TEI urges Canadian government to abandon proposed legislation relating to foreign investment entities.

• Position: Tax Executives Institute

On March 23, 2006, TEI President Michael P. Boyle submitted a letter to the Canadian Minister of Finance James A. Flaherty urging the government to abandon proposed legislation affecting foreign investment entities. TEI's letter was prepared under the aegis of its Canadian Income Tax Committee, whose chair is David V. Daubaras of General Electric Canada. Vincent Alicandri of Hydro One Networks, Inc. contributed substantially to the development of TEI's comments. Also contributing to TEI's comments were Monika M. Siegmund of Shell Canada Limited, Carmine A. Arcari of the Royal Bank of Canada, and Karina 0 of Nortel Networks Corporation.

On July 18, 2005, the Department of Finance released the fifth version of draft legislation relating to Foreign Investment Entities (FIE) and Non-Resident Trusts (NRT). On behalf of Tax Executives Institute, I am writing to provide TEI's comments on the proposed legislation relating to Foreign Investment Entities.

BACKGROUND ON TAX EXECUTIVES INSTITUTE

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,800 professionals manage the tax affairs of 2,800 of the leading companies in North America, Europe, and Asia and must contend daily with the planning and compliance aspects of Canada's business tax laws. 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. Our non-Canadian members work for companies with substantial activities and investments 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 OF DRAFT LEGISLATION AND TEI'S COMMENTS

The draft Foreign Investment Entity (FIE) legislation released by the Department of Finance on July 18, 2005, is intended to replace the current rules in respect of the "offshore investment fund" rules found in section 94.1 of the Income Tax Act ("the Act"). The current draft of the legislation replaces drafts released previously on June 22, 2000; August 2, 2001; October 11, 2002; and October 30, 2003.

The current rules in sections 94.1 are anti-avoidance provisions that are intended to prevent taxpayers from inappropriately deferring or avoiding tax (including conversion of income to capital gains in specific situations). Current section 94.1 applies where a taxpayer has invested in an offshore investment fund and one of the main reasons for the investment is to reduce or defer the tax liability that would have applied to the income generated by the underlying assets of the fund if such income had been earned directly by the taxpayer.

In announcing the original draft of the legislation in June 2000, the Department's press release explained its purposes, as follows:

It is important that the income tax system not provide a means for Canadians to avoid Canadian income tax by transferring funds to offshore trusts or accounts. The proposed rules intend to provide a fair and workable approach to dealing with this complex area. As noted in our previous submissions, the government's objective of curbing illegitimate tax avoidance effected through "transfers to nonresident entities" is unassailable--and TEI supports such efforts because it will forestall shifts in the tax burden to already compliant taxpayers--but we do not believe that the proposed new and complex FIE provisions are necessary to achieve the government's goals. Current section 94.1 provides the government substantial tools to curb tax-motivated transfers. Moreover, the decision in Walton v. The Queen, 98 D.T.C. 1780, vindicated the policy underlying section 94.1 and enhanced that provision's efficacy in combating tax avoidance effected through offshore investment funds. We urge the government to optimize enforcement of the current provisions in the Act before adding new provisions.

As important, the government's announcement regrettably understates the scope, nature, and far-reaching effect of the proposed legislation because the draft rules go significantly beyond the stated purpose of combating "tax avoidance." Indeed, the proposed legislation implements a comprehensive new regime for taxing indirect foreign investment.

We commend the Department's ongoing commitment to the consultative process and its making important revisions to the proposed legislation in the most recent and previous drafts. While the Department has made progress in addressing the overlap with other provisions of the Act, the "band aid" approach to perfecting this proposed legislation has not corrected its most significant deficiencies. The rules remain overbroad, extraordinarily complex, and confusing. As a result, the provisions will interfere with legitimate business operations, impede Canadian business expansion abroad, and undermine Canada's competitiveness.

Although the current draft helpfully reduces the number of instances where a non-resident corporation operating an active business might qualify as a FIE, TEI continues to believe that, once an entity is trapped in the labyrinth of the FIE rules, compliance may prove impossible. We also continue to question whether the Canada Revenue Agency (CRA) will, anymore than taxpayers, have the resources to administer these rules. From both compliance and administrative perspectives, the rules would be vastly improved if they were more limited in scope and focused solely on remedying abuses. To the extent that the government can identify specific abuses, it should propose narrower, targeted solutions. Otherwise, the compliance challenges posed by the proposed legislation will spawn inadvertent, unavoidable non-compliance by otherwise compliant taxpayers.

Fundamentally, we urge the government to withdraw the proposed legislation because:

* It would apply to numerous, compliant taxpayers that are not attempting to avoid Canadian tax by "transferring funds to offshore trusts or accounts."

* It overlaps section 17 and will interfere with many legitimate commercial transactions.

* The information necessary to comply with the proposed legislation's myriad reporting requirements or to take advantage of one or more relieving provisions or elections is either (1) unavailable generally or (2) likely unavailable to a Canadian taxpayer where, as will generally be the case, it is a minority investor and lacks the requisite control to compel production of the necessary information. Consequently, most taxpayers with a FIE will be subject to the prescribed rate of return regime (the imputed interest method) imposed by proposed subsection 94.1(4).

* The Minister, in certain circumstances, is accorded seemingly untethered authority to make various determinations, including whether a business is an investment business, property is exempt, and an entity is a FIE or a qualifying entity, with taxpayers having no right to appeal various determinations.

* The proposed legislation impedes foreign investment by Canadian companies and impairs their global competitiveness. For example, during negotiations over proposed business transactions, potential foreign investees have objected to providing the financial information that would enable a Canadian minority investor to comply with the proposed FIE rules. In many cases, the investee's reluctance arises from the additional burden imposed on the foreign companies to prepare detailed information solely for a Canadian minority investor. Where the foreign investee is also a competitor, the foreign company has objected to supplying additional information that might create a competitive advantage for the minority Canadian investor. Specific examples summarizing how the rules have affected the negotiation of foreign investments by Canadian companies are attached in Appendix 1.

* The rules apply retroactively to taxation years beginning after 2002.

Finally, taxpayers are suffering from "draft legislation fatigue" with respect to the proposed rules. The multiple revisions have succeeded in confusing taxpayers about the likely scope and operation of the "final" legislation. Moreover, given the legislation's mind-numbing complexity (and the myriad revisions over the years) taxpayers will need more time to digest and analyze the proposed legislation and, after determining whether the information is available and obtainable, to make necessary changes to their information systems. Hence, the implementation of the proposed legislation should be delayed substantially in order to afford taxpayers time to undertake a proper analysis and implement the necessary information system changes. We recommend, at a minimum, that the coming-into-force date be no earlier than taxation years commencing after December 31, 2006.

TEI's questions, comments, and concerns about specific provisions are set forth below.

FOREIGN INVESTMENT ENTITIES--SECTIONS 94.1 TO 94.4--DEFINITIONS

1. Arm's Length Interest

   The definition of an "arm's length...