude business interruption insurance premiums. This will eliminate needless disputes between taxpayers and CCRA and provide consistent treatment of the revenue and expense. We invite the Department's view of the recommendation.
33. Stock Option Deduction
In last year's liaison meeting agenda, TEI requested that the Department consider amending section 7(3) of the Act to afford companies a deduction for stock options. The Department's response expressed concern about providing a deduction where companies do not have a cash cost for issuing treasury shares. Would the Department consider amending paragraph 7(3)(b) to exclude a cost incurred by the qualifying person for the acquisition of the shares listed on a prescribed stock exchange where the employee is not entitled to a deduction under paragraph 110(1)(d) in respect of the acquisition of those shares?
34. Reassessment Interest
The non-deductibility of interest charged on late payment of income tax is both punitive and at odds with other industrialized countries' income tax regimes. The most relevant comparison is the United States where debit interest charged by the IRS is deductible by business taxpayers in computing taxable income. Because debit interest is charged at a higher rate than credit interest, and in most cases accrues at an earlier date, there are substantial incentives for taxpayers to comply with their payment obligations. The added cost of disallowing the deduction for debit interest acts as an unreasonable penalty. Would the Department consider amending the Act to permit the deduction of debit interest?
35. Recently Enacted Subsection 85(1.11)
The recently enacted exception to the definition of eligible property in subsection 85(1.11) provides that subsection 85(1) cannot be used in a transfer of a foreign resource property held by a taxpayer (hereinafter the "transferor") to a non-arm's length Canadian subsidiary (hereinafter the "transferee") where "it is reasonable to conclude that one of the purposes of the disposition ... is to increase the extent to which any person may claim a deduction under section 126" (e.g., a foreign tax credit claim (FTC)). (Emphasis added.) The technical notes to Bill C-22 explain that this provision is "intended to counter the avoidance of income-based limits on the foreign tax credit in section 126 that might be achieved through the sale of direct or indirect interests in foreign resource property at less than fair market value."
The roll-down of profitable foreign oil and gas assets to a transferee within the same Canadian corporate group will almost always result in an increase in the FTC claim of the transferee because, for example, it may not have previously owned any profitable foreign properties generating foreign tax liabilities. Hence, for purposes of subsection 85(1.11), the roll-down will almost always increase the extent to which at least one person (the transferee) may claim a deduction under section 126. Accordingly, on each transfer of a foreign resource property in a transaction otherwise qualifying under subsection 85(1), it will be necessary to determine whether it is reasonable to conclude that the increase to the transferee's (or any other person's) FTC was one of the purposes of the disposition.
TEI is concerned that CCRA could almost always assert that the "purpose test" in subsection 85(1.11) is satisfied, which would extend the reach of the statute far beyond the stated reason for introducing subsection 85(1.11). At a minimum, the "purpose test" creates uncertainty. One of the principal reasons Canadian oil and gas companies transfer foreign branches to Canadian subsidiaries is to limit exposure to the additional legal liabilities that can arise when a foreign operation moves from the exploration stage to development and production. Another non-tax reason to transfer the assets is to ease compliance with various obligations arising under foreign operating agreements. Inappropriabe or uncertain tax results arising from the application of the "purpose test" may well inhibit, or even preclude, Canadian oil and gas companies from employing this traditional and prudent form of financial management.
In order to minimize ambiguity and uncertainty from the administration of subsection 85(1.11), TEI recommends that a new subsection be added stating that, so long as the elected amount pursuant to subsection 85(1) is not less than the lesser of the fair market value of the transferred property and the aggregate of unamortized Foreign Exploration and Development Expense and unamortized Cumulative Foreign Resource Expense that is reasonably allocable to the transferred property, subsection 85(1.11) is not applicable. We invite the Department to comment on the proposal.
Tax Executives Institute appreciates the opportunity to present its comments in respect of pending income tax issues. We look forward to discussing our views with you during the Institute's December 5, 2001, liaison meeting.
