Enhancing the Competitiveness of Canada’s International Tax System (Part 6)

By: Nick Pantaleo

The Elephant in the Room

In previous posts, Wally made compelling arguments supporting a territorial system for taxing foreign active business income. His conclusions are consistent with the 2008 recommendations of the Advisory Panel on Canada’s System of International Taxation.

So, why aren’t we there already?

Well, with respect to foreign active business income earned by foreign affiliates, we are almost there. Canada will cede taxation of such income to the source country if it has a tax treaty or tax information exchange agreement (TIEA) with that country. As PwC stated in its 2012 budget submission, with a total of 124 tax treaties and TIEAs either signed or under negotiation, isn’t it time to declare our “carrot and stick” approach a success and drop this requirement?

What about exempting capital gains on the sale of shares of foreign affiliates earning active business income? That seems to be more difficult.

As the Advisory Panel indicated, there are technical issues to attend to, namely:

• reviewing the excluded property definition to ensure it is neither too restrictive nor too loose;
• tightening the foreign affiliate threshold;
• assessing the impact on capital dividend accounts;
• determining if a holding period is required and if so, how long; and,
• preventing dividend stripping.

These are not insurmountable hurdles, including the latter, which ostensibly means co-ordinating with section 55, something my co-writers and I, in a paper written for the 2009 Canadian Tax Foundation conference, said should be possible. 

Arguably, the most difficult hurdle is justifying exempting the sale of shares of foreign affiliates while continuing to tax the sale of shares of domestic Canadian companies. 

First, let’s remember that we are not talking about exempting shareholdings that represent passive investments or investments in non-active foreign affiliates. Also, with the recent changes to the definition of taxable Canadian property, in many cases non-residents are not even subject to Canadian tax on the sale of Canadian companies – and that is a good thing for Canadian investment and it is consistent with international norms.

But, will exempting the sale of shares of foreign affiliates be an incentive for Canadian companies to make foreign rather than Canadian investments? If that is true, why have we been prepared for so many years to exempt foreign active business income? Because, as the Advisory Panel revealed, studies show that outbound investment generates positive benefits for the Canadian economy.

Moreover, in 30 years of advising a number of Canadian companies, I have never heard of a CEO passing on an opportunity to make a foreign investment because a future sale of that investment would be taxable in Canada. In other words, Canadian companies invest offshore when it makes sense to do so – no one is holding back waiting for Canada to adopt a full exemption system.

So, what is real problem? Is it that old elephant in the room – interest deductibility?

It could be that the continued taxation of the sale of shares of foreign affiliates is intended to be the toll charge Canadian companies must pay to deduct interest on funds borrowed to invest in foreign affiliates. This might explain the need for the recent proposals dealing with upstream loans and the requirement to track a third surplus account. 

At the very least, the recent proposals suggest that the government is not close to exempting sale of shares of foreign affiliates.

If this is true, other competitiveness enhancing measures need be considered. Stay tuned!