Pending Canadian income tax issues.

• Position: Tax Executives Institute's Canadian Income Tax Committee

On December 14, 1994, Tax Executives Institute held its annual liaison meeting on pending income tax issues with officials of the Canadian Department of the Finance. (A separate liaison meeting was held on pending excise tax issues.) In connection with the income tax meeting, the Institute submitted the following comments, which were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is John J. Marczynski of Abitibi-Price Inc. Also participating in the liaison meeting were C. Graham Kennedy of MacMillan Bloedel Limited, the Institute's Vice President-Region I, and other members of the Canadian Income Tax Committee, as well as TEI President Linda B. Burke.

Tax Executives Institute welcomes the opportunity to present the following comments on several pending tax issues, which will be discussed with representatives on the Department of Finance during TEI's December 14, 1994, liaison meeting. If you have any questions about these comments, please do not hesitate to call either C. Graham Kennedy, TEI's Vice President for Canadian Affairs, at (604) 661-8549 or John J. Marczynski, chair of the Institute's Canadian Income Tax Committee, at (416) 369-6821.

1. Background

   Tax Executives Institute is an international organization of approximately 5,000 professionals who are responsible - in an executive, administrative, or managerial capacity - for the tax affairs of the corporations and other businesses by which they are employed. TEI's members represent more than 2,800 of the leading corporations in Canada and the United States.

   Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

2. Setting Priorities:

   Spending Versus Taxing

   1. General

      In his February Budget speech, the Minister affirmed a long-range goal of eliminating the deficit and, for 1995-1996 specifically, paring the annual deficit, now running at about $40 billion, to $32.7 billion. To even approach the 1995-1996 deficit target, it is essential for the government to implement strong corrective measures immediately. Reports point to a "quick fix" of increasing various corporate taxes as the principal avenue for restoring the government's solvency. Thus, if the tax increase proposals reported under consideration this past summer were adopted, the corporate sector would bear the brunt of tax increases. Further corporate tax increases, however, would surely affect the competitiveness of Canadian business in the global marketplace. Consequently, we recommend that the government look to the spending side of the ledger and reform the structural root causes that contribute to the ever-expanding deficit.

   2. Proposals To Tax

      Pensions

      In addition to our concern over possible corporate tax increases, we are alarmed by the suggestion that registered retirement savings plans (RRSPs) and pension plans be taxed - whether indirectly by limiting contributions to the plans or by taxing them directly. The government's apparent willingness to adopt ad hoc proposals to change radically tax policies that have been built upon years of consultation and compromise will undermine the primary source of private savings and may lead to increased demands in the future for social welfare spending to offset diminished private pension income.(1) Consequently, we believe that, before any changes are made to either the RRSP or pension plan regimes, substantial time must be allowed for discussion and consultation.

   3. Re-Engineering

      Canadian Government

      In response to shrinking profits, companies often re-examine how they conduct operations. The exigencies of the marketplace discipline companies to rethink and challenge continuously their fundamental ways of doing business; in short, companies must continuously re-engineer to survive. We submit that it is essential for the government to embrace the same sense of urgency and "reinvent" itself The government should examine its operations and program-delivery mechanisms to determine whether substantial cost savings may be achieved through a better deployment of people, tasks, and technology. Re-engineering may not only reduce the government's operating costs, but also result in better service for its customers, the public, and re-energize the government work force.

      Canada's confederation, of course, adds complexity to the re-engineering process. Yet, the provinces themselves have made similar promises to reduce and eliminate their deficits, and hence, face constraints and choices similar to the federal government's dilemma. In order to achieve meaningful improvements and to eliminate or reduce redundant services or procedures, we urge that the provinces be made a part of the re-engineering process and ask the Minister to lead a re-engineering of both levels of government operations in Canada.

3. Repeal of Recapture

   of Research Allowance

   Although the section 37.1 additional allowance for scientific research and experimental development expenditures expired in 1983, the recapture rules of subsection 37.1(3) apply to assets acquired after that date. In response to TEI's 1993 liaison agenda submission, the Department expressed agreement with a proposal to repeal section 37.1(3). Would the Department confirm its view that section 37.1(3) should be repealed and advise us on when an amendment may be proposed?

4. Financing Transactions

   All businesses depend upon multiple, diverse sources of financing to maintain and expand their operations. In recent years, intense competition among domestic and foreign sources of business financing has led to the development of a substantial number of derivative financial instruments and arrangements, which have been designed to meet the complex and sundry needs of multinational borrowers. To remain competitive, Canadian businesses are under enormous pressure to cut costs. The reduction in borrowing and foreign currency costs achieved by participating in innovative derivative transactions, though often measurable in relatively small increments of basis points, permits Canadian businesses to remain competitive - especially where those incremental basis point savings are applied to huge sums.

   Despite the proliferation of these complex instruments, the tax consequences of the various payment made pursuant to, or collateral to, the derivative financing transactions re main clouded by uncertainty. The uncertainty has been exacerbated by the following factors:

   * the perpetual evolution, and chameleon-like nature, of these financial instruments; * the confusing array of jurisprudential principles distinguishing the tax treatment of interest from capital and ordinary debt transactions, and the overall lack of precedent on the treatment of the more complex financial derivative transactions; * the absence of clear administrative guidance, a deficiency exacerbated by -

   * the cancellation of IT-114 on June 10, 1994, leaving no guidance on Revenue Canada's assessing practice in respect of discounts, premiums, and bonuses on debt obligations; and * the possible revision of IT-233R, creating uncertainty about the circumstances under which Revenue will treat a leasing arrangement as an acquisition for tax purposes.

   While it seems both imprudent - indeed, impossible - to legislate detailed tax rules in respect of every type of financial instrument or transaction, the government should provide guidance and broad tax principles to permit taxpayers to structure their financing transactions and to report the tax effects of those transactions properly. Costly litigation over unresolved tax issues is undesirable for both taxpayers and the government. Accordingly, we recommend that the Department establish broad principles on the taxation of financing activities. Those broad principles would form the basis for further detailed administrative guidance from Revenue Canada on the taxation of various aspects of common financial instruments and arrangements including:

   * leasing; * asset securitization; * discounts, premiums, and bonuses on financial instruments; and * interest rate or foreign exchange swap and hedging transactions.

   We further recommend that the Department encourage Revenue to publicize, through interpretation bulletins and information circulars, the government's administrative position and assessing practice. The guidance should be updated as necessary to reflect developments attributable to new legislation, jurisprudence, or the evolution of financial instruments. We would be pleased to meet with officials from the Department or Revenue Canada to assist in the development of the requested guidance.

5. Canadian Withholding

   Tax

   Subparagraph 212(1)(b)(vii) of the Act provides a withholding tax exemption for interest payable by a Canadian resident corporation to a nonresident with whom the corporation is dealing at arm's length, provided the corporation issuing the debt is not obligated to pay more than 25 percent of the principal amount of the obligation within 5 years of its issuance.

   Some Canadian companies have difficulty borrowing from foreign lenders and meeting the two prescribed conditions to establish entitlement to the withholding tax exemption. For example, where a Canadian partnership or trust is involved, the trust or partnership must reorganize itself to ensure that the borrower is a...