Revenue Canada liaison meeting on income tax issues.

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

On December 13, 1994, Tax Executives Institute held its annual liaison meeting on pending income tax issues with officials of Revenue Canada-Customs, Excise and taxation. (A separate liaison meeting was held on pending excise tax issues.) The meeting was arranged under the aegis of TEI's Canadian Income Tax Committee, whose chair is John J. Marczynski of Abitibi-Price Inc., and the Institute's delegation was chaired by C. Graham Kennedy of MacMillan Bloedel Limited, the Institute's Vice President-Region I. Reprinted below are the questions that the Institute submitted to Revenue Canada in advance of the liaison meeting.

Tax Executives Institute, Inc. welcomes the opportunity to present the following comments and questions on several pending tax issues, which will be discussed with representatives of Revenue Canada Customs, Excise and Taxation during TEI's December 13, 1994, liaison meeting. If you have any questions in advance of that meeting, 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. 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 the incremental basis point savings are applied to huge sums.

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

   * the perpetual evolution, and chameleon-like nature, of derivative financial instruments;

   * the confusing array of juris-prudential 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 and - indeed, impossible - to legislate detailed tax rules in respect of every type of financial instrument or transaction, the government should provide dance to enable taxpayers to structure their financing transactions and report the tax effects of those transactions properly. Costly litigation over unresolved issues is undesirable for both taxpayers and the government. Accordingly, we have recommended that the Department of Finance establish broad principles concerning the taxation of financing activities. Those 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 recommend that Revenue Canada publicize, through interpretation bulletins and information circulars, its administrative position and assessing practice. The guidance should be updated to reflect developments attributable to new legislation, jurisprudence, or the evolution of financial instruments. We would be pleased to meet with officials from Revenue Canada to assist in the development of the requested guidance.

2. Revenue Canada

   Audit Practice

   Although some large-file auditors embrace taxpayer participation in the design of the audit plans and believe that a new paradigm of cooperation will lead to better tax administration, there remains a wide divergence in the conduct of large-file audits. For example:

   * Some auditors do not inform taxpayers about the details of their audit plans. In addition, proposed audit adjustments are often not brought to the attention of the tax department on a timely basis thereby preventing resolution of an issue before a reassessment. Auditors often fail to provide updates on the progress of their audits and whether the information they have been supplied is sufficient.

   * Some auditors emphasize adjusting timing issues, insisting, for example, on reductions in accruals established under generally accepted accounting principles where subsequent invoices show lower amounts. Both the auditor and taxpayer may expend inordinate amounts of time and resources on accounting estimates - issues that are largely timing in nature since a subsequent year's estimate will be increased or decreased to account for the variance from actual results.

   * Some auditors propose adjustments unsupported by, or even contrary to, established precedent by, for example, disallowing capital losses on interest-free loans to foreign corporations despite the decision in Floyd Glass (92 DTC 1759), or disallowing the manufacturing and processing tax credit on interest income in disregard of the decision in Canadian Marconi (86 DTC 6526).

   We understand that Revenue Canada, through liaison meetings with groups such as the Large Business Advisory Committee, is reviewing its procedures to improve the audit process. TEI supports these initiatives. To this end, we offer the following comments:

   * Audits should focus on issues where there are a high probability of both improper treatment and adjustments of sufficient magnitude to be a material concern to Revenue Canada. Audit plans should generally not focus on areas requiring substantial taxpayer efforts to produce documentation where the potential revenue for the government is small.

   * Auditors should rely more on analytical techniques (e.g., trend and ratio analysis, comparisons to prior years) to assess the risk of misstatements. Employing such...