December 6, 2010
Please Respond To:
Rodney C. Bergen
Managing Director, Tax and Financial Analysis
The Jim Pattison Group
1800-1067 West Cordova St.
Vancouver, BC V6C 1C7
604.488.5231
Bergen@jp-group.com
The Honourable James M. Flaherty, P.C., M.P.
Minister of Finance
Finance Canada
L’Esplande Laurier
140 O’Connor Street
Ottawa, Ontario K1A 0G5
Canada
Re: August 27, 2010, Legislative Proposals
Dear Minister Flaherty:
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.”[1]
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 1 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 Canco owns all of the outstanding shares of a non-resident corporation (Forco) that carries on an active business in a country that does not have a tax treaty with Canada. Canco and Forco have calendar taxation years and Forco earns $100 of taxable surplus in 2010. In December 2010, Canco agrees to acquire the shares of a corporation resident in Canada (Target) from arm’s length sellers with the closing occurring in 2011. Target owns all the outstanding common and preferred shares of a dormant subsidiary (Subco) resident in another foreign country and the preferred shares of Subco are treated as debt in the country where Forco carries on business.
Under the proposed amendments, Forco would be denied a deduction for UFT in respect of its 2010 taxable surplus because Target (a PPOP in respect of Canco by virtue of Canco’s rights to acquire shares of Target) is, for tax purposes in the country where Forco carries on business, considered to own fewer shares of Subco (also a PPOP in respect of Canco) than it is considered to own under the Act. Absent a deduction for the UFT on its taxable surplus, the earnings of Forco will be subject to Canadian tax when distributed to Canco. TEI submits that the resulting double taxation of Forco’s earnings is inconsistent with the tax policies that govern foreign investments by Canadian taxpayers.
The draft rules are also inconsistent with the explanation of the 2010 Budget. Under the draft legislation, a PPOP is not required to own an “equity percentage” in the relevant foreign affiliate. As a result, the foreign accrual tax for FAPI may be denied where the “hybrid security” is in a company that has no direct or indirect interest in the foreign affiliate that earns FAPI or taxable surplus (including in a related Canadian company or a company that is deemed to be related as a result of paragraph 251(5)(b)). For large corporate groups that hold numerous securities in entities in various foreign jurisdictions, the proposals would, at a minimum, require substantial effort (and likely significant restructuring of holdings) to eliminate potential traps that would prevent relief from foreign taxes. Indeed, in many cases, a security may be issued without regard to the manner in which it is treated in other foreign countries because the tax treatment would be irrelevant.[2] Moreover, it may not be possible — and it is certainly impractical — to determine the character of every security issued by every PPOP under the tax laws of every jurisdiction where any foreign affiliate is subject to tax.
The lack of connection between the proposals and their intended prophylactic purpose is illustrated by Example 1 in the Notes to subsection 91(4.1).[3] Under the facts of the example, it is unclear why FAT would be denied in respect of any FAPI earned by FA1, FA2, or FA3. Specifically, if the hybrid security (the REPO in the examples) is treated as debt in the United States, the applicable U.S. tax would be reduced by the payments on that security, but FAT would still be denied on any U.S. tax in respect of any FAPI earned by FA1, FA2, or FA3. The proposals are simply overbroad.
TEI recommends narrowing the August 27th proposals to be coextensive with the purposes stated in the 2010 Budget. Specifically, the proposals should (i) include an “equity percentage” requirement in the definition of PPOP (as describe in the 2010 Budget) and (ii) require that the character of any “hybrid security” be relevant for purposes of determining the tax consequences of the foreign income to which the relevant foreign tax relates.
Effective Date. The proposals generally apply to taxation years ending after March 4, 2010, and thus will affect a taxpayer’s current taxation year, increasing the Canadian tax liability on any FAPI or dividends paid from taxable surplus. Indeed, where a Canadian corporation and its foreign affiliate have different tax year ends, the proposals can apply as early as the 2008 year. The retroactive application of the proposed rule is especially harsh where commercial or contractual restrictions may inhibit taxpayers from restructuring the forms of their investments. TEI recommends making the provisions prospective or providing appropriate transition relief for ordinary commercial financing arrangements. At a minimum, in order to afford taxpayers time to restructure their investments or otherwise take the necessary action to change the characterization of the investments under applicable foreign law to equalize the ownership percentage under the foreign and Canadian tax law treatment of the instrument, the coming-into-force provision should apply no earlier than taxation years beginning after the Announcement Date of August 27, 2010.
