Finance Committee on May 15th, 2007

[Brian Ernewein]

I believe the issue of interest deductibility has been examined on a number of occasions. The Auditor General had occasion to mention it specifically with some detail in 1992 and 2002. The technical committee on business taxation, the so-called Mintz committee, looked into it and made recommendations on it in 1997. Perhaps the report was released in early 1998.

From a tax policy perspective the issue is the balance one strikes between what some would describe as competitiveness and neutrality or fairness, and whether or not one should provide an interest deduction for foreign investments when the underlying income is not subject to tax. In the material put out by the minister yesterday, the balance is that interest will be allowed to be deducted in Canada for foreign investments, but it won't be allowed where that Canadian deduction essentially represents the second deduction supplementing one taken outside of the country.

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

Starting with the macroeconomic issue, at one point in the 1970s Canada received more foreign direct investment than it put out. Then around 1996 the trend reversed and we now actually buy more from them than they buy from us.

You made reference to the Mintz committee. It was presumably working on the historical data prior to about 1999. Has the department done an update to look at how the environment has changed between 1997-98 and 2007? Did that form any of the basis for the minister's positioning in the budget?

[Brian Ernewein]

Certainly changes have occurred to the tax system and the economy generally in that time. One change in particular that I would point to is the rather dramatic reduction in our tax rate since that report was issued. I made the comment before a committee hearing on another matter in the past couple of weeks that within a couple of years' time, our tax rate will be 50% lower than it was at the time of the technical committee's work.

Now, I don't want to take up your time, Mr. McKay, but I think that can get into the point of whether, in the situation when you're talking about a double-deduction scenario, the prior or the given is that the first deduction would be taken in Canada or in another jurisdiction. If we're getting our tax rates down, then I think one can say, in a single-deduction scenario, it's more likely that the deduction will be taken in the other country, which means that the extra deduction is being taken in Canada, thus costing our tax base and affecting revenues.

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

That was actually one of the criticisms of those who were looking at the minister's statement yesterday, that effectively the latest incarnation of this particular initiative will actually enhance revenues in foreign jurisdictions and won't make any difference, or will reduce revenues, in the Canadian jurisdiction.

You have to ask yourself, how does that make any sense at all?

[Brian Ernewein]

I was anticipating the question. Let me speak to it more directly.

The assumption or the premise in those sorts of contentions is that the deduction in Canada is a given and the deduction in the foreign country is the gravy. I think that's not immune to challenge.

To take our example, our major trading partner, the United States, has a statutory tax rate that will be roughly five points higher than Canada's. In that circumstance, if you're allowed to take an interest deduction on a borrowing for a U.S. investment and you have to choose to make it in Canada or the U.S., then all other things being equal, I'd suggest you would make it in the U.S., where the tax deduction of the interest will be worth 35¢ on the dollar versus 31.5¢ on the dollar in Canada in a couple of years' time. On that view, the extra deduction is the Canadian one.

I think you heard Roger Martin suggest that we have more work to do in relation to our tax rates, that we are in good shape, perhaps because the United States has a relatively high tax rate, but that we're not better than everywhere else in the world, or better than everywhere else in the industrialized world. However, with the type of strategy that gets our tax rates down—we're targeting to get ourselves at the bottom of the G-7 tax rate structure—that sort of analysis has more traction and leads you to the view that the deduction will be taken generally, all other things being equal, in the country where the investment is made rather than in Canada.

[The Chair, Conservative, Brian Pallister]

Thank you very much, sir.

Mr. Crête, you have seven minutes.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Thank you, Mr. Chairman.

Thank you for coming.

In 2002, the Auditor General made the following observation regarding the Department of Finance:Tax arrangements for foreign affiliates have eroded Canadian tax revenues of hundreds of millions of dollars over the last 10 years.

Also, let me quickly read out recommendation 11.114:To protect the integrity of the tax base, the Department of Finance should obtain and analyze current information to reassess the tax revenue impact and the rationale ofallowing foreign-owned Canadian corporations to deduct interest on borrowed funds related directly or indirectly to investments in foreign affiliates, andallowing tax-privileged entities in treaty countries to bring income into Canada tax-free.

The Auditor General told us that you still have not answered this question. Could you tell us whether you have the information that she asked for? Do you intend to respond to this request made by the Auditor General?

[Brian Ernewein]

I believe we did provide a departmental response to the Auditor General in relation to the 1992 and 2002 reports. It does boil down, at its most fundamental, to a policy question for Parliament as to whether we should have an exempt surplus regime where we do or don't impose an additional Canadian tax on the active business income generated by foreign affiliates of Canadian companies.

