The March 19, 2007 Budget proposed to effectively disallow an interest deduction for a Canadian corporation on money borrowed to acquire shares of, or otherwise fund, a foreign affiliate. As we discussed in our previous publication, this was a dramatic change from Canada’s existing system that would have eroded the competitiveness of Canadian corporations in the expansion of their operations abroad. The change was to have been effective January 1, 2008, with limited transitional rules for existing debt.
The proposal met with significant opposition from tax experts and the business community. On May 14, 2007, at a Board of Trade meeting in Toronto, Finance Minister Jim Flaherty unveiled a retreat from this controversial proposal. The new approach, renamed the "Anti-Tax-Haven Initiative", has significantly restricted the scope of the Budget measure. The focus is limited to preventing "double dipping", whereby multinational corporations claim a deduction for interest expenses both in Canada and in the foreign country in which the money is used.
These new proposals are difficult to justify in Canadian tax policy terms. They result in an increase in foreign taxes. It is not clear what Canadian tax policy objective is achieved by policing foreign tax systems. A likely consequence is that Canadian corporations will forego the interest deduction in the foreign country rather than be denied a Canadian interest deduction under the new proposals. Canada would in fact benefit if its multinational corporations reduce foreign taxes payable, as there would be more funds available to reinvest and earn returns and the value of their foreign affiliates would increase. Moreover, these new proposals will continue to significantly erode the competitiveness of Canadian corporations in the expansion of their foreign operations.
There is no change in the Canadian tax that is payable if a Canadian corporation borrows in Canada to invest in a foreign affiliate directly or through a "double dip". The only difference resulting from a double dip is the existence of a deduction in the foreign jurisdiction. Further, the Minister has focused on a particular "double dip" structure known as "towers". Any perceived abuse created by this structure exists solely by virtue of the US "check-the-box" regulations which allow partnerships to be treated as corporations and corporations as flow-through entities for US tax purposes.
The transitional rules have been extended and loosened. The new rules will not apply until 2012, which affords greater transitional relief than proposed in the Budget although not as long as the 10 years recommended by the Mintz Report. During the transition period, the existing rules will continue to apply to both new financings and financings in place on the date of the Budget. Thus, all Canadian corporations are entitled to continue to take advantage of the existing rules until 2012.
Reversing the Budget proposals, Minister Flaherty confirmed that Canada will continue to allow a Canadian corporation to deduct interest on money borrowed to buy shares of, or otherwise fund, a foreign affiliate, irrespective of whether the foreign affiliate’s income bears any foreign tax or the fact that the Canadian corporation may bear no tax on the repatriation of the foreign affiliate’s profits back to Canada. Instead, only certain planning structures that are perceived as "tax loopholes" will be affected.
The new rules are intended to prevent the use of "double dipping". One example presented by the Minister involved a Canadian corporation borrowing money to invest in equity of a foreign affiliate (Finco), which, in turn, lends the funds to another foreign affiliate (Opco). Prior to the proposals, Canco would have been entitled to deduct interest on its borrowing, Canco would not have been subject to Canadian tax on the income of Finco, and Opco would likely obtain a tax deduction in the jurisdiction where it operates.
Under the proposals Canco will be restricted in claiming an interest deduction in Canada to the extent that the income earned by Finco on the loan to Opco is taxed at a rate lower than the Canadian rate. Although the rules are described as being anti-tax-haven, there is no requirement that a tax haven be used: the rules apply to the extent that Finco pays less tax than it would in Canada.
Also under attack are "tower" structures commonly used to finance US operations, which also achieve a "double dip". These structures involve a borrowing by a partnership that may be treated as a corporation for US tax purposes (by virtue of the US check-the-box regulations). Canada respects the legal form of the partnership, so the deduction for the interest paid by the partnership effectively flows through to its Canadian partners. However, because the US treats the partnership as a corporation for US tax purposes, the structure affords an interest deduction in the US and no US withholding tax. It should be noted that the US introduced anti-"double dip" measures on March 19, 2007, which may be tied to the introduction by the Minister of the Budget measures and the new rules.
A likely consequence of the new rules is that Canadian corporations would claim an interest deduction in Canada and forego it in the foreign jurisdiction, thereby increasing foreign taxes with no change in Canadian taxes.
A Technical Roundtable of tax experts, chaired by the Department of Finance, will be created to provide input in the drafting of legislation which is expected to be released in the fall. If the new rules are implemented, it is important that the rules are clear so that Canadian corporations may structure their foreign expansion with certainty.
International Tax Expert Panel
The Minister announced that he will continue with the establishment of a panel (previously announced in the Budget) to undertake further study and consultations, with a view to identifying measures to improve the fairness and competitiveness of Canada’s system of international taxation. The panel will prepare an interim report by the end of 2007 and a full report in 2008.
In his oral comments at the Board of Trade meeting, Minister Flaherty indicated that the panel will address the issue of foreign multinational corporations loading up their Canadian subsidiaries with debt – often referred to as "debt dumping" or "debt pushdown" - and the adequacy of Canada’s thin capitalization rules.
In addition, he noted that the updated Canada-US tax treaty, which will include an exemption for withholding tax on interest, would be signed within 90 days. Enactment may take some time thereafter as it would need to be passed by both the Canadian and US governments.