17 May 2022 IFA Roundtable - Finance Update
Email this ContentThis summarizes comments made at the Department of Finance Roundtable for the IFA conference 17 May 17, 2022. The Finance presenters were:
Trevor McGowan, Director General, Tax Legislation Division
Peter Repetto, Senior Director of the International Outbound Taxation sections, Tax Legislation Division
The moderators were Kim Maguire (Bennett Jones) and Phil Halvorson (EY).
Pipeline of Consultations
Maguire: Please give an update on the status of the proposed consultations.
McGowan: His list of the more substantial consultations:
- The December 2021 draft legislative proposals for a digital services tax: Finance is currently working on revisions coming out of the stakeholder feedback.
- The February 4, 2022 draft legislative proposals regarding s. 160 planning; audit authority and enhanced trust reporting; as well as the interest measure: Finance is working through the comments – see also below.
- The April 7, 2022 Budget, which initiated a “large” consultation on Pillar 2 (submissions requested on July 7) and included a number of pointed questions.
- The April 29, 2022 release on hybrid mismatches with feedback due by June 30, 2022: it would be a good idea to get feedback in sooner rather than later, as the proposed in-force day is shortly after June 30.
- Finance would typically look to a summer release (by the start of August) of draft legislative proposals for the measures announced in Budget 2022, but for which draft legislation was not prepared – but sometimes this slips.
- The Budget 2022 fall economic statement announced a timeline for the consultation on modernizing the GAAR: consult over the summer; analyze the results in the fall; and look to release draft legislative proposals by the end of 2022. To facilitate that timeline, Finance is working to release a consultation paper, probably before the end of June.
- There is no specific date (but hopefully soon) for releasing transfer pricing proposals for consultation. There is a fairly advanced draft, which Finance is working on with CRA.
EIFEL Proposals
Maguire: Do you have any general comments on the types of submissions you have received on the EIFFEL proposals?
Preference for general-scope amendments
McGowan: Over 60 submissions were received so far, and there is a lot of work for Finance to work through them. Finance cannot commit to a release time but it would be great to include them in as part of the summer release.
A general point before Peter Repeto’s comments regards a number of requests for specific exemptions from the rules, e.g., for taxpayers in specific sectors, such as real estate, infrastructure or utilities, or for optional carve-outs, such as public benefit projects (mentioned in the BEPS Action 4 report), which would generally apply, e.g., in the case of P3 infrastructure projects.
The draft legislation reflects the government’s preferred approach, which is that, to the extent possible, the provisions are neutral as to sector. In general terms, providing exemptions, especially in respect of a brand new set of rules, is sub-optimal. It involves a difficult legislative exercise in ring-fencing specific businesses or activities and it can create non-neutralities, as well as scheme ambiguity. It would be much better for the legislators, and for those applying rules in novel circumstances, to have a basis rule that works appropriately across all sectors and that do not rely on specific exclusions.
Finance’s preference, where possible, would therefore be to amend the base rule rather than providing specific solutions. This includes the group ratio rule, which is intended to generally allow groups, or standalone entities that are not a member of any group, that naturally have higher levels of external debt to deduct a higher ratio of net third-party interest expenses. Finance hopes to be able to make adjustments to the base rules so that they work appropriately in all circumstances without a need for any specific exclusions.
Some areas of major further consideration
Halvorson: Could you discuss some of the main technical issues raised in the submissions, and whether the government is considering any changes to address them?
Repetto: The submissions raise a number of technical issues but, in the interests of time, I will focus mainly on broader policy and design issues that have been raised.
Effective date/ grandfathering
Repetto: One issue relates to implementation dates and grandfathering. Some stakeholders have asked for the effective date to be deferred to 2024. Some have also requested the grandfathering of existing third-party debts, at least in certain circumstances, and the government will certainly be briefed regarding those requests and the rationales provided for deferral and grandfathering.
