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TEI urges Canadian government to abandon proposed legislation relating to foreign investment entities.

On March 23, 2006, TEI President Michael P. Boyle submitted a letter to the Canadian Minister of Finance James A. Flaherty urging the government to abandon proposed legislation affecting foreign investment entities. TEI's letter was prepared under the aegis of its Canadian Income Tax Committee, whose chair is David V. Daubaras of General Electric Canada. Vincent Alicandri of Hydro One Networks, Inc. contributed substantially to the development of TEI's comments. Also contributing to TEI's comments were Monika M. Siegmund of Shell Canada Limited, Carmine A. Arcari of the Royal Bank of Canada, and Karina 0 of Nortel Networks Corporation.

On July 18, 2005, the Department of Finance released the fifth version of draft legislation relating to Foreign Investment Entities (FIE) and Non-Resident Trusts (NRT). On behalf of Tax Executives Institute, I am writing to provide TEI's comments on the proposed legislation relating to Foreign Investment Entities.


Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,800 professionals manage the tax affairs of 2,800 of the leading companies in North America, Europe, and Asia and must contend daily with the planning and compliance aspects of Canada's business tax laws. Canadians constitute 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. Our non-Canadian members work for companies with substantial activities and investments in Canada. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

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


The draft Foreign Investment Entity (FIE) legislation released by the Department of Finance on July 18, 2005, is intended to replace the current rules in respect of the "offshore investment fund" rules found in section 94.1 of the Income Tax Act ("the Act"). The current draft of the legislation replaces drafts released previously on June 22, 2000; August 2, 2001; October 11, 2002; and October 30, 2003.

The current rules in sections 94.1 are anti-avoidance provisions that are intended to prevent taxpayers from inappropriately deferring or avoiding tax (including conversion of income to capital gains in specific situations). Current section 94.1 applies where a taxpayer has invested in an offshore investment fund and one of the main reasons for the investment is to reduce or defer the tax liability that would have applied to the income generated by the underlying assets of the fund if such income had been earned directly by the taxpayer.

In announcing the original draft of the legislation in June 2000, the Department's press release explained its purposes, as follows:
 It is important that the income tax
 system not provide a means for Canadians
 to avoid Canadian income
 tax by transferring funds to offshore
 trusts or accounts. The proposed rules
 intend to provide a fair and workable
 approach to dealing with this complex

As noted in our previous submissions, the government's objective of curbing illegitimate tax avoidance effected through "transfers to nonresident entities" is unassailable--and TEI supports such efforts because it will forestall shifts in the tax burden to already compliant taxpayers--but we do not believe that the proposed new and complex FIE provisions are necessary to achieve the government's goals. Current section 94.1 provides the government substantial tools to curb tax-motivated transfers. Moreover, the decision in Walton v. The Queen, 98 D.T.C. 1780, vindicated the policy underlying section 94.1 and enhanced that provision's efficacy in combating tax avoidance effected through offshore investment funds. We urge the government to optimize enforcement of the current provisions in the Act before adding new provisions.

As important, the government's announcement regrettably understates the scope, nature, and far-reaching effect of the proposed legislation because the draft rules go significantly beyond the stated purpose of combating "tax avoidance." Indeed, the proposed legislation implements a comprehensive new regime for taxing indirect foreign investment.

We commend the Department's ongoing commitment to the consultative process and its making important revisions to the proposed legislation in the most recent and previous drafts. While the Department has made progress in addressing the overlap with other provisions of the Act, the "band aid" approach to perfecting this proposed legislation has not corrected its most significant deficiencies. The rules remain overbroad, extraordinarily complex, and confusing. As a result, the provisions will interfere with legitimate business operations, impede Canadian business expansion abroad, and undermine Canada's competitiveness.

Although the current draft helpfully reduces the number of instances where a non-resident corporation operating an active business might qualify as a FIE, TEI continues to believe that, once an entity is trapped in the labyrinth of the FIE rules, compliance may prove impossible. We also continue to question whether the Canada Revenue Agency (CRA) will, anymore than taxpayers, have the resources to administer these rules. From both compliance and administrative perspectives, the rules would be vastly improved if they were more limited in scope and focused solely on remedying abuses. To the extent that the government can identify specific abuses, it should propose narrower, targeted solutions. Otherwise, the compliance challenges posed by the proposed legislation will spawn inadvertent, unavoidable non-compliance by otherwise compliant taxpayers.

Fundamentally, we urge the government to withdraw the proposed legislation because:

* It would apply to numerous, compliant taxpayers that are not attempting to avoid Canadian tax by "transferring funds to offshore trusts or accounts."

* It overlaps section 17 and will interfere with many legitimate commercial transactions.

* The information necessary to comply with the proposed legislation's myriad reporting requirements or to take advantage of one or more relieving provisions or elections is either (1) unavailable generally or (2) likely unavailable to a Canadian taxpayer where, as will generally be the case, it is a minority investor and lacks the requisite control to compel production of the necessary information. Consequently, most taxpayers with a FIE will be subject to the prescribed rate of return regime (the imputed interest method) imposed by proposed subsection 94.1(4).

