Canada: Canadian Tax @ Gowlings – December 2006

Last Updated: January 16 2007

Edited by Vince Imerti

Contents

  • Revised Canadian Tax Proposals for Trusts and Foreign Investment Entities
  • The Supreme Court of Canada's Decision Taken out of Context: A Case Comment on Imperial Oil Ltd. v. Canada

Revised Canadian Tax Proposals For Trusts And Foreign Investment Entities

On November 9 of this year the Canadian Minister of Finance released revised proposed amendments to the Canadian tax treatment of so-called "non-resident trusts" (or "NRTs") and "foreign investment entities" (or "FIEs"). These proposals have had a long and chequered history. They were first proposed by a previous Minister of Finance, from a previous government, in the Federal Government's Budget of 1999. Draft legislative proposals to implement these changes have been released on several occasions, and have been the subject of considerable criticism from tax advisers because of their breadth and because of technical issues in their application.

The most recent previous version of these proposals had last been released for public comment in July of 2005 and generally were to be applicable from January 1, 2003. Needless to say, many taxpayers and their advisers were a bit baffled as to how to respond to legislative changes that were to be effective with retrospective impact, but that had not been enacted and were still subject to change.

The new proposals both address some of the technical issues previously identified (although not always in the manner that tax advisers had hoped) and defers the application of the new rules until, generally, January 1, 2007.

The proposals had as their genesis the concern on the part of Canada's tax policy makers that Canadian taxpayers were abusing the then applicable rules to move investment assets outside of Canada and beyond Canada's tax net. The view was that both the then applicable rules for non-resident trusts and "foreign investment funds" needed to be strengthened.

Overview of the Rules

Although broad in their potential application, the proposed NRT rules should generally not be of concern in a commercial context, but only in what might be labelled "personal" circumstances. In very general terms, the NRT rules will cause a trust that is not resident in Canada to be liable for Canadian tax on its income if a resident of Canada has contributed property to the trust. In such a case, the liability for the Canadian tax of the trust can potentially be visited upon the contributor of the property or upon any Canadian resident beneficiaries, within certain limits.

Of greater concern in a commercial context will be the proposed FIE rules. These rules can apply to a Canadian resident investor in a non-resident corporation, trust, partnership or other entity. In general terms, a taxpayer that holds an interest in a FIE at the end of a taxation year will be required to include in its taxable income for the year one of three different amounts under three different regimes. First, the taxpayer may be required to include an imputed amount of income from the FIE (the "Prescribed Rate of Return Regime"). Alternatively, the taxpayer may be entitled to elect or, in certain circumstances will be required, to include in income for the year the increase or decrease in the fair market value of the taxpayer's interest in the FIE (the "Mark-to-Market Regime"). Finally, in certain circumstances, the taxpayer may be able to simply include in income his or her proportionate share of the FIE's actual income for the year.

In all three cases the income inclusion will apply notwithstanding the fact that the taxpayer may not have received any distributions from the FIE. However, mechanisms are included in the rules to try to prevent double taxation from arising upon the receipt at a later date of distributions from the FIE or from the disposition of the taxpayer's interest in the FIE.

Among the circumstances in which these new rules can be of concern is where a taxable resident of Canada invests in a non-Canadian investment fund. Although the FIE rules include exemptions that should apply in most such circumstances, the exemptions are very much fact specific, and will have to be reviewed in each circumstance. Moreover, because availability of the exemptions will generally depend on the particular investments of the fund, it will usually be difficult for advisers to provide complete assurances that these rules will not apply.
By Tim Wach

The Supreme Court Of Canada's Decision Taken Out Of Context: A Case Comment On Imperial Oil Ltd. V. Canada

Tax cases ordinarily do not attract much attention at Canada's highest court. However, the Supreme Court of Canada has again addressed tax issues with its recent decisions in Imperial Oil and its sister case Inco. On one level, the issue in Imperial Oil and Inco was straightforward: could the taxpayer's entire foreign currency loss stemming from the redemption and purchase of debentures it had issued be deducted from income as a borrowing cost under s. 20(1)(f)(i) of the Income Tax Act ("ITA")? While in most cases, gains or losses stemming from foreign exchange fluctuations relating to borrowings are considered to be on capital account, the taxpayers in Imperial Oil and Inco argued that their losses were connected to issuing a debt instrument and were therefore arguably akin to a borrowing cost, which is deductible on income account under s. 20(1)(f).