However, the government is committed to moving forward expeditiously with a BEPS Action 4-style interest limitation rule that generally aligns with Canada’s peers. The Action 4 report was released in 2015, and many peer countries have had these measures in place for several years now. The Canadian measures were announced in the 2021 Budget, over a year and a half before the proposed effective date of January 1, 2023, and the measures also contain some significant features to ease the transition into the new rules such as a higher 40% ratio applicable for the first year, as well as an elective carryforward of excess capacity from up to three pre-regime years. These are all important considerations when considering what is an appropriate effective date.
Excluded entity carve-out
Repetto: Numerous submissions on the “excluded entity” entity have requested their expansion in various ways. Some have noted that, in the April budget, there was a proposal to increase the threshold limit for eligibility for the small business deduction from the existing limit of $15 million of taxable capital employed in Canada to $50 million, and have requested a corresponding change for purposes of defining the CCPCs that are exempted from the EIFEL rules. We are considering that request.
Another request was to increase the de minimis threshold for the rules from the proposed annual group-wide net interest expense limit of $250,000 to something higher that would be more in line with the de minimis threshold in other countries under their Action 4 regimes. We will need to give further consideration to this.
A number of submissions also describe what they perceive to be purely domestic entities or groups that they view as being outside the policy scope of the EIFEL rules, but which do not come within the excluded entity definition, because, e.g., of the requirement that all or substantially all of the interest and financing expenses of an entity be paid to persons other than tax-indifferent investors. We recognize that the conditions to qualify for the excluded entity definition, and in particular the exclusion for what can be viewed as purely domestic entities and groups, are relatively stringent. We are exploring some ways that they could be potentially relaxed without compromising the integrity of the rules. We are interested in exploring whether most of the requests for specific carve-outs, for sectors or types of businesses, could be appropriately dealt with, through an expansion of the excluded entity definition, and the availability of the group ratio rule that would perhaps provide somewhat greater relief than under the current version.
Group ratio haircut
Repetto: We have also received comments that the group ratio does not provide adequate relief, particularly due to the haircut that applies in the case of ratios over 40%. As might be apparent from both the discussion in the Action 4 report and the Explanatory Notes to the draft EIFEL rules, one of the main reasons for the haircut was to address inflated ratios that can result where there are loss or negative entities in a consolidated group. We will explore whether that particular concern can be addressed in a more targeted way in order to ensure appropriate relief under the group ratio rule.
Transfers by financial institutions
Repetto: We are also considering how financial institutions could potentially be permitted to transfer their excess capacity to other group entities, at least in certain circumstances or to certain categories of entities. This should not be done without compromising the integrity of the rules. We are also considering potentially narrowing the definition of a “relevant financial institution” under the rules.
Anti-avoidance rules
Repetto: A number of submissions have also commented on the broad scope of specific anti-avoidance rules in the EIFEL regime and have requested further guidance as to the targeted transactions. We are seriously considering what further guidance we could provide and agree that, if possible, it would be appropriate to provide some guidance in the Explanatory Notes as to targeted transactions. We also recognize the need to clarify that certain transactions are not intended to be caught, such as typical loss consolidations.
Secondary technical issues
Repetto: Those are most of the main broad policy and design issues that have been raised. We do not have sufficient time to address a lot of the more technical issues, but I would like to comment on at least two of them.
Resource deduction addback
Repetto: Some submissions have noted that, while there is an add-back for CCA deductions in the adjusted taxable income computation, there is no such add-back for deductions in respect of various resource expense pools. This was intentionally omitted in the legislation, as we had some concerns about providing that add-back. However, in light of the submissions we have received, we are now considering potentially providing an add-back in respect of resource expense pool deductions.
Foreign affiliate issues
Repetto: We have also received very helpful submissions on potential design options for the application of the EIFEL rules in relation to foreign affiliates. It was always our intention to add specific rules addressing this issue in the final legislation, and we are now working on this.
(To reiterate, these are not the only issues we have decided to seriously consider or to remedy.)
S. 18.2(12)
Halvorson: S. 18.2(12) raises a number of concerns. As drafted, income received from related foreign entities may not be included in IFR, which may have a significant impact where Canadian parent companies act as the market-facing entity to raise the debts for its wider MNE group.