* The Minister, in certain circumstances, is accorded seemingly untethered authority to make various determinations, including whether a business is an investment business, property is exempt, and an entity is a FIE or a qualifying entity, with taxpayers having no right to appeal various determinations.

* The proposed legislation impedes foreign investment by Canadian companies and impairs their global competitiveness. For example, during negotiations over proposed business transactions, potential foreign investees have objected to providing the financial information that would enable a Canadian minority investor to comply with the proposed FIE rules. In many cases, the investee's reluctance arises from the additional burden imposed on the foreign companies to prepare detailed information solely for a Canadian minority investor. Where the foreign investee is also a competitor, the foreign company has objected to supplying additional information that might create a competitive advantage for the minority Canadian investor. Specific examples summarizing how the rules have affected the negotiation of foreign investments by Canadian companies are attached in Appendix 1.

* The rules apply retroactively to taxation years beginning after 2002.

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. Moreover, given the legislation's mind-numbing complexity (and the myriad revisions over the years) taxpayers will need more time to digest and analyze the proposed legislation and, after determining whether the information is available and obtainable, to make necessary changes to their information systems. Hence, the implementation of the proposed legislation should be delayed substantially in order to afford taxpayers time to undertake a proper analysis and implement the necessary information system changes. We recommend, at a minimum, that the coming-into-force date be no earlier than taxation years commencing after December 31, 2006.

TEI's questions, comments, and concerns about specific provisions are set forth below.


A. Arm's Length Interest

The definition of an "arm's length interest" is relevant in determining whether a taxpayer's particular participating interest will qualify as an "exempt interest" under paragraph (e) of that definition and whether an interest has a "readily obtainable fair market value" as defined in subsection 94.2(1). The explanatory notes issued with the draft legislation provide that a particular interest is an "arm's length interest" only if the following criteria are met:

* It is reasonable to conclude that there are at least 150 persons each of which holds participating interests in the non-resident entity that, at that time, are identical, to the particular participating interest, and have a total fair market value of at least $500 [emphasis added];

* The fair market value of the participating interest held by the taxpayer or an entity or individual with whom the taxpayer does not deal at arm's length does not exceed 10 percent of the total of all amounts each of which is the fair market value, at that time, of a participating interest in the non-resident entity held, at that time, by any entity or individual and that is identical to the particular participating interest; and

* It is reasonable to conclude that participating interests identical to the particular interest can be acquired and sold by members of the public in the open market or can be acquired from and sold to the non-resident entity by members of the public.

The challenges that taxpayers face in satisfying the "arm's length interest" criteria include the following:

* The names of the shareholders of companies listed and traded on a public stock exchange are generally not available to other shareholders. Accordingly, how will a taxpayer be able to determine whether there are at least 150 shareholders?

* How will a taxpayer determine whether each of the required 150 or more shareholders holds identical participating interests having a total value of at least $500?

* How will a taxpayer determine the fair market value of each of the identical participating interests held by the required 150 or more entities or individuals? Will a "control" premium (whether actual or effective), if any, be attributable to any particular interest? Will it be necessary for each Canadian taxpayer having a participating interest to obtain valuations for each identical interest held by each shareholder?

The July 18, 2005, proposed amendments do not address our concerns. The requirements in the draft legislation are very similar to those prescribed by regulation 4800 for purposes of permitting a corporation to elect "public corporation" status and for a trust to qualify as a "mutual fund trust." Unlike regulation 4800, however, pursuant to which the entity makes the determination of its status as a public corporation or mutual fund trust, the draft legislation requires the determination of the "arm's length" nature of the interest to be made by an investor that in all likelihood would not have access to pertinent information with which to make the determination. We do not believe investors will be able to make a determination whether the interest is an "arm's length interest."

B. Carrying Value

Under the proposed rules, a nonresident entity that holds at least 50 percent of its assets in "investment property" may be considered a FIE. Hence, the definitions and measurement of "carrying value" for "investment property" are central to the application of the draft rules. The "carrying value" of a property held by an entity is either the fair market value of the property (assuming the taxpayer makes a proper election) or, in all other cases, "the amount at which the property would be valued at that time for the purpose of the entity's financial statements." The definition of financial statement, in turn, provides that the financial statements must be prepared in accordance with generally accepted accounting principles used in Canada or accounting principles substantially similar to generally accepted accounting principles used in Canada. (Emphasis added.) Under proposed paragraph 94.1(2)(b), this will include GAAP used in the United States or in countries that are members of the European Union.

First, TEI is pleased that the legislation permits taxpayers to submit financial statements prepared in accordance with either Canadian generally accepted accounting principles (GAAP) or GAAP used in the United States or a country that is a member of the European Union (E.U.). For investments in the United States or E.U. countries, the exception will eliminate the administrative burden of restating financial statements in accordance with Canadian GAAP. We recommend, however, that this policy be expanded to permit taxpayers to submit financial statements prepared in accordance with GAAP prescribed by countries that adhere to the International Financial Reporting Standards promulgated by the International Accounting Standards Board.

In addition, we have the following specific questions and comments regarding the definition of "carrying value":

* For financial statements prepared for entities outside of the United States and the European Union, what does the phrase "substantially similar" to generally accepted accounting principles in Canada mean?

* How will the many differences in industry accounting rules and practices be taken into account in determining whether the foreign rules are substantially similar to Canadian GAAP?

