Originally published in Blakes Bulletin on Tax, May 2007
On May 14, 2007, the Minister of Finance withdrew a controversial budget proposal to deny interest deductions for debt relating to foreign investments. The withdrawal of the budget measure, first announced on March 19, 2007, had been widely anticipated. At the same time, the Minister announced a more focused proposal, referred to as the "anti-tax haven initiative". The revised proposal will not come into effect until January 1, 2012, effectively deferring any change to existing rules for almost five years. While the May 14 release describes the new proposal as a "mechanism" to implement the original budget proposal, the budget proposal has in fact been effectively withdrawn.
Original Budget Proposal
Existing rules permit a Canadian corporation to deduct interest payable on debt incurred to acquire common shares, including common shares of a foreign affiliate. Canada’s existing "exemption" system for foreign affiliates frequently results in Canada not taxing active business income earned by a foreign affiliate. This arguably presents an asymmetry; the financing costs of an investment in shares of a foreign affiliate are deductible, while the corresponding income stream, if and when it arises, may be exempt from Canadian tax. Nonetheless, this system has been in place for many years, and had regularly been defended since the early 1990s by the Finance Department.
The budget proposed a significant and unexpected reversal in tax policy. Under the budget proposal, interest expense incurred to acquire shares of a foreign affiliate generally would not be deductible unless and until those shares generate income that is taxed in Canada. The proposed rules were to apply to interest accruing from January 1, 2008 for debt incurred on or after budget day; for existing debt, the rules were to apply to interest accruing from January 1, 2009 (for related party debt) and January 1, 2010 (for third party debt). Many taxpayers and advisors expressed concerns not only about the adverse impact of the proposed rules, but also with regard to their proposed application to existing term debt arrangements that in many cases would extend beyond the transitional period.
The budget proposal generated significant controversy. The proposal would have made a fundamental change in longstanding practice, with a limited transitional period. A growing chorus of opposition emerged in Canada’s business community, as the proposal was expected to significantly increase the cost of capital to Canadian corporations, thus limiting the ability of Canadian companies to compete in a global market, particularly with respect to cross-border mergers and acquisitions. The government’s decision to withdraw the proposal will no doubt be viewed favourably by many taxpayers.
It is interesting that the release of the budget proposal, on March 19, 2007, coincided with the release of "dual consolidated loss" regulations by the U.S. government. Many observers believe the two governments co-ordinated their releases to effectively eliminate well-known "double dip" structures – with the U.S. announcement ending the viability of certain hybrid debt structures and the Canadian announcement shutting down the "tower" structure.
The May 14 Announcement
The May 14 announcement seems intended to scale back the broad budget proposal to a more modest proposal, albeit one that would still end the viability of some specific arrangements such as the "tower" structure.
An across-the-board denial of interest deduction is no longer proposed. Interest relating to an investment in a foreign affiliate will generally continue to be deductible, subject to the narrower restriction described below. Most importantly, no change to existing law is proposed to take effect until January 1, 2012.
Under the new proposal, beginning January 1, 2012, no deduction will be available for a corporation’s interest expense relating to an investment in a foreign affiliate to the extent of the corporation’s "double dip income". Very generally, a Canadian corporation will have "double dip income" if:
- the corporation has a foreign affiliate,
- that foreign affiliate earns income from an inter-affiliate debt obligation,
- that debt obligation can be linked to corresponding debt of the corporation,
- that income is deemed to be "active" business income, and
- that income has borne foreign taxes at rates less than Canadian statutory rates.
Double dip income would not generally arise where a Canadian corporation borrows to acquire shares of a foreign affiliate in the absence of a related inter-affiliate debt obligation at the level of the foreign affiliate. It would not arise merely because of inter-affiliate leasing or licensing arrangements. It could, however, arise where a "low" taxed foreign affiliate earns income on inter-affiliate debt. Income of a foreign affiliate could be subject to "low" foreign taxes either because the affiliate is resident in a country with a favourable tax regime, such as Barbados or Ireland, or because the affiliate is not treated as a taxable entity, as in the case of some double dip structures. It could also arise where the foreign affiliate pays less than the Canadian statutory tax rate due to deduction of loss carryovers or other amounts in the foreign jurisdiction.
The May 14 release describes two examples of transactions the proposal is intended to affect. The first example involves a Canadian corporation that has borrowed to invest in a foreign affiliate that functions as a financing entity for the corporate group. Such a structure would typically involve a subsidiary resident in a lower tax jurisdiction such as Barbados or Ireland. The subsidiary would lend the funds invested by the Canadian taxpayer to other foreign entities within the same corporate group. Interest earned by the financing affiliate would be deemed active business income. The second example involves "double dip" arrangements such as the "tower" structure. This structure has been used to fund acquisitions or operations in the U.S. and involves a partnership of Canadian corporations. The partnership is treated as a corporation for U.S. tax purposes. The partnership generally owns a U.S. limited liability company that functions as a financing affiliate for other U.S. subsidiaries.
The government’s new focus on these fact patterns is interesting. It is difficult to see why a Canadian corporation’s ability to deduct interest should depend on the extent to which foreign income has borne foreign taxes. The Canadian revenue base is unaffected by the existence or non-existence of foreign taxes on foreign income. Yet, this seems to be the main criterion for non-deductibility of interest. It would appear that the Canadian government felt compelled to introduce proposals to end double dip structures in order to complement parallel initiatives announced in the U.S. on March 19, 2007.
The Minister of Finance also announced that an expert panel would be established to undertake further study and consultations with respect to Canada’s system of international taxation. This panel is to provide an interim report by the end of 2007 and a final report by the end of 2008. The panel will be asked to consider the issue of the amount of debt supporting investments made by Canadian taxpayers in foreign affiliates, as well as the existing thin capitalization rules restricting the deduction of interest paid by a Canadian corporation to significant non-resident shareholders. The full mandate of the panel is expected to be announced in the near future.
Finally, the Minister noted that he expected that the amended Canada-U.S. Income Tax Convention, which will include an exemption for withholding tax on interest and recognition of U.S. "limited liability companies", would be signed within 90 days.
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