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MINTZ REPORT OUT: THE DEBATE BEGINS
The Department of Finance today released the report prepared by the Technical Committee on Business Taxation chaired by University of Toronto economist Jack Mintz. This Committee was established in 1996 to consider ways of improving the tax system to promote job creation and economic growth, simplifying the taxation of businesses to facilitate compliance and administration, and enhancing fairness to ensure that all businesses share the cost of providing government services. The overall thrust is to make the tax system more neutral and also more competitive internationally. Any recommendations by the Committee were to leave overall tax revenues from business unchanged.
The Committee's Report contains a wide range of recommendations on the business tax structure, including reduced federal and provincial corporate tax rates, a broader tax base, and a new 25% advance corporations tax.
The Minister of Finance, Paul Martin, emphasized that the recommendations reflect the views of the Committee and not of the government. He said he will ask the Standing Committee on Finance of the House of Commons to review the Report in the context of its ongoing examination of policy over the coming years. These comments, as well as the government's current focus on reducing personal tax, might suggest that the Committee's recommendations may not be acted upon for some time.
GENERAL CORPORATE MEASURES
A more neutral system whereby the corporate income tax rate for all industries is lowered toward international norms is proposed. At the same time, a number of base-broadening measures to improve efficiency and fairness would be undertaken which, when taken together, should not change the aggregate amount of taxes paid by business. The lower rates would help to make Canadian business more competitive internationally and should reduce the incentive to shift income out of Canada and deductions into this country. Further, the lower rates and base-broadening measures should reduce the distortions and inefficiencies in the income tax system.
Tax Rates: The Committee recommends that Canada's corporate tax rates be brought into line with other major competing countries by lowering the overall corporate rate to 33%, composed of 20% federal tax (down from 28%) and 13% provincial (down from an average of 14%). The rate would apply to all corporations; the manufacturing and processing credit would be eliminated. The federal small business tax rate would range from 11% to 14% based on levels of employment. Provinces would be encouraged to reduce their small business rate by 1%. The federal corporate surtax would be eliminated, resulting in an increase to the large corporations capital tax (LCT) that is currently reduced by the surtax. Foreign parent companies would have a reduction in their ability to claim foreign tax credits.
Capital Cost Allowance (CCA): The Committee recommends a general review be undertaken of CCA for all asset classes to more closely align these to economic lives. The Committee also recommends that the write-off for classes 38 and 43, which includes manufacturing and processing assets, be reduced from 30% to 25%. Finally, it concludes that some of the assets in class 12 (including computer software, tools and library books) may no longer deserve a 100% write-off; if they have a useful life of at least four years, they should be given a 50% CCA rate instead.
Loss Transfer System: One area where the Canadian corporate tax system is less flexible than the U.S. is in loss transfers within a corporate group. Generally, companies which meet an 80% ownership test can file a consolidated U.S. corporate return. In 1985, the federal government issued a discussion paper which proposed a loss transfer system for Canada, but the report was never implemented in part due to lack of agreement amongst the provinces. The Committee recommends a renewal of these discussions to implement a loss transfer system. As part of such a system, the Committee feels that existing rules which allow deductions to be claimed on a discretionary basis be made mandatory so that taxable income more closely parallels accounting income. This is because discretionary deductions such as CCA, R&D expenses and exploration and development expenses can be held back or increased to alter tax losses and loss utilization.
Capital Taxes: The Committee identified the many differences between the federal LCT base and the capital tax base of the provinces as well as differences amongst the provinces. To reduce administration for both companies and the revenue authorities, it recommends a harmonization of the base for all jurisdictions and implementing a tax collection agreement for capital taxes. However, the Committee believes that all capital taxes should be made non-deductible from taxable income because they are not taxes based on profits. This would affect provincial capital taxes as LCT is already only creditable against corporate surtax which itself is recommended to be repealed. To help alleviate the cost of this recommendation, and in view of the overall increase to provincial tax revenues arising from other recommendations, the Committee recommends that provincial capital taxes be reduced.
