Finance Committee on May 10th, 2007

[The Chair, Conservative, Brian Pallister]

Good morning, committee members. Good morning to our witnesses today and also to those in Toronto.

Pursuant to Standing Order 108(2), our briefing on tax havens and tax avoidance will continue.

I'll go through the witnesses in the order I have them here. You've each been told you have a maximum of five minutes to present. We know this is an incredibly complex issue and defies a five-minute summary of any kind, but we have to allow time for exchange with committee members, as you're aware.

We thank you for participating in this process.

We begin with Nick Pantaleo of Price Waterhouse Coopers. Welcome. Over to you, sir, for five minutes.

[Nick Pantaleo, Partner, Price Waterhouse Coopers]

Good morning.

My name is Nick Pantaleo. I am a partner with Price Waterhouse Coopers and I have specialized in international taxation for most of my 20 years as a tax adviser.

I appreciate the opportunity to speak to this committee to discuss the proposal included in the March 19 federal budget to restrict the deductibility of interest.

The proposal has proven to be very controversial and has been roundly criticized in the Canadian business and tax community. The primary concern is that the proposal will make Canadian corporations less competitive, not only in international markets but in Canada as well.

For the reasons I will outline shortly, I strongly believe that more study and analysis is necessary before introducing restrictions on interest deductibility.

The budget also proposed the establishment of an advisory panel of experts to study, consult, and recommend measures to improve the fairness of Canada's international tax system.

Any proposal to restrict the deduction of interest should be made at the same time other changes are made to the system and should not be significantly out of step with actions taken by Canada's trading partners.

I do not believe that the budget proposal should proceed. Instead, the matter should be referred to the panel for further discussion and public consultation to eliminate the current uncertainty that many Canadian companies are currently facing.

An important feature of the Canadian system is to permit Canadian taxpayers to deduct interest in respect of financing investments, including investments in foreign affiliates. This feature is not a tax loophole, nor did it develop by chance. It reflects a deliberate policy choice that for 35 years has been an integral part of the Canadian system for taxing foreign-sourced income.

The key objective of that system is to ensure the right balance between two basic needs: on the one hand, the need to protect the Canadian tax base, and on the other hand, the need to ensure Canadian corporations are competitive. The rules that permit a tax deduction for interest in respect of investments in foreign affiliates have always been considered to be consistent with that objective.

In short, Canada has been prepared to pay a cost in the form of granting a Canadian interest deduction to enhance the competitiveness of Canadian companies and thereby garner the resulting economic benefits, but Canada has not been prepared to write a blank cheque.

From my perspective, there are four principal features of the Canadian system for taxing foreign-sourced income that are relevant to this discussion. The first feature is that the system provides for the deferral from Canadian tax of foreign business income earned by foreign affiliates.

Under the second feature, Canada turns over primary taxing authority to the foreign jurisdiction in which foreign business income is generated. On the distribution of such income to Canadian corporate taxpayers, Canada effectively provides a foreign tax credit against Canadian income tax, or it provides a complete exemption from Canadian tax. This is done to ensure the income is not taxed twice.

As for the third feature, currently access to the exemption aspect of our rules is achieved through Canada's treaty network, but that access is not dependent upon the degree to which the foreign income has been taxed. Instead, Canada defers to the foreign country to decide whether and to what extent it will exercise its taxing jurisdiction. Another proposal in the budget will ensure that this feature will also apply to those jurisdictions that have a suitable exchange of tax information agreement in place with Canada.

The final feature of the system is that foreign passive income, as well as Canadian-sourced income shifted offshore through deductible charges, is subject to tax in Canada on a current basis, with credit given for any related foreign taxes paid.

The budget documents state that the restricted interest proposal is intended to prevent the mismatch between income and expenses. Put another way, the concern is that the current system provides too much of a foreign tax credit or exemption with respect to foreign income earned by a foreign affiliate.

This tax policy concern has received and is receiving attention from other countries in their design or re-evaluation of their system for taxing foreign-sourced income earned through their own foreign affiliates. But invariably, these countries seek to ensure that such restrictions on interest deductibility do not impair the ability of their companies to compete globally. In my view, the budget proposal provides no such assurance. In particular, the proposal effectively eliminates the deferral of taxation of foreign business income to the extent of the restricted interest deduction. Eliminating this deferral would be inconsistent with the approach taken by almost any other country in the world.

