TEI comments on proposed Canadian legislation.

• Position: Tax Executives Institute

December 6, 2010

On December 6, 2010, Tax Executives Institute filed the following comments with Canada's Department of Finance on draft legislation released August 27, 2010. TEI urged that the proposals relating to foreign tax credit generator transactions, the reportable transaction regime, and non- resident trusts be narrowed in order to avoid impairing many ordinary commercial transactions. TEI's comments were prepared under the aegis of its Canadian Income Tax Committee, whose chair is Carmine A. Arcari of the Royal Bank of Canada. Contributing substantially to the development of TEI's submission were Glenn Stadtegger and Alan Wheable of TD Bank and Vincent Alicandri of Hydro One Inc. Jeffery P. Rasmussen, TEI Tax Counsel, coordinated the preparation of the Institute's comments.

On August 27, 2010, the Department of Finance released draft legislative proposals amending the Income Tax Act, Canada (the Act) to implement tax measures from the 2010 Budget message as well as several other previously announced tax initiatives. On behalf of Tax Executives Institute, I am writing to urge the Department of Finance to narrow the foreign tax credit generator provision, which is overbroad, catches legitimate financing arrangements and ownership structures, and impedes ordinary commercial transactions. In addition, we have comments and recommendations relating to the proposals for Non-resident Trusts (NRTs) and the disclosure of "reportable" transactions.

Tax Executives Institute

TEI is the preeminent international association of business tax executives. The Institute's nearly 7,000 professionals manage the tax affairs of 3,000 of the leading companies in North America, Europe, and Asia. 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 nine geographic regions, and must contend daily with the planning and compliance aspects of Canada's business tax laws. Many of our non-Canadian members (including those in Europe and Asia) work for companies with substantial activities in Canada. The comments set forth in this letter reflect the views of TEI 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. In furtherance of this goal, TEI supports efforts to improve the tax laws and their administration at all levels of government. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the issues raised by the August 27, 2010, draft legislation.

Foreign Tax Credit Generator (FTCG) Transactions

General Policy. The Explanatory Notes (hereafter "the Notes") issued by the Department of Finance in connection with the draft legislation state that "[n]ew subsections 91(4.1) to (4.5) of the Act, together with new rules in section 126 of the Act and section 5907 of the Regulations, are intended to address tax schemes established by taxpayers with the intent of creating foreign tax credits and similar deductions for foreign tax the burden of which is not, in fact, borne by the taxpayer. The main thrust of all of these schemes is to exploit asymmetry as between the tax laws of Canada and those of a relevant foreign jurisdiction in the characterization of equity and debt instruments."'

The policy underlying the proposals--denying foreign tax credits (FTCs) or deductions where the foreign taxes have never been paid or where the foreign tax is refunded--is unassailable. The proposed rules, however, will cause double taxation of many Canadian companies that employ ordinary commercial financing arrangements or commonplace ownership structures for their foreign affiliates. Indeed, the rules are not targeted at a particular subgroup of foreign affiliates located in a jurisdiction where a hybrid instrument exists or where phantom foreign taxes might be generated, but affect all the foreign affiliates of Canadian companies in a related group. In addition, the proposed rules seemingly apply to hybrid instruments issued by one Canadian entity to another Canadian entity.

Discussion. The interaction of draft subsections 91(4.1) and 5907(1.03) with the definition of "pertinent person or partnership" (PPOP) in draft subsections 91(4.5) and draft income tax regulation 5907(1.06) would deny deductions for foreign accrual tax (FAT) or underlying foreign tax (UFT) in respect of foreign accrual property income (FAPI) or taxable surplus of a foreign affiliate, if at any time in the year, a PPOP in respect of the Canadian taxpayer is considered, under the foreign tax law of the country in which the FAPI or taxable surplus is earned, to own fewer shares (or less of an ownership interest) of any pertinent person (in respect of the Canadian taxpayer) than the Canadian taxpayer is considered to own for purposes of the Act. Similarly, where a taxpayer is considered to have a lesser direct or indirect share of a partnership's income under the relevant foreign tax law than it is considered to have under the Act, draft subsection 126(4.11) would deny FTCs in respect of the income of the partnership. In other words, the proposed rules would deny relief for foreign taxes where, under a foreign jurisdiction's tax law, a Canadian corporation is considered to own a smaller direct or indirect interest in a foreign entity than the Canadian taxpayer would own under Canadian tax law. As a result, foreign tax relief for foreign taxes that have actually been borne, directly or indirectly, by a taxpayer in bona fide arrangements will be denied.

Two examples illustrate the overbreadth of the rules:

Example 1. Assume that a Canadian corporation (Canco) owns all of the outstanding common and preferred shares of a corporation resident in Canada (Cansub), which carries on an active business in Canada. Because of a repurchase (REPO) agreement, the preferred shares of Cansub are characterized as debt under U.S. tax law. Canco also owns all the outstanding common shares of a corporation resident in the United States (USco) and USco has no other securities outstanding. USco earns $100 of FAPI in 2010.

Under the proposed amendments, the deduction for any FAT associated with USco's FAPI would seemingly be denied by draft subsection 91(4.1) since Canco (a PPOP in respect of Canco) is considered to own fewer shares of Cansub (also a PPOP in respect of Canco) for U.S. tax purposes than Canco is considered to own for purposes of the Act. This is the result even though (i) U.S. tax is actually borne directly by USco (and indirectly by Canco), (ii) the holding of the preferred shares of Cansub is entirely unrelated to the FAPI earned by USco or the amount of FAT claimed in respect of the FAPI, and (iii) the characterization of the preferred shares of Cansub is irrelevant in determining the amount of U.S. tax that USco owes. Example I thus illustrates that, contrary to the stated purpose of the proposed provisions, the rules would deny a deduction for real taxes incurred. TEI submits that there is no sound tax policy reason for denying a Canadian taxpayer a deduction for foreign taxes on FAPI when the tax has actually been incurred.

Example 2. Assume that...