* How will taxpayers and government auditors develop the information necessary to calculate the substituted values based on Canadian GAAP? The only information available may well be the financial statements prepared on a non-Canadian GAAP basis.

* In order to apply the proposed legislation, CRA personnel will need to be trained to recognize and understand the differences among Canadian, U.S., E.U., and "other" countries' generally accepted accounting principles. We question whether CRA will have sufficient resources to train its auditors to determine whether the accounting principles applied by an entity are substantially similar to Canadian GAAP.

* How should a taxpayer ascertain the fair market value of the assets of a corporation for purposes of determining whether to elect to base "carrying value" on fair market? If the taxpayer makes the election, will the value of intangible property not on the balance sheet be recognized?

* There are frequent disputes within the accounting profession about the application of generally accepted accounting principles to various transactions. Hence, the requirement to restate financial statements of an entity into Canadian (or substantially similar) GAAP will be fertile ground for contentious and unproductive disputes between taxpayers and CRA in determining whether the entity is a FIE. The audit disputes, in turn, will increase the cost of business for Canadian taxpayers conducting business outside Canada thereby rendering them less competitive with local businesses.

We recommend that the requirement to restate certain foreign financial statements to Canadian GAAP in any circumstances be eliminated. Adopting this change would more closely conform the proposed rules to the controlled foreign affiliate (CFA) regime, including the rules for computation of exempt surplus, taxable surplus, etc. At a minimum, the explanatory notes should refer to pronouncements of accounting principles by accounting standard-setting bodies (apart from those in the United States or European Union) that the Canadian government would consider substantially similar to Canadian GAAP.

C. Designated Cost

For participating interests acquired before 2003, the definition of "designated cost" requires the taxpayer to include in (or deduct from) such cost the amount by which the fair market value of the participating interest at the end of the last taxation year that begins before January 1, 2003, exceeds (or is lower than) the cost amount to the taxpayer. TEI remains of the view that most taxpayers will not have access to information that will permit them to compute the fair market value at the designated time. Hence, they will not be able to determine the initial "designated cost" of such participating interests.

D. Entity

The definition of "entity" includes a "fund," an "organization," and a "syndicate," but TEI is uncertain what enterprises, operations, or entities the government intends to encompass by these terms. Accordingly, we reiterate our recommendation that the Department provide a definition for each term.

E. Exempt Business

Paragraph (a) of the definition of "exempt business" in subsection 94.1 (1) includes a business:
 carried on by the entity as a foreign
 bank, a trust company, a credit union,
 an insurance corporation or, if the entity
 is controlled by a taxpayer resident in
 Canada that is described in subparagraph
 95(2.1)(a)(i), a trader or dealer in
 securities or commodities ... [Emphasis

TEI questions the need for the requirement that an entity that is a regulated trader or dealer in securities be controlled by a taxpayer resident in Canada. For the entity to satisfy the requirement, the entity would seemingly need to be a controlled foreign affiliate of the taxpayer, an interest in which that would also be an "exempt interest" within the meaning of subsection 94.1(1). Consequently, there does not appear to be a rationale why the business must qualify as an "exempt business." Alternatively, a taxpayer's participating interest in a non-Canadian controlled regulated foreign trader or dealer in securities would seemingly never qualify as an exempt business. The latter result is, in our view, inappropriate and should be modified.

Indeed, whether the foreign entity is a controlled foreign affiliate should not be relevant. Rather, the focus should be on establishing an objective measure of the foreign entity's income that is earned in a regulated financial environment. Hence, consistent with the foreign affiliate rules, we recommend that the income from the above businesses be treated as active business income or, for this purpose, as income from an exempt business irrespective of whether the entity is a controlled foreign affiliate.

F. Exempt Interest

An investor will not be subject to proposed section 94.1 if a participating interest in a foreign entity is considered an "exempt interest" as defined in subsection 94.1(1). The most common forms of "exempt interests" include:

* A participating interest in a CFA, including an affiliate that is a CFA because of an election made under paragraph 94.1(2)(h).

* A participating interest representing at least 10 percent of the votes and value of a "qualifying entity" (generally a corporation or partnership all or substantially all of the carrying value of its property is throughout the period attributable to property other than "investment property" and other investments noted in our comments on "qualifying entity").

* There is no tax avoidance motive (as described in paragraphs 94.1(2)(k) to (n)) for acquiring the interest, and either
 --the participating interest is an
 arm's length interest in a FIE resident
 in a country where there is a
 prescribed stock exchange and the
 interests are listed on a prescribed
 stock exchange


 --the participating interest held
 by the taxpayer is a FIE that was
 formed, organized, or continued
 under and is governed by the
 laws of a country (other than a
 prescribed country) with which
 Canada has entered into a tax
 treaty and under that treaty the
 FIE is resident in that treaty country,
 and the participating interest
 in the FIE is an "arm's length

The definition of "arm's length interest" provides that a participating interest will be deemed to be an arm's length interest if at least 150 persons own such participating interests and each of those persons owns participating interests with a total value of at least $500; the participating interest owned by the taxpayer or an entity with which the taxpayer does not deal at arm's length does not exceed 10 percent of the fair market value of the FIE; and the interest may be purchased and sold by any member of the public in the open market.

