Canadian Finance Minister Jim Flaherty announced this morning that the controversial changes proposed in his March 19th Budget on financings by Canadian multinationals of foreign acquisitions will be narrowed and the effective date postponed until 2012.  Deductibility of interest expense incurred on loans taken by Canadian companies to finance foreign acquisitions or existing foreign operations is generally preserved.  However, in what is being billed as an "anti-tax haven initiative", interest deductions in Canada will be denied after 2011 if they are associated with foreign tax savings stemming from so-called “double-dip” financing strategies.  This proposal still represents a fundamental change in the tax environment in which Canadian-based multinationals, since 1972, have been able to structure foreign acquisitions and operations and it will certainly have adverse effects for many taxpayers.

The Ground Shifts to “Double Dips”

Faced with an onslaught of broad-based criticism on its original Budget proposals in this area, the Government begin backtracking in late April, by claiming, somewhat incredulously, that it really didn’t intend to restrict interest deductibility generally, but rather to attack foreign “double dip” tax planning by Canadian MNEs.

A basic transaction (“single dip”) sees a Canadian company borrow to invest in the shares of a foreign affiliate.  Since 1972, Canadian companies have been entitled to deduct interest incurred to make acquisitions (including by way of share acquisition or investment) against any source of income, notwithstanding that, generally, dividends received from shares of either Canadian target companies or from subsidiaries based in countries with which Canada has tax treaty relations (under the so-called “exempt surplus” rules) are not taxable.

A double dip involves the use of certain inter-company arrangements resulting in a reduction of foreign taxes by creating interest expense in the foreign operating company without eliminating the tax deduction available in Canada.  These arrangements generally involve a foreign subsidiary of a Canadian-based multinational, which makes loans to foreign operating subsidiaries in the group and which is based in a country which will not impose substantial tax on its financing income.  Exceptionally, in the case of acquisitions and operations in the U.S., the structure often does not involve a third country, but rather "hybrid" entities, that is, entities (whether formed in Canada or the U.S.) which are accorded differential characterization as a taxable entity or a flow-through entity in the two countries.  Such arrangements are often referred to as "Tower" or "reverse hybrid" structures.

Today’s Announcement

In a speech this morning to the Toronto Board of Trade (accompanied by a press release by his Department), Mr. Flaherty withdrew his proposal to deny generally the deductibility of foreign subsidiary-related interest expense.  But commencing with interest payable on or after January 1, 2012, interest on such loans will be denied to the extent of the Canadian corporation's "double dip income".  The Government proposes to enact a series of complex rules that are designed to reduce, effectively on a dollar-for-dollar basis, the tax benefit in Canada from foreign subsidiary-related interest expense which is associated with the tax that has been saved in the foreign country by the use of double-dip structures.  The Government also announced a panel of tax experts to be appointed to review the draft legislation, as well as an advisory panel with a broader mandate to review Canadian principles of international taxation more generally.

Although the new initiative has been clothed in the mantle of a campaign for "international tax fairness", it would appear quite clear that this proposed rule will simply mean that Canadian-based multinationals will tend to dismantle, after 2011, group double dip financing activities.  The actual proposals do not even mention the use of tax havens.  Instead, the interest expense will be denied in Canada to the extent that the interest expense incurred in the other jurisdiction and which could otherwise be repatriated back to Canada under current rules is not subjected to a level of tax at least equivalent to a notional Canadian corporate tax rate (currently 31%).  With this rule in place, it will be very unlikely that any Canadian multinational would want to go through all of the complexity and associated risks with international financing structures, in effect, to simply become a funnel for channelling tax dollars from a foreign country to Canada.  Instead, it would appear that the only effect of this proposal will be to increase tax revenues of foreign governments.  This hardly seems to be a well-thought out and desirable proposal for the benefit of Canada.

Policy Perspective

Leading up to today's announcement, Finance Minister Jim Flaherty mounted a spirited defence to the criticism levied against his original proposal by claiming that “Double dipping just isn’t fair”.  Policing foreign tax reduction schemes is an unusual step for Canada to take, given its place in the world economy.  The foreign tax savings associated with such structures flow back to the benefit of Canadian companies and – rather than costing Canadian tax revenue – can raise two additions to Canadian tax revenue.  One relates to eventual dispositions of the company’s stock at higher values and the other relates to enhanced dividend distributions by the company.

Although the preferred way of handling this issue would have been to take it off the current legislative agenda and have the whole area studied fully by an independent panel before making any changes to the current system, that route would have been perceived as too much of a policy reversal.  Instead, we are to have a proposed rule today that will only be effective in 2012.  This will presumably give the Government enough time to reconsider its positions in light of the report to be received from the advisory panel of experts.

For additional information, please contact  Nathan Boidman in our Montréal office at (514) 841-6400 or John Ulmer in our Toronto office at (416) 863-0900.

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.