TEI's recommendations to the new Canadian government for its 2006 Budget Legislation.
Tax Executives Institute (TEI) commends the new Government for holding pre-budget consultations in advance of its first budget message. The consultations provide an important avenue to gather input from Canadians across the country. TEI is pleased to offer several recommendations to foster economic growth and job creation, promote a favorable 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 6,000 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 compose approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, 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 Government to adopt the following recommendations in its 2006 budget message:
* Implement phased corporate income tax rate reductions and eliminate the corporate surtax as soon as practicable and accelerate the effective date of the elimination of the Large Corporation Tax (LCT) to January 1, 2006.
* In connection with the reduction of the Goods and Services Tax rate, afford businesses sufficient time and transitional rules to update their information and recordkeeping systems in order to facilitate orderly implementation while minimizing their costs and administrative burdens.
* Expeditiously negotiate and implement a new provision in the Income Tax Convention with the United States eliminating withholding taxes on all dividends and interest for payments to both related and unrelated parties.
* Abandon or substantially narrow the Reasonable Expectation of Profit test in draft legislation clarifying the deductibility of interest and other expenses.
* Abandon draft legislation in respect of Foreign Investment Entities and Non-Resident Trusts and 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.
* Implement a corporate loss transfer system or group loss relief mechanism.
Implement Phased Corporate Income Tax Rate Reductions, Eliminate the Corporate Surtax, and Accelerate Elimination of the Large Corporation Tax
In its November 14, 2005, Economic and Fiscal Update, the previous Government re-announced proposals to reduce the corporate income tax rate from 21 percent to 19 percent over a period of years through 2010 and eliminate the corporate surtax by 2008. In addition, the Update announced a proposal to accelerate elimination of the Large Corporation Tax (LCT) effective as of January 1, 2006. In its election platform, the Conservative Party said that it would "make good ... on the business tax relief' and "deliver" the promises made by the previous Government. TEI agrees that the adoption of these three policy measures will attract investment, generate economic growth, and create well-paying jobs for Canadians. Hence, we urge the new Government to include these proposals in its first budget message. Business income tax reductions will substantially increase the attractiveness of Canada for both foreign and domestic investors. Increased capital investment in Canada, in turn, will spur productivity, promote employment, and enhance the prospects for sustainable economic growth. The announcement of phased corporate income tax rate reductions and a scheduled date for elimination of the corporate surtax will 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 effectively a job-killing tax on capital, accelerating the LCT's demise to January 1, 2006, would immediately improve the competitiveness of the Canadian business tax system.
Afford Businesses Time to Implement Proposed GST Rate Reductions and Provide Appropriate Transition Rules
In her April 4, 2006, Speech from the Throne, the Governor General announced that the Government would reduce the rate of the Goods and Services and Harmonized Sales Tax by one percentage point. Although the rate reductions will be welcomed, businesses require lead time to modify their information systems and recordkeeping processes. For example, businesses will need to update, test, and debug software in order to ensure the proper tax is collected, remitted, and claimed as input tax credits. In addition, questions will arise relating to transactions that straddle the effective date of the rate change that will need to be answered in the implementing legislation or other administrative guidance. For example, a customer may purchase a product or service before the new rates go into effect but return the product (or request a refund) after the effective date. Similarly, long-term contracts entered into prior to the effective date may be partially or fully paid before the effective date, but the sale or lease of the goods (or other performance of the taxable supply) may not occur until after the rate change. Finally, many business forms, invoices, marketing materials, and other stationery will have to be reprinted to reflect the new rates; similarly, CRA and the harmonized provinces will need to update their printed forms, instructions, and other guidance (including the electronic versions) to reflect the revised rates.
To reduce administrative burdens, we recommend that the Government consult widely with various industries in order to determine and set the earliest optimal effective date for the rate reductions as well as to develop transition rules to smooth the implementation of this vital initiative. TEI stands ready and willing to work with the Department of Finance in this endeavour.
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 withholding taxes cause 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, thereby promoting 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 eliminating withholding taxes on cross-border payments between the United States and Canada. Hence, we regret that the 1995 Protocol stopped short of the goal.
