Pending income tax issues: December 3, 2003.

• Position: Canadian Department of Finance

On December 3, 2003, Tax Executives Institute held its annual liaison meeting with the officials of the Canadian Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of 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 3, 2003, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Mario M. Tombari, TEI's Vice President for Canadian Affairs, at 514.932.6161, ext. 2943, 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 5,400 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 member 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. Non-Resident Withholding Taxes on Dividends and Interest

   1. General. Studies, such as one prepared by the C.D. Howe Institute, have shown a strong link between the elimination of withholding tax on dividends and interest and increased foreign direct investment. The Howe Institute's study claims that elimination of withholding on all dividends and interest would result in an increase in capital investment in Canada of approximately $28 billion, and an increase in income of over $7.5 billion annually. The study also summarizes the detrimental effects that withholding taxes have on Canada, including restricting the free flow of capital, deterring foreign direct investment, and interfering with efficient global company operations. The study's conclusions are especially cogent in respect of the Canada-U.S. tax treaty because the United States is a key market for Canadian goods and services as well as key source of investment capital for Canadian enterprises.

      Recently, the United States negotiated a nil withholding rate for dividends under the U.S.-U.K. tax treaty and under its protocols with Australia and Mexico. The United States and Japan have also announced that certain intercompany dividends will be exempt from withholding taxes under their new income tax treaty. TEI invites a discussion of the steps the Department of Finance is undertaking in respect of the Canada-U.S. treaty negotiations to ensure that Canadian residents can secure similar benefits and effectively compete with these jurisdictions for increased capital investments, exports, and jobs.

   2. Effect of U.S. Tax Legislation. Under the Jobs and Growth Tax Reconciliation Act of 2003, dividends paid to U.S. individuals by most U.S. public companies and qualifying foreign corporations, including public Canadian companies whose shares are listed on U.S. stock exchanges, will be taxed at a maximum rate of either 15 or 5 percent. The same U.S. tax act also changed the U.S. foreign tax credit rules, reducing the foreign source income of dividends qualifying for the reduced tax rate to 15/[35.sup.ths] of the dividend amount. As a result, dividends paid by Canadian public companies to U.S. shareholders that are subject to the 15-percent Canadian withholding tax will be taxed at higher rates than a dividend from a U.S. corporation because, in many cases, the foreign tax credit for the Canadian withholding tax will not be fully available for U.S. individuals.

      A number of Canadian members of TEI are concerned that the lower after-tax yield on dividends from Canadian public companies will lead U.S. investors to favour U.S. stocks. The potentially reduced demand for Canadian company shares could have a negative effect on stock prices and increase the cost of capital. We invite the Department's comments on the following questions.

1. Does the Department have a long-term strategy or objective to phase-out withholding taxes on interest and dividends for related and unrelated parties?

2. Does the Department agree that it would be desirable and appropriate to negotiate a nil withholding tax rate on dividends in the next protocol to the Canada-U.S. treaty? Such a step would make the Canada-U.S. treaty consistent with the recent U.S. treaties with the U.K. and Australia.

3. If a nil withholding tax on all dividends (from related and unrelated parties) cannot be achieved in the short term, would the Department consider negotiating a reduction of the withholding tax rate to no more than 10 percent on all dividends paid by Canadian public companies to individual U.S. shareholders? Such a reduction would mitigate the adverse effects of the changes in the U.S. tax rates and foreign tax credit rules. In addition, would the Department consider negotiating a nil withholding tax on dividends paid to a corporate shareholder that holds at least 10 percent of the voting shares of the Canadian company?

2. Regulation 105

   Following a TEI submission on Regulation 105 in 2002, representatives from the Department of Finance met with TEI for an informative discussion about the issues arising from the requirement to withhold taxes on payments to non-resident service providers. Additional information was submitted after the meeting outlining the process for obtaining a waiver of withholding in the United States (Form W-8 BEN). What is the status of the Department's review of the potential for either repealing Regulation 105 or making significant changes to the legislation or regulation in order to ease the administrative burden for obtaining waivers of withholding?

3. Interest

   1. The difference in the treatment of simple and compound interest under the Income Tax Act (hereinafter "the Act") seems anomalous and without a proper policy basis. Would the Department consider permitting compound interest to be deductible on an accrual basis?

   2. Since the Act seemingly does not permit the deduction of interest that becomes due upon the occurrence of a contingent event if that event occurs in a taxation year subsequent to the year in which the interest would have accrued, issues frequently arise in respect of whether interest is considered to be contingent. Would the Department consider adding a clause to subsection 20(1), as follows:

   "an amount which would otherwise be deductible in a prior year except for paragraph 18(1)(e) and that has not been deducted and that would no longer be affected by paragraph 18(1)(e)" 4. Reimbursement of Arrears Interest

   The Act does not specifically address the treatment of a refund of previously paid arrears interest. Section 161.1 permits a taxpayer to offset arrears interest payable against taxable refund interest through a reallocation of refunded amounts between taxation years. The purpose of the provision is clear: to ensure that timing differences (e.g., depreciation expense) reallocated between taxation years do not create non-deductible interest in one year and taxable refund interest in another year. In addition, paragraph 18(1)(t) addresses the non-deductibility of amounts paid or payable under the Act and provincial tax amounts are addressed under paragraph 18(1)(a). Paragraph 20(1)(11) provides a deduction for interest repaid by a taxpayer to a Government (whether Federal or provincial) "as was paid in the year and as can reasonably be considered to be a repayment of interest that was included in computing the taxpayer's income."

   A recent CCRA release (No. 2002-0164407, January 16, 2003), discusses reimbursements of non-deductible arrears (debit) interest previously paid by a taxpayer. The document addresses interest on Crown charges and states that subparagraph 12(1)(x)(iv) does not distinguish between a deductible and non-deductible expense. The view expressed is that a refund of previously paid non-deductible interest would be included in income absent an election under subsection 12(2.2).

   TEI believes the interpretation of subparagraph 12(1)(x)(iv) enunciated in the release would impose a significant punitive financial burden on taxpayers where a refund of non-deductible interest is made. CCRA's previous administrative position of not taxing refunds of previously paid, non-deducted amounts provided an equitable application of the Act. The interpretation in the release would result in the government collecting a windfall even where all the issues reassessed are reversed on appeal.

   Assuming that CCRA's interpretation is correct, TEI recommends that paragraph 12(1)(x) be amended to exclude from income amounts received "in respect of an outlay or expense" that were not deducted or deductible by the taxpayer at any time. TEI's recommendation essentially addresses the mirror image of paragraph 20(1)(ll). Alternatively, paragraph 12(1)(x) could be amended to exclude amounts that were not deductible because of paragraphs 18(1)(a) and (t). A third option would be to expand the list of elections that are eligible for late filing under subsection 220(3.2) and Regulation 600 in order to include...