Proposed amendments to the Income Tax Act restricting the deductibility of interest and other expenses.

• Position: Canada

March 5, 2004

On March 5, 2004, Tax Executives Institute submitted the following comments to the Department of Finance relating to proposed legislation that would restrict the deductibility of interest and other expenses. The Institute's comments were developed by the Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Limited. Numerous members of the Committee participated in the development of the comments. Contributing substantially as the principal drafter of the comments was John M. Allinotte of Dofasco, Inc.

On behalf of Tax Executives Institute (TEI), I am writing to express TEI's concerns regarding proposed amendments to the Income Tax Act (hereinafter "the ITA" or "the Act"), relating to the deductibility of interest and other expenses.

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 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.

Summary of TEI's Comments

On October 31, 2003, the Department of Finance released for public comment draft amendments to section 3.1 of the Act. The draft proposals follow-up on concerns expressed in the February 18, 2003, federal budget message that "recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest expenses, in computing income from a business or property for purposes of the Income Tax Act." (1) The Department's objectives are to clarify that (1) "income" for purposes of the Act is "net" income, in accordance with the generally accepted understanding of the Act prior to the Supreme Court of Canada's decision in Ludco Enterprises Ltd. v. Canada, (2) and (2) "net income" excludes "capital gains and losses." In addition, the Department believes that draft subsection 3.1(1) should be introduced in order to institute a statutory "reasonable expectation of profit" (REOP) test. A statutory test would replace the common law REOP rule, as recently interpreted by the Supreme Court of Canada in Brian J. Stewart v. The Queen.

Although the Department's goals are clear and seemingly circumscribed, the proposed amendment to subsection 3.1(1), relating to limits on losses, is far broader than necessary to achieve those goals. The emphasis of the proposed legislation on establishing a "cumulative profit" and requiring taxpayers to link expenditures to a "source" of business or property income in order to ensure their deductibility raises a number of administrative and policy concerns. Specifically, the proposed changes modify the longstanding treatment of interest and other commercial expenses that taxpayers and Canada Revenue Agency (CRA) have long considered fully deductible. Indeed, the proposals go substantially beyond restoring the Act to the pre-Ludco status quo for the treatment of such expenses. In addition, the commercial, or "profit," purposes of large corporations' investment and business activities are rarely, if ever, questioned by the CRA, but the proposed changes could trigger unwarranted and unnecessary audit scrutiny of such issues. As important, TEI believes the Stewart decision enunciates a clear and rational tax policy basis for distinguishing commercial activities from personal and hobby-related expenditures. Moreover, the generally accepted understanding of the Act pre-Ludco was that income is "net" income and that "net income" is synonymous with "profit" for determining a "source of income." Thus, the draft legislation poses a substantial risk of creating confusion and ambiguity and imposing unwarranted restrictions on the ability of commercial enterprises, especially large-file taxpayers, to deduct the costs of producing their "net" income. In summary, we believe the proposed changes will have a broad and adverse effect on the administration of the Act. We encourage the Department to withdraw the proposed legislation and craft narrower rules that will not create unnecessary restrictions on deductions claimed by commercial enterprises.

Conceptual Changes to the Act

Proposed new subsection 3.1(1) provides that a taxpayer will be considered to have a deductible loss from a source that is a business or property only if, in that taxation year, it is reasonable to assume that the taxpayer will realize a cumulative profit during the time the taxpayer has carried on, or can reasonably be expected to carry on, the business or has held, or can reasonably be expected to hold, the property. The proposed legislation thus creates a continuing requirement to test--in respect of each source that is a business or property in each taxation year that the income source generates a loss--whether the taxpayer has a reasonable expectation of profit (REOP). Specifically, the deductibility of each expenditure must be evaluated from a narrow statutory tax perspective and perhaps even in isolation from the taxpayer's overarching business objectives and marketing strategy. Such microanalysis of business operations on an annual basis would be burdensome, expensive, time-consuming, and not value added.

The concept of "net income" has been a part of the Act for many years and is generally synonymous with "profit." The concept of determining a "cumulative profit" or annual testing of whether a cumulative profit is reasonably likely, however, has never implicitly or explicitly been part of the Act. As important, there has never been a requirement to link an expense to a particular source in order to ensure the deductibility of the expense. The implementation of this concept in the Act is unnecessary and is likely to spawn significant controversy and litigation about its scope and meaning.

In taxation years in which a loss occurs, all the business decisions, ventures, and operations that affect--or may have ever affected--the determination of the taxpayer's loss must be justified or re-justified. No such requirement has ever existed under the Act and it is unclear what recordkeeping procedures or accounting systems would be necessary--or can reasonably be developed--to prove the required linkage between the source, the deductions, and a taxpayer's REOP. In addition, since the provision applies solely to disallow losses, the draft legislation would encourage CRA auditors to use hindsight...