On May 14, 2007 The Honourable Jim Flaherty, Minister of Finance, announced significant changes to the interest deductibility proposals that were introduced as part of the International Tax Fairness Initiative in the March 19, 2007 federal budget (the “2007 Budget”).1 These proposals would have significantly restricted the ability of taxpayers to deduct interest in Canada on borrowed money relating to investments in foreign affiliates. The May 14th announcement is beneficial to taxpayers as it significantly reduces the scope of the proposed rules (which are now intended to apply only to certain double dip financing structures), and defers their application (they are now applicable only to interest payable after 2011). The Minister of Finance also announced on May 14th that a new protocol to the Canada-U.S. Tax Treaty should be signed within the next 90 days.
Existing law generally allows taxpayers to deduct interest on borrowed money used for the purpose of earning income, regardless of whether the related income is effectively exempt from corporate level tax in Canada through a 100% dividends received deduction. The 2007 Budget proposed rules that would defer and, in many cases, deny the deductibility of interest and other borrowing costs relating to investments in foreign affiliates. (See our March 19, 2007 Osler Update “Budget Briefing 2007”).
In response to many concerns raised by tax professionals and members of the business community, the Department of Finance announced, in the May 14th release, significant changes to these proposals. Detailed legislation to implement the revised proposals is expected to be released early this summer and introduced in the House of Commons this fall.
Principal differences between the 2007 Budget and May 14th Proposals
The following chart summarizes the principal differences between the original interest deductibility proposals described in the 2007 Budget Notice of Ways and Means Motion and their intended replacement as described in a technical description released by the Department of Finance on May 14th.
May 14, 2007: Proposed Anti-Double Dip Rule
The Minister of Finance’s speech suggested that the revised proposals are intended to address the use of double dips through tax havens and tower financing structures (which structures are designed to achieve a double dip where certain entities are characterized differently for Canadian and U.S. tax purposes). Although the Minister of Finance referred to the proposals as an “anti-tax haven” initiative, the technical description of the rules is not limited to tax havens or tower financing structures; it applies generally to certain double dip transactions. Specifically, a corporation will not be allowed a Canadian deduction for interest relating to investments in foreign affiliates that is paid or payable after 2011 to the extent of the corporation’s double dip income.
“Interest relating to investments in foreign affiliates” is defined broadly to include interest and other borrowing costs (net of related interest income) in respect of direct or indirect investments in a foreign corporation that is a foreign affiliate of the taxpayer or of a person or partnership not dealing at arm’s length with the taxpayer. The rule is to apply to a variety of investments in a foreign affiliate, including acquisitions of shares or indebtedness, loans and contributions to capital and any other income-earning investment, as well as any unpaid purchase price in respect of interests in the foreign affiliate.
A corporation’s “double dip income” is the total of its participating percentage2 of the recharacterized income of each foreign affiliate share owned by it at any time in the taxation year. Double dip income is reduced by a grossed-up deduction for foreign taxes paid in respect of the recharacterized income (generally preventing the rule from applying only where foreign taxes are paid at a rate of at least 31%, although the amount of the interest deductibility denial would vary inversely with the foreign taxes paid on the double dip income).
Presumably, additional rules will be needed to prevent the proposal from applying in respect of income earned by a foreign affiliate that would otherwise be subject to a high foreign tax rate; but, where no foreign tax is actually paid. For example, a foreign affiliate may not pay foreign tax if it has foreign losses or tax credits in a particular year, if its income is subject to tax by another member of a consolidated group, or due to timing differences resulting in double dip income in one year and foreign tax in another. Also, anomalies could arise as a result of different methods of computing income – since double dip income is to be computed using Canadian rules and the applicable foreign tax would be determined using foreign rules. Many of these complexities could be avoided if the rule was further restricted to certain perceived abuses. For example, to the extent that the proposal is intended to be an “anti-tax haven initiative,” a definition of “tax haven” could be added. While “tax haven” is not defined for Canadian tax purposes, guidance is available from the Organisation for Economic Co-operation and Development which defines a tax haven as a jurisdiction with:
- no or only nominal taxes;
- a lack of effective exchange of information; and
- a lack of transparency.