Because of the practical challenge of obtaining the information to establish that an entity is an "exempt interest," few companies will likely qualify for the relief that the Department intends. The challenges that taxpayers face in satisfying the "exempt interest" criteria include the following:

* The "residence" test is a legal question that depends on all the facts and circumstances and in many cases the information necessary to determine the residence of an entity may be unavailable. For example, under many countries' corporate laws, the location of a company's board of directors meetings is relevant in determining the corporation's residence. How will a taxpayer obtain that information in order to determine the residence of the corporation? Moreover, the policy rationale for incorporating a residence test is unclear. Why should it make any difference whether a corporation listed on the New York Stock Exchange is resident in the United States or Bermuda?

* The determination whether an entity is a "qualifying entity" will require access to detailed financial and other information generally unavailable to most shareholders. Additional comments on this issue are set forth below.

* As noted in our comments on the definition of "arm's length interest," shareholders can rarely obtain information about other shareholders, including the value of their interests. Thus, how will a taxpayer determine whether there are at least 150 other shareholders and that the value of each shareholder's participating interest is at least $500? We submit that they will not be able to do so.

Despite the government's likely intent to afford taxpayers meaningful exceptions and broad relief from the FIE rules, TEI believes that only a participating interest in CFAs will clearly qualify as an "exempt interest." A lack of access to sufficient financial and other information will likely stymie most taxpayers' efforts to ascertain whether their investment interests qualify as an "exempt interest."

G. Financial Statements

Please refer to our comments under "Carrying Value."

H. Foreign Investment Entity

Generally, a FIE is any nonresident entity unless at the end of its taxation year the "carrying value" of the entity's "investment property" is less than 50 percent of the "carrying value" of all of the entity's assets. A FIE does not include an entity with respect to which its principal business is not an investment business.

TEI welcomes the exclusion from FIE status for entities whose principal business is not an investment business. The determination whether an entity's principal business is an investment business is based on a facts-and-circumstances test or, if the taxpayer elects, by comparing "net accounting income" from investment properties and investment businesses with "net accounting income" from the entity's entire business. Since the exceptions to the FIE definition can only be determined at the entity's year end, it will not be possible to determine an entity's status as a FIE at other specific times, such as when an investment is made or at the year end of the investor if such year does not coincide with that of the foreign entity as required in the definition.

Subparagraph 94.1(2)(e)(i) provides that the principal business of the entity is determined by reference to the facts and circumstances, including the fair market value of assets used in the activities carried on by the entity during the year, the amount of time spent by the entity's employees in carrying out those activities, the amount of expenditures incurred by the entity in respect of those activities, and the revenue derived by the entity from those activities. In TEI's view, the facts-and-circumstances test will not be available to most taxpayers because the required information cannot be obtained by minority shareholders.

Moreover, the election to base the determination of the entity's principal business activity on a comparison of "net accounting income" from investment properties and investment businesses may not be available to taxpayers. A net-income-oriented test requires access to a greater level of detailed information (e.g., cost of goods sold and other expenses) than a revenue-based test and we question whether taxpayers will have sufficiently detailed financial information to make a net-income based determination. In similar tests under the Act (e.g., the definition of a leasing business), the entity's principal business is determined based on a comparison of revenues. In addition, under a net-income test, an entity sustaining business losses from a substantial operating business might be considered to be engaged in an investment business simply because it owns a minor investment property that produces a positive yield during a loss year. The latter result is clearly inequitable and perhaps unintended. TEI recommends that the government revise the elective test and base it on revenues rather than net income.

In addition, for the reasons expressed above in respect of the definition of "carrying value," it will be very difficult for taxpayers to determine whether an entity is a FIE and, in turn, determine whether it should elect to base the reported "carrying value" on the fair market value of the assets.

Next, the current draft rules are inconsistent with the proposed legislation's policy objective where a foreign entity directly or indirectly holds significant Canadian investment properties. Specifically, the rules do not exclude from the various tests the assets, businesses, or entities already within the Canadian tax net. For example, assume a taxpayer acquires a participating interest in a foreign entity with two significant categories of assets. The first category consists of foreign "active business" assets (i.e., non-Canadian assets that are business assets or shares of foreign entities that carry on a business that is not an investment business) and represents 49 percent of the carrying value of all the foreign entity's assets. The second category of assets consists of shares of a Canadian corporation that carries on an investment business and makes up the remaining 51 percent of the carrying value of the foreign entity's assets. Under the proposed rules, the foreign entity would be a FIE of the taxpayer. This is clearly an unintended result. Accordingly, the current proposals should be amended to prevent "Canadian assets," the income from which is subject to Canadian tax, from "tainting" a foreign entity as a foreign investment entity.

Finally, for purposes of determining whether the principal business of an entity for the year is an investment business, the Minister may demand additional information pursuant to subparagraph 94.1(2)(e)(iii). If the taxpayer fails to supply the demanded information within 60 days (or such longer period as determined by the Minister), the principal business of the entity will be deemed to be an investment business. As a practical matter, it is unlikely that additional detailed information will be available under either alternative. Accordingly, taxpayers will likely not be able to avail themselves of this exclusion from the FIE definition. Moreover, there appears to be no appeal from the Minister's determination that an entity carries on an investment business. This is unacceptably arbitrary. We recommend that a determination whether an entity carries on an investment business be subject to appeal.