R&D Incentives: The Committee compared Canada's Scientific Research and Experimental Development (R&D) regime to those of other industrialized countries and concluded that Canadian incentives were high by international standards. The Committee suggested that the combination of lower corporate tax rates, combined with a slightly reduced level of R&D credits, would redirect some of the current incentive away from finding innovations toward using them and thereby produce a more efficient business tax environment. The Committee recommends phasing out the deduction of R&D capital and replace it with a new 35% capital cost allowance class, and reducing the general R&D credit from 20% to 15% and the small business credit from 35% to 27%. It also suggests qualifying smaller enterprises be provided with a full refund of the R&D credit for both current and capital spending to assist the financing of such assets.
Other Harmonization: At present, the provinces of Ontario, Quebec and Alberta have their own corporate tax systems with separate calculations of taxable income and different incentives. The Committee recommends moving to a common taxable income base for federal and provincial purposes and a common method of allocating income and capital subject to tax in each jurisdiction. This would reduce flexibility for provinces to have their own incentives and additional taxes, so the Committee suggests that these be accomplished through tax credits and surtaxes.
NEW CORPORATE DISTRIBUTION TAX
A major recommendation of the Committee is a restructuring of Canada's system for taxing Canadian corporate dividends. In the 1988 tax reform, the government introduced a tax on corporations paying dividends on taxable preferred shares and short-term preferred shares (Part VI.1 tax and Part IV.1 tax). This was the first step to a full advance corporation tax (ACT) system as currently exists in the U.K. [It is interesting to note that the U.K. has announced it will repeal its ACT system in 1999.] The Committee is concerned that there is still the ability to pay dividends on common shares which entitle shareholders to the dividend tax credit, even though the paying company may not be in a tax paying position.
The Committee therefore recommends implementing a 25% corporate distribution tax (CDT) for all taxable dividends paid to resident and non-resident shareholders and concurrently eliminating the existing Part VI.1 and IV.1 taxes. The term preferred share and guaranteed preferred share rules would be retained. The system would have the following features:
- The 25% gross-up and dividend tax credit would be retained;
- Every company would maintain a tax-paid dividend account from which dividends would be paid first with no CDT liability;
- Federal and provincial corporate income tax would be creditable against CDT; excess CDT arising could be carried back three years and forward ten years;
- Dividends paid between corporations would generally be subject to CDT to the payor and be added to the recipient's tax-paid dividend account. The exception is for dividends paid between related companies or when a votes and value test was met (which might be 25%) provided both companies elect;
- Deductible dividends received from foreign affiliates' exempt surplus and taxable surplus as well as foreign branch income which is not taxed because of foreign tax credits would all go into the tax-paid dividend account;
- An elective transfer system would allow CDT to be transferred between related corporations, similar to the system for Part VI.1 tax;
- Transition rules would be required to deal with current retained earnings. The Committee suggests that any surplus accumulated in the five years prior to the new system be counted, not the surplus for all prior years. Further study is recommended on this issue.
CAPITAL GAINS EXEMPTION
While the $100,000 capital gains exemption was repealed in 1994, the $500,000 exemption for qualifying small business shares and farms was retained. The Committee believes that this has not motivated investment and risk-taking as intended but that there is evidence that small business owners and farmers are not contributing the maximum RRSP contribution limits each year. Accordingly, they recommend repeal of the exemptions with relief for accrued gains to the date of the change (allowing an increased cost basis to be created) and introducing a new enhanced RRSP contribution for the future. The RRSP contribution room of owners of these properties could be increased to the extent of realized capital gains (up to $500,000) subject to the cumulative total by which the individual's contribution limits since 1991 have been less than the maximum limits for each year. Intergenerational tax-deferred rollovers would also be reinstated for small business shares.
The recommendations do not address a number of important tax issues related to financial institutions. The federal Task Force on the Future of the Financial Services Sector has been examining the regulatory structure affecting financial institutions. This Task Force's Report will likely be issued this year and a research study on the taxation of financial institutions jointly sponsored by the Task Force and the Committee is being completed. The Committee members believe that the net tax burden on this sector should only be changed when the future regulatory regime is clear. However, the Committee's general recommendations would provide significant benefits to larger institutions. For this reason, a temporary increase in the federal non-creditable capital surtax on deposit-taking institutions and a new similar surtax for insurance companies is recommended as a transitional measure so that their current tax burden remains the same under the Committee's recommended tax regime pending the outcome of this regulatory review. This non-creditable surtax is already a discriminatory tax in our view and using it to increase taxes further is regrettable.
