Draft legislation relating to foreign investment entities and non-resident trusts: May 13, 2003.

• Position: Canada

On May 13, 2003, TEI submitted the following comments on the October 2002 draft of Canadian legislation relating to Foreign Investment Entities and Non-Resident Trusts. The comments, which took the form of a letter from TEI President J.A. (Drew) Glennie to Minister of Finance John Manley, were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Ltd. Contributing substantially to the development of TEI's comments were Vincent Alicandri of Hydro One Networks, Inc., Carmine A. Arcari of Royal Bank of Canada, David M. Penney of General Motors of Canada Limited, and Alan Wheable of Toronto Dominion Bank.

On June 22, 2000, the Department of Finance (hereinafter the Department) released draft legislation relating to Foreign Investment Entities (FIE) and Non-Resident Trusts (NRT). In response to public comments and consultations on the draft proposals, the Department announced modifications, delayed the implementation date, and extended the consultation period. Tax Executives Institute submitted comments on the modified draft in February 2001 and met with representatives from the Department of Finance in May 2001. Subsequently, another draft of the legislation was released on August 2, 2001. Acknowledging that the August 2001 draft represented an improvement, TEI expressed continuing concerns about the revised FIE and NRT draft legislation, respectively, in separate letters dated October 25, and October 31, 2001.

On October 11, 2002, a Notice of Ways and Means Motion was released setting forth another revised draft of the FIE and NRT legislation. In view of the abbreviated period between the release of the revised legislation and the proposed implementation date of January 1, 2003, TEI submitted a letter on December 16, 2002, urging that the legislation be withdrawn or deferred in order to afford time for consultations and to permit taxpayers to modify information systems to comply with the roles. On behalf of TEI, I am writing to elaborate on our December 16 letter and provide detailed comments outlining our concerns about the October 2002 draft of the FIE and NRT legislation.

Background

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,300 professionals manage the tax affairs of 2,800 of the leading companies in Canada, the United States, and Europe 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 eight geographic regions. Our non-Canadian members (including those in Europe) work for companies with substantial activities 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 in Ottawa (and Washington), as well as in the provinces (and the states), 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.

Overview of Draft Legislation and TEI Comments

The draft Non-Resident Trust (NRT) and Foreign Investment Entity (FIE) legislation released by the Department of Finance on October 11, 2002, is intended to replace the current rules in respect of foreign trusts in section 94 of the Income Tax Act (hereinafter "the Act") and the "offshore investment fund" rules found in section 94.1 of the Act. The draft legislation replaces the drafts released previously on June 22, 2000, and August 2, 2001.

The current rules in sections 94 and 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 applies where a person resident in Canada transfers or loans property to a foreign trust that has one or more beneficiaries resident in Canada. 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 June 2000 draft of the legislation, the Department's press release explained the provisions, 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 area. Although the government's objective of curbing illegitimate tax avoidance effected through "transfers to offshore trusts and accounts" is unassailable--and TEI supports such efforts because it will prevent shifts in the tax burden to already compliant taxpayers--we do not believe that the proposed new and complex FIE and NRT provisions are necessary to achieve the government's aims. Current sections 94 and 94.1 provide 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 combatting tax avoidance effected through offshore investment funds. We urge the government to re-double its efforts to enforce 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 far beyond the stated purpose of combatting "tax avoidance." Indeed, the proposed legislation implements a comprehensive new regime for taxing indirect foreign investment. Moreover, the proposed FIE rules substantially overlap the foreign accrual property income (FAPI) system of taxing foreign affiliates. In contrast with the perceived rush to implement the proposed FIE rules, the FAPI rules were deferred, in most cases, from their introduction in 1972 until full implementation in 1976. The approach allowed the government to undertake a substantial study of the scope and potential effect of the FAPI rules. TEI submits that the FIE rules are as comprehensive in scope and far-reaching in effect as the FAPI rules and recommends that before the government moves forward with the proposed FIE rules that it undertake a similar study.

The October 2002 draft legislation includes important revisions from previous drafts, but the latest rules remain overbroad, extraordinarily complex, confusing, and, in the case of the proposed FIE rules, continue to overlap and conflict with the entire foreign affiliate regime, including section 17 in respect of loans to non-residents. As a result, the provisions will interfere with legitimate business operations. In addition, the proposed FIE rules simply do not mesh well with the proposed NRT rules.

Although the latest version of the draft legislation helpfully reduces the number of instances where a non-resident corporation operating an active business could qualify as an 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 Canada Customs and Revenue Agency (CCRA) will, anymore than taxpayers, have the resources to properly 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 perceived 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 believe the draft legislation remains unworkable and we again 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."

* The proposed legislation is overbroad, overlaps the foreign affiliate regime as well as section 17, and catches many legitimate commercial transactions.

* The information necessary to comply with the proposed legislation's myriad reporting requirements 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 obtain the necessary information.

* The information that would permit taxpayers to take advantage of one or more of the relieving provisions or elections in the proposed legislation 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 obtain the necessary information.

* The Minister, in certain circumstances, is accorded...