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On June 6, 2012, TEI President David M. Penney submitted comments to Canadian Minister of Finance James Flaherty on a "foreign affiliate dumping" measure included in the 2012 Canadian Budget. 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 comments were Carolyn A. Mulder of Wal-Mart Canada Corporation and David V. Daubaras of GE Canada. Also contributing to the submission were: Rodney C. Bergen of the Jim Pattison Group; Angelo Bertolas of TD Bank; Pierre M. Bocti of Hewlett-Packard (Canada) Co.; Bonnie Dawe of Finning International, Inc.; John Lisi of Cunningham Lindsey, Inc.; Lynn Moen of Walton International Group, Inc.; Marvin E. Lamb of Imperial Oil Limited.; Doug Powrie of Teck Resources Limited; Jill Wysolmierski of Avnet, Inc.; and Scott M. Zahorchak of Alcoa, Inc. Jeffery P. Rasmussen of the Institute's legal staff coordinated the development of the Institute's comments.

Original Submission

On March 29, 2012, the federal government's 2012 budget (hereinafter "the budget") was introduced, setting forth a proposal to amend the Income Tax Act of Canada (hereinafter "the Act" or ITA) by adding a measure to prevent "foreign affiliate dumping" into Canada. On behalf of Tax Executives Institute, I am writing to express our concerns about the excessive breadth of this anti-avoidance proposal as well as the subjective and unworkable tests prescribed for distinguishing bona fide commercial transactions from abusive transactions. Unless the proposal is narrowed, relief afforded (in the budget measure or other provisions of the Act), and workable tests crafted for distinguishing bona fide investments, the proposal will substantially undermine the attractiveness of Canada as a destination for foreign investments.

Background on Tax Executives Institute

TEI is the preeminent association of in-house business tax executives worldwide. 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 Montreal, Toronto, Calgary, and Vancouver, which together make up one of our nine geographic regions. Many of our non-Canadian members including those in Europe and Asia work for companies with substantial activities in Canada. Thus, both Canadian resident and non-resident members must contend daily with the planning and compliance aspects of Canada's business tax laws, including the financing of those businesses with equity, third-party debt, and intercompany loans. The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Budget Proposal Background

The 2008 Advisory Panel on Canada's System of International Taxation ("the Advisory Pane") identified certain "debt dumping" transactions involving foreign affiliates as abusive. Although not formally defined by the Advisory Panel, "debt dumping" was described as a situation where a foreign-controlled Canadian corporation is leveraged with related- or third-party debt (often guaranteed by the non-resident parent), which the Canadian resident corporation uses in an internal group restructuring to purchase shares, generally preferred, of another non-resident corporation controlled by the foreign parent. The interest expense from the loan reduces the Canadian resident corporation's tax liability and the return on the preferred shares is often from exempt surplus. In addition to using increased interest deductions to reduce the tax liability of the Canadian group, the non-resident parent corporation often extracts cash from Canada but avoids withholding taxes by structuring the transaction as a share purchase by the Canadian resident company. The Advisory Panel concluded that such transactions can reduce the Canadian tax base without providing a significant economic benefit to Canada.

The budget proposes to curtail "foreign affiliate dumping" transactions through two measures applicable to certain investments in non-resident corporations (the subject corporation) by a corporation resident in Canada (CRIC) controlled by non-resident parent corporation. First, a CRIC will be deemed to have paid a dividend to the parent equal to the fair market value of any property transferred, or obligation assumed or incurred, by the CRIC in respect of its investment in the subject corporation. Second, no amount will be added to the paid-up capital of the shares of the CRIC in respect of the investment and no amount will be added to the contributed surplus of the CRIC for purposes of determining its capital under the thin capitalization rules. Under the proposal, an "investment" in a subject corporation includes the acquisition of any shares (or options on shares), a contribution to capital, a transaction that creates an amount owing from the subject corporation to the CRIC, or an acquisition of the subject corporation's debt by the CRIC.

A relieving measure is prescribed in order to permit CRICs to undertake bona fide business transactions without being ensnared by the rules. Seven factors are prescribed for determining whether a CRIC's transactions may reasonably be considered to have been made for a bona fide business purpose other than to obtain a tax benefit.