This result also seems contrary to the Action 4 Final Report, which suggests that interest limitation rules should not impede a group’s flexibility to borrow wherever it is commercially optimal and then on-lend to achieve a more proportional distribution of net interest expense throughout the group. Can Finance comment?
Repetto: As you noted, the BEPS Action 4 report generally contemplates that, where a group borrows from an arm’s length lender at the parent level, and on-lends to, e.g., a foreign subsidiary to fund the subsidiary’s active business, the resulting interest income reduces the parent’s net interest expense. That allows the group flexibility to borrow wherever commercially optimal and then on-lend. The on-lending has the effect of achieving a more proportional distribution of the interest expense across the group, which can be an appropriate policy outcome.
The draft rules are not generally intended to prevent that kind of structuring, but proposed 18.2(12) would appear to have that unintended result, which we intend to correct. We are, however, considering what safeguards or restrictions may be required – for example, whether there is a need for restrictions to whom the on-loan can be made and whether there is a need for certain conditions on the use of the borrowing.
Timing
Halvorson: Do you have any other thoughts on EIFEL?
Repetto: Ideally, in the case of a measure such as EIFEL, we would find a way to include a revised draft in our summer legislative release. It will be challenging to meet that timeline here, given the volume and nature of the submissions, and the complexity of the rules.
FAPI
Maguire: Regarding the tax-deferral advantage of earning FAPI through a CCPC, is it the intention that the rule (which we have not seen yet) apply with respect to all FAPI or might there be exceptions for example where the FAPI is a result of the recharacterization purposes rule in s. 95(2)(b), or when the income is related to real estate in the foreign country?
Repetto: The intention was that all amounts included in income in respect of FAPI would be subject to the new relevant tax factor for substantive CCPCs as proposed in the Budget. It is that relevant tax factor that would apply in claiming a deduction is respect of foreign accrual tax. This is of course consistent with the approach under the existing rules, which include all FAPI inclusions in a CCPC’s aggregate investment income.
That said, Finance is always interested in suggestions on these types of proposals – in this case, suggestions as to whether certain amounts included in FAPI should remain subject to the old relevant tax factor for CCPCs.
It would be helpful if any such submissions could detail real life examples.
Hybrid Mismatch Rules
Deemed business income
Halvorson: The hybrid mismatch rules adopt a unique approach in Canadian tax law where the application of the rules depends on foreign tax-treatment and foreign tax outcomes of certain financial instruments or arrangements. This may result in tension or mismatches with policy objectives of other schemes in the Act.
For example, absent the proposed hybrid mismatch rules, s. 95(2)(a), or the definition of FAPI itself, may result in certain payments between foreign affiliates to not result in FAPI even if there is foreign deduction/non-inclusion mismatch.
Can Finance comment on its intentions for how the hybrid rules may be expected to interact with Canada’s foreign affiliate and FAPI regime, particularly in respect of either actual payments between foreign affiliates that would not result in FAPI under the existing rules in the Act or, in the case of a non-interest bearing loan, would not, if a notional expense on the loan were actually paid, result in FAPI under existing rules in the Act?
Repetto: Note that instruments between two non-resident entities can constitute hybrid mismatch arrangements as defined under these rules, and that feature of the rules will be necessary for, among other things, the imported mismatch rules that are contemplated for inclusion in the second package of hybrids legislation which, as announced in Budget 2021, the government intends to release at a later time and which would be effective no earlier than 2023. The government plans to release that second legislative package with plenty of time for appropriate consultation.
The hybrid rules were also generally intended to apply for purposes of computing FAPI. However, they are not intended to override the recharacterization rules in s. 95(2)(a), or other provisions of the foreign affiliate rules such as the definition of FAPI, which has a carve-out for inter-affiliate dividends. If a payment on an inter-affiliate instrument is deductible in computing the payor affiliate’s active business income under foreign law, but produces a deduction/ non-inclusion mismatch because there is no corresponding income inclusion to the payee affiliate under the foreign law, it is not intended that the hybrid rules would apply to include an amount in FAPI of the payee affiliate.