I. Investment Property

1. Hedging Transactions. Under paragraph (1) of the definition of "investment property" in subsection 94.1(1), a derivative financial product is generally classified as an investment property of an entity. No explicit exception is provided for derivatives employed to hedge the risks of non-investment properties or business transactions that are undertaken in the ordinary course of an active business. As a result, the provision is overbroad. TEI recommends that paragraph (l) be revised, as follows:
 except where the derivative financial
 product can reasonably be determined
 to be related to the hedging,
 in whole or in part, of risks of the
 business, a derivative financial
 product (other than a commodity
 future to which the exception in
 paragraph (g) applies); or ... [Emphasis
 added to highlight TEI's
 proposed language.]

Indeed, paragraphs (g) (relating to commodities and commodity futures), (j) (relating to currency), and (m) (relating to interests or options in respect of property described in paragraphs (a) to (1)) similarly lack explicit exceptions for property used in whole or in part to hedge other business property or transactions. Furthermore, the carve-out in paragraph (p) for exempt commodities should be expanded to encompass all commodity transactions related to the hedging, in whole or in part, of risks of the business. Finally, we reiterate our recommendation that the Department reconsider whether the definition of investment property should be revised to treat fluctuations in the value of hedged property and the hedging item symmetrically.

2. Intellectual Property. The July 18, 2005, draft legislation adds "intellectual property" to the list of investment property types. As a result, an "investment business" will include entities whose principal purpose is to derive income or profits from the disposition of intellectual property. It is unclear, however, how the principal purpose test will be applied. For example, self-developed intellectual property generally has little or no carrying value. Thus, when a foreign business is sold, the gains from the sale of the intellectual property could potentially be considered as an investment gain even though the self-developed intellectual property has been used in the conduct of an active business.

In addition, given the substantial variances in the carrying values and types of intellectual property, taxpayers in substantially similar businesses may have very different tax results. For example, assume Taxpayer A owns shares in Foreign Entity A. Foreign Entity A internally develops its intellectual property, which has a fair market value of $1 million and a carrying value of nil. Foreign Entity A also holds other business assets worth $500,000. Under these facts, Foreign Entity A would not be considered a FIE. In contrast, assume Taxpayer B owns shares in Foreign Entity B. Foreign Entity B purchases, for a fair market value of $1 million, the same intellectual property that Foreign Entity A self developed. As a result of the purchase, the carrying value of the intellectual property for Foreign Entity B is $1 million. Foreign Entity B also holds other business assets worth $500,000. Thus, Foreign Entities A and B own the same intellectual property with a fair market value of $1 million and each has active business assets worth $500,000. Despite the similar business characteristics, Foreign Entity B would, after July 18, 2005, be considered a FIE because more than 50 percent of the carrying value of its assets consists of investment property. Similarly disparate treatment would arise depending on whether an acquisition of a foreign entity with intellectual property assets is accounted for under the pooling or purchase method of accounting.

If intellectual property is retained in the list of investment property, TEI recommends that the Department craft an exception for self-developed and purchased intellectual property that is used in an active trade or business.

J. Qualifying Entity

The definition of "qualifying entity" in subsection 94.1(1) is relevant for determining whether (1) a participating interest in an entity is an "exempt interest" and (2) certain property is "investment property." A "qualifying entity" is an entity all or substantially all of the carrying value of the property of which, throughout the period, is attributed to the carrying value of the following types of property:

* Properties other than investment property;

* Participating interests in or debts of other entities in which the entity has a significant interest (i.e., shares having at least 25 percent of the votes and value of the other entity) or a "strategic interest" (i.e., an interest that satisfies the conditions of clause (b)(ii)(B) of the definition of qualifying entity in subsection 94.1(1)), if the other entity is an entity whose principal business is not an investment business;

* Investment property that is property or proceeds from the disposition of property to be used in acquiring the foregoing property, or

* Investment property that is held by the particular entity and acquired within the preceding 36 months as a result of qualifying activities.

We question whether any minority shareholder will be able to obtain the necessary financial and other information in order to determine whether an entity is a qualifying entity. The challenge will be compounded when an entity has a participating interest in a second-tier company and the investor is attempting to ascertain whether the participating interest is a "significant interest" or whether the upper-tier entity exercises "significant influence" over the lower-tier entity. We recommend that the government provide a more efficacious definition of "qualifying entity" because few investors in non-investment businesses will be able to obtain the information necessary to satisfy the definition of a qualifying entity.

K. Significant Interest

A corporation is considered to have a "significant interest" in an entity --whether a corporation, partnership, or non-discretionary trust--where its interest represents at least 25 percent of the votes and value of the entity. Where a taxpayer holds a "significant interest" in an entity, "look through" rules apply to aggregate the lower-tier company assets with the upper-tier corporation owner's assets for purposes of determining whether the upper-tier companies are considered FIEs.