On another level, the issue in these cases could be described as a battle between the taxpayer's contextual approach and the Minister's textual approach. The Minister ultimately won the day, with the slimmest of margins, a four to three victory. The taxpayers and their contextual approach went down swinging, embraced by a strong minority decision. At the risk of oversimplification, it is probably fair to say that the majority view seemed to be more concerned with maintaining the integrity of the text of the ITA and thus had a more restrictive view of s. 20(1)(f)(i). The minority view, on the other hand, seemed to be heavily influenced by the practical realities of the taxpayer and thus took a more expansive view of s. 20(1)(f)(i).

Background

In both of these cases the taxpayer had issued debentures denominated in U.S. dollars. Between the date of issue and the date of redemption of the debentures the U.S. dollar had appreciated against the Canadian dollar and taxpayer suffered a foreign exchange loss on redemption. In both cases the taxpayer took the position that it was entitled to deduct from income the entire loss under s. 20(1)(f)(i) of the ITA or, alternatively, that it was entitled to deduct 75 percent of the loss under s. 20(1)(f)(ii) and that the remaining 25 percent was by default a capital loss under s. 39(2). The Minister disallowed both of these deductions on the basis that the losses were on capital account under s. 39(2) and not deductible under s. 20(1)(f).

Decision

The majority of the Supreme Court adopted a textual approach, allowed the appeals and upheld the Minister's assessments. LeBel J., writing for the majority, held that s. 20(1)(f) of the ITA does not permit the deduction of foreign exchange losses, which must be claimed as capital losses under s. 39. He indicated further that the purpose of s. 20(1)(f) is to address a specific class of financing costs arising out of the issuance of debt instruments at a discount, and therefore should not be construed as a broad provision allowing for the deduction of a wide range of costs attendant upon financing in foreign currency.

Furthermore, he indicated that the text, scheme and context of s. 20(1)(f) indicate that the deduction is limited to original issue discounts, namely shallow discounts in para. (f)(i) and deep discounts in para. (f)(ii). Although the word "discount" does not appear in s. 20(1)(f), the opening words set out what is commonly accepted as the definition of a discount. Moreover, there is no express mention in s. 20(1)(f) of a foreign currency exchange. These factors suggest that the primary referent of s. 20(1)(f) is something other than foreign exchange losses, namely, payments in the nature of discounts. Furthermore, the scheme of s. 20, which provides deductions for virtually all costs of borrowing, does not imply that foreign exchange losses are also deductible. The other costs enumerated in s. 20 are intrinsic costs of borrowing. Foreign exchange losses arise only where the debtor chooses to deal in foreign currency. They belong to a different class than the costs in s. 20.

While both the majority and the minority indicated they were adopting a contextual approach, the minority more closely applied that approach. The minority view was clearly more influenced by the actual realities of the transaction and, more importantly by the context in which they occurred. The minority saw a single borrower-lender transaction and applied the text of the ITA to the facts of the case. On the other hand, the majority was clearly influenced by the strict wording of the provision and strictly applied the facts of the case to the text of the ITA. To this end, they were forced (in our view, somewhat artificially) to parse and distribute the transaction amongst various sections of the ITA to adhere to the text.

In statutory interpretation cases, the Court must often decide between a textual or a contextual approach. The cases go both ways and are difficult to reconcile. On this day, the textualists won, but only by a single judge. So, score one for the textualists, although it would be foolhardy to count the contextualists down and out. Undoubtedly, another rematch between these views is on the horizon.
By Stevan Novoselac and Blair Trudell

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