“Recharacterized income” of a foreign affiliate is the total of its property income that is recharacterized as being income from an active business under paragraph 95(2)(a) of the Income Tax Act (Canada) that is attributable to a specified debt owing to the foreign affiliate. A “specified debt” owing to a foreign affiliate is a debt that arose as part of the series of transactions that included, and can reasonably be considered to have been funded by the proceeds of, indebtedness on which interest relates to investments in foreign affiliates.
The proposals will also apply to restrict the deductibility of interest in one corporation where a related corporation earns double dip income. Specifically, excess double dip income of one corporation may be deemed to have been earned by a related corporation to the extent that the latter corporation has excess interest relating to investments in foreign affiliates.
Finally, the proposals indicate that similar rules will apply to foreign affiliates of a partnership.
The proposed rules will apply to interest payable on or after January 1, 2012. Accordingly, Canadian businesses will have about four and a half years to comply with the new double-dip restriction rules. The 2007 Budget had originally suggested that the proposed interest deductibility rules would apply after 2007 for new debt and would be phased in over two years for debt existing on March 19, 2007. Thus, the new transition period marks a significant improvement over the 2007 Budget proposals. Moreover, unlike the transitional rules proposed in the 2007 Budget, the new rules do not differentiate between arm’s length and non-arm’s length debt. The Minister of Finance noted in his speech that the implementation of these rules will only occur after the corporate tax rates have been reduced to 18.5% in 2011.
Use of Additional Tax Revenue
The Minister of Finance indicated that any tax revenues raised by this proposal will be directed to corporate tax rate reductions as part of the federal government’s goal of achieving the lowest marginal effective tax rate in the G7. While this commitment to use new tax revenues to reduce corporate taxes is encouraging, it may be very difficult to measure or trace. In particular, to the extent that taxpayers respond by leaving debt in Canada and foregoing a foreign interest deduction, there may be only additional foreign tax revenues. Also, it will be difficult to monitor situations where taxpayers respond by leaving debt offshore and foregoing a Canadian interest deduction. The Department of Finance has not provided an estimate of the tax revenues that the revised proposals are expected to generate. The Department’s estimate in the 2007 Budget that the original proposals would generate between $10 million and $40 million of additional revenue was widely considered to be exceedingly low.
Creation of Various Panels
A Technical Roundtable of tax experts, to be chaired by the Department of Finance, will be created to assist in the development of the anti-double dip legislation. The Technical Roundtable will invite tax professionals to work with government officials in developing and implementing the enabling legislation.
A separate advisory Expert Panel (proposed in the 2007 Budget) will undertake to build on the 2007 Budget measures, identifying and studying ways to improve the fairness and competitiveness of Canada’s international tax system. The Minister of Finance has commented recently that the Expert Panel may consider introducing measures that would curb the practice of “debt dumping” (i.e., loading up a Canadian subsidiary with large amounts of debt to achieve certain tax advantages). The Expert Panel, whose mandate and composition will be announced soon, will be expected to produce an interim report before the 2008 Federal Budget is announced and a final report before the 2009 Federal Budget is announced.
The Minister of Industry will also launch an International Competitiveness panel that will study the issue of whether the anti-double dip proposals will contribute to the “hollowing out” of corporate Canada. However, the Minister of Finance has indicated that he is confident that the panel’s findings will not be adverse to these proposals and, based on recent reports (including those by the Institute for Competitiveness & Prosperity and Statistics Canada), will confirm the growth in the global competitiveness of, and global investment by, Canadian firms.
Canada-U.S. Tax Treaty
The 2007 Budget noted that an agreement in principle has been reached with respect to changes to the Canada-U.S. Tax Treaty (which is to include, among other things, recognition of treaty benefits for U.S. limited liability companies and the phasing out of withholding tax on interest payments). The Minister of Finance reiterated these changes on May 14, 2007 and noted in his speech that a protocol to the Canada-U.S. Tax Treaty should be signed within the next 90 days.