Overriding Tax Policy Concern about the Budget Proposal

Canada has made great strides in increasing its competitive position in the global economy. The reform of the Canadian corporate tax structure and the targeted reduction of the corporate income tax rate to 25 percent have been critical in enhancing Canada's competitiveness and muting the effect of the recent global recession. Regrettably, the interaction of the foreign affiliate dumping proposal, the upstream loan proposal in the Foreign Affiliate Amendment package released by the Department on August 27, 2011, and current subsection 15(2) of the Act will so restrict a CRIC's ability to manage and invest its cash flows that the effective corporate income tax rate on non-resident corporate groups will be viewed as increasing from 25 to approximately 30 percent or more depending on the withholding rate on dividends. A CRIC with temporary cash surpluses will be compelled to invest its cash in low-yielding Canadian bank deposits (or short-term Canadian debt instruments) or repatriate the funds to the non-resident parent, subject to withholding tax.[1]

Thus, the budget proposal will effectively reverse the incentives afforded by the corporate income tax reductions of the last 10 years and contravenes the propositions in Compete to Win that "raising Canada's overall economic performance through greater competition will provide Canadians with a higher standard of living"[2] and that in "the new world economy, Canada must be ready to keep pace with change and develop a global mindset that is open to two-way trade, investment and talent."[3]

While TEI supports the government's targeting of abusive tax-motivated "foreign affiliate dumping" transactions, we are concerned about the effect of the overbroad budget proposal on legitimate transactions. The Advisory Panel addressed transactions that improperly reduce the Canadian subsidiary's tax liability where there is no corresponding increase (or potential increase) in value in Canada (or in Canada's tax base) from the investment. The Advisory Panel's report expressly acknowledged that not all transactions are offensive and supported business expansion through investments in non-resident businesses, related-party borrowings, and guaranteed debt to finance non-Canadian investments. As important, it is unclear from the budget documents whether the Department has conducted a study of the proposal's broader economic effects. Before implementing the proposal, we encourage the Department to undertake such a study because we believe the proposal may well have a deleterious effect. At a minimum, the proposal might discourage foreign-based companies from locating robust treasury management functions in Canada. Even worse, the proposal may lead to a hollowing out of treasury and general management functions in Canada and a net out-migration of related jobs.[4]

In TEI's view, the objectionable feature of the proposal is that CRICs will be unable to redeploy funds outside of Canada without satisfying a narrow business purpose test. Such an unprecedented restriction will set Canada's tax system apart from its principal trading partners and adversely affect a foreign investor's view of Canada. The proposal also discriminates against foreign-owned parent corporate groups since domestic companies will be able to invest or loan funds freely outside of Canada within the corporate group without having to satisfy a cumbersome business purpose test.

The balance of TEI's comments are directed at the specifics of the proposal, but we urge the Department not to lose sight of our overriding concern: Cash that cannot be redeployed in a corporate group's business will likely be considered trapped or subject to a higher than nominal income tax rate on the parent company's financial statement.[5] Moreover, a foreign parent company may or may not be able to claim a foreign tax credit for the withholding taxes on deemed dividends, but in the United States and other jurisdictions that permit deferral of foreign earnings with a credit, the withholding tax is a real — and likely permanent — reduction in reported earnings if companies do not have the flexibility to manage when and how funds are repatriated or redeployed in the business.[6]

Business Purpose Test

As described by the Department, the proposed rules are not intended to apply to "legitimate expansions of . . . Canadian-based businesses." To distinguish whether an investment is made by a CRIC instead of being "made or retained" by the non-resident parent (or another non-arm's length nonresident) primarily for bona fide purposes other than to obtain a tax benefit, proposed paragraph 212.3(5) enumerates seven "factors that are to be given primary consideration" for determining whether the business purpose test is satisfied.[7]

While the factors are seemingly intended to serve as independent tests, in practice they are interrelated and will be difficult to distinguish from one another. Significantly, it is unclear whether satisfying any one test will be deemed conclusive of a bona fide purpose or, alternatively, taxpayers must satisfy a combination, a majority, or all of the factors. As important, the tests require fact-intensive inquiries that in most cases are highly subjective. Thus, despite taxpayers' best efforts to document compliance with subsection 212.3(5), they will be subject to considerable uncertainty and second-guessing by auditors from Canada Revenue Agency (CRA). Once foreign-owned multinationals determine that the foreign affiliate regime is not predictably available to their Canadian companies, new or additional investment into, from, or through Canada will be deterred.

