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The Federal Budget’s Interest Restrictions
– Clear and Present Danger?

by David Louis, B. Com., J.D., C.A., Tax Partner
Minden Gross LLP, a member of MERITAS Law Firms Worldwide. 

(*This release is based on an article published in Tax Notes #531, April 2007, and in Tax Topics, #1829 both published by CCH Canadian Limited.)  

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Last week’s federal Budget contained proposals (Budget Resolutions 24-29) that do nothing less than disallow interest deductions in respect of investments in foreign affiliates in the vast majority of situations.  While one firm’s Budget night release described this as the “most significant tax policy development in the international area since . . .1972”, I am not sure that a lot of practitioners fully appreciated the ramifications of the proposals, at first anyway.  In fact, some of the Budget papers themselves gave the impression that the interest disallowance applies to investments in “tax havens”.  However, the significance of the proposals became more apparent as the week wore on, and by the weekend, were becoming almost tantamount to the Budget itself[1]. 

Make no mistake: the proposals potentially apply to any corporation that borrows to acquire the shares of a foreign affiliate, whether it resides in the US or somewhere in the Caribbean.  Contrary to the impression that some commentary gave, the proposals are not confined to exotic international financing structures.  They potentially apply to any borrowing to finance a foreign affiliate.  It’s that basic.

The restrictions on interest deductibility are on a tight time frame.  They will apply to interest payable after 2007 on debt incurred on or after Budget day.[ii]  Pre-existing non-arm’s length debts will be subject to the restrictions after 2008;[iii]  and the restrictions will apply to interest payable on pre-existing arm’s length debts after 2009.[iv]  Although the Budget indicates that the last-mentioned deadline is in recognition of difficulties companies might have in restructuring debt, since such debt typically has a fairly long term with stringent penalties often applying to prepayment, it is questionable whether many borrowers will be able to restructure in time.

As the Budget papers indicate, the disallowance rules (which apply separately to each foreign affiliate) will be achieved through an adaptation of the existing “tracing” rules for interest.  While (in general) the deductibility of an interest expense will continue to depend on what the borrowed money giving rise to that expense is used for, the financing of a foreign affiliate (in particular) will no longer support an immediate deduction.  Instead, the interest expense will be “pooled” for a deduction “if and as the foreign affiliate shares generate non-exempt income”.  More precisely, the amount included in income so as to allow the deduction will be net of deductions in respect of foreign affiliate dividends, etc.[v]

While there has been some suggestion about counter-measures to achieve deductibility, e.g., so-called “cash damming”, these must contend with a broadly-worded anti-avoidance rule which is built into the proposals[vi].  In any event, cash damming is difficult to achieve in the best of circumstances; the prospect of using cash to invest in what is often a speculative foreign venture may pose additional risks. 

Rationale for the Proposals

The rationale for these proposals is that Canada’s current tax system allows tax deductions for interest on money borrowed to finance affiliates, while income from active businesses of a foreign affiliate does not attract Canadian tax as it is earned and, in the case of treaty countries, can be repatriated to the corporate level in the form of exempt surplus dividends.  Thus, the Budget characterizes the deduction as a “subsidy”.  This concept is not new.  A similar recommendation was made in the Mintz Committee Report[vii] released almost a decade ago, and was highlighted as an issue in the Auditor General’s reports of 1992 and 20022[viii]. 

The policy concerns that have been expressed over Canada’s existing rules are not groundless.  But the increasing cries of impairing competitiveness of Canadian businesses have a great deal of justification.  Very often, especially with small or medium sized businesses, expansion into a foreign country will give rise to start-up losses so that foreign financing would not be immediately deductible.  Another issue is whether such companies would be able to obtain foreign financing to begin with.[ix]  While borrowing in, say, New York State may not pose much of a problem for even a fledgling business, how about South Carolina?  Brazil? The Ukraine?[x] 

Especially for larger public corporations, international investment decisions are made taking the tax effects into account.  Knocking out tax deductions in midstream could make an important difference to the company’s financial performance – to the point that vulnerability to foreign takeovers has been suggested[xi].  A comparison of the current proposals and the Mintz Committee Report recommendations reveals the severity of these proposals in these respects.  While the Mintz Committee Report likewise recommended the disallowance of interest expenses on indebtedness incurred to invest in foreign affiliates,[xii] it also called for a “generous transition period” in view of transactions committed to under the existing rules, as well as a threshold amount of accumulated indebtedness in order to lighten the load for small and medium sized businesses.  (I think that the ability of these businesses to finance international expansion is much more critical than it was a decade ago, when much of the expansion was south of the border.  Consider such initiatives as outsourcing in developing countries, expansion into the former Soviet Bloc, and so on.[xiii])

Even with these exemptions, the proposals were nonetheless described as, commercially, “the most provocative” in the Mintz Committee Report.[xiv]   If Mintz was “provocative”, what is the appropriate term for a proposal that appears without current consultation, and with no exemptions whatever?  As I peer out from my office onto the TD Centre behemoths, my guess is that the tax drones in the neighbouring towers spend a big chunk of their waking hours doing outbound financing transactions, virtually all of which must have been blown to bits by the proposal.  Canadian financial institutions will not only lose a lot of transactions, they may also lose customers to foreign-based banks which are better equipped to finance outside of Canada[xv].  (Ironically, this might be heightened by other Budget proposals which may adversely affect Canadian lenders: the Canada-U.S. Treaty is to be amended so that withholding tax and cross-border interest payments will be eliminated.[xvi]  Once the Canada-U.S. withholding exemption, in respect of arm’s length interest payments comes into effect[xvii], withholding on interest will be eliminated for all arm’s length non-residents.)   

To make such fundamental changes without warning does little to build confidence in Canada’s business environment, especially when this is hard on the heels of other proposals in the international area which the business community is finding problematic. 

There is no point in debating whether these proposals should have been put forward – we’re in it, and the potential for economic damage is significant.  The biggest damage will occur if they drag on like the other proposals in the international area.  Each day that goes by where there continues to be a real possibility that they may come to pass, there will be a clear and present danger of serious financial damage, as uncertainty will mean that financing business will leave the country.  Another fundamental issue is how a “provocative” – and seemingly dormant – suggestion can suddenly re-emerge a decade later, without further discussion, or safeguards for pre-existing transactions and smaller businesses.  I can understand a surprise announcement when there is a clear and present danger to the tax base, as was the case with income trusts.  However, I am not aware of any similar threat which would justify these proposals.  So on reflection, perhaps as disturbing as the proposals themselves is the e process involved: the government seems to be following a course of ushering in fundamental changes to tax policy without consultation with the business and tax communities.