A number of countries have or are in the process of examining interest deductibility in the broader context of possible reforms to their system of taxing foreign-sourced income. Several of these countries seem to be dealing with interest deductibility in a comprehensive manner. Their focus is not only on domestic tax base erosion caused by interest on borrowings for outbound foreign investment but also on domestic tax base erosion arising from inbound investment by foreign corporations and in some cases the domestic tax base erosion resulting from domestic investments of their own corporations.

As the experience of other countries attests, the nature and scope of a tax deduction that is provided in a domestic tax system in respect of investments, including foreign investments, is a complex matter and must be carefully integrated with the other objectives of the system. Given its economic size, Canada cannot afford to deviate significantly from international norms, at least not without jeopardizing the competitiveness of Canadian companies.

Accordingly, the budget proposal deserves further analysis and study in a more comprehensive manner, to take into consideration not just the factors that were of critical importance and relevance in formulating the current interest deductibility policy 35 years ago, but also current economic developments and realities. I believe the budget documents, in fact, anticipate that such a study is necessary and it will take place.

Thank you.

[The Chair, Conservative, Brian Pallister]

Thank you very much, sir.

We'll continue with Robert Raizenne from Osler, Hoskin and Harcourt. Welcome to you, sir.

[Robert Raizenne, Osler, Hoskin & Harcourt]

Thank you, sir.

I should start by saying that I've been practising as a corporate and international tax lawyer for more than 25 years, and I've been teaching corporate and international tax at the law school level for most of that time. So I've spent a fair bit of time learning and studying and practising in this particular area.

I thought I would start briefly by just touching on the two topics, in the sense of looking at the convocation notice I received. It seems that what we're dealing with here are tax havens and tax avoidance.

I wanted to start by first asking myself, “What is a tax haven?” I think it's a very useful point for us to spend a couple of minutes dealing with. We usually think of “tax haven” in the sense of a low-tax country, so we usually think of it in terms of geography. That's true, but it only goes so far. In the modern world, not only do we think of tax havens as particular low-tax jurisdictions; we also can think of high-taxing jurisdictions as being tax havens, in the sense that certain features of their tax systems can be used in such a way as to generate tax advantages.

So when we talk about tax havens, it's very difficult in the modern context to actually fix upon what jurisdictions we are talking about. By certain standards, Canada is a tax haven.

When we look at all the different tax features in the form of tax preferences that are part of our tax system, we have very important low-tax features, and these low-tax features have been put into our income tax legislation purposefully. They are not accidental or unintended features of our tax system. We have such things as international banking centre rules; we have very generous R and D rules; we have accelerated tax depreciation rules; we have all sorts of regional incentives that are built into our tax system. All of these tax preferences, in particular contexts, go to make Canada into something like a synthetic tax haven.

Just as that's the way our system operates, we have to look at the 200 other jurisdictions in the world that we're interacting with in the same context. That means, I think, that any effort to formulate the rules and function of tax havens is going to require a very important definitional exercise, which is the question of what we are talking about.

The second topic is the tax avoidance topic. I think it's important that we understand also that we have a very highly regulated system of taxation in Canada. We have numerous rules, many of which are layered one on top of the other, to deal with the issue of how to tax income earned in low-tax jurisdictions outside Canada. We have the so-called foreign affiliate rules, which are basically rules that govern multinational Canadian business. We have the foreign investment entity rules, which effectively deal with individual investors who are going offshore. We have transfer-pricing rules. We have foreign reporting rules with very significant penalties, which require taxpayers to report on an ongoing basis what it is they're doing offshore. It's important to remember that all Canadian taxpayers, including Canadian multinationals, are subject to this panoply of very complicated rules.

As was pointed out by Mr. Adams, I think, in his testimony here on Tuesday, we now have 86 bilateral tax treaties. We have numerous multinational tax audit initiatives. We're doing lots in this area.

When we turn to the budget, I think it's important that we keep in focus that the last time we looked at these issues, we had a 14-year process, starting in 1962 and ending in 1976, before we changed what was then the old tax system. I would join Nick's point that we certainly shouldn't be contemplating the type of significant changes that are included in the 2007 budget without taking a serious and hard look at those ideas and considering what we should be doing.

