TEI comments on proposed Canadian legislation restricting interest deductions.

• Position: Tax Executives Institute

On May 11,2007, Tax Executives Institute submitted the following letter to Canadian Minister of Finance James Flaherty, commenting on the 2007 Budget proposals restricting the deductibility of interest on indebtedness incurred to finance investments in foreign affiliates. TEI's comments were prepared under the aegis of its Canadian IncomeTax Committee, whose chair is David L. Penney of General Motors of Canada Limited. Contributing substantially to the development of TEI's comments was Julie Muirhead, also of General Motors of Canada Limited.

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On March 19, 2007, the government released its 2007 budget proposals. The accompanying message reported significant progress in the tax treaty negotiations between Canada and the United States to eliminate withholding taxes on interest. The message also announced the government's intention to introduce legislation eliminating withholding taxes on interest paid to arm's length non-residents of all countries. Tax Executives Institute applauds both measures.

Budget 2007 also includes a proposal to deny a deduction for interest and other costs incurred in respect of money borrowed to directly or indirectly acquire shares or indebtedness of a foreign affiliate (hereinafter "the Proposals"). On behalf of TEI, I am writing to express TEI's concerns about the Proposals.

Background

TEI is the preeminent international association of business tax executives. The Institute's 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 Proposals.

Longstanding Policy Undergirds the Current Rules

Since 1972, Canada has afforded Canadian taxpayers a deduction for interest on borrowings in Canada to finance investments in foreign affiliates. In addition, active business income earned by the foreign affiliates in designated treaty countries is considered "exempt surplus" and, to the extent dividends are paid by the affiliate to a Canadian taxpayer from such surplus, is not taxable. Consistent with international tax norms, the exemption reflects Canada's acknowledgement that (i) the foreign jurisdiction possesses the primary right to tax the active business income earned in that jurisdiction and (ii) taxing the income again in Canada would result in double taxation.

The deductibility of interest on borrowings to invest in foreign affiliates has been a cornerstone of Canadian tax policy that the Department of Finance has consistently and ardently defended. (1) The deduction promotes foreign investments by Canadian companies and enhances their ability to expand globally. Moreover, substantially all of Canada's major trading partners afford a comparable deduction to domestic enterprises for interest incurred on funds borrowed to invest in foreign affiliates. Some of those trading partners employ an exemption system similar to Canada's for dividends from foreign affiliates while others utilize a foreign tax credit system that mitigates double taxation of foreign profits. Accordingly, denying interest deductibility to Canadian companies will put Canadian companies at a substantial disadvantage compared with foreign competitors.

Competitive Disadvantage for Canadian Companies

A variety of studies, including a 1997 report submitted to the Technical Committee on Business Taxation (hereinafter "the Mintz Committee"), (2) have documented the economic benefits flowing to Canada from foreign expansion by Canadian companies. Such benefits include increasing the number of high-paying, high-skilled jobs in Canada to manage Canadian companies' global affairs and fostering the competitiveness of Canadian companies. Global expansion impels companies to compete more effectively and efficiently by operating closer to their global customers and suppliers, increasing their access to local markets, reducing transportation and other logistical costs, and diversifying foreign exchange and other business risks. The studies consistently confirm that it is in the best economic interests of Canada to have strong Canadian-based multinationals.

If implemented, the Proposals would significantly increase the cost of capital for Canadian companies, making it far more expensive to finance the start-up, acquisition, and growth of foreign businesses. For example, where a Canadian company and a foreign company are bidding to acquire the same foreign target, the foreign acquiring company would likely be able to deduct the interest cost of debt financing whereas the Canadian company would not. As a result, the foreign company would be able to offer a higher price for the target company or obtain financing more easily and at a lower after-tax cost. Similarly, in a bid for a Canadian company with foreign affiliates, a foreign acquirer would have a competitive advantage of a lower after-tax cost of debt financing. (3)

The proposed limitation on interest deductibility would also hinder the internal growth of Canadian foreign affiliates. In many cases, foreign affiliates are unable to borrow in foreign jurisdictions because of the instability or immaturity of capital markets in such jurisdictions, local regulatory restrictions, political or other risks in the foreign jurisdictions, or the foreign affiliate's lack of cash flow (especially during a business's start-up phase). In addition, a foreign affiliate may not be able to borrow at competitive rates abroad compared with the Canadian rates available to the Canadian parent. As a result, Canadian parent companies frequently finance the expansion and growth of their foreign affiliates through equity investments or inter-company loans. If the debt to finance the affiliates' business growth cannot be pushed down into the foreign entity or the interest (for a loan to, or equity investment in, a subsidiary) cannot be deducted in Canada because of the Proposals, the Canadian group will be at a competitive disadvantage vis-a-vis companies headquartered in other jurisdictions. (4)

Finally, the Proposals would make Canadian companies vulnerable to takeovers by foreign competitors. The increased cost of capital resulting from the Proposals would likely increase Canadian companies' effective tax rates, which will decrease their value (share price) and make them vulnerable to takeovers by foreign entities. Once acquired, it is likely that the high-wage, high-skill head-office jobs in Canada would be eliminated.

Existing Debt and Foreign Affiliate Structures

Businesses generally make investment decisions based on the after-tax returns. Since Canadian businesses have relied on the government's longstanding policy to structure their foreign investments and financing, denying a deduction for the associated interest expense would, in many cases, turn a currently profitable operation into a loss.

Moreover, the term of the debt financing for investments in foreign affiliates generally extends beyond the proposed effective date of the Proposals (December 31, 2008, for non-arm's length debt and December 31, 2009, for arm's length debt). Indeed, commercial debt obligations frequently have terms to maturity of 10 years or more. Consequently, Canadian companies will be compelled to choose between paying significant prepayment fees to terminate current debt arrangements prematurely in order to move the debt offshore (at potentially less favourable borrowing rates and terms) or continue existing arrangements and pay nondeductible interest. Either choice is economically inefficient and will hurt Canadian companies. (5) To avoid imposing significant refinancing costs on businesses, the grandfathering rules for current financial arrangements should be expanded or the transition period substantially lengthened. Broad grandfathering rules or a generous transition period for existing debt arrangements was a critical component of recommendations advanced in the Mintz Committee's Report. (6)

The Proposals Exacerbate Uncertainty and Create Significant Compliance Challenges for Taxpayers

The Proposals significantly exacerbate the current uncertainty about the tax treatment of outbound...