The Report reviews the taxation of companies in the mining and oil and gas industries and, in particular, the special resource allowance that is deductible by mining and oil and gas companies in lieu of the various and substantial non-deductible special provincial taxes and royalties paid by these companies. The Committee concludes that it is appropriate to continue to disallow the deduction of provincial resource levies and provide a resource allowance in lieu of this deductibility. To improve the current system, the Committee recommends:
- The federal government consider, after consultation with the provinces, the restructuring of the resource allowance to base it on income from resource activities net of all (including interest and exploration and development expenses) related deductions at the current rate of 25%. The Committee further recommends that such changes should only occur after a transition period of at least five years;
- The gradual lowering of the general corporate tax rate recommended in the Report should not apply to resource income until the provincial consultations have been carried out and the impact of the restructuring of the resource allowance, together with the broadening of the tax base and general rate reductions as proposed, have been fully reviewed;
- The maximum rate of write-off on development costs would be reduced from 30% to 25% after a three-year advance notice;
- The existing rule permitting up to 100% deduction for capital costs incurred in connection with new mines or major expansion of existing mines should be repealed and replaced by a new depreciation class with a maximum of 25% declining balance rate. This should apply after a five-year advance notice;
- The cost of acquiring new mining properties should, as is the case for oil and gas, be treated as a capital cost deductible at a 10% annual rate after advance notice;
- The flow-through share rules will be adjusted to reflect the new relationship between corporate and personal rates.
The Committee discusses objectives related to the taxation of international income, various systems available, and alternatives that were considered. In its analysis, the Committee refers to the tax systems of Canada's major trading partners as a basis for comparison and measurement.
Outbound Investment: With respect to the taxation of foreign affiliates, the Committee's view is that the existing regime is fundamentally sound and should be maintained. While alternative systems may have advantages, they would be much more complex and likely would discourage foreign direct investment by Canadian multi-nationals.
The Committee has, however, recommended that the present definition of foreign affiliate should be strengthened so that only significant equity interests in foreign affiliates would qualify. An approach suggested is a 10% "votes and value" test. The Committee does not consider it necessary to change the definition of controlled foreign affiliate.
The report examines in some detail the issue of deductibility of interest expense related to foreign investment by Canadian investors. The Committee concludes that interest expense with respect to investments in foreign affiliates should be restricted and sets forth several recommendations:
- Interest expense of Canadian taxpayers on debt that is incurred to invest in foreign affiliates should be disallowed;
- The tracing method should be used for purposes of identifying the amount of indebtedness allocable to investments in foreign affiliates;
- Interest expense that is disallowed should be added to the tax basis of the shares of the relevant foreign affiliate and accumulated in a "disallowed interest account". This account could be used to offset dividends received on the relevant shares out of taxable surplus but not used to offset Foreign Accrual Property Income (FAPI);
- To assist small and medium-sized businesses, an exemption should be provided for up to $10 million of accumulated indebtedness related to investments in foreign affiliates (to be shared amongst members of an associated group);
- There should be grandfathering and/or a generous transition period with respect to these new rules.
The Committee's view is that the FAPI regime, after the important 1995 amendments, is generally sound and protects the Canadian revenue base. The Committee has, however, made certain recommendations in this area:
- The FAPI exemption for inter-affiliate transactions should be maintained, but payments should be included in taxable surplus in all cases where the income is received by an entity located in a treaty jurisdiction that is expressly denied benefits under that treaty. Thus, for example, a Barbados International Business Corporation would not be eligible to earn exempt income on loans made to other affiliates;
- The government should actively renegotiate existing treaties to exclude tax-privileged entities to ensure that such entities are denied access to the exemption system with respect to income from inter-affiliate transactions;
- The FAPI exemption for inter-affiliate payments should be revised to exclude those situations in which the payor affiliate is related to the financing subsidiary solely as a result of share ownership by a foreign parent. The Committee is concerned about such "second-tier" financing transactions that may be eroding the Canadian domestic tax base;
- Foreign trust structures identified by Revenue Canada should be challenged in the Courts and/or appropriate amendments be made to Canada's tax legislation, so that Canadian tax on investment income for these trusts is not inappropriately avoided. The Committee also suggests that Revenue Canada aggressively audit taxpayers for the possible application of the offshore investment fund rules.