The considerations that I think have led to the development and the institution of an exemption system in Canada are to, first, not tax the profits as a matter of international competitiveness, and second, not impose a tax on their repatriation to Canada, to make it more neutral and to facilitate the payment of the profits back to Canada.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

But, sir, do you have any figures? Can you tell us where the Auditor General's request stands today? For the past, current or coming fiscal year, what are your real figures or your estimation of the impact of this motion? Can you give us a summary of your analysis of this matter? At present, we know that a sum of $4 billion is being transferred from tax treaty countries tax-free. Could you give us a summary of what your department knows about this issue?

[Brian Ernewein]

Thank you very much for the question. We do not have the numbers today on the dividends being paid out. We saw that you raised this question with the Canada Revenue Agency when they were here last week, and we are trying to find some numbers on that front.

We do have some Statistics Canada information on the total levels of Canadian direct investment in various countries. I can give you my copy later if you're interested, or refer you to the location of that.

But I want to emphasize, in addition to answering your question directly, that I don't believe it's right to suggest that whatever the dollar value of dividends coming back from foreign corporations or foreign corporations in a particular country may be, you can simply apply a Canadian tax rate to that income to determine a revenue loss number.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

The Auditor General asked you for this in 2002. Five years later, you still have not responded. This morning, we heard about a tax credit that people could get for these dividends. The company receives tax-free money and the taxpayer is entitled to a tax credit on tax-free money. Do you have any figures for the tax credits awarded for these dividends? Surely, you must know how much they amount to.

[Brian Ernewein]

I don't believe we have the information to give you today on the actual amount of dividends on a per country basis. We are trying to get that, and assuming we're able to pull that together we will provide it.

I don't believe it's correct to suggest that multiplying the amount of the dividends by a Canadian tax rate would represent the amount of Canadian tax revenue involved. If one were to tax the profits from active business operations generated by foreign affiliates of Canadian companies in treaty companies, the likely result would be what we've seen in other countries that operate a foreign tax credit system--that the income wouldn't be paid back to Canada.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Due to the fact that you are not giving us certain pieces of information, we have to make estimations based on the information that we have. In that sense, the department is still vague about the available information. On the international level, you know, for instance, how the fiscal system in the United States works with regard to dividends. Have you evaluated Canada's need for changing its tax system? Do you know whether it would be better to replace our model, which involves a tax treaty, with a system like the one used by the United States or Japan? Do you have an opinion about this issue?

[Brian Ernewein]

On the considerations that inform whether we have an exemption or credit system, with an exemption system we end up having a neutrality between us and other foreign competitors in relation to foreign investment. We don't have an additional Canadian tax, current or deferred, that'll apply to Canadian investors carrying on foreign operations. The counter to that is we lose neutrality in relation to the taxation of Canadian income versus the taxation of this foreign income.

The system Canada has had in place with treaty countries for approximately 35 years is an exemption system. We won't impose any current tax, and we won't impose any tax on the income when it's brought back.

Other countries, including some of the largest countries in the world--the U.S., the U.K., and Japan to a considerable extent--have the same deferral opportunity. They do not tax foreign business income of their companies' foreign affiliates as it is earned. It remains non-taxable by the U.S. as long as it's left outside of the country. If and when it is returned to the country it is subject to tax, with a credit for any underlying tax.

If the foreign affiliates of those U.S. companies, for example, invest outside of the U.S. and generate business income outside of the U.S., they are able to leave that income offshore free of U.S. tax. But when they bring it home they are subject to a potential 35% tax. That has led many U.S. companies to not bring the income home, and a couple of years ago there was what could be described generally as a tax amnesty by the U.S. to have companies bring the income home so it could be employed in the United States.

[The Chair, Conservative, Brian Pallister]

Thank you, Monsieur Crête.

Mr. Wallace, seven minutes.

[Mike Wallace, Conservative, Burlington, ON]

Thank you, Mr. Chairman.

Thank you for coming. I appreciate the tax department being here. We had the revenue side last week, which was great. I'm assuming you guys are working together as departments to try to resolve the tax haven issue. You're on both ends of the equation.

One argument that has been made to me came via e-mail from some local constituents. Maybe you could help me out a little bit on this.

The claim, really, is that for Canada to have overall competitiveness, we have to have tolerance for the double dipping and the other structures. That's the only way Canadian companies can be competitive.

From a tax department point of view, do you have any comment on whether that's an accurate statement? Or how do you feel about that?

[Brian Ernewein]

I think there are two levels at which to answer the question. In a mechanical, mathematical, or arithmetical analysis, you can't simply look at the value of the interest deduction....

I'm sorry, I should start further back.

There are some situations in which other countries will allow a double deduction to be taken. This is an international issue in other countries, including the U.S. and others. In our material that we put out yesterday, we provide brief descriptions of it. They are all recognizing that this is a challenge. They're all taking actions to try to deal with it in some manner. But you will find throughout the world other jurisdictions that may allow a double deduction in circumstances where we've proposed to constrain it.

Is that the end of the arithmetical analysis? No, I suggest not. I think, then, one has to go on to determine how, in their circumstance, if they're allowing an interest deduction, that stacks up against our system generally.