Specific comments on each of the factors are, as follows:

a. More Closely Connected

Paragraph 212.3(5)(a) requires the business activities carried on by the subject corporation be "more closely connected to the business activities carried on by the Canadian subsidiary than to the business activities carried on by any non-resident corporation with which the Canadian subsidiary does not deal at arm's length."

TEI believes that a proposed test based on "weighing" whether an investment is more closely connected with one or another entity is impractical for several reasons. First, it is unclear what documentation will satisfy the test. Is the "more closely connected" criterion based on a comparison of the product lines or services offered by the Canadian and non-resident parent? If so, how is such a test satisfied if the Canadian and non-resident businesses are identical except in scope and size? What if there are substantial differences in the product lines or services between the non-resident and Canadian businesses but an expansion of the Canadian business through the acquisition of foreign affiliate will fill a gap in the Canadian product or service line?

More important, if a non-resident parent company is already established in a particular line of business but the Canadian company is not, is the Canadian company precluded from ever investing in an offshore business similar to one operated by the parent since the business would seem "more closely connected" to the non-resident parent? Similarly, how will this test apply if a non-resident parent corporation decides to expand by purchasing a new, global business and the vendor has active Canadian business assets, including foreign affiliates in a similar business line below the Canadian business? To which entity's business is the new line of business "more closely connected" if, from a structuring and managerial perspective, it makes more sense for the Canadian business assets, including foreign affiliates acquired with that global business, to be operated by existing Canadian management? A final reason the test is impractical is because it will require the production and examination of evidence from outside of Canada (e.g., examination of the business lines, activities, and duties of officers of the parent or other non-resident company). We are unaware of any precedent for determining a Canadian business purpose by reference to documents or records from outside of Canada.

We believe this factor might be helpful if it simply stated that the "foreign affiliate activities are connected to the business activities of the CRIC." Thus, we recommend eliminating the "more closely" test as such. In its stead, the test might permit a foreign affiliate investment where "the Canadian company has a business purpose for making an investment." A general business purpose test would be more easily applied (and justified) than a comparison of business activities of different entities, especially since the activities of a non-resident parent and a CRIC are constantly evolving.

b. Terms and Conditions of Shares

Paragraph 212.3(5)(b) requires consideration of whether shares in an investment made by a CRIC fully participate in the profits of the investment or otherwise shares in the appreciation of the subject corporation's value.

TEI submits that this requirement is inconsistent with the Advisory Panel's report, which states that increases in the value of foreign investments are beneficial to the Canadian economy and thus should be encouraged. Indeed, from a policy perspective, TEI questions why increases or potential increases in the value of foreign investments should not be relevant in determining a taxpayer's bona fide, non-tax purposes. If a Canadian taxpayer acquires a fully participating interest in a foreign affiliate that carries on an active business, significant economic synergies in the form of increased know-how (whether marketing, operating, or research) and job opportunities will accrue to Canada in the same fashion as if the investment were made by a domestic Canadian company.

c. Investment at the "Direction or Request" of a Non-Resident Corporation

Paragraph 212.3(5)(c) requires a determination of whether the investment was made "at the direction or request" of a non-arm's length non-resident.

Regrettably, there is no standard means for determining the managerial autonomy or decision-making authority of one member of a multinational (or group of officers) vis-à-vis other members (or officers of another member or parent). Some decisions are made unilaterally by the parent; some are made unilaterally at the subsidiary level within an overall strategy framework set by the parent; some decisions are made after collaboration between the parent and subsidiary or multiple subsidiary officer groups. Except where a decision is made by fiat at the parent level, it will generally be unclear when an investment is made "at the direction or request" of a non-resident corporation as opposed to being made by the CRIC. As important, because the senior management of the non-resident parent is ultimately responsible for setting the broad corporate strategy executed by subsidiary managers, it will likely always be possible to find shreds of evidence that even the most independent Canadian decision was made "at the direction or request" of a non-arm's length non-resident. The uncertainty created by such second-guessing makes this test untenable as a marker for a bona fide transaction.