Disclosure of Reportable Transactions with
“Confidential” or “Contractual” Protection
Proposed subsection 237.3(1) would create an information reporting regime for certain “reportable transactions.” The aim of the proposal is to provide Canada Revenue Agency with an early warning system to counter potentially abusive transactions. Although TEI supports measures to prevent shifting the tax burden to compliant taxpayers, the definitions for the hallmarks of reportable transactions are so broad that many ordinary commercial transactions may well be swept into the reporting regime without regard to whether the transaction or series is an abusive avoidance transaction.
As explained in the Notes, a reportable transaction is an “avoidance” transaction (within the meaning of subsection 245(3)), or series of transactions that includes the avoidance transaction, in which two of three hallmarks is present in respect of the transaction or series. The three hallmarks are (i) certain “fee” arrangements, (ii) agreements with “confidential protection,” and (iii) agreements with “contractual protection.” Where an advisor or promoter in respect of an avoidance transaction or series of transactions, or any person who does not deal at arm’s length with the advisor or promoter, has or had “confidential protection” or “contractual protection” in respect of a transaction or series of transactions, the transaction may be reportable. “Confidential protection” in respect of a transaction or series of transactions means “anything that prohibits the disclosure to any person or to the Minister of the details or structure of the transaction or series under which a tax benefit results . . . .” “Contractual protection” includes any form of insurance or indemnity that protects a person from the loss of tax benefits.
The hallmark of confidential protection is broadly drafted. Indeed, it seemingly encompasses the prohibition against disclosure that is imposed on lawyers by the solicitor-client privilege. Specifically, the interaction of the definition of confidential protection with paragraph (b) of the definition of “reportable transaction” would cause the hallmark to be present wherever a promoter or advisor has a duty or obligation that prohibits disclosure (as opposed to a right to prevent disclosure). As a result, TEI is concerned that any legal advice in respect of any transactional structure may be caught by the proposed confidential protection provision. Although the Notes helpfully clarify that paragraph (b) of the definition is intended to address situations where the advisor obtains confidential protection — implying that the provision does not apply where the advisor is bound by a duty of confidentiality — the proposed statutory language of paragraph (b) in the definition of “reportable transaction” is not so clearly limited.
TEI recommends that the definition of “confidential protection” be amended to exclude prohibitions on disclosure that arise from the solicitor-client privilege. If such an exclusion cannot be crafted, the phrase “has or had” in paragraph (b) of the definition of “reportable transaction” should be narrowed substantially to better target the types of confidential arrangements that the Notes identify as problematic avoidance transactions. Specifically, the provision should address arrangements where the promoter or advisor “obtains” a right to assert confidential protection as opposed to being bound by a duty because of having rendered legal advice to a client.[4]
Next, although the purpose of the provisions is to require reporting of avoidance transactions, the line between acceptable tax planning and an avoidance transaction is rarely clear. Thus, taxpayers involved in complex but common transactions (such as a section 85 rollover election or an amalgamation transaction) may well report a transaction if two of the three hallmarks are also present. Indeed, we believe that the definitions are so broad that cautious taxpayers will report — and CRA will be compelled to examine — many non-avoidance transactions simply because it unclear whether the tax benefits of the transaction are clearly contemplated by the Act or are considered a “misuse or abuse” of the Act. To minimize taxpayer reporting burdens and to narrow the scope of information reporting that CRA must review, the Department should substantially narrow the hallmarks for reportable transactions. The transactions of interest are most likely those involving a contingent-fee arrangement (or other guarantee of performance) coupled with an avoidance transaction.
Finally, under the proposed definitions, a vendor in a share sale transaction can be considered to be a promoter providing “contractual protection” where it makes standard commercial representations regarding the tax attributes of a target company and the contract for the sale of shares includes standard indemnification provisions. In addition, in order to prevent disclosure of confidential company information during negotiation or bidding for companies or business units, nondisclosure agreements are typically signed. Such agreements provide “confidential protection” to the target and the vendor that may trigger a reporting obligation if the fee hallmark is also triggered. TEI recommends that the Department provide carve outs from the hallmarks of “confidential protection” and “contractual protection” to exclude ordinary commercial agreements that are entered into in connection with the purchase or sale of business units.