I made mention of the U.S. a little earlier. With the U.S. having a statutory tax rate, and a marginal effective tax rate that's going to be a few points higher than our own, then one has to consider whether our overall tax system and tax effects of our system essentially make a firm as well or better off under the general regime without being able to get a double deduction than another country's company that has higher tax rates, for example, or taxation of the income on repatriation to that country but with an interest deduction.

So you have to look at the tax advantage generally. You have to look at the overall business environment. Secondly, Advantage Canada from the fall identifies not only tax advantages but other advantages that Canada is working to build upon.

As a final point, I had mentioned the qualitative assessment or value judgment. Even when one is prepared to take other countries' systems and competitiveness concerns into account and to be very mindful in setting one's own tax policy, I think there's a question about whether there is a point of neutrality and fairness that causes one to ask whether, despite what some other countries might do in particular circumstances, we should allow a double deduction in our own case. The decision reflected in the minister's announcement is that this is where we will draw the line.

[Mike Wallace, Conservative, Burlington, ON]

I have a second question. And by the way, I was here for all the presentations earlier, but I wasn't able to be here for the questioning.

In the report I have in front of me, we talk about the United States, Germany, France, and the United Kingdom as countries that we're using to compare with in terms of international tax avoidance. One of the previous presenters mentioned Australia, which we often look to in order to see if they have similar issues. Could you tell me what's happening with Australia and if they're doing anything different from what we're doing?

My second part to that question is that I think we've committed to a task force to look at this issue. I want to know, in terms of the international marketplace, your view of what that task force should be doing.

[Brian Ernewein]

Perhaps I'll take on the second part of the question and ask my colleague to speak to the first.

On the task force, I expect you're referring to the expert panel that the minister is proposing to set up. There was reference in the budget as well. It's to look at other issues or other possible modifications to the Canadian tax system for international income that might improve the fairness and the competitiveness of the regime.

I might mention one thing as an example. This suggestion has come to us from a number of quarters since the budget as something we should be looking at--and I'll concede that some have suggested we should be looking at it instead of what we're doing while others have said it's something we should be looking at as well as what we're doing. This is the issue of so-called debt dumping, the question of whether there's being too much debt placed by foreign owners of Canadian companies onto the Canadian firms, pointing out--and my colleague will pick up on this--some other jurisdictions and what they do with respect to limitations on the total amount of interest a firm could bear.

So no pronouncements on that, but it seems to us to be perhaps some fertile ground for the panel to look at.

[Lawrence Purdy, Senior Chief, Tax Legislation Division, Tax Policy Branch, Department of Finance]

To answer the first part of your question, the situation in Australia bears many comparisons to Canada on a lot of different fronts, including taxation. Historically, Australia and Canada have operated very similar systems. Indeed, many aspects of the Australian system were patterned on Canada's system.

But over the last 20 or 25 years, the Australians have been quite venturesome in working out how to deal with the kinds of challenges Canada is now faced with. They too have faced those same challenges, as every developed country does. They've moved through different approaches and they've ended up, for the time being, with a very different approach from anything that's currently under contemplation in Canada.

I must interject that I'm by no means an expert on the Australian tax system, so this reflects my understanding of it. But the Australian approach is to apply a limit on deductibility generally with respect not only to foreign investment, but also domestic investment, and to say a limited amount of debt can be used in the financing of a business's subsidiaries, for example, and representing debt in excess of that ceiling is not deductible.

We have a limited form of this rule with respect to inbound investment, in what we refer to as our “thin cap” or thin capitalization rules. But Australia and one or two other countries have taken this concept further and applied it across the board, domestically and foreign, inbound and outbound.

[Mike Wallace, Conservative, Burlington, ON]

Very good. Thank you.

Thank you, Mr. Chairman.

[The Chair, Conservative, Brian Pallister]

Thank you.

We continue with Mr. Pacetti now. Five minutes, Mr. Pacetti.

[Massimo Pacetti, Liberal, Saint-Léonard—Saint-Michel, QC]

Thank you, Mr. Chairman.

Thank you to the witnesses. It's always good to have the finance officials here.

I want to focus on interest deductibility. I'm trying to understand. If CRA were to catch--for lack of a better word--a company double-dipping, they would disallow the deduction. They would not allow the deduction. So I'm not sure why double-dipping is something we're concerned about, because if we're able to catch it, they would deny it, and it would be up to the multinational to prove it wasn't the case.

[Brian Ernewein]

In some situations CRA may be challenging transactions as being too aggressive, and this may reflect on the discussion you had the other day with the agency. But for better or worse, CRA would not seek to challenge under the current law the sort of transaction outlined in the material we put out yesterday and--

[Massimo Pacetti, Liberal, Saint-Léonard—Saint-Michel, QC]

But what would be the difference? Double-dipping is not allowed now. If you found out about double-dipping through whatever mechanism you want to use through your audits, it would still not be allowed. So nothing has changed.