To make this test workable, TEI recommends that Canadian taxpayers be required to demonstrate only (1) ownership in the common equity interest of a foreign affiliate and (2) proper exercise of the oversight and due diligence required as a matter of corporate governance for that foreign affiliate.

d. Governance, Reporting, and Compensation Relationships

The balance of the business purpose tests in paragraphs 212.3(d)-(g) look to which entity initiates negotiations with respect to certain investment transactions, which entity exercises the principal decision-making authority, whether performance or compensation for senior Canadian officers is linked to an investment in a foreign affiliate, and whether the senior officers of the foreign affiliate are accountable to senior officers of the CRIC.

TEI questions how these tests are relevant for determining the economic benefit to the CRIC, especially where the CRIC owns common shares in a foreign affiliate, future appreciation accrues to the CRIC, and cash will eventually be repatriated to the CRIC on the shares (or the shares will be sold). As previously explained, decision-making authority within any entity of a multinational group or entity will range from nearly autonomous to fully subordinate, with many decisions made collaboratively by the officers in different entities within the group. Similarly, the reporting and compensation of the groups will vary. Without clear standards for application and, as important, an understanding of the importance of each of these tests vis-à-vis the other factors, taxpayers will find it difficult to document compliance in a fashion that cannot be second-guessed by CRA.

Acceptable Business Transactions

TEI supports the government's objective of protecting the Canadian tax base, but there are a number of commonplace financing transactions that will be caught by this proposal in its current form. Some involve borrowing funds and deducting interest expense in Canada; some do not. In TEI's view, none of the transactions discussed in this section should be considered abusive.

The description accompanying the budget proposal expresses concern about "acquisitions of shares of a foreign affiliate that are made with internal funds of the Canadian subsidiary — such transactions provide a mechanism for foreign parent corporations to extract earnings from their Canadian subsidiaries free of Canadian dividend withholding tax." Although this can occur, it is not always, or even usually, the case. Where a Canadian subsidiary is a controlled foreign affiliate of a foreign parent, it is difficult to understand the abuse of the Canadian tax system where the CRIC's internally generated cash is invested in a downstream investment and the CRIC shares in both the growth potential of the downstream investment and in future cash repatriations. Ultimately, the economic return from a downstream investment will flow back to Canada either as dividends for ultimate repatriation to the foreign parent (subject to Canadian withholding tax) or as a gain on the sale of the foreign affiliate shares.

Historically, non-resident parent companies have frequently funded foreign affiliates by contributing funds to Canadian subsidiaries for contribution to controlled foreign affiliates for use in their business activities. In these arrangements, the Canadian entities act as conduits in funding foreign affiliates' business operations. The budget proposal has two effects: (1) the paid up capital (PUC) of the shares issued by the CRIC to the parent is adjusted (to prevent future repatriation to the parent via PUC reductions), and (2) the equity contribution from the CRIC to the foreign affiliate will trigger a deemed dividend subject to withholding tax. As a result, multinational businesses with longstanding presence in Canada will no longer be able to fund foreign affiliates of Canadian subsidiaries with equity infusions routed through Canada. It is unclear what abuse of the Canadian tax system the proposal is aimed at remedying unless it is the "avoidance" of Canadian withholding tax on PUC reductions.[8]

Finally, proposed subsection 212.3(3) will limit downstream loans to affiliates other than loans that arise in the ordinary course of the business and are repaid within a commercially reasonable period. TEI sees no abuse in lending to a related group member at market interest rates (or a rate greater than the Canadian company's cost of funds) where Canada has a net positive yield from the incremental loan. It is also unclear whether "earning interest" is considered a bona fide business for a non-financial company. If not, the entire amount of cash transferred would be considered to be a dividend to the Canadian subsidiary's parent. We recommend clarifying that loans to foreign affiliates that bear an arm's length interest rate are not subject to the proposed rules.