If the instrument is a non-interest bearing loan that otherwise meets the requirements mentioned above, such that, had the loan been interest bearing, the interest payments would have qualified for recharacterization under s. 95(2)(a), then it would also fall within this favourable policy that I just mentioned.
This being the current policy intent, it is always subject to change in the future, including if Finance were to become aware of any new facts concerning any variations on these transactions that altered its policy analysis. We are also interested in receiving submissions, analyzing how the hybrid proposals as drafted technically apply to these structures and any technical drafting suggestions to ensure appropriate outcomes under the rules in respect of these types of structures. More generally, we are interested in submissions on whether, and in what circumstances, the hybrid’s rule should apply in computing FAPI in the context of foreign affiliates more generally.
Straddling foreign taxation year
Halvorson: Hybrid mismatch rules apply in respect of payments arising on or after July 1st, 2022, but with respect to non-interest bearing loans, there is no payment per se. However, s. 118.4(9) may deem the debtor to make a payment in the year equal to the deductible amount, where the deductible amount generally means the amount that would be deductible by a debtor in respect of notional interest expense on the debt in computing its relevant foreign income or profits tax for a taxation year. My question is, in the case of a foreign taxation year that straddles the coming into force on July 1st 2022, can you confirm that the deemed amount should not include the portion of the deductible amount for that year that could be considered to arise before the July 1st 2022 date?
Repetto: We can confirm that, in the case of a non-interest bearing loan, the intention is to apply the hybrids rules in respect of the deductible notional interest expense only to the extent it accrued on or after July 1st of this year. Any portion of the notional interest expense that accrued before July 1st is not intended to be subject to the rules. However, the intention is different in the case of an actual payment on an interest-bearing instrument where the actual payment is made on or after July 1st. In that case, even if the actual payment relates, at least in part, to an amount that accrued before July 1st, it is intended that the entire actual payment be subject to hybrid’s rules, not just the portion that relates to the notional interest that accrued after July 1st.
Where no cross-border element
Halvorson: Unlike conditions for hybrid financial instrument arrangements and hybrid transfer arrangements, s. 18.4(14) does not include a condition that the deduction/non-inclusion mismatch arise due to the hybridity of the transaction or arrangement, nor is there an obvious condition that the arrangement or the payment require any kind of cross-border element.
Was it intended that these rules apply to arrangements that have no cross-border element? (The Action 4 report definition of “hybrid mismatch arrangement” includes a “cross-border element.”)
Repetto: Yes, payments between two Canadian-resident taxpayers can, in certain cases, come within the scope of the substitute payment mismatch rules. This is intended. On our reading of the Action 2 report, this position is consistent with that report. The report specifies that, in certain cases, there can be an “in-scope” mismatch between two domestic entities.
That said, we are interested in hearing any views as to why the scope of the rules should be narrowed, such as by adding a requirement that there be some form of foreign element to the transaction. For example, suppose the substitute payment is in respect of the transfer of an instrument, where the issuer of that instrument is non-resident?.
Submissions will generally be more useful if they set out specific real-life transactions that would be inappropriately caught by the proposed rules, and cite the specific Canadian rules that are relevant to the mismatch.
Mandatory Disclosure Rules
Maguire: What is Finance’s reactions to recent submissions on proposed mandatory disclosure rules?
McGowan: We have received over 25 submissions from stakeholders for the consultation that ended April 5th. We’re currently working through the submissions, including with CRA where appropriate, with a view to releasing amendments for further consultation, possibly later on this summer, although that hasn’t been determined yet.
We are considering all submissions, but for now I’d like to address three of the CBA submissions.
Solicitor-client privilege
McGowan: The first is the recommendation that the exception for solicitor-client privileged information, in the existing and proposed rules, be broadened to specify, for greater certainty, that the reporting requirements do not apply in respect of any information in respect of which the person subject to the reporting obligation reasonably considers that solicitor-client privilege applies.
Another submission is that the ITA definition of “solicitor-client privilege” in s. 237.3(1) be removed, or drafted in a manner that conforms with recent jurisprudence. We intend to do so. Instead, any mention of “solicitor-client privilege” would draw from the jurisprudence instead of a statutory definition. A statutory definition needlessly risks defining the term too broadly (depriving CRA of information it should really have) or too narrowly (giving CRA information it really should not have). Using the prevailing definition instead helps avoid either scenario.