[The Chair, Conservative, Brian Pallister]

Thank you very much, sir.

We'll continue with James Hines, who is from the National Bureau of Economic Research. Mr. Hines, welcome to you; five minutes is yours.

[Prof. James R. Hines, Jr., Richard A. Musgrave Collegiate Professor of Economics and Professor of Law, University of Michigan]

Thank you and good morning.

My name is James Hines, and I'm the Richard A. Musgrave collegiate professor at the University of Michigan.

There are roughly 45 major tax havens in the world today. Tax havens are widely used by international investors. In 1999, 59% of American multinational firms with significant foreign operations had affiliates in one or more tax havens.

American firms exhibit unusual activity levels and income production in foreign tax havens. Of the property, plant, and equipment held abroad by American firms in 1999, 8.4% was located in tax havens. Employment abroad by American firms was likewise concentrated in foreign tax havens, with 6.1% of total foreign employee compensation located in tax haven affiliates. American firms located 15.7% of their gross foreign assets in the major tax havens in 1999, and affiliates in these countries accounted for 30% of total foreign income in 1999. Much of reported tax haven income, of course, consists of financial flows from other foreign affiliates that parent companies own indirectly through their tax haven affiliates.

Tax havens are viewed with alarm in parts of the high-tax world, where there are concerns that their use may divert economic activity from countries with higher tax rates and erode their tax bases.

Alternatively, tax havens could encourage investment in other countries, if the ability to relocate taxable income into tax havens improves the desirability of investing in high-tax locations, or if low tax rates reduce the cost of goods and services that are inputs to production or sales in high-tax countries.

In fact, evidence compiled by Mihir Desai and Fritz Foley of Harvard University and by me indicates that the use of foreign tax havens appears to stimulate activity in nearby high-tax countries, a one percent greater likelihood of establishing a tax haven affiliate being associated with two-thirds of a percent greater investment and sales in nearby non-haven countries.

Should capital exporting countries such as Canada be concerned by rising home-country investment in tax havens? No, they should not: this growth simply reflects the growing scope and financial sophistication of multinational enterprises. Much of the use of foreign tax havens is designed to avoid foreign taxes or to avoid the need for costly financial transactions that would otherwise be required to prevent triggering avoidable tax obligations. Neither of these should be causes of concern to capital exporting countries; on the contrary, the use of tax havens by Canadian firms likely stimulates business activity in Canada.

Does the availability of foreign tax havens offer unfair tax advantages for sophisticated international investors? It might at first appear so, but on further reflection, matters are not so simple, since multinational firms from one country compete with each other and compete with firms from around the world who also use tax havens.

This international competition ultimately drives pretax returns available from investments in tax havens down to break-even levels, much as the market for tax-exempt debt drives down returns and largely removes the benefits of acquiring such debt. As a result, those who invest in tax havens cannot earn supranormal returns from doing so. This competitive process implies that there is no unfair advantage to be had by investing in tax havens.

Would it be wise to limit the deductibility of domestic expenses, such as interest, for firms with significant foreign investments? Certainly it makes no sense to single out investments in tax havens for this purpose, since the use of tax havens is part of the ordinary international investment process. One might limit interest deductibility for all foreign investment, but doing so has the effect in practice of distorting the ownership of capital assets away from their most productive uses.

The problem is that foreign countries do not permit deductions for interest expenses that home countries deny. As a result, denying home country deductibility of interest expenses incurred for foreign investment would discourage foreign investment relative to domestic investment and thereby reduce the productivity of business enterprises in Canada.

The fact that a rising share of Canadian foreign investment is going through foreign tax havens is not actually relevant to the issue of interest deductibility. There are two reasons why not.

First, this is largely a holding company phenomenon; the vast bulk of what is called tax haven income is earned and taxed in countries other than tax havens.

Second, the competitive process implies that even income that is earned in tax havens is implicitly taxed by foreign competition that lowers pretax returns available there. As long as you tax purely passive foreign income on financial assets that are parked in tax havens, there is no need to limit domestic interest deductibility.

