Federal Government Narrows Interest Deduction Restrictions
May 2007
Release No: 07-03
In the weeks following the Federal Budget, Finance Minister Jim Flaherty had been roundly criticized for his 2007 budget proposal that would deny interest deductibility in Canada on funds borrowed to finance foreign operations. On May 14, 2007, Minister Flaherty announced that the budget proposals will be narrowed to concentrate on planning involving arrangements that are commonly referred to as a double dip. A double dip is generally planning that allows a corporation or a corporate group to claim a deduction in Canada and in a foreign country for the same interest expense. In addition, for those corporations subject to the narrowed rules, the transitional period until the new rules come into effect has been lengthened to almost 5 years.
For those corporations that were seeking a single interest deduction in Canada, these changes are welcome news, as no restrictions should apply. Although this is a positive development, it is still difficult to understand why a deduction in Canada will be denied simply because another country will allow a deduction.
Background and Original Budget Proposal
Under existing rules, Canadian corporations can deduct interest expense on money borrowed to finance foreign affiliates, even if the income generated in those affiliates may never be subject to Canadian tax. Dividends received by Canadian companies from foreign affiliates which are resident in countries that have a tax treaty with Canada (such as the U.S.) are not subject to Canadian tax if the dividend is paid out of foreign source active business income (which is referred to as a payment out of “exempt surplus”). Therefore, in many situations, the interest paid and deducted in Canada relating to foreign affiliate borrowings becomes a deduction against Canadian source business income.
Under the original budget proposals, the interest deductibility restrictions would have applied to interest payable after 2007 on new debt, which is debt incurred on or after March 19, 2007. Existing non-arm’s length debt would have been subject to the new rules for interest payable after 2008 or after the expiry of the current term of the debt, whichever is sooner. With respect to arm’s length debt, the original budget proposals would have applied to interest payable after 2009 (or after the expiry of its current term, whichever is sooner).
The New “Anti-Tax-Haven Initiative”
On May 14, 2007, the Minister announced a new “Anti-Tax-Haven Initiative”. In fact, this announcement actually reflects a narrowing of the original announcement and a longer phase-in period. In particular, despite the reference to tax havens, it would appear that the initiative is specifically targeting double-dips, whether or not a tax haven is involved.
According to the Finance Minister, a double dip is “a structure to finance investments abroad that, in short, allows two tax deductions for only one investment in a foreign affiliate.” As the government sees this planning as inappropriate from a tax policy perspective, it will move to block interest deductibility for double dips, which include so-called “tower structures” (which is a plan involving Canadian and U.S. entities to provide an interest deduction for both Canadian and U.S. tax purposes).
In broad terms, the Finance Minister has proposed that a deduction will not be allowed in Canada for interest that relates to investments in foreign affiliate situations where the corporation or corporate group is entitled to deduct the same or an equivalent expense in another country. In addition to those corporations that appear to be caught by this announcement, we would also suggest that any borrowings related to foreign affiliates should be reviewed when the draft legislation becomes available.
It is worth pointing out that this change may still be detrimental to Canadian corporations financially, which could have a negative impact on the Canadian tax base. Assuming that a Canadian-based corporate group chooses to claim a single interest deduction in Canada, this really means that more foreign tax will be paid (due to a lack of an interest deduction abroad) which would potentially lower the value of the corporate group and indirectly lower income that is subject to Canadian tax due to weaker general profitability.
New Effective Date
The government also announced that the revised proposals will apply to interest payable on or after January 1, 2012. In addition, unlike the original announcement, no distinctions will be made for transactions on or after Budget day, or based on arm’s length versus non-arm’s length debt. This will give those corporations affected about
4 ½ years to adjust to the new rules.
Other Considerations
The government also announced that a panel of experts will be formed to undertake further study and consultations, with a view to building on the measures in the March 2007 budget, and identifying additional measures to improve the fairness and competitiveness of Canada’s system of international taxation. The panel will be asked to produce an interim report by the end of 2007 and a final report in 2008.
It is worth keeping in mind that a number of international proposals were included in the 2007 Federal budget, which remain unaffected by the May 14, 2007 announcement. For more information on these changes, ask your BDO advisor for a copy of Fast Fact Release No: 07-02, Canada Makes Major Changes to International Tax Rules.
For more information on how these rules will affect you, contact your BDO advisor.
Please note: this material is general in nature and should not be relied upon
to replace the requirement for specific professional advice. © May 2007, BDO Dunwoody LLP