Reporting timing
McGowan: The third submission deals with reporting in respect of transactions that have yet to be completed. Again, this involves a balancing act, where we want tax-disclosure in respect of transactions as early as possible, in order to provide timely information and analysis, but at the same time we do not want disclosure of false starts. The reportable and notifiable transaction-reporting requirements that have been developed are based on the day in which the person becomes contractually obligated to enter into the transaction, or the day on which the person actually enters into the transaction. We think these questions are fairly clear, and capable of being answered with sufficient certainty that disclosure can be made, and also avoids the false start problem.
Multiple reporting
Maguire: There is some concern that the proposed mandatory disclosure rules require multiple reporting of the same transaction or series by multiple advisors. Can you discuss the concerns around multiple reporting, and could you comment on whether the definition of “advisor” might be narrowed to, e.g., to exclude in particular legal professionals, who are not providing the tax advice, but might only be involved in implementation, and have no insight into the tax-planning behind the transaction?
McGowan: All of the following examples are subject to solicitor-client privilege – reporting would not be required where it would breach privilege.
The general aim of the rules is to have a broader category of people who are required to make disclosure. That is not based on the type of advice provided, and is broader than that. It includes advisors who are not providing tax advice, and that inclusion is deliberate. We consider this to be consistent with existing rules, such as the civil penalty rules in s. 163.2, which can apply where people assent or acquiesce in the making of a false statement.
Regarding the multiple disclosure point, that is something that we gave a lot of thought to. One of the guiding principles for the implementation of the mandatory disclosure measure was, to the extent possible, to be consistent with the proposals from the BEPS Action 12 report. This is one of those examples.
I think the main suggestion was that the optimal approach would be more in line with the tax shelter rules in s. 237.1. That is where you have a scheme that is based on scheme reference numbers and/or requiring promoters to maintain client lists. I think that the UK has done something similar. They did say, as an alternative, that it would be acceptable to provide multiple reporting in respect of these arrangements. It was a choice between that, and implementing the primary recommendation of having a more formal registration scheme, with reference numbers and things like that, and we considered that approach to be too onerous.
Therefore, if it was thought that something closer to our tax shelter identification rules was preferable, we would be interested in that.
That is why the rules are the way they are. It does come with a number of benefits, which are reiterated in the BEPS report. Requiring multiple disclosures can help CRA and other tax authorities with risk-assessment, and help incentivize accurate reporting, and it is also consistent with what has been done internationally – I think the US and Quebec also require multiple reporting.
Filing timelines
Maguire: Is there anything else you want to say on this topic?
McGowan: We have heard about filing obligations and timelines. We try to be consistent with international norms, and certainly we were criticized for having such late filing deadlines in the past.
We received comments on how CRA would publicize notifiable transactions. The thought was that publication by the Minister of National Revenue (on CRA’s website) would provide the most timely pipeline for delivering notifiable transactions. It can take a while to get things published in the Canada Gazette, and in any event it may be harder to find things there than on the CRA website.
Thresholds and penalties
McGowan: De minimis thresholds were raised as well. In the BEPS Action 12 report, those were considered to be inconsistent with the use of a main purpose test. We also heard about penalties, and again we are trying to be consistent with international norms and with Quebec, and we feel that we’ve landed in the same range.
BEPS Pillars Update
Pillar 1
Halvorson: If you don’t mind summarizing the last 10 years of work in about a minute, please provide an update on Pillar 1!
McGowan: Let’s focus on the October 2021 Agreement.
Intensive negotiations have been underway since the October Agreement. A Pillar 1 plan on the detailed design of the elements was agreed to in the October statement. This includes development of detailed model rules for national legislation, and a multilateral convention to implement the new system.
The OECD has been releasing elements of the draft proposals for public comment as each of the elements reaches maturity. We acknowledge that the timelines (generally a couple of weeks) provided for public comment are unfortunately very short, reflecting the tight deadlines that were agreed to by political leaders. We appreciate the constructive input that has been received from stakeholders in Canada and around the world as part of the process.
