In the 2007 Federal Budget (delivered March 19, 2007) the Minister of Finance announced that new legislation would be introduced to restrict the deductibility of interest on funds borrowed by a Canadian corporation to finance a "foreign affiliate". The concern, according to the Minister, was that corporations should not be able to deduct interest on money used to earn income that is effectively exempt through Canada's form of participation exemption.

Under the original Budget proposal, corporatins would have been denied a current interest deduction for interest paid on money borrowed to finance foreign affiliates to earn "exempt dividends" ("exempt dividends" are those paid out of a foreign affiliate's "exempt surplus", which includes in particular active business income of the foreign affiliate from a country with which Canada has concluded a double taxation treaty). This deduction was to be replaced with a carry-forward amount that could be deducted in future years to the extent that the foreign affiliate generates non-exempt income for the Canadian corporation (in other words, income, including capital gains, other than exempt dividends received out of the exempt surplus). The new proposal was to take effect on a staggered basis between 2007 and 2009.

The original announcement was ill conceived and generated a storm of protest from business and from tax professionals. As a result, on May 14 the Minister of Finance announced changes to the original proposal. The substituted proposal is more targeted than in the Budget but also more arbitrary, denying a deduction only for an amount referred to as "double dip" income. This requires a calculation of the foreign affiliate's income "attributable to" certain specified debts owing to the foreign affiliate, and will vary according to the amount of foreign income taxes paid in respect of that income. Furthermore, the proposal will now apply only to taxation years beginning in 2012.

The changes, while welcome, were accompanied by justifications that backtracked significantly from the rationales originally advanced by Finance to support the proposal. Instead, the stated purpose of the revised proposals is an attack on "double-dip" and so-called "tower structures" designed to generate interest deductions in offshore jurisdictions as well as in Canada. It is our understanding, from our conversations with various interested parties, that Finance's primary concern is so-called "second-tier financing" structures in which Canadian subsidiaries of foreign parents borrow to further finance other entities in the corporate group. Although we feel that (for various reasons) the attack on "double-dip" and "tower structures" is without policy merit, Finance appears to be digging in its heels to preserve some sort of proposal, even if it has little in common with the original proposal.

It was also proposed that a committee of Government officials and tax professionals study this matter further. However, given some of our recent experience with new and sweeping legislation dealing with international tax concepts in Canada, it may be that these amendments (which do not yet even have the form of draft legislation) will never see the light of day in the current proposed form. At the very least, further thinking and further amendments will almost certainly be needed.