International business is a critical component of any wealthy economy in the world today. Limiting the interest deduction for foreign investment has the unfortunate effect of distorting investment patterns. Ultimately, the cost of imposing heavy tax penalties on foreign investment is borne by domestic workers in the form of lower wages as their economies become less productive.

[The Chair, Conservative, Brian Pallister]

Thank you, Mr. Hines.

Roger Martin is with us by video conference. He is the dean of the Rotman School of Management.

Mr. Martin, we invite you to proceed. Thank you.

[Dr. Roger Martin, Dean, Rotman School of Management, University of Toronto]

Thank you, Mr. Chairman.

I'm going to take a little different tack from what I'd planned coming in here, because I don't think repeating what these very smart individuals have already said makes any sense. I agree with Mr. Pantaleo, Mr. Raizenne, and Dr. Hines on what they've said.

Maybe I'll just step back and ask, what is the context that I would encourage the committee to take as the setting in which all of this is happening? We've seen, in the last 25 years, a massive globalization of the business world, so lots of corporations are globalizing, operating in more countries, and facing situations where they are operating under very different tax jurisdictions. As was pointed out, there are many more tax treaties than there used to be and all sorts of complicated rules.

What's happening is that the opportunity for international tax arbitrage is increasing dramatically, and companies--wisely, as Dr. Hines has said--in the interest of being as efficient and effective as they can be, are being much more sophisticated than they would have been 25 years ago on this front. That's not going to change. If anything, they're going to get more sophisticated as more opportunities arise.

The big question for Canada is what's the incentive that we create for these companies to be more aggressive rather than less on international tax planning? I think the fact that we are an exceedingly highly taxed jurisdiction as it relates to corporations is the root issue we should be looking at. So I think this is why the corporations right now are very upset with this particular measure. It's not because it's crazy; it's an attempt to get more neutrality in the tax system. But any tax that increases for us, to make us an even higher corporate tax jurisdiction, will hurt our corporations and cause them to come and object to this.

I think we will have these kinds of challenges in trying to get neutral tax regimes on the corporate side as long as we have, along with Germany and the U.S., the highest marginal effective tax rates on corporate income in the world. I think that's what the committee should be paying attention to, the need to get that rate down considerably, because right now we have a tax system that, overall, discourages corporations from making investment. The result is that corporations invest less in Canada in machinery and equipment than they should to make themselves more productive. That is the bigger question, not the question of particular measures of interest deductibility.

Thank you very much.

[The Chair, Conservative, Brian Pallister]

Thank you very much, Dean Martin.

We'll conclude with Finn Poschmann from the C.D. Howe Institute. Welcome, Finn.

[Finn Poschmann, Director of Research, C.D. Howe Institute]

Good morning, Mr. Chairman and members of the committee. Thank you for inviting me back. I'm only sorry I can't be there in person.

One great thing about being down the batting order is that the key background information is all on the table and I can get straight to the meat of the matter. Of course the meat is the question of interest deductibility with respect to debt incurred for investments in foreign affiliates. Today it's framed as dealing with tax havens, but nonetheless that's the issue.

On this, I have a very few simple points. The first one is that the world has changed a lot in the past 35 years since the current framework for international taxation was put in place. The big change is in the size and the direction of investment flows. Canada has historically been very dependent on investment capital flowing in from abroad, but it's quite different now. Data released just yesterday from Statistics Canada will show you that for ten years now Canadians' foreign-directed investment abroad has exceeded foreigners' investment here. That's a big change.

At the same time, the complexity of the transactions has grown. Multinationals now more commonly steer investment through low tax jurisdictions and pursue other advanced international tax strategies. This has given rise around the world to concerns about threats to national tax revenues.

Now, Minister Flaherty perceives such a threat in Canada, and it's reasonable that he should. To see why, let's consider how Canada does things compared to our G-7 partners.

Canada generally permits dividends from foreign affiliates to be patriated, to come back to Canada tax-free or exempt, on the assumption that it's already been taxed in the foreign jurisdiction, which is often a low tax jurisdiction. Keep in mind that there is a difference between a low tax jurisdiction and a tax haven.