Inbound Investment: The Report reviews the taxation of income earned by non-resident investors. With respect to withholding taxes, the Committee's view is that the present Canadian position with respect to the level of withholding taxes under bilateral tax treaties is appropriate and requires no modification at the present time. The Committee recommends that the withholding tax exemption for interest payments to arm's-length non-resident lenders should be extended to all indebtedness (presently, there are only limited exemptions). The exemption should, however, be denied where there is a back-to-back loan or a similar financial support arrangement.
The Report also considers Canada's thin capitalization rules. The Committee makes the following recommendations with respect to these rules:
- The existing ratio of 3-to-1 should be revised to a 2-to-1 ratio;
- The rules should apply to Canadian branches of foreign corporations, partnerships and trusts, as well as Canadian corporations;
- The existing provisions with respect to back-to-back arrangements using third-party intermediaries should be strengthened.
The Committee also considers non-resident-owned investment corporations (NROs) and has recommended the repeal of the NRO provisions subject to a transitional period.
The Committee reviews transfer pricing and notes that it is aware of concerns that, because of the changes to the U.S. rules, there has been a tendency for businesses to establish transfer pricing practices that result in a greater proportion of income being recorded in the United States than would otherwise be the case. As a result, there is a threat posed to the Canadian tax base. The Committee seems to endorse the 1997 federal budget measures in this area, subject to a few modifications to make proposed penalties less onerous and limit Revenue Canada's ability to recharacterize transactions.
The Committee also briefly touches on two emerging issues in the global marketplace in its Report, electronic commerce and tax competition. The Committee favours continued debate and analysis with respect to electronic commerce issues in Canada, within the OECD and by businesses undertaking electronic commerce, but does not provide any specific recommendations. With respect to tax competition, the Committee notes that certain jurisdictions are actively engaged in tax competition by establishing tax holidays, tax-free zones, and other tax preferences. The Committee encourages the government of Canada to participate at the international level in discussions to curtail "the most harmful effects of tax competition".
Employers' EI: Private sector employers currently pay about $11 billion in Employment Insurance (EI) premiums -- a charge on business that approximates about one-half of the federal corporate income tax levied in 1996. The Committee considered whether EI contributions could be more closely linked to the costs that an employer, or an industry, imposes on the EI system, in effect introducing an element of user-pay. It concluded that a partial expense rating system, not unlike Workers' Compensation, would provide benefits overall:
Employees' contributions would not vary with their employer's status, and no individual industry or employer would face increased rates. The recommendation contemplates an overall drop in the level of EI contributions.
- employers would have an inducement to reduce use of the program;
- many aspects of universality or sharing broadly would remain;
- overall economic activity would enhance the GDP.
Environmental Taxes: The Committee specifically focused on the "user payer" principle, from an environmental perspective, in examining the federal fuel excise tax, presently 10c and 4c per litre of gasoline and diesel automotive fuel respectively. It concluded there was little relationship between the pollutant qualities of fuels and their tax burden. The Committee therefore recommends that the federal government work with the provinces to replace these taxes with more broadly based, revenue neutral, environmental taxes designed to reduce the use of fuels that pollute more heavily, a sort of "carbon tax" approach.
COMPLIANCE AND ENFORCEMENT
The Committee recognizes the complexity of Canada's various tax systems, both income and commodity. It puts forth six distinct recommendations for reducing and simplifying the compliance burden:
- Harmonizing legislation among both federal and provincial statutes to reduce compliance burdens;
- Harmonizing administrative provisions in the federal commodity and income tax statutes administered by Revenue Canada;
- Drafting legislation in a simplified, more comprehensible style, and providing useful, clear technical notes to assist in understanding the law;
- Technically sanctioning in law the present ability of Revenue Canada to settle issues, ostensibly to contain the risks of litigation;
- Legislating Revenue Canada's ability to settle tax debts (now exercised informally) and to pursue tax debts more commercially;
- Adding new civil, not criminal, penalties to apply to promoters and advisors who offer "obviously faulty" advice - a potentially disturbing proposal that could affect taxpayers' abilities to take genuinely contrary or aggressive positions to those of Revenue Canada.
As part of its review, the Committee considered new taxes that could be used to replace or reduce existing ones; these include taxes on financial transactions, wealth, and cash flow. However, the Committee does not favour the adoption of any of these taxes.
The Report's recommendations will require considerable analysis to determine how they would affect particular corporations. We will be issuing more detailed commentary over the coming weeks.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
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