Non-Resident Trust (NRT) Proposals
The NRT proposals have taken a long and winding road to reach their current state. First released in 2001 and amended frequently since, the draft rules will deem certain non-resident trusts to be resident in Canada for most income tax purposes and thus cause Canadian resident beneficiaries and Canadian resident contributors of such a trust to be jointly and severally liable for all or some of the non-resident trust’s Canadian income tax. The lengthy consultation process, which TEI is pleased to have participated in, has significantly fine-tuned the legislation, narrowing its scope while sharpening an otherwise blunt anti-avoidance tool. Although the improvements are helpful, we remain concerned about the substantial complexity of the NRT rules as well as their excessive breadth. Concededly, the Act will never be simple, but we question whether the tax avoidance the provisions target can ever justify the enormously complex thicket of rules. Thus, while we support the government’s efforts to curb the inappropriate use of trusts to shift income outside of the Canadian tax net, the rules should not erect barriers to the international competitiveness of Canadian companies entering into bona fide commercial arrangements. We offer the following comments and recommendations to improve the draft NRT rules and ensure that ordinary commercial transactions are not unintentionally caught.
a. Definition of “Arm’s Length Transfer”
In previous submissions, TEI has expressed reservations about the definition of “arm’s length transfer” in the NRT proposals. Although the August 27, 2010, version of the definition is an improvement over prior iterations, the definition remains convoluted and thus will potentially subject too many transactions to the NRT rules. Specifically, unless transactions satisfy the criteria in paragraphs (b)(i) to (b)(vii) of the definition, the NRT provisions may inadvertently apply to many commercial transactions undertaken in the ordinary course of business between unrelated parties. TEI believes that any transfer of property or payment between unrelated parties should qualify as an “arm’s length transfer” except where the circumstances described in paragraph (a) of the definition are met.
Other specific concerns and recommendations about the definition are, as follows:
1. Paragraph b(ii) – Payments for Paid-up Capital
Paragraph b(ii) of the definition of “arm’s length transfer” prescribes the conditions under which a payment in respect of paid-up capital will be considered arm’s length. Regrettably, the provision is unworkable except in the simplest cases. Leaving aside the potential difference between “stated capital” and “paid-up capital,” there are a number of challenges in applying the definition.[5] As a result, payments for paid-up capital between unrelated parties may not be considered an “arm’s length transfer” because the initial amount paid for a particular share may either be unknown or untraceable to a particular share of capital stock. Indeed, shares of the same class of stock are generally fungible and identical to all other shares of the class, so ordinary, plain vanilla transactions would seem to be caught by the provision. For example, assume in year 1 that a corporation issues 100 shares for $5 cash each. In year 10, another 100 shares are issued for $45 cash each. At that time, the stated capital and paid-up capital for each share will be $25 each. If there is a stated capital reduction of $20 in respect of each share, the payment would not be treated as an arm’s length transfer even where all the shares are owned by the same person.
TEI recommends that two changes be made to the definition of payments for paid-up capital. First, the provision clearly should not apply to publicly traded shares and we urge the Department to provide such an exception. Second, the Department should permit the averaging of the paid-up capital across all shares of the same class held by a single person or partnership.
2. Paragraph b(v) – Payments for Loans as Arm’s Length Transfers
Paragraph b(v) of the definition of “arm’s length transfer” prescribes the conditions under which payments for loans will be considered arm’s length. As noted in previous submissions, TEI is concerned about the seeming requirement that the loan be reflected in a single agreement. Common commercial practice for complex loans is to the contrary, with significant loan transactions often being reflected in multiple documents and agreements. For example, security and subordination requirements, which are highly relevant to the pricing of a loan, are often set forth in ancillary documents and agreements. TEI recommends that the reference to “agreement” in this paragraph be revised to permit all collateral agreements between the transferor and the person or partnership to be considered in determining whether a loan or loan payments are arm’s length transfers.
b. Exempt Foreign Trust
A NRT that satisfies the definition of “exempt foreign trust” is not considered a Canadian resident for purposes of new subsection 94(3) of the Act and is thus exempt from the NRT rules. Paragraphs (e), (f), and (g) of the definition helpfully exempt foreign trusts established or maintained for the administration of employee benefit and pension plans. TEI appreciates the clarifications made to these exclusions in this draft.
Paragraphs (d) (relating to charitable trusts) and (g) (relating to pension trusts) of the definition require that the foreign trust be established or maintained in a jurisdiction with an income tax system for the exclusion to apply. It is unclear from a policy perspective why this requirement is necessary. Charities established and operating in countries that lack an income or profits tax are no less deserving of favoured treatment simply because the jurisdictions in which they operate do not levy income- or profits-based taxes. Similarly, employees working in countries that do not impose an income or profits tax are no less deserving of superannuation benefits that a qualified employee benefit plan trust would provide because the host country imposes no income- or profits-based tax. Moreover, should a foreign jurisdiction replace its income tax system with, say, a broad-based consumption tax, it is unclear why a charitable or pension trust located in that jurisdiction should lose its exempt status and thereby be subject to the NRT rules. TEI recommends that the requirement that the foreign jurisdiction maintain an income tax be deleted from both paragraphs.
c. Restricted Property
The term “restricted property” is relevant in applying a number of NRT provisions, including the definitions of “arm’s length transfer” and “exempt foreign trust.” The Notes explain that the provision serves an anti-avoidance purpose since, absent the rules, corporate shares and indebtedness might be used to circumvent the NRT rules. Because of concerns expressed during the consultations about the scope of the definition of restricted property, the Department has added subsection 94(14) to the draft rules in order to suspend the application of the “restricted property” rules in certain circumstances.