TEI questions whether a company owning a 25-percent interest in a subsidiary entity will possess sufficient control of the underlying entity to obtain the information necessary to apply the "look through" rule. A similar concern was voiced when the government announced the draft 1995 foreign affiliate proposals (i.e., adding the prescriptive rules that address the treatment of investment income) and also when the government announced modifications to section 17. In each case, the government revised the draft legislative provisions in order to accommodate incorporated joint ventures by adopting a 10-percent-of-votes-and-value test for foreign affiliates and for the arm's length exemption in subsection 17(3).

After considering the differing percentage of ownership rules for applying the "significant interest" test and the foreign affiliate regime, TEI is unable to form a specific recommendation about which ownership threshold is preferred. On one hand, applying differing ownership threshold tests for the FIE regime and the foreign affiliate regime would cause considerable complexity. On the other hand, lowering the ownership threshold in the FIE rules to a 10-percent-of-votes-and-value test for application of the "look through" rules would increase the number of taxpayers unable to obtain the information necessary to comply with the FIE provisions. Hence, while making no recommendation on the proper level of ownership for a "significant interest," we believe the differing ownership tests for the FIE and foreign affiliate regimes underscore that the entire FIE legislation is not integrated with the foreign affiliate regime.


A. Paragraph 94.1(2)(e)--Determining Whether the Principal Business Is an Investment Business

Please refer to the comments under the definition of "Foreign Investment Entity."

B. Paragraph 94.1(2)(h)--Entity Treated as a Controlled Foreign Affiliate

Where a taxpayer's interest in a FIE represents at least 10 percent of the votes and value of the FIE, paragraph 94.1(2)(h) would permit a Canadian taxpayer to make an irrevocable election to treat a qualifying FIE as a CFA. For many taxpayers, treating a FIE as a CFA would ease the administrative burden of coping with these rules, and hence the election is welcome. The administrative relief the government intends to accord taxpayers, however, may be unduly circumscribed. Specifically, under paragraph 94.1(2)(i) a taxpayer's election to treat a FIE as a foreign affiliate would be rendered invalid unless the taxpayer can demonstrate to CRA within 60 days of a written demand by the Minister that the FAPI income of the entity has been properly reported. Since few Canadian taxpayers will be able to obtain the information necessary to calculate FAPI income for non-controlled entities, most taxpayers will not be able to avail themselves of the CFA election. The relief intended to be provided by this subsection should be broadened in order to be effective.


Under paragraphs 94.1(2)(e), (p), (q), and (r), the Minister may request certain additional information. If the taxpayer does not supply the information within 60 days of the request (or such longer period as determined by the Minister) or if the information is unsatisfactory to the Minister, the taxpayer is denied the benefit of certain provisions. In addition, in any subsequent appeal of the Minister's decision, the taxpayer is seemingly permitted to rely only upon information previously submitted to the Minister.

TEI believes that the 60-day time frame to respond to a request from the Minister for additional information is insufficient. By definition, the taxpayer is not in control of a FIE and, thus, will likely be unable to obtain the documentation on demand. In the unusual case where information might be available, taxpayers should be accorded a reasonable period of time, depending on all the facts and circumstances of the taxpayer's relationship to the entity, to produce the additional documents.

In addition, the provision denying the taxpayer the opportunity to provide supplementary information at a later date is punitive and should be reconsidered.

Finally, the provisions fail to prescribe (a) the contents of the Minister's notice of demand for information, (b) the conditions under which the Minister may demand supplemental information, (c) the standards for determining the clarity, reasonableness, and relevance of the Minister's demand, and (d) the standard or process through which the taxpayer can establish that its response should be considered satisfactory to the Minister. In order to avoid arbitrary decisions and inconsistent treatment of taxpayers, TEI recommends that the scope and particulars of the Minister's demand for information be subject to a reasonableness requirement and a relevance standard. In addition, taxpayers should be accorded a right to judicial review of whether the Minister's demands are reasonable and relevant and whether the documents produced should be considered to satisfy the Minister's request for information.


The definition of "readily obtainable fair market value" in subsection 94.2(1) is relevant in determining whether a taxpayer may elect to apply the "mark-to-market" regime in respect of a participating interest in a non-resident entity. A "readily obtainable fair market value" of a particular participating interest in a non-resident entity will be considered to be available--

(a) where participating interests identical to the participating interests are listed on a prescribed stock exchange, qualify as an arm's length interest of the taxpayer (computed without the 10-percent limitation), there is a published trading price for the particular interest for each of the last 10 consecutive trading days, and within the 30-day period that begins before the particular time there are at least 10 trading days of the identical participating interest on that stock exchange, or

(b) where identical participating interests have conditions attached that require either the non-resident entity or the holder of the interest to redeem or purchase the interest at a price equal to its fair market value. The redemption price must be a price that would have been acceptable to entities dealing at arm's length and the conditions must attach to the security "throughout the particular period."

With respect to condition (a), it is unclear how a taxpayer can satisfy the condition that a thinly traded security actually traded for 10 consecutive days.

In respect of condition (b), we have the following comments and questions:

* If the mirror-image put and call options were not included as part of an ownership interest that was issued prior to January 1, 2003, will the mark-to-market regime ever be available to the taxpayer? Alternatively, if participating interests issued prior to January 1, 2003, can be amended after that date in order to include the specified conditions, will the requirement that the conditions attach "throughout the particular period" be satisfied and thus the mark-to-market regime available for the participating interests?

