Canada's "foreign affiliate dumping" proposal.

June 6, 2012

On June 6, 2012, Tax Executives Institute submitted the following comments to Canadian Minister of Finance James Flaherty on a "foreign affiliate dumping" measure included in the 2012 Canadian Budget. TEI's comments were prepared under the aegis of its Canadian Income Tax Committee, whose chair is Carmine A. Arcari of the Royal Bank of Canada. Contributing substantially to the development of TEI's comments were Carolyn A. Mulder of WaI-Mart Canada Corporation and David V. Daubaras of GE Canada. Also contributing to the submission were: Rodney C. Bergen of the Jim Pattison Group; Angelo Bertolas of TD Bank; Pierre M. Bocti of Hewlett-Packard (Canada) Co.; Bonnie Dawe of Finning International, Inc.; John Lisi of Cunningham Lindsey, Inc.; Lynn Moen of Walton International Group, Inc.; Marvin E. Lamb of Imperial Oil Limited.; Doug Powrie of Teck Resources Limited; Jill Wysolmierski of Avnet, Inc.; and Scott M. Zahorchak of Alcoa, Inc. Jeffery P. Rasmussen, TEI Senior Tax Counsel and liaison to the Canadian Income Tax Committee, coordinated the development of the Institute's comments.

On March 29, 2012, the federal government's 2012 budget (hereinafter "the budget") was introduced, setting forth a proposal to amend the Income Tax Act of Canada (hereinafter "the Act" or ITA) by adding a measure to prevent "foreign affiliate dumping" into Canada. On behalf of Tax Executives Institute, I am writing to express our concerns about the excessive breadth of this anti-avoidance proposal as well as the subjective and unworkable tests prescribed for distinguishing bona fide commercial transactions from abusive transactions.

Unless the proposal is narrowed, relief afforded (in the budget measure or other provisions of the Act), and workable tests crafted for distinguishing bona fide investments, the proposal will substantially undermine the attractiveness of Canada as a destination for foreign investments.

Background on Tax Executives Institute

TEI is the preeminent association of in-house business tax executives worldwide. The Institute's 7,000 professionals manage the tax affairs of 3,000 of the leading companies in North America, Europe, and Asia. Canadians constitute 10 percent of TEI's membership, with our Canadian members belonging to chapters in Montreal, Toronto, Calgary, and Vancouver, which together make up one of our nine geographic regions. Many of our non-Canadian members including those in Europe and Asia work for companies with substantial activities in Canada. Thus, both Canadian resident and non-resident members must contend daily with the planning and compliance aspects of Canada's business tax laws, including the financing of those businesses with equity third-party debt, and intercompany loans. The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Budget Proposal Background

The 2008 Advisory Panel on Canada's System of International Taxation ("the Advisory Panel") identified certain "debt dumping" transactions involving foreign affiliates as abusive. Although not formally defined by the Advisory Panel, "debt dumping" was described as a situation where a foreign-controlled Canadian corporation is leveraged with related- or third-party debt (often guaranteed by the non-resident parent), which the Canadian resident corporation uses in an internal group restructuring to purchase shares, generally preferred, of another non-resident corporation controlled by the foreign parent. The interest expense from the loan reduces the Canadian resident corporation's tax liability and the return on the preferred shares is often from exempt surplus. In addition to using increased interest deductions to reduce the tax liability of the Canadian group, the nonresident parent corporation often extracts cash from Canada but avoids withholding taxes by structuring the transaction as a share purchase by the Canadian resident company. The Advisory Panel concluded that such transactions can reduce the Canadian tax base without providing a significant economic benefit to Canada.

The budget proposes to curtail "foreign affiliate dumping" transactions through two measures applicable to certain investments in non-resident corporations (the subject corporation) by a corporation resident in Canada (CRIC) controlled by nonresident parent corporation. First, a CRIC will be deemed to have paid a dividend to the parent equal to the fair market value of any property transferred, or obligation assumed or incurred, by the CRIC in respect of its investment in the subject corporation. Second, no amount will be added to the paid-up capital of the shares of the CRIC in respect of the investment and no amount will be added to the contributed surplus of the CRIC for purposes of determining its capital under the thin capitalization rules. Under the proposal, an "investment" in a subject corporation includes the acquisition of any shares (or options on shares), a contribution to capital, a transaction that creates an amount owing from the subject corporation to the CRIC, or an acquisition of the subject corporation's debt by the CRIC.

A relieving measure is prescribed in order to permit CRICs to undertake bona fide business transactions without being ensnared by the rules. Seven factors are prescribed for determining whether a CRIC's transactions may reasonably be considered to have been made for a bona fide business purpose other than to obtain a tax benefit.

Overriding Tax Policy Concern about the Budget Proposal

Canada has made great strides in increasing its competitive position in the global economy. The reform of the Canadian corporate tax structure and the targeted reduction of the corporate income tax rate to 25 percent have been critical in enhancing Canada's competitiveness and muting the effect of the recent global recession. Regrettably, the interaction of the foreign affiliate dumping proposal, the upstream loan proposal in the Foreign Affiliate Amendment package released by the Department on August 27, 2011, and current subsection 15(2) of the Act will so restrict a CRIC's ability to manage and invest its cash flows that the effective corporate income tax rate on non-resident corporate groups will be viewed as increasing from 25 to approximaTEIy 30 percent or more depending on the withholding rate on dividends. A CRIC with temporary cash surpluses will be compelled to invest its cash in low-yielding Canadian bank deposits (or short-term Canadian debt instruments) or repatriate the funds to the non-resident parent, subject to withholding tax. (1)

Thus, the budget proposal will effectively reverse the incentives afforded by the corporate income tax reductions of the last 10 years and contravenes the propositions in Compete to Win that "raising Canada's overall economic performance through greater...