TEI welcomes the addition of subsection 94(14) to “turn off” the restricted property rules. We believe, however, that paragraph (c) of the definition of restricted property is still too narrow to serve its intended purpose. Specifically, given the lack of a group consolidation regime for Canadian companies, most large multinational companies will own items described in paragraph (a) or (b) of the definition. To provide full relief, we recommend revising paragraph (c) of “restricted property,” as follows (deletions are in strikethrough font and additions are in italics):
(c) property
(i) that the person or partnership acquired as part of a series of transactions (determined without the application of subsection 248(10)) described in paragraph (a) or (b) in respect of another property, and
(ii) all or substantially all the fair market value of which is derived in whole or in part, directly or indirectly, from that other property that is restricted property.
Discussion. TEI believes the first proposed parenthetical phrase in subparagraph (c)(i) is necessary because, under the current interpretation of “series” under subsection 248(10), it is nearly impossible to determine the end of any “series.”
Next, under the current definition for restricted property, the transfer of even the smallest amount of tainted “restricted property” will infect any related property transferred along with restricted property. Thus, property with, say, a value of $1 billion that would otherwise be considered the object of an arm’s length transfer could be converted to restricted property by the transfer of an obscure but restricted property (or property right) with a value of, say, $0.01. To avoid this, we recommend adding the phrase “all or substantially all” to subparagraph (c)(ii) to permit the transfer of property rights with de minimis value. The phrase has a well-accepted meaning under many provisions of the Act.
Finally, the current formulation of subparagraph (c)(ii) of the definition does not integrate well with proposed subsection 94(14). There are additional circumstances where the application of the restricted property rule should be suspended. For example, assume a public company that is traded on the Toronto Stock Exchange holds shares within the group that are described in paragraph (a) of the definition of restricted property. Assume further that a private holding company, as part of its ordinary investment activities, purchases a small portfolio investment in the shares of the public company. Under the current formulation of subparagraph (c)(ii), the shares of the private holding company will become restricted property by virtue of the private company’s acquiring a de minimis investment in a public company’s shares. The mere ownership of property that is not itself restricted property (i.e., the shares of the public company) should not transmogrify the private holding company into restricted property. We believe the additional recommended changes to subparagraph (c)(ii) provide an appropriate exclusion from the definition of restricted property.
d. Paragraph 94(2)(c)
Paragraph 94(2)(c) provides an exemption from the property contribution rules for loans made in the ordinary course of business by specified financial institutions. TEI welcomes this helpful clarification and recommends that the concept be expanded. One of the primary uses of trusts in commercial practice is securitization and similar financing arrangements. An important ancillary service for competing for such business is the ability to provide derivatives and similar financial products to manage interest rate, foreign exchange, credit, and liquidity risks. For Canadian financial institutions to be competitive, a broader exemption would be beneficial.
e. Section 94.2
If a resident trust beneficiary, either alone or together with persons not dealing at arm’s length with the resident beneficiary, holds 10 percent or more of the specified fixed interests in a non-resident commercial trust, the trust is deemed to be a controlled foreign affiliate of the resident beneficiary for purposes of certain provisions of the Act.
The 10-percent ownership threshold for the application of the proposed provision is far less “control” than normally required for the application of the controlled foreign affiliate provisions. Where a foreign trust is widely held and a Canadian taxpayer holds only a relatively small percentage of the trust, compliance with the proposed provisions will be extremely challenging. As a result, TEI recommends that the list of foreign trusts exempted from the application of the provision (by the parenthetical language in subsection 94.2(1)) be expanded to include paragraph (h) (at least where the direct ownership of the trust is less than 50.1 percent). Thus, subsection 94.2(1) should be revised, as follows:
For the purposes of subsections (2) and 91(1) to (4) and sections 95 and 233.4, an exempt foreign trust (other than a trust described in any of paragraphs (a) to (g) (h) of the definition “exempt foreign trust” in subsection 94(1)) is deemed to be at a particular time a controlled foreign affiliate of each particular person that is a resident beneficiary . . . .
