Proposed changes to cross-border financing.
The budget of Monday, March 19, 2007 included several measures which would affect cross-border financing and the taxation of foreign affiliates. It is proposed to virtually eliminate interest expense incurred with respect to the investment in foreign affiliates. On a positive note, taxpayers can expect the elimination of withholding tax on interest paid between residents of Canada and the United States.

The deductibility of interest and other borrowing costs on money borrowed to invest in foreign affiliates would be severely restricted. Interest on money borrowed to invest in a foreign affiliate is currently deductible, even if dividends from the affiliate are exempt from tax in Canada.

Interest on money borrowed to invest in a foreign affiliate will be broadly defined and will include borrowed money used to acquire a share or debt of a foreign affiliate of the taxpayer or a non-arm’s length person or to lend to or contribute to the capital of such a foreign affiliate. The proposal also applies to an amount payable for property that is a share or debt of such a foreign affiliate. It will also include borrowed money that may reasonably be considered (having regard to all the facts and circumstances) to have been used to assist, directly or indirectly, a non-arm’s length person or partnership to invest in a foreign affiliate. That would presumably apply to prevent the use of Canadian intermediaries to facilitate the investment. In addition, a specific anti-avoidance rule is proposed that will apply to amounts payable that may reasonably be considered to be in connection with a transaction or event or series of transactions or events a main purpose of which was to avoid the application of the proposed rules.

The disallowed interest expense will be pooled and carried forward and may be deducted to the extent the taxpayer recognizes taxable income from the investment through foreign accrual property income (FAPI), interest on indebtedness owed by the foreign affiliate or taxable capital gains from the disposition of shares or debt of the foreign affiliate. However, it appears that the interest may not be deducted until the taxable income from the investment exceeds non-taxable income from the investment such as exempt surplus dividends and deductions for foreign accrual taxes. The disallowed interest pool will be eliminated if control of the taxpayer is acquired.

These proposals can be expected to have a significant impact on the ability of Canadian companies to compete internationally, and it is expected that there will be considerable protest from the business community.

Changes to FAPI and surplus rules
Currently, Canadian rules provide an exemption for dividends paid out of exempt surplus of a foreign affiliate. Exempt surplus generally includes active business income earned in a country with which Canada has a tax treaty. Dividends paid out of taxable surplus are included in income with an effective credit in respect of foreign taxes paid. Taxable surplus includes, among other items, active business income earned in countries with which Canada does not have a tax treaty.

In light of the proposed restriction on interest deductibility, the budget proposes to extend exempt surplus treatment to non-treaty countries, but only those countries with which Canada has entered into a tax information exchange agreement (TIEA). However, if the other jurisdiction does not agree to enter into a TIEA within 5 years of being requested to do so by Canada, income earned in that jurisdiction will be taxed in Canada on an accrual basis as FAPI, which is punitive compared to the current treatment as taxable surplus. In the case of circumstances where Canada is already in the process of negotiating a TIEA with a country, taxation as FAPI will only occur if the TIEA has not been completed before 2014.

The budget also proposes to restrict a foreign affiliate’s ability to earn deemed active business income on certain transactions with related parties. For taxation years of affiliates that begin after 2008, income earned by a foreign affiliate from certain transactions with related non-residents, such as loans, royalties, rent and factoring income, will be included in FAPI unless the payor is a foreign affiliate of the taxpayer in which the taxpayer has a “qualifying interest” (generally shares representing a direct or indirect interest of 10% of the votes and value of the payor).

An extensive package of draft legislation to amend the foreign affiliate rules has been outstanding for several years. To some extent certain of these proposals could be viewed as inconsistent with the budget proposals. The budget documents state that these proposals will be reviewed and evaluated in the light of the budget measures “to ensure the appropriate functioning of the system at a technical as well as a policy level”.

In addition, the Minister will create an advisory panel of tax experts with a view to “identifying additional measures to improve the fairness of Canada’s system of international taxation”. The panel will be asked to make recommendations for consideration in the 2008 budget.

Canada-U.S. treaty negotiations
The budget contains some good news for taxpayers. It announced that an agreement in principle has finally been reached on changes to the Canada-U.S. tax treaty, with formal negotiations expected to be concluded in “the very near future”. As expected, the parties have agreed to eliminate withholding tax on payments made to arm’s-length lenders. This will occur as of the first year after which both countries have signed and ratified the new treaty. U.S. negotiators have also succeeded in obtaining a phased elimination of withholding tax on interest paid to non-arm’s length lenders, an idea long resisted by Canada. For the first year after the treaty is ratified, the withholding rate will be reduced from 10% to 7%; in the second year the rate will be 4% and in the third and subsequent years the rate will be 0%.

Once these phased reductions are in effect, the government has stated that it will eliminate all domestic withholding tax on interest paid to arm’s-length lenders, regardless of their country of residence.

The government also announced that agreement in principle has been reached, as expected, to extend treaty benefits to U.S. LLCs. There will also be harmonization of the tax treatment of pension contributions in Canada and the U.S. and new rules to clarify the treatment of stock options.

Income Tax Act to allow phased-in retirement
To provide more flexibility to employers to offer phased retirement programs, and to increase the reward to older workers from fulltime work, Ottawa is proposing to amend the Income Tax Act regulations to allow an employee to receive pension benefits from a defined-benefit registered pension plan, and simultaneously accrue further benefits.

The new regulations will allow employers to offer qualifying employees up to 60% of their accrued defined benefit pension, while accruing additional pension benefits on a current service basis in respect of their post-pension commencement employment.

To ensure that this measure has a positive impact on labor supply, it will be limited to employees who are at least 55 years of age and who are otherwise eligible to receive a pension without the plan imposing an early retirement reduction.