Recommendations to Mitigate the Proposal's Burdensome Effects

TEI believes that the government can achieve its goal of preventing abusive foreign affiliate dumping without effectively increasing the tax rate or creating cash-trap issues for multinationals. Specifically, we recommend:

• Amending subsection 15(2), the proposed upstream loan rules, and the proposed foreign affiliate dumping rules to permit Canadian subsidiaries of non-resident corporate parent groups to lend surplus cash upstream and downstream to related parties free of withholding tax as long as the loans generate net positive taxable income in Canada. This change would eliminate the severe cash restrictions the budget proposal and upstream loan proposal will impose on foreign-based multinationals while still preventing abusive debt-dumping transactions. In addition, this proposal would permit foreign groups to raise capital in Canada via Canadian subsidiaries and on-lend the proceeds to the related group as needed. In addition to generating net tax revenues for Canada, such amendments would enhance Canadian capital markets industries, generate additional investment opportunities for Canadian investors, and increase Canada's attractiveness in the global capital markets in line with the goals set out by the government in Advantage Canada.
• Revising proposed paragraph 212.3(l)(c) to permit a CRIC to hold fully participating investments in a controlled foreign affiliate[9] that carries on an active business.
• Deeming the bona fide business purpose test to be satisfied where the terms and conditions of a transaction are essentially the same as transactions entered into by parties dealing at arm's length.[10]

Expanded Grandfather Relief and Technical Corrections Required

Even if the Department of Finance disagrees with TEI's recommended changes to mitigate the harsh policy effect and administrative burdens of the proposal, certain amendments to the proposal are critical to prevent seemingly unintended effects on existing corporate structures.

First, a deemed dividend will arise in respect of any Canadian restructuring where new share capital of foreign affiliates is issued as a result of the transaction, including routine amalgamations following the acquisition of a Canadian company holding investments in foreign affiliates or a drop down of a foreign affiliate held by a first-tier Canadian subsidiary of foreign parent to a second-tier Canadian subsidiary. Presumably this was unintended and TEI recommends that the Department develop a technical amendment to provide relief for routine restructuring transactions for existing corporate groups.

Second, no relieving provision is provided in respect of withholding taxes upon a subsequent actual distribution or repatriation. Where the deemed dividend provisions of the proposal engender a withholding tax, a second layer of withholding taxes will arise on subsequent cash distributions relating to the investments. The Department should provide relief from the second layer of (duplicative) withholding taxes upon actual repatriations.

Third, the proposal provides no relief where the non-resident parent corporation holds less than a 100-percent interest in the investment in the CRIC. In such cases, the entire deemed dividend and 100 percent of the withholding tax on the deemed dividend falls on the controlling non-resident parent even where it owns as little as 51 percent of the CRIC. The Department should develop a technical amendment to make the deemed dividend and the attendant withholding tax proportionate to the non-resident corporation's ownership of the CRIC.

Conclusion

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 comments or recommendations in the submission, please do not hesitate to call Mr. Arcari at 416.955.7972 (or carmine.arcari@rbc.com) or David V. Daubaras, TEI's Vice President for Canadian Affairs, at 905.858.5309 (or david.daubaras@ge.com).

Respectfully submitted,

Tax Executives Institute
David M. Penney
International President

cc: Brian Ernewein, General Director, Tax Policy Branch
Shawn D. Porter, Director, Tax Legislation Division
Dave M. Beaulne, Senior Chief, Tax Legislation Division
David V. Daubaras, 2011-2012 Vice President for Canadian Affairs
Carmine A. Arcari, 2011-2012 Chair, TEI's Canadian Income Tax Committee