Now, dividends that are not exempt would generally be taxable in Canada, with a credit for tax actually paid in the foreign jurisdiction. That's the general picture in all G-7 countries. Either foreign source income is taxable, with a credit, or it comes in exempt. But what about the flip side--the big question about interest deductibility with respect to those investments and affiliates? This is where Canada probably stands out a little, with fairly loose limits, and this has led many multinationals to book debt in Canada without bringing economic activity with it--reducing their Canadian tax liability--and that is what has attracted the minister's attention.

Professor Hines made a few superb points on whether or not this is something we need to worry about. But clearly the minister is worried about it and has proposed a course of action for dealing with it. The question is what to do about it, and when I said that Canada had very loose rules with respect to interest deductibility, that is not to say other countries necessarily have very tight ones. There are lots of rules, lots of very different rules, but they generally all do have rules on interest. The difference is that none of them, none of the G-7 countries, have a simple blanket denial on interest deductibility. Whether you're looking at France, Germany, Italy, or Japan, interest deductibility is key to the ratio of debt to assets or to equity, or limited as a percentage of earnings, but there's no simple denial.

This, of course, is what has Canadian businesses worried, worried because the minister's proposal is more restrictive than what their international competitors will face. For instance, a German firm could still route investments through the Netherlands when buying assets in the United States, enabling that firm to raise capital at a lower cost than the Canadian firm bidding for the same assets. This means Canadian firms absolutely will have a tougher time expanding in global markets, will face a higher cost of capital, and will have a harder time reaching scale efficiencies, delivering good value for money in the domestic market.

But there's more. When Canadian firms invest in foreign affiliates through offshore entities, they build trade flows with other foreign jurisdictions that their alternate investments flow to. So more trade means more business in Canada. In other words, the international financial system, and the tax system that goes with it, help build the Canadian economy, not just others.

So all this is to say that the minister is right when he says that the international tax system needs a look at. There is no question that many businesses' tax structures are finely tuned to take advantage of differences between countries' tax rates and tax systems. There is no question that part of the issue for Canada is the rules on interest deductibility. What there is a question about is whether the budget proposals are the right ones, or whether better options, such as lower tax rates or better-tuned rules on interest deductibility, would be the shrewder course. I think that's what we need to be looking at.

Thank you.

[The Chair, Conservative, Brian Pallister]

Thank you very much, Mr. Poschmann. Nice to hear from you again.

We'll begin our questions now with Mr. McKay. Mr. McKay, seven minutes.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Thank you, Chair.

Thank you all for your very good presentations.

I was particularly struck by Mr. Raizenne's testimony, in which he said that we have 86 bilateral tax treaties. It was a 14-year process to work out the taxes that we currently have. It's a very complicated and layered set of rules. We have a general anti-avoidance rule, the rule of all rules, if you will.

So you have what is a very sophisticated, competitive system. Then you have the budget dropping a bomb into the system by saying “cracking down on corporations that have avoided paying their fair share of taxes by using tax havens”. Well, “cracking down” appears to be pejorative; use of “tax havens” appears to be pejorative; “have avoided paying their fair share of taxes”, again, is pejorative. Then further on, to expand it, it says “by eliminating the deductibility of interest incurred to invest in business operations abroad”.

This is a very peculiar way to go about addressing what I hear all the witnesses say may be something of a problem. I was therefore struck by Mr. Pantaleo's testimony that surely to goodness you would consult about this before you drop this bomb onto the tax system.

I would put it to all the panellists. If in fact we could wind this thing back, what would be your advice to the minister, in terms of how you would structure a panel and what the questions might be that the panel might look at, and would you include an economic analysis of the puts and takes, the benefits, and also the liabilities that flow from it, as Mr. Poschmann said, and increased trade flow and other economic opportunities that Dr. Hines referred to?

I'd be interested in asking you how you would see a proper analysis being done of this apparent issue.

[Robert Raizenne]

I'll take the first cut at that.

I would have thought we'd go back to the way things used to be done, which is that we used to have a white paper process on the finance side. I would have thought that what might have been good would have been to strike a panel to consider this over some period of time. I don't think that necessarily needs to be a very long time, but that what we would get from that panel is a white paper presentation as to what they think should be done.

Then there would then follow some sort of consultation process, whereby there would be public debate as to the pros and cons of the recommendations that had been made.

