Under the current rules, interest on money borrowed by a corporation to finance investments in its subsidiaries will in most circumstances be fully deductible in computing its income, even where the subsidiary in question is a foreign subsidiary the income of which is not subject to Canadian income tax either at the time that income is earned or when the earnings are repatriated to Canada in the form of dividends.  In a major policy shift, the Government is now proposing to substantially restrict the deduction of interest on money borrowed to finance investments in foreign subsidiaries.

The Budget proposes that interest relating to an investment in a foreign affiliate of a taxpayer will no longer support an immediate deduction.  Instead, the interest expense will only be deductible to the extent that the investment in the foreign affiliate results in income that is taxable in Canada, (either on an accrual basis as foreign accrual property income or "fapi", or to the extent that there is a subsequent inclusion of dividend or interest income (or of taxable capital gains from dispositions of shares or indebtedness of the foreign affiliate) in the taxpayer's income without an off-setting deduction.  Disallowed interest of the taxpayer generally may be carried forward to be used for deduction against future years' income from foreign affiliates, but will disappear on a change in control of the taxpayer.

The denial of the deduction of interest will apply:

• in the case of interest on a debt incurred on or after March 19, 2007 (otherwise than pursuant to an agreement in writing entered into before that date), to any period that begins after 2007
• in the case of interest on a non-arm's length debt (other than a newly-incurred debt described above), to any period that begins after 2008 (or when that non-arm's length debt expires, if earlier)
• in the case of interest on an arm's length debt (other than a newly-incurred debt described above), to any period that begins after 2009 (or when that arm's length debt expires, if earlier) The above non-deductibility rules also will apply to "other borrowing costs," a concept which the Budget Papers do not define further.

The above non-deductibility rules also will apply to "other borrowing costs," a concept which the Budget Papers do not define further.

The Budget also contains rules addressing indirect investment situations and an anti-avoidance rule intended to capture series of transactions.  Any draft legislation to implement these proposals (if they proceed), will inevitably be quite complex.

Withholding Tax on Cross-Border Interest Payments

The Budget announces that Canada and the United States expect formal negotiations on an updated Canada-U.S. Income Tax Treaty to conclude in the very near future.  Under the current Treaty, withholding tax on cross-border interest payments is reduced to a maximum of 10%; the updated Treaty will provide for a full exemption from withholding tax on cross-border interest payments.

For interest paid between arm's length persons, the elimination of withholding tax will become effective as of the first calendar year that begins after the updated Treaty comes into force.  For interest paid between non-arm's length persons, the exemption will be phased in over three years, so that the maximum withholding tax rate will be 7% in the first year following entry into force of the updated Treaty, 4% in the second year and 0% in the third year.

In addition, the Budget proposes that, once the withholding tax exemption under the Treaty on both arm's length and non-arm's length interest comes into effect, Canadian withholding tax will be eliminated on interest paid to all arm's length non-residents, regardless of their country of residence.

Treaty Residence for LLCs

The updated Canada-U.S. Income Tax Treaty will extend treaty benefits to U.S. LLCs.

Expansion of Exempt Surplus

Under the current rules, the most important component of "exempt surplus" (in general terms, earnings that can be paid by a foreign affiliate to Canada without being subject to Canadian corporate tax on foreign-source dividends) is earnings that are traceable to an active business carried on by a foreign affiliate in a country with which Canada has concluded an income tax treaty (Canada has not entered into income tax treaties with most tax haven jurisdictions).

The Budget Papers explain that because the deductibility of interest on the financing of foreign affiliates will now be restricted, it is no longer necessary to link the concept of exempt surplus to the presence of a tax treaty.  The Budget proposes that if a comprehensive tax information exchange agreement ("TIEA") between Canada and another country is in force and has effect at any time after March 19, 2007, that country will be treated as a treaty country for these purposes.