f. Retroactivity
The proposed NRT provisions would apply generally to transfers occurring on or after January 1, 2007. TEI does not believe that the provisions satisfy the five-part test for retroactive application of legislation summarized in the Comprehensive Response of the Government of Canada to the Seventh Report of the Standing Committee on Public Accounts (September 18, 1995). Indeed, since this is the seventh iteration of the draft proposals and each version has included substantial revisions, taxpayers have not had fair notice of the scope or reach of the current provisions. Hence, we recommend that the provisions apply no earlier than the Date of Announcement of August 27, 2010.
g. Effect of Explanatory Notes
The Notes include a number of interpretations and examples that are helpful in illustrating the application of these very complex technical proposals. Hence, we regret the inclusion of the standard caveat in the introduction that “[t]he notes are intended for information purposes only and should not be construed as an official interpretation of the provisions they describe.” Taxpayers and CRA alike would benefit from having the Notes considered authoritative guidance.
Consultation Period
The draft legislation was released for consultation on August 27, 2010, and the Notes were issued on September 10. TEI regrets that it was unable to submit its comments by the requested consultation deadline of September 27, but we believe that the extremely complex provisions and their potentially far-reaching effects warrant substantially more time for deliberation and comment. We urge the Department to consider the technical complexity of the legislation as well as the scope of its application when setting consultation deadlines.
Conclusion
TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience to discuss these comments and recommendations. TEI’s comments were prepared under the aegis of the Institute’s Canadian Income Tax Committee, whose chair is Carmine A. Arcari. If you should have any questions about the submission, please do not hesitate to call Mr. Arcari at 416.955.7972 (or carmine.arcari@rbc.com) or Rodney C. Bergen, TEI’s Vice President for Canadian Affairs, at 604.488.5231 (or Bergen@jp-group.com).
Respectfully submitted,
Tax Executives Institute
Paul O’Connor
International President
cc: Louise Levonian, Associate Deputy Minister, Tax Policy Branch
Brian Ernewein, General Director, Policy and Legislation, Department of Finance
Gérard Lalonde, Director, Tax Legislation, Department of Finance
Rodney C. Bergen, TEI Vice President for Canadian Affairs
Carmine A. Arcari, Chair, TEI Canadian Income Tax Committee
Explanatory Notes in Respect of Legislative Proposals Relating to the Income Tax Act and Related Acts and Regulations, Department of Finance, Canada, at 161(September 2010).
There are many commercial reasons for issuing preferred shares or other equity securities treated as debt in foreign jurisdictions. For example, the taxpayer may wish to fix the value of a security at a particular amount, protect against downside risk on the investment, satisfy regulatory capital restrictions, or minimize foreign taxes. In many cases, such securities may be issued without regard for the Canadian tax rules or potentially without regard to the tax rules in any foreign country (such as where shares of a Canadian corporation are issued to a Canadian parent corporation). Thus, the proposals are punitive because they may apply regardless of whether foreign taxes are paid and economically borne by the taxpayer.
In Example 1, Canco, a corporation resident in Canada, owns all the shares of FA1, a U.S. resident corporation. FA1 owns all of the common and preferred shares of the capital stock of FA2, also a U.S. resident corporation. FA2’s common shares are worth $200 and its preferred shares are worth $100. FA2 owns all the shares of FA3, also a U.S. resident corporation. FA1 sells its preferred shares of FA2 to Canco for $100 cash and, at the same time, enters into an agreement to sell those shares back to FA1 at a fixed price and time in the future. Consequently, under U.S. tax principles, Canco is considered to have loaned the $100 of cash to FA1 and is not considered to own the preferred shares of FA2. In the Analysis, the Notes state that “since Canco is considered, under the relevant foreign tax law, to own less than all of the shares of FA2 that it is considered to own under Canadian tax law, subsection 91(4.1) can potentially apply. However, it will only have an effect where FA1, FA2 or FA3 has FAPI for which Canco wishes to claim a FAT deduction.” TEI submits that even with the existence of the hybrid instrument, the structure in Example 1 of the Notes does not artificially create foreign income tax. The U.S. income taxes of the FA1 consolidated group are clearly borne by that group and indirectly by Canco and thus should be eligible for relief. Indeed, REPO agreements are common financing arrangements for Canadian multinationals.
Under the U.S. reportable transaction regime, a transaction is considered to be offered under “conditions of confidentiality” if the advisor places a limitation on disclosure of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of the advisor’s tax strategies. The U.S. provision’s structure avoids infringing on the client’s right to obtain confidential advice in respect of its transactions and tax strategies.
The proposed legislation uses paid-up capital rather than stated capital, and we appreciate that the distinction is necessary in order to reflect the development of corporate tax law.