Legislative proposals and draft income tax regulations relating to the treatment of foreign affiliates December 6, 2004.

On behalf of Tax Executives Institute (TEI), I am writing to express TEI's concerns about proposed technical amendments to the Income Tax Act (hereinafter "the ITA" or "the Act") and Income Tax Regulations that would substantially revise the treatment of foreign affiliates. The technical amendments are part of the Legislative Proposals and Draft Income Tax Regulations released by the Department of Finance on February 27, 2004 (hereinafter "the technical bill").

Background

Tax Executives Institute is the preeminent international association of business tax executives. The Institute's 5,400 professionals manage the tax affairs of 2,800 of the leading companies in Canada, the United States, and Europe. 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, and must contend daily with the planning and compliance aspects of Canada's business tax laws. 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, 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

The 400-plus page draft technical bill released in February 2004 affects numerous provisions in the Act and Income Tax Regulations. Many provisions are uncontroversial and were previously released in the December 2002 draft technical bill. For the most part, the technical bill will bring much-needed clarity and certainty of tax treatment for taxpayers and Canada Revenue Agency (CRA) alike thereby minimizing unnecessary disputes. We commend the Department for drafting the comprehensive bill and for affording taxpayers many ameliorative changes as well as beneficial transition rules.

In some areas, however, the technical bill goes far beyond effecting technical amendments and addresses real or perceived policy issues. Although TEI supports many of the proposed policy changes set forth in the bill, a number of provisions--especially those in Part 2 relating to the foreign affiliate regime--are overbroad, unnecessarily complex, and impose undue compliance burdens on taxpayers. We believe the foreign affiliate provisions would benefit from additional consultations, especially since many provisions have been significantly modified from the December 2002 draft technical amendments or are completely new.

In crafting a policy for taxation of foreign affiliates and investments, developed countries choose among policy options ranging from a territorial system of taxation (which, in turn, can range from direct exemptions for various types of income to indirect participation exemptions) to more complex foreign tax credit regimes supplemented by income and expense allocation rules. Historically, Canada has followed a middle path by adopting a foreign tax credit mechanism for a limited number of specified foreign investments and taxing the balance of foreign investments on the capital gains realized in excess of book value (i.e., including the exempt surplus).

Although some commenters have suggested that adoption of a purely territorial system for taxing foreign investments would enhance Canada's international trading status, TEI believes that the current system for taxing foreign investments has proven generally administrable and balances numerous fiscal and economic policy objectives, including taxpayers' compliance burdens. Indeed, a significant advantage of the current system is that operating businesses outside of Canada owned by Canadian resident shareholders can carry on their day-to-day business affairs on a level playing field with their host-country competitors. We regret that the proposed changes to the foreign affiliate regime would undermine that advantage by imposing a new tax burden or layering an additional set of labyrinthine compliance rules on an already complex regime. Either burden would effectively deter additional foreign investments by Canadian companies.

Moreover, if the technical bill's changes are adopted together with the proposed legislation for Foreign Investment Entities and Non-Resident Trusts, the complexity of Canada's system of taxing foreign investments would escalate exponentially. The adoption of either or both bills would impair the objective of promoting the global competitiveness. We urge the Department of Finance to heed a cautionary note sounded by the former U.S. Assistant Treasury Secretary for Tax Policy who said, in respect of the U.S. system:

Viewed from the vantage point of an increasingly global marketplace, our tax rules appear outmoded, at best, and punitive of U.S. economic interests, at worst. Most other developed countries of the world are concerned with setting a competitiveness policy that permits their workers to benefit from gloBalization.... [O]ur international tax policy seems to have been based on the principle that if we have a competitive advantage, we should tax it! Thus, we encourage the Department to consider whether there are simpler means to address the government's concerns. A voluntary self-assessment system is not well served where the rules become so complex that taxpayers cannot reasonably comply or where a tax is triggered by technical "foot faults."

In addition to ongoing consultations on the substantive policy and technical issues identified below, the Department should expand the technical notes and elaborate on the underlying policy framework of many of the provisions. Given the complexity of the rules, more "real world" examples should be included in order to illustrate commonplace, but factually complex situations. For example, the current draft of the explanatory notes generally assumes that foreign affiliates have only a single class of shares outstanding. When applying the draft legislation to the simple fact patterns presented in the examples, the tax results are clear and simple. Where the facts are more complex, e.g., where multiple classes of shareholdings exist, the draft rules become far more ambiguous and challenging. We recommend that the explanatory notes include many more examples to illustrate the application of various provisions to more complex foreign affiliate capital structures.

Our comments below address specific provisions in the technical bill but, given the scope and complexity of the foreign affiliate regime as well the interaction of the draft provisions with the Act as a whole, our analysis remains ongoing.

Section 42

Section 42 of the Act provides rules governing warranties, covenants, and other conditional or contingent obligations given by a taxpayer in respect of the disposition of properties. The revisions to section 42 in the draft technical bill helpfully clarify the treatment of proceeds paid or received upon a disposition of property where the amount is paid or received subsequent to the year of disposition of the underlying property.

From a conceptual standpoint, it is unclear why the proposed amendment is included among the revisions to the foreign affiliate rules in Part 2 of the technical bill rather than with the general revisions in Part 1. TEI recommends that the Department include this proposed change in Part 1. If the Department believes that that provision should be incorporated in the foreign affiliate revisions, TEI encourages the Department to explain the connection between the provision and the foreign affiliate rules.

In order to obtain the benefit of the revision to section 42, taxpayers are required to hold their tax returns for the year of disposition open until the filing due date for the year in which the additional proceeds are paid or received. Where a tax attribute might be carried back, a taxpayer may wish to file its return for the year of disposition of the property well before the due date of a subsequent year's return. TEI recommends that taxpayers be permitted to elect to report all amounts subject to section 42 in the year that the amount subject to section 42 becomes receivable or payable. Such an election would permit taxpayers to file their returns without risk of under- or over-reporting income for the taxation year of the disposition of the property.

Restrictive Covenants

The Department has expressed concern that amounts received in respect of restrictive covenants are not being subjected to tax even though such amounts are effectively proceeds of a disposition. TEI agrees that the Department's concerns warrant modifications to the Act, but the draft changes are overbroad, especially where the correlative draft amendment to section 68 applies, because the new provisions might apply to items that are neither income nor capital gains. For example, the definition of restrictive covenant would seemingly apply to the standard negative covenants in commercial loan documents. We believe the Department's objectives can be achieved and the definition narrowed by adding the phrase "related to the...