Archived - Backgrounder
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Draft Legislative Proposals Relating to
the Income Tax Act and Income Tax Regulations
To protect Canada’s tax base and to respond to three Federal Court of Appeal decisions, the proposed changes to the income tax rules would clarify:
- that, if a taxpayer (or another taxpayer who does not deal at arm’s length with the taxpayer) has a right to reduce an amount in respect of an expenditure, the amount of the expenditure shall be considered for income tax purposes not to exceed the least amount to which it can be reduced under the right. For greater certainty, this treatment will also apply where the right is contingent upon the occurrence of an event, or in any other way, if it is reasonable to conclude that the right will become exercisable;
- that withholding tax under Part XIII of the Income Tax Act will apply (subject to the application of Canada’s tax treaties) to interest paid or credited by a person who is resident in Canada (the payer) to any non-resident person in respect of a debt that is owed to a non-resident person who does not deal at arm’s length with the payer; and
- the rules for computing a life insurance corporation’s segregated fund policy reserves.
Descriptions of each of these decisions and the related proposed amendments are set out below.
Collins v. The Queen, 2010 FCA 12
The Income Tax Act (the “ITA”) provides that taxpayers who earn income from a business or property may deduct expenses incurred for the purpose of earning that income on an accrual basis. In general, such expenses and outlays of a current nature that become “payable” in a taxation year are deductible in computing income for that year, regardless of whether the expense or outlay is paid only in a subsequent taxation year. A similar principle applies in respect of the cost of a capital outlay.
An amount is considered to be “payable” by a taxpayer under the ITA in a taxation year if the taxpayer is legally obligated to pay a fixed and ascertainable amount in respect of that year. An existing provision of the ITA (paragraph 18(1)(e)) expressly precludes any deduction in respect of an expense or outlay as, or on account of, a “contingent liability or amount”. This limitation applies if the liability to pay the amount, or the amount to be paid, is “contingent” on the happening of some future event. The Collins decision has adverse implications with respect to the application of this rule.
In Collins, two taxpayers deducted accrued, but unpaid, interest expense even though they had an existing right to satisfy their interest obligations by electing to pay a substantially lower amount of interest. The Federal Court of Appeal found that it was not the original obligation to pay the interest that was contingent, but that it was each taxpayer’s subsequent decision to exercise the option to pay the lower amount that was contingent. Accordingly, the effect of this decision was to allow for interest payable under the original obligation to be deducted in computing income even though both taxpayers had a right to elect to pay a lower amount.
In response, and in general terms, the Government proposes to clarify through amendments to the ITA that the amount of a taxpayer’s unpaid expenditure otherwise deductible for income tax purposes does not include an amount in respect of which the taxpayer, or a person that does not deal at arm’s length with the taxpayer, has a right to reduce or eliminate. For greater certainty, this treatment will also apply where the right is contingent upon the happening of another event, or in any other way, if it is reasonable to conclude having regard to all the circumstances that the right will become exercisable. In the Collins case, this would mean that the interest payable under the original obligation in excess of the lower amount that the taxpayer could elect to pay would not be deductible for income tax purposes unless and until it was actually paid.
This proposal is to apply in computing income for taxation years that end on or after Announcement Date.
Lehigh Cement Limited v. The Queen, 2010 FCA 124
The Lehigh decision concerns a Canadian corporation that was part of a foreign-based multinational group. It had a loan outstanding to a non-resident member of the group and Part XIII withholding tax was payable on interest paid on the loan. In 1997 the right to receive interest payments on the loan was sold by the non-resident member of the group to an arm’s length Belgian bank, but it continued to hold the principal portion of the debt. The issue before the Federal Court of Appeal was whether, in this situation, the general anti-avoidance rule applied to impose Part XIII tax on interest paid to a non-resident person that dealt at arm’s length with the Canadian payer, if the principal amount of the debt remained with a non-arm’s length non-resident. The Federal Court of Appeal held that it did not.
Canada imposes withholding tax on interest paid by a resident of Canada to a non-resident that does not deal at arm’s length with the payer. The imposition of withholding tax on interest paid to non-residents represents the exercise by Canada of its right to tax income arising in Canada. However, Canada has exempted from tax payments of interest made to arm’s length non-residents in order to give Canadians improved access to international capital markets and to lower their borrowing costs. The sale by a non-arm’s length non-resident of the interest portion of a loan to a non-resident that deals at arm’s length with the payer in order to avoid withholding tax is not consistent with these objectives, since the debt is still held by a non-arm’s length party and the borrowing cost for the resident of Canada is unchanged.
Accordingly, it is proposed that the ITA be amended to clarify that withholding tax under Part XIII of the ITA will apply (subject to the application of Canada’s tax treaties) to interest paid or credited to a non-resident (whether the non-resident person deals at arm’s length with the payer of the interest or not) on a debt owed to a non-resident that does not deal at arm’s length with the payer. This proposal is to apply to arrangements put in place on or after Announcement Date.
The Queen v. National Life Assurance Company of Canada, 2008 FCA 14
The National Life Assurance Company of Canada decision determined that certain policy reserves may be computed without reference to any liabilities of an insurer in respect of a segregated fund other than liabilities in respect of an obligation on the part of a life insurer to make a guarantee payment.
It is proposed that the Income Tax Regulations be amended, in response to the Court decision, to ensure that policy reserves computed under sections 1404 and 1405 of the Income Tax Regulations are computed excluding only the reserves of the insurer in respect of a benefit that is payable to a policyholder from a segregated fund. This proposal is to apply to the 2012 and subsequent taxation years.