Pending income tax issues: December 4, 2002.

• Position: Canadian Department of Finance

On December 4, 2002, Tax Executives Institute held its annual liaison meeting with officials of the Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared by TEI's Canadian Income Tax Committee whose chair is Monika M. Siegmund of Shell Canada Limited.

Tax Executives Institute welcomes the opportunity to present the following comments on income tax issues, which will be discussed with representatives of the Department of Finance during TEI's December 4, 2002, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Glenn G. Wickerson, TEI's Vice President for Canadian Affairs, at 403.233.1135, or Monika M. Siegmund, Chair of the Institute's Canadian Income Tax Committee, at 403.691.3210.

Background

Tax Executives Institute is an international organization of approximately 5,300 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, the United States, and Europe.

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 eight geographic regions. In addition, a substantial number of our U.S. and European 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.

1. Reorganizations

   1. Expansion of Tax-Free Reorganization Provisions

      During the past several liaison meetings, TEI has requested that the Department consider expanding the Canadian reorganization rules. In summary, we believe the provisions should be amended to permit the following:

      * Tax-deferred wind-ups of wholly owned Canadian corporations into partnerships;

      * Tax-deferred transfers of assets between Canadian partnerships;

      * Tax-deferred transfers of assets from partnerships to trusts; and

      * Tax-deferred transfers of assets from corporations to trusts.

      Would the Department of Finance please advise whether consideration is being given to expanding the tax-free reorganization rules to include any of these additional forms of reorganizations?

   2. Share-for-Share Exchanges

      The October 2000 Economic Statement announced that a share-for-share exchange rollover rule would be developed in order to afford Canadian resident shareholders tax deferral where the only consideration received in exchange for the shares of a Canadian corporation are shares of a foreign corporation. Would the Department provide a status report on this measure? The announcement said the legislation would be drafted in consultation with the private sector. Has that consultation been completed, and would the Department be prepared to provide details of the draft legislation being considered? TEI recommends that the scope of this review and consultation be expanded to include not only this issue but the other areas noted in part A above.

   3. Divisive Reorganizations

      The rules governing divisive reorganizations confound practitioners and taxpayers. Hence, TEI suggests that the Department reconsider its approach to divisive reorganizations. Specifically, we urge the Department to provide a more specific regime that directly addresses such transactions rather than leaving them in their current form as an exception to an anti-avoidance rule. We believe that the lack of a comprehensive regime addressing these transactions causes Canadian-based businesses to be less efficient in their use of capital than their competitors headquartered in Canada's major trading partners.

2. Large Corporation Tax (LCT) Amendments

   TEI believes that the Large Corporations Tax (LCT) is a profit-insensitive tax that increases the cost of capital and adversely affects investment, productivity, and, ultimately, employment in Canada. As a result, TEI recommends that the LCT be repealed immediately or phased out over a very short period of time. (1) This course of action will reduce Canada's overall tax burden and maintain or enhance the system's competitiveness with other OECD countries that are also implementing tax reductions. Until the LCT is eliminated, however, certain amendments are required.

   1. Consequential LCT Amendments for Changes in Financial Accounting Methods

      Where a taxpayer adopts a newly prescribed financial accounting reporting method, the new method can produce a significant change in its LCT liability when compared with the LCT computed under the old financial reporting method. Since most changes in financial accounting reporting methods are subject to extensive disclosure and a public review period prior to implementation, there is ample time to determine whether the government would obtain a capital tax windfall as a result of a change in method. Indeed, in order to mitigate the effect of financial accounting method changes on the computation of LCT liability, the Department should implement consequential amendments to section 181.2 with the same effective date as proposed changes in financial accounting standards. TEI recommends that the Department establish a process to review proposed changes in financial accounting methods and implement the necessary consequential amendments on a timely basis. TEI would be pleased to participate in such a process.

   2. Hedged Debt

      In question XXIII of the December 11, 1996, liaison meeting with the Department of Finance, TEI provided a detailed example relating to hedged debt and asked whether Finance would consider introducing an amendment to the Act in order to permit taxpayers to take hedge assets and liabilities into account in the calculation of taxable capital. Subsequent to the meeting, the Department of Finance indicated that it was prepared to recommend the introduction of such an amendment. To address deferred unrealized foreign exchange gains and losses generally, paragraphs 181.2(3)(b.1) and 181.2(3)(k) were added to the Act. Representatives from the Department have inquired whether the hedged-debt issue has been addressed by those amendments. Regrettably, TEI believes the answer to be, "no." (See Appendix I for additional detail.)

      Would the Department of Finance provide a status report on the hedged-debt issue and advise when it anticipates introducing an amendment, with effect for taxation years commencing on or after January 1, 1996, that would ensure that hedge assets and liabilities are both taken into account in the calculation of taxable capital?

   3. GAAP Reporting Effect on Rate-Regulated Industries

      Rate-regulated entities have generally accounted for expenses such as income taxes, pension costs, and environmental liabilities on a pay-as-you-go (cash) basis. Increasingly, rate-regulated entities are giving balance sheet recognition to differences between the amounts reflected through the rate-setting process and the amount that would otherwise be recognized under generally accepted accounting principles (GAAP). For example, assume an entity establishes a liability under GAAP for estimated future expenditures to remediate contaminated land. Because such expenditures are recoverable through rates charged to customers, the entity will also establish a "regulatory asset." This method of financial statement presentation is optional under Canadian GAAP and required under U.S. GAAP. Recently, though, Canadian accounting standard-setting bodies have been moving in the direction of adopting U.S. balance sheet reporting models for such amounts.

      Under relevant federal and provincial tax legislation, such recorded liabilities are included in taxable capital as reserves (e.g., see paragraph 181(3)(b) for LCT purposes) and taxed accordingly. If a rate-regulated entity gives balance sheet recognition to both a regulatory asset and the GAAP liability in respect of a particular item, there will be an increase in capital tax because the recorded liability will not be offset by a reduction in retained earnings for an accrued expense or an investment allowance for the regulatory asset. Such tax increases are generally recovered from customers through higher utility rates.

      Unregulated entities that follow accrual accounting for a similar environmental liability do not, under current (2) rules, record an asset; rather they charge such expenses on an accrual basis against earnings for the year. Since the increase in the GAAP liability is offset by a reduction in retained earnings, unregulated entities will not incur the additional capital tax cost. In contrast, rate-regulated enterprises will generally incur additional capital tax (all other things being equal) to the extent that the increase in the GAAP liability on an accrual basis exceeds the reduction to retained earnings (which, again, is on a cash basis for such companies). Because of the long-term nature of many liabilities, the increased capital tax is an ongoing, permanent annual cost that will be passed through to customers, adversely affecting their competitive position.

      For rate-regulated entities that are required to establish regulatory assets or liabilities, TEI believes section 181.2 should be amended to permit the taxpayer to reflect the net difference between the GAAP liability and regulatory asset balance for purposes of computing LCT. Alternatively, rate-regulated entities should be permitted to establish an investment allowance for the regulatory asset. We invite a discussion of TEI's proposal.

3. "Misuse or Abuse"...