The 60% limit will be based on the amount of pension benefits that would be paid from the plan if the employee were fully retired.

There will be no requirement that the partial pension be based on a reduction in work time or that there be a corresponding reduction in salary.

Higher age limits for Registered Plans
Ottawa is proposing to increase the conversion age for RRSPs, RPPs and deferred profit-sharing plans to 71 from 69. Changes in the 2007 budget would affect the 2007 and subsequent calendar years. This reverses a change made in the 1996 federal budget, which lowered the conversion age limit from 71 to 69.

The extra two contribution years will allow clients to contribute a maximum of $19,000 in 2007 and $20,000 in 2008.

The measure will benefit individuals who turn 69 in 2007, when no further contributions or benefit accruals would have been permitted under such plans, and the benefits transferred to a registered retirement income fund, or used to buy a qualifying annuity.

The measure will also benefit individuals who turn 70 or 71 years of age in 2007. If contribution room is available, RRSP contributions will be permitted in 2007 and 2008 for 70-year olds, and in 2007 for 71-year olds.

In addition, the requirement for a specified minimum amount to be withdrawn from a RRIF will be waived for 2007 and 2008 in the case of RRIF annuitants who turn 70 in 2007, and for 2007 for RRIF annuitants who turn 71 2007.

Notably, a RRIF annuitant who is 71 or younger at the end of 2007 will be able to reconvert the RRIF to an RRSP, as long as the re-established RRSP is converted to a RRIF before the end of the taxation year in which the individual turns 71.

Existing registered plan annuities can be amended without adverse tax consequences. As well, employers will be allowed to amend their RPPs to allow continued benefits and contributions for employee-plan members who are 71 or younger at the end of 2007.

Ottawa to get tough on tax havens
The government intends to crack down on offshore tax avoidance through a mixture of new rules, improved co-operation with other jurisdictions, and stronger audit and enforcement efforts by Canada Revenue Agency.

The government is planning to add $15 million to CRA’s budget in 2007-2008, and a further $50 million in 2008-2009 to aid its beefed-up auditing and enforcement efforts. The focus of these resources will be in enforcing the tax system for the reporting of foreign income and cross-border transactions. Particular emphasis will be placed on transfer pricing transactions and complex international tax avoidance cases.

Some of the government’s enforcement efforts will also be focused on verifying and collecting taxes owing on income and sales generated in Canada. These resources will be used to find and challenge taxpayers participating in aggressive tax shelters, who fail to report all of their income, or who have made unsubstantiated GST/HST refund claims.

Additionally, the Department of Finance plans to create an advisory panel of tax experts to study international taxation issues, and look for other ways to ensure fairness. The panel will be asked to provide detailed recommendations to the government for consideration in next year’s budget.

Lifetime capital gains exemption expanded
The budget proposes increasing the lifetime capital gains exemption to $750,000. The income tax system currently provides a lifetime capital gains exemption on up to $500,000 of capital gains realized on the disposition of qualified farm and fishing property or qualified small business corporation shares.

However, this increase falls far short of the federal Conservative’s 2006 campaign promise to permit tax deferral on gains reinvested within six months. Tax experts have urged the government to follow through on this promise.

Global credit growth poses challenge for banking systems
Sustained high global credit growth is stretching an increasing number of developed country banking systems, including Canada’s, and remains a concern, says Fitch Ratings in a new report.

Median real global credit growth was sustained at over 11% last year -- its highest since the eve of the Asian crisis in 1997” says Richard Fox, senior director in Fitch’s Sovereign team. “This has raised vulnerability to potential bank systemic stress, as measured by Fitch’s Macro-Prudential Indicator.”

He adds that 70% of developed country banking systems now exhibit ‘moderate’ or ‘high’ vulnerability to potential stress compared to only half of emerging market systems. “However, developed country banking systems are also judged by Fitch as generally ‘strong’ and therefore in a better position to weather adverse shocks, while emerging market systems are, with some notable exceptions, typically ‘weak’ as measured by Fitch’s Banking System Indicator,” Fox adds.

Iceland remains in the highest risk category and continues to exhibit the most extreme indications of potential stress, Fitch said. Although an adjustment process is underway and lending growth has slowed, private sector credit still rose by more then 63% of GDP last year, it noted.

Credit-to-GDP has also continued to rise rapidly in Ireland, Spain and San Marino, but these countries are in the moderate risk category since real exchange rate and asset price trends do not exceed the trigger values Fitch uses to assess heightened risk levels.

By contrast, Australia and Canada do exhibit this combination of conditions - though to a much less extreme degree than Iceland, Fitch said, and move into the riskiest category. “Australia and Canada are examples of developed countries where the real exchange rate has been sufficiently above trend to trigger its riskiest designation since 2004 and 2005 respectively. But the acceleration of credit growth has been more gradual, only rising more than 5% above trend in 2006,” it says, noting that credit growth has been more sudden in Canada, rising by over 13% of GDP in 2006.

“However, all six of these developed countries have ‘strong’ or, in Australia’s case, ‘very strong’ banking systems, as measured by Fitch’s Banking System Indicator. This measures intrinsic banking system quality or strength and needs to be judged alongside the MPI in gauging overall bank systemic risk. Strong banking systems - as found in almost all developed countries - are better able to deal with the potential stresses that Fitch’s macro-prudential analysis aims to identify,” it says.

A noteworthy change amongst updated Banking System Indicators is the strengthening in China’s banking system to BSI ‘D’, due to financial reforms, strengthened capitalization, reduced non-performing loans and strong economic conditions. Half of all emerging market banking systems are to be found in this category, which nevertheless exhibits significant weaknesses compared to international peers.