Introduction
Restrictions on deductibility of contingent amounts
Withholding tax on non-arm's length cross-border interest payments
Modifications to rules for computing life insurers' segregated fund policy reserves
On March 16 2011 the Department of Finance released for public consultation its draft proposals to amend the Income Tax Act (Canada) and the Income Tax Regulations concerning:
- the deductibility by a taxpayer of contingent amounts;
- the withholding tax applicable to interest payments made to non-residents; and
- the tax treatment of a life insurance corporation's reserves in respect of its segregated fund policies.
The Department of Finance has proposed these draft amendments in response to three Federal Court of Appeal decisions: Collins v The Queen, Lehigh Cement Limited v The Queen and The Queen v National Life Assurance Company of Canada.
Restrictions on deductibility of contingent amounts
In Collins, the Federal Court of Appeal overturned the Tax Court's decision to disallow the taxpayers' interest deductions under Paragraph 20(1)(c) of the act. The taxpayers were equal partners who obtained a secured loan in 1981 under an Alberta government finance programme to construct an apartment building on owned land. The loan was secured by a mortgage on the property. In 1993 the mortgage agreement was restructured to create a new mortgage with a 20-year term and to require the taxpayers to make minimum annual interest payments of C$20,000 for each of the first 15 years, with any remaining unpaid accrued interest due and payable at the end of the 16th year. For their 1994 to 1996 tax years, the taxpayers made the minimum annual interest payments, leaving unpaid accrued interest of C$154,372, C$160,254 and C$168,782 (for 1994, 1995 and 1996, respectively). In calculating their income for 1994 to 1996, the taxpayers deducted the unpaid interest amounts, as well as the minimum interest payments actually made.
The Tax Court held that the unpaid interest was not deductible under Paragraph 20(1)(c) because it was not "payable" in the years deducted. The Federal Court of Appeal allowed the taxpayers' appeal, concluding that since the taxpayers computed their income on an accrual basis, the permissible interest deduction in a particular year was the amount of interest accrued in respect of that year, whether or not interest was paid or fell due in that year. Accordingly, the taxpayers were entitled to deduct interest as it accrued, regardless of the date on which payment was due.
To reverse the effect of that decision, the Department of Finance proposes to add a new Section 143.4 to the act, which will provide that if a taxpayer has a right to reduce or eliminate an amount in respect of an expenditure that is otherwise deductible for the purposes of the act or that otherwise forms part of a capital property to the taxpayer at a time when the taxpayer is not bankrupt, then the amount of the expenditure must be correspondingly reduced for tax purposes under Section 143.4(2), except to the extent of any amount paid by the taxpayer to obtain the right to reduce. For the purposes of these rules, a 'right to reduce' is defined as including a right that is contingent upon the occurrence of an event, or in any other way if it is reasonable to conclude, having regard to all circumstances, that the right will become exercisable.
If all or part of the contingent amount is paid by the taxpayer in a subsequent tax year for the purpose of earning income, proposed Section 143.4(3) will deem the amount to:
- have been incurred by the taxpayer in the particular year;
- have been incurred for the same purpose and have the same character as the expenditure so reduced; and
- have become payable by the taxpayer in respect of the particular year.
These deeming rules will ensure the deductibility of the payment, provided that the requirements for interest deductibility in Paragraph 20(1)(c) are otherwise met.
An anti-avoidance rule in proposed Section 143.4(6) will apply if it is reasonable to conclude that one of the purposes of having a right to reduce an amount in respect of an expenditure after the end of the taxation year in which an expenditure otherwise occurred was to avoid a reduction under Section 143.4(2). In such case the anti-avoidance rule will deem a right to reduce to exist in the taxation year in which the expenditure otherwise arose, thereby triggering the application of the expenditure reduction rule in Section 143.4(2).
A special rule in proposed Section 143.4(4) will provide that if a taxpayer acquires a right to reduce an amount in respect of an expenditure in a year subsequent to that in which the expenditure occurred (other than in a situation in which the anti-avoidance rule applies), then the taxpayer will be deemed to have received a "subsequent contingent amount" in that year in the course of earning income from a business or property which must be included in income under Paragraph 12(1)(x) of the act.