Expansion of Fapi

There is a related incentive to encourage foreign governments to enter into TIEAs with Canada. If a non-treaty country does not agree to a TIEA, generally within five years of being approached by Canada to do so, active business income earned in that jurisdiction by a controlled foreign affiliate will be treated as fapi to the Canadian taxpayer and taxed in Canada on an accrual basis.

The current rules in many circumstances deem payments such as rents, royalties and interest received by a foreign affiliate of a taxpayer from another related non-resident corporation which would otherwise be income from property (and fapi), to be active business income.  The Budget Papers state that "this result is not appropriate where the Canadian company has little or no equity interest in the payor foreign corporation, as the Canadian company will not share in the profits of, or any increase in the value of, the payor foreign corporation."  Accordingly, the Budget contains proposals (effective for taxation years of foreign affiliates that begin after 2008) that will restrict the application of these deemed active business income rules to situations where the Canadian taxpayer (or a related corporation resident in Canada) has a "qualifying interest" in the payor corporation (an existing concept under the Canadian income tax rules that is generally intended to refer to a direct or indirect economic interest of at least 10 per cent).

Other Notable Income Tax Changes

• The Budget confirms the Government's intention to proceed with the functional currency reporting initiative originally announced in the 2006 Budget. Under this initiative corporations that are required, for financial reporting purposes, to report in a functional currency other than the Canadian dollar would be permitted to determine income for Canadian income tax purposes in that functional currency.

• The Budget proposes to increase the rate of capital cost allowance for certain depreciable capital property including an increase in the CCA rate for buildings used for manufacturing or processing from 4% to 10% and an increase in the CCA rate for other non-residential buildings from 4% to 6%.  These proposals will generally apply to buildings acquired on or after March 19, 2007.
  The Budget proposes to temporarily increase the CCA rate on manufacturing and processing machinery and equipment from 30% computed on a declining balance basis to 50% computed on a straight line basis. The increase will be applicable to eligible machinery and equipment acquired on or after March 19, 2007 and before 2009.

• The Budget proposes to extend the eligibility for the 15% mineral exploration tax credit to flow-through share agreements entered into on or before March 31, 2008.  Under a proposed "look-back" rule funds raised with the benefit of the credit can be spent on eligible exploration to the end of 2009.

• The Budget proposes to extend the capital gains exemption for donations of publicly-listed securities to gifts made to private foundations on or after March 19, 2007. To address concerns that persons connected with a private foundation may, by virtue of their and the foundation's combined shareholdings in a company, have influence over a corporation that they may use for their own benefit, the Budget also contains proposals to introduce certain reporting requirements where a foundation holds more than 2% of the outstanding shares of any class of a corporation, and divestiture requirements where a foundation, together with all non-arm's length persons, holds more than 20% of the shares of any class of a corporation.

• The Budget proposes to increase the lifetime capital gains exemption on the disposition of qualified farm and fishing property or qualified small business corporation shares from $500,000 to $750,000. These proposals will apply to dispositions that occur on or after March 19, 2007.

• The Budget proposes to expand qualified investments for Registered Retirement Savings Plans and other registered plans to include investment grade debt that is part of a minimum $25 million issuance and securities (other than a futures contracts) listed on a "designated stock exchange". Most major domestic and international stock exchanges will qualify as a designated stock exchange, including all exchanges that currently qualify as a "prescribed stock exchange". These changes are effective after March 18, 2007.

• The Budget proposes to extent the maturity date for Registered Retirement Savings Plans, Registered Pension Plans and Deferred Profit Sharing Plans to the end of the year in which the annuitant or member turns 71 years of age. Under the current rules, these plans mature at the end of the year in which the annuitant or member turns 69 years of age.

Please do not hesitate to call  Neal Armstrong (416-863-5543 ), Colin Campbell (416-863-5529), Raj Juneja (416-863-5508), Paul Lamarre (416-367-7439),  or Carl MacArthur (416-367-7441) in our Toronto office or Brian Bloom (514-841-6505) in our Montréal office if you would like further information.

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practises nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstance. For particular applications of the law to specific situations, the reader should seek professional advice.