The last edition of CanadianTax @ Gowlings contained a discussion of a significant proposal from the 2007 Canadian Federal Budget which would significantly curtail the deductibility of interest on money borrowed by Canadian corporations to finance foreign affiliates. As indicated in our last edition, the proposal would eliminate the current interest deduction for borrowed money used to finance foreign affiliates, and replace it with a carry-forward that can be deducted in future years to the extent that the foreign affiliate generates non-exempt income for the corporation (in other words, income, including capital gains, other than exempt dividends received out of the "exempt surplus" of a foreign affiliate – being Canada's form of participation exemption). As announced in the Budget, this proposal is to take effect for interest payable in 2007 on debts incurred on or after March 19, 2007; for interest payable after 2008 on non-arm's-length debt outstanding on March 19, 2007; and for interest payable after 2009 on arm's length debt outstanding on March 19, 2007.
In the weeks since the Budget was released, the measure has attracted considerable opposition from the Canadian business community. Respected tax expert Jack Mintz, who led the 1997 Technical Committee on Business Taxation which first advanced a similar (but narrower) proposal, criticized both the breadth and implementation of the proposals. Opposition politicians and corporate leaders have both questioned the effect of the proposal on Canadian competitiveness.
There have been recent signs that Finance is considering tightening the proposal to affect fewer borrowers. The Budget documents, and subsequent statements by Finance officials including the Minister, indicated that the Department introduced the proposals because of concerns with Canadian investment in tax havens; however, the proposal as drafted applies to all foreign affiliates. It is also 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. This is mirrored in the Minister's public criticism of "double-dipping" of interest deductions. However, this is at odds with how Finance described the rationale for the proposal in the Budget documents. Nevertheless, it appears that the grounds on which the proposal is based are shifting – a sign that changes to the proposal may be imminent.
The Minister of Finance has been quoted in media reports as saying that he will announce changes to the proposal on Monday, May 14. He has also announced that he may either extend the transition period or "grandfather" existing debts, and that the proposal will not entirely eliminate interest deductibility for foreign financings. The Minister is scheduled to speak at an conference of the International Fiscal Association to be held in Toronto on Thursday, May 17 and further clarification may be available at that time.
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