1. December 1996 Liaison Meeting Agenda Item XXIII Regarding the Large Corporation Tax and 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.
The following example illustrates the financial statement presentation under the new rules: On January 1, 1996, Canco issues a US$100 M denominated debt when the exchange rate is US$1 = 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$1 = 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$1 = CAN $1.30. The financial statement presentation at that date is:
Asset Liability Debt $130 M
Under the rules 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?
Department of Finance Response (prepared by TEI members and reviewed by the Department for distribution): 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.
2. December 2000 Liaison Meeting Agenda Item 18 and Department of Finance Response Regarding Acquisition of Control (87(9))
Assume that a private corporation with several shareholders, none of which controls the private corporation, engages in a triangular amalgamation with a widely held public company in order to form a new public company parent of the amalgamating companies. Following the amalgamation, the former shareholders of the private company own a majority of shares of the new parent. Under these circumstances, the Act provides that both the predecessor public and private corporations undergo an acquisition of control. Since no one of the former shareholders of the private corporation controlled the private corporation or the new parent, TEI believes that there should not be an acquisition of control of the private company for purposes of subsection 87(9). Would the Department consider amending the Act to provide that no "acquisition of control" occurs in the transaction described above?
Department of Finance Response
Normally, in a triangular amalgamation, a subsidiary of the future parent amalgamates with a target corporation to form an amalgamated corporation and the shareholders of the target receive shares of the parent on the amalgamation. The parent ends up controlling the amalco.
The closest parallel to this situation appears to be the case described in paragraph 256(7)(e) of the Act. However, that paragraph requires the acquiring corporation to function almost exclusively as a holding corporation for the transferred corporation. The issue the TEI raises is whether this rule ought to be modified to ignore an acquisition of control in situations where less than 95% of the acquiring corporation's value is derived from the transferred corporation. We believe that this proposition raises new policy issues, but will give further consideration to the question.
(1) Interpretation #182 (December, 1990).
(2) Document 9415515 (December 8, 1995) and Document 9428025 (January 8, 1996).
(3) Round Table 9638910--Hedged debt and Part 1.3 (December 10, 1996).
(4) Even where an employee is allowed a foreign tax credit for taxes paid in the country in which he is not resident, the result is to require the payment of the higher of the two taxes.
(5) The diplomatic notes of the new US-UK tax treaty provide specifically that, in the case of an employee who (i) was granted a stock option while employed in one country, (ii) was employed in both countries during the period between grant and exercise, (iii) remains in that employment on the date of exercise, and (iv) would otherwise be taxable in both countries in respect of the option gain, the employee will be taxable in the country in which he or she is not a resident at the time of exercise only to the extent of the portion of the option gain which relates to the period between grant and exercise during which he or she was employed in that non-residence country. (Emphasis added.)
(6) In 1996, the definition of resource profits in regulation 1204(1.1) was revised to state that deductions from Gross Resource Profits include all amounts deducted by the taxpayer in computing income except for specified deductions. Subparagraph 1204(1.1)(a)(iv) specifically excludes the deduction of amounts deducted in the computation of income from a business or other source that does not include a resource activity. For purposes of the definition of resource activity in Regulation 1206(1), the production or processing of a substance by the taxpayer includes activities that are ancillary to, in support of, for the purpose of, or as a consequence of production or processing of the substance, regardless of whether it has begun, or will ever begin, or has ceased. The definition was expanded in response to jurisprudence in order to ensure that, where production or processing has not yet begun or ceases, normal production and processing operating costs and other direct or supporting costs in respect of that income source will reduce resource profits.
|Printer friendly Cite/link Email Feedback|
|Date:||Nov 1, 2001|
|Previous Article:||TEI comments on providing additional capitalization guidance: November 7, 2001.|
|Next Article:||Pending income tax issues: December 4, 2001. (Canada Customs and Revenue Agency).|