The proposed amendments will apply in respect of taxation years that end on or after March 16 2011.
Withholding tax on non-arm's length cross-border interest payments
In Lehigh Cement, the Federal Court of Appeal reversed the Tax Court's decision applying the general anti-avoidance rule (GAAR). Lehigh borrowed money from a consortium of Canadian banks. A related Belgian corporation later acquired Lehigh's debt and Lehigh remitted withholding tax on the interest payments. The terms of the debt were later amended so that the debt complied with the former 5/25 withholding tax exemption for arm's length interest. The Belgian corporation then sold all of its right to interest payable on the debt to an arm's-length Belgian bank. Following the restructuring, Lehigh paid directly to the Belgian bank all interest payable on the debt and did not withhold on the basis that the 5/25 exemption applied.
The Tax Court held that the GAAR applied - the 5/25 exemption had been abused because Lehigh had not borrowed money from the Belgian bank or from any other non-resident lender. On appeal, the Federal Court of Appeal held that the GAAR did not apply. It ruled that the wording of the 5/25 exemption was broad enough to include any interest payable by a Canadian resident corporation to a non-resident, and that the government failed to provide sufficient proof that the 5/25 exemption was not intended to benefit a non-resident person who is legally entitled to be paid interest on a debt as a result of a transaction by which the right to be paid the interest is split from the right to be paid the principal amount.
In response to this decision, the Department of Finance proposes to expand Paragraph 212(1)(b)(i) of the act so that withholding tax will apply to interest (other than fully exempt interest) paid or payable "in respect of a debt or other obligation to pay an amount to a person with whom the payer is not dealing at arm's length". The amendment is intended to ensure that withholding tax applies (subject to the application of Canada's tax treaties) to interest paid or credited by a Canadian resident person to any non-resident person (whether arm's length or not) if the interest payment is in respect of a debt that is owed to a non-resident person with whom the payer does not deal at arm's length.
The proposed amendment will apply to interest that is paid or payable by a person or partnership on or after March 16 2011, other than interest that is paid in respect of a debt or obligation incurred by the payer before March 16 2011 and to a recipient that acquired the entitlement to the interest as a consequence of an agreement or other arrangement entered into by the recipient, and evidenced in writing, before March 16 2011.
Modifications to rules for computing life insurers' segregated fund policy reserves
In National Life Assurance Company of Canada, the Federal Court of Appeal dismissed the government's appeal from a Tax Court decision that held that, in computing the amount of its policy reserve claim under Section 138 of the act, Paragraph 1406(b) of the regulations permitted the taxpayer to compute its policy reserves without reference to any of its liabilities in respect of its segregated fund policies, other than liabilities in respect of an obligation to make a guarantee payment.
In response to the courts' interpretation of Paragraph 1406(b) of the regulations, the Department of Finance proposes to amend the provision to ensure that an insurer's policy reserves computed under the regulations will exclude only the reserves of the insurer in respect of a benefit that is payable to a policyholder from a segregated fund. As a result, amounts determined under the regulations will include liabilities for guarantees in respect of the insurer's segregated fund policies, as well as the portion of the insurer's policy reserves relating to its net commissions, investment and administrative expenses for its segregated fund policies. The Department of Finance states that this amendment is intended to ensure that the acquisition expenses associated with segregated fund policies are amortised appropriately over the term of the policy.
This amendment will apply to the 2012 and subsequent taxation years. The draft legislation also proposes to modify existing transitional rules in Section 138 of the act for insurers in respect of their life insurance businesses carried on in Canada as a result of the proposed change to Paragraph 1406(b) of the regulations. The transitional rules will be modified to ensure that any increase or decrease in an insurer's reserves resulting from the segregated fund policy changes will be taken into account when computing income for tax purposes over a five-year period.
For further information on this topic please contact Stephanie Wong at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email ([email protected]).