Studies, such as one by the C.D. Howe Institute, (1) 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 found 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 are especially cogent in respect of Canada-U.S. trade because the United States is both a key market for Canadian goods, services, and investments by Canadians, and a key source of investment capital for Canadian enterprises. Since the withholding tax rates between the United States and Canada were last revisited in 1995, (2) 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 inter company dividends from withholding taxes. Finally, 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 Government to negotiate a new treaty 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 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, (3) 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 to institute a statutory "reasonable expectation of profit" (REOP) test.
Although the Department's goals are clear, circumscribed, and supportable in principle, the proposed amendment to add subsection 3.1(1) to the Act, relating to limits on losses, is 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 in order to ensure their deductibility raises a number of administrative and policy concerns. Specifically, the proposed changes would modify the long-standing treatment of interest and other commercial expenses that taxpayers and 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. Indeed, the proposals go substantially beyond restoring the Act to the pre-Ludco status quo for the treatment of such expenses. TEI believes the Supreme Court of Canada's decision in the Stewart (4) 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. (5) 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. (6) 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. (7) 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. (8) In addition, the 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 expressed by TEI and others during the consultations and said that it will develop "a more modest legislative initiative that would respond to those concerns while still achieving the Government's objectives." (9) TEI will be pleased to consult further with the Department upon release of a revised proposal.
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 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 is pleased to have participated in consultations with the Department of Finance on the legislation. (10) Moreover, TEI fully supports the Department's efforts to strengthen the integrity of the tax system while ensuring that amendments to the Act are targeted, sustainable, and administrable. We regret to say that, despite the many helpful changes the Department has incorporated in the draft rules since their initial release, the proposed legislation remains overbroad, extraordinarily complex, and confusing.
Fundamentally, we believe the draft legislation is unworkable and again--as in previous pre-budget consultation statements--urge the Government to withdraw it 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. (11)
* 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 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, taxpayers 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 prospective and apply 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. (12)
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. 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. (13) 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 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. The introduction of a formal system for sharing tax losses and other tax attributes among groups of related corporations would bring the Canadian tax system in line with that of most other developed countries in the world. Hence, we urge the new Government to consider its introduction.
Tax Executives Institute appreciates the opportunity to participate in the 2006 pre-budget consultations. We would be willing to discuss these recommendations with representatives from the Department of Finance and would be pleased to respond to any questions you may have about this submission.
(1.) Mintz, Jack M. Withholding Taxes on Income Paid to Nonresidents: Removing a Canadian-U.S. Border Irritant, C.D. Howe Institute Backgrounder (March 5, 2001).
(2.) The 1995 Protocol to the Canada-U.S. treaty provides that the two countries would consult within three years on further reductions in withholding taxes. Since that time, we have urged and continue to urge both countries to implement nil withholding rates on cross-border payments between the two countries to the maximum extent feasible.
(3.) Ludco Enterprises Ltd. v. The Queen, 2001 S.C.C. 62.
(4.) Brian J. Stewart v. The Queen, 2002 S.C.C 46.
(5.) 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, however, 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.
(6.) 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.
(7.) For example, a company may make strategic investments in a losing enterprise in order to (1) pre-empt 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.
(8.) 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.
(9.) 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.
(10.) On March 23, 2006, TEI submitted comments to the Department of Finance on the July 18, 2005, version of the FIE legislation. That letter constitutes TEI's sixth set of written comments on the FIE or NRT legislation. In addition, there have been several meetings, including annual liaison meetings, with representatives of the Department of Finance to discuss the legislation.
(11.) For example, a close examination of these very complex rules suggests that dues paid to a non-resident international labor union may well be considered investments in foreign investment entities, even though there would likely be little or no imputed income if the dues were deducted by an individual member when computing taxable income. This is but one example of the unintended consequences that these overbroad rules will produce.
(12.) 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.
(13.) Of 30 OECD member countries, Canada is 1 of only 9 countries that does 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). For an updated 2005 survey, see Donnelly & Young, Tax Rates and Losses in the OECD: Can Canada Compete?, 42 TAX NOTES INTERNATIONAL 67 (April 3, 2006).
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