I just want to make one other point, which is this issue of how tax policy interacts with competitiveness. This is a very difficult issue. It's a very complicated issue. I really think that it's an issue that needs to be aired fully, and it is really dealt with in the budget documentation in a very cursory and offhand fashion.

[The Chair, Conservative, Brian Pallister]

Just for the teleconference participants, I will generally leave it to the committee members to chair their own section of time. So this would be Mr. McKay's responsibility at this point, as to who he wishes to—

[John McKay, Liberal, Scarborough—Guildwood, ON]

It could be either Mr. Poschmann or Dean Martin. I'd be interested in hearing what they have to say.

[Dr. Roger Martin]

Sure. I'll lead off.

I just want to second Mr. Raizenne's comments. I really think that if you were going to set up a panel to think about this, the fundamental question before them should be how to create an internationally competitive corporate tax system for Canada. Ours now is uncompetitive, and dramatically so. It is one of the most unattractive corporate taxation systems in the world. That's not where we want to be. I think it's so critical for competitiveness that I would take that as a general question, not a specific narrower question about interest deductibility.

[John McKay, Liberal, Scarborough—Guildwood, ON]

I address this to all of the panel. What are, in your view, the unintended consequences of proceeding in the fashion the minister has chosen, namely to make this pretty bald statement in the budget? What is the reaction of business or economists to proceeding in that fashion?

Dr. Hines.

[Prof. James R. Hines, Jr.]

Moving in that direction, I agree with Dean Martin: you're already starting from a situation where Canada's tax system, by the standards of the world as a whole, is not terribly competitive. You would be moving in the opposite direction, in the wrong direction, making it less competitive.

What would that mean? It would mean that Canada would be a less attractive home for multinational firms, number one. Number two, even the firms that are here will wind up less productive in the long run, so you wind up with lower national incomes. I don't understand why a country would want to go in that direction.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Are there any others who want to pick up on that?

[Nick Pantaleo]

If I could, there is also an immediate consequence to the proposal, which is just the general uncertainty that it creates in the current environment. There are a number of transactions that are dependent upon the ability to deduct interest. Indeed, a number of investments would have been made and economics determined on the basis of interest deductibility. This puts a significant monkey wrench into all of that. There's an immediate issue about dealing with the period of time we're in right now.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Is that an anecdotal view on your part, or is that direct evidence and within your personal knowledge?

[Nick Pantaleo]

It's within my personal knowledge. In fact, I have clients who had deals going the next day that had to be stopped because they were not sure just how the budget proposal was going to affect them. It was that significant to their transactions.

[The Chair, Conservative, Brian Pallister]

Mr. St-Cyr, you have seven minutes.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

Thank you, Mr. Chairman.

I suppose everybody will agree that today's topic is very complex and difficult. I suppose that it is also the reason why we have lost all the students who were here at the beginning of the meeting.

I would like to deal with the issues separately. We have heard people talking about productivity and about tax evasion as if they were linked but they are two different things. Of course, it is obvious that corporations will always become more productive when we reduce their tax obligations but it is a totally different matter. The tax rate of Canadian corporations affects their productivity. However, there has to be some balance.

When we talk about rules allowing corporations to escape from local tax rates, it obviously makes them more competitive but only because they do not have to submit to local rules or because they find ways to avoid paying tax. We have heard recently in this committee about the double dipping issue which allows some corporations to deduct twice or more the same interest from the taxes that they have to pay.

Do you think it is acceptable? As far as interest deductibility is concerned, I seem to understand that nearly everybody is in favor but do you think it is acceptable? Do you think it is a good thing that corporations can practice double dipping, triple dipping and so on? If it is not acceptable, is there a way for us to identify those cases and, ultimately, to prevent or control that?

[Robert Raizenne]

Again, I'll take the first stab at answering that question.

I think it's important to understand that the fundamental way in which the international tax system works is effectively comity, which is an international principle to the effect that we do what we want here and foreign countries do what they want to do in their own jurisdiction. When we mix up notions of avoidance and evasion and low tax rates, I think we're missing the fundamental point, which is that it's the right of the sovereign country where the income is earned to maintain its own tax system and to determine what its tax rate should be.

If in Canada we chose to cut corporate tax to let's say 25%, how would we feel if a foreign country intervened and said “That rate is too low, so we're going to jack it up”?