* Few, if any, corporations are likely to issue a security instrument or participating interest that satisfies condition (b). Such provisions in a security instrument would wreak havoc with the corporation's debt-equity ratios because the holders' interests can be redeemed at any time. Moreover, such securities might cause a company to violate its debt covenants.

* Condition (b) seems far too restrictive when applied to a FIE that is similar to a mutual fund trust or mutual fund corporation where the redemption price (whether determined by the issuer or by the holder) is determined and payable by reference to the fair market value at pre-established dates or periods within the year (e.g., month-end or quarter-end). We believe that entities whose securities are similar to a mutual fund trust or a mutual fund corporation should qualify as having a "readily obtainable fair market value."

It is unlikely that taxpayers will be able to satisfy the "arm's length interest" requirement with respect to condition (a) except for participating interests in a non-resident entity that are widely held, actively traded, and listed on a prescribed stock exchange. (See the comments under "arm's length interest.") Furthermore, since few, if any, corporations will actually issue an instrument that satisfies condition (b), the mark-to-market regime will also likely be available only for participating interests in a non-resident entity that is widely held, actively traded, and listed on a prescribed stock exchange.


Subsection 94.2(12) provides that when a participating interest is no longer subject to the mark-to-market rules under subsection 94.2(4), the taxpayer is deemed to have acquired the participating interest at the beginning of the following taxation year at a cost equal to its fair market value. The explanatory notes state that this subsection could apply, for example, where a taxpayer's interest in a FIE ceases to have a "readily obtainable fair market value." As a practical matter, a taxpayer in such circumstances will be required to obtain a valuation for the investment. The cost of obtaining the valuation is an additional example of the practical barriers to the use of the mark-to-market rules.


Subsection 94.2(20) provides that, in certain circumstances, amounts subject to an income inclusion under subsection 94.2(4) in respect of a participating interest in a non-resident entity may be reported as capital gains and losses rather than as income from property. The subsection may be utilized when all or substantially all the amounts that are required to be added or deducted in computing the taxpayer's income relates to realized or unrealized capital gains or losses. Regrettably, investors with minority interests likely will not have access to the detailed level of information necessary to obtain the intended relief.


The accrual method is available to qualifying taxpayers to report income from a foreign investment entity. As with the mark-to-market method, however, the accrual method is unlikely to be available for most taxpayers because a minority investor will not be able to obtain the information necessary to comply with the accrual method's requirements. We have the following additional concerns about the accrual method:

* The "income allocation" and "loss allocation" definitions provided in subsection 94.3(1) require that the income of the non-resident entity be calculated (with certain listed exceptions) as though the entity had been resident in Canada throughout its existence. Hence, the income (and losses) of the non-resident entity are seemingly to be computed using Canadian rules. The detailed information required to make this computation, however, will simply not be available to a minority investor.

* The income, losses, and foreign tax of the non-resident entity is allocated to a Canadian taxpayer by multiplying each such amount by a fraction, the numerator of which is the fair market value of the interest held by the Canadian taxpayer and the denominator of which is the fair market value of all participating interests. Again, it is unlikely that the detailed information required to compute the fair market value of the Canadian taxpayer's proportionate share of each amount will be available to a minority investor.

* Under paragraph 94.4(3)(e), one of the prescribed conditions for applying the accrual method is that the taxpayer must file with its tax return filed on or before the taxpayer's filing due-date for the particular year, prescribed information in prescribed form. The explanatory notes state that it is contemplated that the prescribed information would include: financial statements, capital cost allowance schedules, capital gain and loss calculations, a detailed calculation of the specified tax, income, and loss allocations, a reconciliation of financial statement income to allocated income, and a description of the reserves claimed. The typical minority investor will be unable to obtain this information.

Regrettably, in all but the most unusual circumstances, the accrual method will not be available because taxpayers will not be able to supply all the required information.


TEI believes the interaction of the proposed FIE rules with section 17 will frequently produce double taxation of distributed income. Assume, for example, that a corporation is a FIE with active business income of $100 that arises primarily from a loan to a non-controlled company. The interest income is deemed to be active business income by subparagraph 95(2)(a)(ii). Assume further that the company pays a dividend of $60 from the deemed active business income. TEI's understanding of the tax consequences of the assumed facts is summarized in Appendix 2.

Although the FIE income may eventually be reversed, it is clear from this simple example that the income to be reported under section 17 will never be reversed through the payment of dividends from the FIE. TEI recommends that the Department amend the draft provisions to eliminate the potential double taxation arising from the interaction of section 17 with the FIE provisions.

Finally, it is unclear how the FIE rules will be harmonized with the mechanics of the current foreign affiliate (FA) rules, especially in respect of corporate mergers, liquidations, and reorganizations. We believe that many unintended instances of double taxation will arise from the sheer complexity of the FIE and FA rules and their interaction with provisions in the Act governing such transactions.


Despite the many helpful changes that the government has incorporated in the draft FIE legislation since its initial release, TEI believes that it remains at once unworkable and misbegotten. Hence, TEI recommends that the government withdraw the proposed FIE legislation and, to the extent that specific abuses are identified, craft targeted solutions to address those transactions or investments that circumvent the current anti-avoidance rules.

TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments.

TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David V. Daubaras. If you should have any questions about the submission, please do not hesitate to call Mr. Daubaras at 905.858.5309, or Monika M. Siegmund, TEI's Vice President for Canadian Affairs, at 403.691.3210.

Appendix 1--Examples where the Proposed FIE Legislation Impedes International Business Transactions and Impairs Competitiveness

Example 1

As part of its overall business strategy, a Canadian corporation makes numerous minority investments (generally in the range of two to eight-percent ownership) in foreign entities. The foreign entities are generally private companies with limited international tax experience. The foreign entities object to complying with requests for FIE information for the following reasons:

1. Legal concerns. Can one minority investor (i.e., the Canadian shareholder) obtain more financial information than other minority investors? Likely, no.

2. Complexity of the FIE rules. The foreign entities have limited experience complying with Canadian tax rules generally and, based on their cursory understanding of the FIE rules, cannot supply meaningful information that would permit the Canadian taxpayer to comply with the various elections and relief provisions.

3. Limited resources and additional costs. Assuming the additional information required under the FIE rules can be legally provided to only one investor, the investees are small companies with limited resources available to gather the information. The costs of complying with the FIE rules are borne, directly or indirectly, by the Canadian minority investor.

The additional costs and complexity of the Canadian reporting requirements affects the negotiation of the transactions as well as the Canadian taxpayers' competitiveness in the negotiations. Moreover, in order to comply with the draft FIE rules on any completed transaction, the Canadian taxpayer is generally compelled to follow the imputed interest method because the information to comply with the various elective relief provisions generally cannot be obtained. Overall, the imputed-interest method increases the taxpayer's administrative costs and tax burdens and impairs its global competitiveness.

Example 2

A Canadian corporation entered into negotiations to sell a portion of its business in exchange for shares in a foreign multinational corporation with a substantial number of foreign affiliates and subsidiaries. If the transaction were completed, the Canadian corporation's investment would have represented approximately a three-percent stake in the foreign multinational. During negotiations, the foreign multinational objected to providing the information required to comply with the FIE rules, citing the following concerns:

1. Legal concerns, complexity, additional costs, and global competitiveness. To address the Canadian corporation's concerns about whether any of the interests in foreign entities would have been FIEs, the parties agreed that a recognized accounting firm would certify to the Canadian taxpayer whether the FIE rules would apply to the foreign entity. The Canadian taxpayer agreed to pay the costs of obtaining the certification.

2. Supplying Competitive Information. The foreign multinational objected to providing competitive information that was not available to the general public.

As a result of the negotiations over the draft FIE provisions, the structure of the proposed transaction was revised to eliminate the share consideration and preclude the application of the FIE rules. Although the transaction was ultimately consummated, the FIE provisions imposed a significant and unwarranted impediment to its conclusion and increased the transaction's overall cost.

Example 3

A Canadian corporation and a foreign multinational contemplated contributing a portion of their businesses (including entities with a substantial number of foreign affiliates and subsidiaries) for a share of a new entity with a 50-percent ownership interest for each. The foreign multinational is a mature, established business that has concluded a number of mergers and acquisitions in various lines of businesses. In other words, the foreign multinational has an extremely complex legal structure with multiple entities and tiers of ownership.

In connection with the negotiations, the Canadian taxpayer identified a number of concerns about structuring the deal. First, the Canadian taxpayer would have been incurred substantial additional due diligence costs in order to understand the application of the FIE provisions to the resulting entity.

Second, the Canadian taxpayer would have incurred substantial ongoing costs of analyzing and complying with the FIE rules (and the relief provisions). Third, extensive and costly analyses would be needed to determine whether the controlled foreign affiliate election would have been advantageous. Finally, it was unclear whether the foreign multinational counterparty would permit the new entity to supply the information necessary to enable the Canadian taxpayer to comply with the proposed FIE legislation.

For various business reasons, the proposed transaction was ultimately abandoned.

Appendix 2--Double Taxation Resulting form the Interaction of the Proposed FIE Rules with Section 17

It is clear form the above that the income to be reported under section 17 will never be reversed through the payment of dividends because of the limitation in clause 94.4(2)(a)(ii), which only considers income included under FIE provision.


1. Assume the equity interest is equal to a loan to a U.S. sister company.

2. Assume the allocated income equals the section 17 income.

3. This amount B-F in the mark-to-market formula definition in subsection 94.2(1). The increase in the fair market value is assumed to be equal to the active business income earned, less the dividends paid.

4. This is C in the mark-to-market formula definition provided in subsection 94.2(1).
FIE Regime Income Method

 Prescribed Mark-to
 Interest Market Accrual

Prescibed interest
amount (1) $100 -- --

Accrual Amount -- -- $100 (2)

FIE income:
 * Increase in
 FMV (3) -- $40 --
 * Amount received
 during the
 year (4) -- $60 --

Dividend income
(Section 90) $60 $60 $60

Section 113(1)
deduction -60 -60 -60

Section 17 income $100 $100 $100

Paragraph 94.4(2)(a)
deduction (60) (60) (60)
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Title Annotation:Tax Executives Institute
Publication:Tax Executive
Date:May 1, 2006
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