[1] As an example of how the proposal will restrict capital flows, increase funding costs, and impair cash management by multinational groups, consider the following: Assume a new Canadian subsidiary of a multinational group receives a significant loan in advance of a multiyear construction and installation project. After the cash is advanced, the Canadian company will manage the temporary cash surplus until progress payments are made to contractors. In some cases, delays in obtaining regulatory approvals for a project may require the Canadian subsidiary to manage the cash for longer than anticipated. Before the 2012 budget and the August 2011 upstream loan proposal, a Canadian subsidiary was able to invest the funds to acquire or finance foreign affiliate operations. The foreign affiliates could also lend to related members of the group with interest income on such loans subject to tax in Canada. Under the new proposal, any investment or loan to foreign affiliates will be subject to withholding tax (as will any loans of cash by the Canadian affiliate to members of the group not owned under Canada). In addition, subsection 15(2) of the Act prevents lending upstream to the parent company without withholding tax (other than for very short time periods and subject to the "series" rules that prevent continuous lending). Even though the Canadian company has earned no income in Canada, it must either leave the cash advance invested in the bank, lend it to the parent group at a withholding tax cost, or distribute the cash to the parent corporation, subject to withholding tax on the distribution and other home jurisdiction tax consequences. In other words, the cash is effectively trapped.
[2] Competition Policy Review Panel, Compete to Win, at p. 1 (June 2008).
[3] Id., at p. 13.
[4] Discouraging the location of any managerial functions in Canada, including treasury decision-making, seems contrary to the goals expressed in the Advisory Panel's report as well as Advantage Canada: Building a Strong Economy for Canadians (Department of Finance, Canada, 2006). Indeed, if a company is discouraged from locating its treasury function in Canada, why would it locate any sophisticated management functions in Canada? Before reforming their controlled foreign corporation regimes, both the United Kingdom and Australia undertook extensive economic studies of the effects. We encourage the Department to do the same before implementing these proposals. In connection with the study, the proposal's effects on Canadian capital markets should also be reviewed.
[5] Companies reporting earnings under U.S. generally accepted accounting principles (GAAP) generally do not accrue a tax liability for withholding taxes so long as the earnings are considered "permanently invested" in foreign affiliates. The deemed distribution provisions of the budget proposal, combined with the upstream loan proposal and subsection 15(2), will seriously impair the cash flow management practices of U.S. multinational companies because any investment other than a Canadian bank deposit or a non-foreign-affiliate debt investment (at currently low or zero interest rates) might violate the budget proposal, the upstream loan proposals, or subsection 15(2). In other words, CRICs will not be able to invest in or lend to other group companies without triggering one of the taxing provisions. In effect, this creates an unacceptable "cash trap" for current and future income earned on investments in and through Canada.
[6] The creditability of the withholding taxes on the deemed distributions for foreign tax credit purposes in other countries is unclear because the loans or investments would likely retain their character as such in most foreign jurisdictions. Repayment of the loan or investment would also not trigger creditability. Hence, the withholding tax may cause a permanent increase in the group's tax liability because the tax is not attributable to "income" earned. Even if the withholding taxes are creditable, the proposal will change the timing of the recognition of the withholding taxes and may permanently reduce reported financial statement income because of other limitations on claiming foreign tax credits. Absent exigent cash needs, multinational companies generally plan cash repatriations to ensure the foreign tax credit is available for withholding taxes and the financial statement effect of such taxes is minimized. The budget proposal impedes that planning.
[7] The factors in subsection 212.3(5) are:

• Whether the business activities of the foreign affiliate are more closely connected to those of the CRIC or certain related Canadian companies versus those of Parent or another non-resident;
• Whether the CRIC fully participates in the profits or increase in value of the foreign affiliate (although if the CRIC does so participate that is not a relevant factor);
• Whether the investment was made at the direction or request of the Parent or other non-resident;
• Whether the CRIC's senior officers (who are resident and work principally in Canada) initiated the negotiations (or, if initiated by the vendor, the principal point of contact is with the CRIC's senior officers);
• Whether the CRIC's senior officers (who are resident and work principally in Canada) have decision-making authority with respect to the investment and exercise that authority;
• Whether the CRIC's senior officers are evaluated or compensated based on the foreign affiliate's results; and
• Whether the senior officers of the non-resident subject corporation report to senior officers of the CRIC and the latter's senior officers have authority with respect to the subject corporation's operations.