Some other elements on which work is underway but not yet consulted on:
- the mechanism for eliminating double-taxation;
- marketing and distributing safe harbours;
- the tax certainty process for dispute prevention and resolution; and
- certain administrative issues.
The tax certainty mechanisms are very important and also novel. Since Amount A is essentially a formulaic allocation of a subset of MNE profits, it is important that there be a mechanism for all of the involved tax administrations to agree in a binding manner on the relevant tax base for a given MNE, and on the share to be allocated to each relevant market jurisdiction. This requires a level of multilateral coordination, which is a massive step forward beyond any existing procedures. We hope to be consulting on this issue in the near future.
Another element of Pillar 1 is the so-called “amount B.” This is a simplification of transfer pricing issues associated with routine marketing and distribution functions on the ground in market jurisdictions. Work on this is ongoing, with the goal of concluding by the end of 2022.
Finally, given the government’s focus and priority on finalizing the Pillar 1 framework and bringing it into operation, the recent budget confirmed that the digital services tax detailed in Budget 2021 would serve as the backup measure. It would only come into force in 2024 if the Pillar 1 multilateral convention had not come into force by that time. Meanwhile, we appreciate the input received by stakeholders in the draft GST legislation received in December, and will continue to refine it so that it is ready if necessary.
Pillar 2
Maguire: In Budget 2022, Finance launched a public consultation on Pillar 2, and posed a long list of questions for stakeholders to consider. Can you give us an idea of specific issues that you’re looking forward to receiving stakeholder input on?
Repetto: The consultation materials state that the Model Rules and Commentary were approved by all the Inclusive Framework members (including Canada), and reflect extensive international negotiations. In addition, the last October political agreement on the Pillars requires that any implementing country do so in a manner consistent with, and leads to outcomes consistent with, the Model Rules and the Commentary. This includes how the country administers its rules.
If a country fails to adhere to the Model Rules in its implementing legislation, the rules are at risk of being deemed non-compliant. For example, its income inclusion rule could be determined to be a non-qualified IIR, which would leave the country’s multinational entities exposed to the application of other counties’ under-taxed profits rules. There is limited flexibility to deviate from the Model Rules – we do not know yet precisely how much latitude we have, and we hope for further guidance soon. In light of the requirement for consistency, however, the consultation is focused mainly on ensuring that the legislation anticipates any necessary adaptations of the Model Rules and Commentary to Canadian tax, and also makes any necessary changes to Canadian tax law to address interactions with Pillar 2.
We are interested in hearing about any and all potential interactions. Some interactions we have identified, that we would be interested in hearing submissions on, include:
- any necessary changes to our foreign affiliate rules to ensure appropriate results where there is a top-up tax liability in respect of Canadian entities, e.g. changes to foreign affiliate surplus regulations to reflect top-up tax, or any adjustments to the ACB of foreign affiliate shares;
- any necessary changes to our foreign tax credit rules, including foreign accrual tax in the FAPI context, e.g. to deny credit for top-up tax under other countries’ Pillar 2 rules; and
- the potential application of the GAAR and Canadian transfer pricing rules in relation to Canadian Pillar 2 legislation.
The government is aware that certain existing Canadian incentives, such as SR&ED, would not appear to qualify for favourable treatment under the Pillar 2 rules – in particular because, under the rules, refundable credits get more favourable treatment than non-refundable credits. This is a clear and well settled aspect of the Model Rules, and reflects significant discussion and negotiation among Inclusive Framework countries, so most countries would regard this as a fundamental element of the rules.
In light of the impact of Pillar 2 on incentives, in this year’s Budget the government committed to review tax incentives for R&D, as part of a broader competitiveness review. That broader review also involves exploring and consulting on the possibility of a patent box.
The Department is also interested in receiving submissions on how, exactly, to ensure that the commentary on the model rules, and any future administrative guidance issued by the OECD, receive the appropriate status, to ensure that Canadian courts interpret Pillar 2 legislation in a consistent manner with those sources.