Canada’s foreign affiliate rules

Canada’s foreign affiliate rules

Jack R. Skinner

On August 7, 1996, Tax Executives Institute submitted the following comments on Canada’s proposed foreign affiliate rules to the Canadian Department of Finance. The comments, which took the form of a letter from TEI President Jack R. Skinner to the Honorable Paul Martin, the Minister of Finance. They were prepared under the aegis of the Institute’s Canadian Income Tax Committee whose Chair is Alan J. Wheable of Canada Trust. J.A. (Drew) Glennie of Shell Canada, 1996-1996 chair of the Committee and the Institute’s 1996-1997 Vice President-Region I, materially contributed to the preparation of the comments.

On March 5, 1996, draft legislation was released that will impose new and substantial information reporting requirements in respect of the foreign affiliates of Canadian taxpayers. The legislation implements the foreign-reporting requirements announced in the February 27, 1995, budget message. In addition, on May 8,1996, representatives from the Department of Finance met with members of Tax Executives Institute (TEI) to explain the reporting obligations under the draft legislation. At that meeting, the Department’s representatives invited TEI to submit comments in respect of both the draft legislation and the draft information return to report the required information.


TEI is an international organization of approximately 5,000 professionals who are responsible — in an executive, administrative, or managerial capacity — for the tax affairs of the corporations and the other businesses by which they are employed. TEI’s members represent more than 2,700 of the leading corporations in Canada and the United States.

Canadians make up approximately 10 percent of TEI’s membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI’s membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of TEI as a whole, but more particularly those of our Canadian constituency.

TEI has historically been concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as in an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels.

Among TEI’s principal objectives are the gathering and dissemination of information on tax issues of wide concern and the development of responsible positions that reflect not only the diversity and professional training of our members but also an appreciation for the practical aspects of tax administration and business decisions. In addition, we strongly believe that tax legislation should be fully consistent with the goals of economic growth, fairness, clarity, and competitiveness.

Proposed Foreign Reporting Requirements

As noted in the March 5, 1996, press release announcing the draft legislation and accompanying draft reporting forms, the stated purpose of the provisions is “to preserve the integrity of the Canadian income tax base, particularly with respect to the use of tax havens by Canadians.” Moreover, “the reporting requirements [are intended to] give Revenue Canada more ability to scrutinize offshore investments held by Canadians and to ensure complete reporting of income.” Hence, draft section 233.3 requires taxpayers with interests in foreign property (shares, bank accounts, real property, etc.) in excess of $100,000 to report and provide details on such holdings. Draft section 233.4 requires taxpayers with foreign affiliates to provide additional financial and tax information with respect to each affiliate. Draft section 233.2 requires information in respect of transfers and loans to foreign trusts. Finally, draft section 233.5 affects the reporting of distributions from foreign trusts.

If the draft legislation and reporting forms were limited to their announced purpose of combatting the use of tax havens for avoidance purposes, TEI would have little quarrel with the reporting requirements. Regrettably, however, the proposed foreign reporting requirements extend far beyond their intended purposes and impose excessive, redundant, and, in the case of non-controlled foreign affiliates, impossible reporting requirements. Hence, TEI believes the rules are contrary to the goals of economic growth, fairness, clarity, and competitiveness. Indeed, complying with the proposed requirements will likely result in a very substantial increase in costs not only to taxpayers — who must modify their accounting information systems to record, store, retrieve, and report the data — but to the government as well since Revenue Canada will presumably examine every element of additional reported data and modify its information systems accordingly Consequently, we believe that the benefits to the government from the proposed reporting requirements — especially those imposed under draft section 233.4 and draft Form T1134 in respect of foreign affiliates — will be substantially offset by compliance costs to taxpayers and administrative costs to the government. TEI members are employed by the largest corporate taxpayers in Canada. Many of the companies are publicly traded (or are subsidiaries of public companies) and, hence, have absolutely no incentive to omit or underreport income from offshore sources. Moreover, these taxpayers devote substantial resources to meeting their tax compliance and reporting obligations. Because they are compelled to participate in the large-case audit program, their domestic and foreign business operations and income are already subject to a high degree of “scrutiny” by Revenue Canada. In addition, much of the relevant information sought under the proposed foreign reporting requirements is already supplied in the course of audits. Consequently, consideration should be given to establishing procedures to permit large-case taxpayers to continue supplying relevant information through the audit process in lieu of imposing an across-the-board, annual reporting requirement in respect of every foreign affiliate. Audit inquiries can generally be tailored to focus on the taxpayer’s specific facts and circumstances, including the scope and nature of the foreign affiliate’s activities. The exercise of proper audit judgment based on an assessment of the risk and magnitude of potential adjustments will permit the government to scrutinize offshore investments while limiting the reporting and documentation burden imposed on both taxpayers and Revenue Canada. Our suggested approach is consistent with the tenor of Revenue Canada’s large-case audit protocol initiative of tailoring audits based on the taxpayer’s particular facts and circumstances. Thus, in TEI’s view, the efficiency of the government’s scrutiny of foreign affiliate activities could be maintained or enhanced without imposing the significant additional reporting obligations contained in the draft legislation and Form.

In summary, we question the need for the elaborate reporting requirements set forth in draft section 233.4 and the accompanying draft Form T1134. In our view, the proper balance between the increased costs of taxpayer compliance and the government’s need for additional information has not been struck — especially where the information sought (1) is unnecessary to achieve the government’s objective to protect the fisc, (2) is already available, or (3) may be supplied through less costly means.

Evergreen Reporting and Filing Deadlines

As proposed by the government, the information sought on Form T1134 in respect of each foreign affiliate must be supplied annually with-in six months of the close of the tax year. Much of that information, however, will not change from year to year. Hence, we believe that burden imposed by the annual reporting requirement can be reduced and the Form streamlined by permitting taxpayers to report only changes that have occurred since previous reports. This is particularly the case in respect of the information contained in Parts I and II relating to the foreign affiliate group structure, ownership, partners, etc. In addition, much of the information required in Part I, section 2, paragraphs A to E of draft Form T1134 is already reported on Form T2. Furthermore, information requested in paragraphs F, G, and H of the same section duplicates information requested in Part III, section 5. We recommend that the government reconsider the volume of information to be supplied on the T1134 with a view to eliminating requests for information supplied in other returns or reports or duplicated on other parts of Form T1134.

The government should also re-consider the deadline for filing Form T1134. In our view, the six-month filing requirement is unrealistic because many foreign jurisdictions permit commercial accounts or tax returns for the foreign affiliates to be filed much later than six months following the close of the year. For example, in the United Kingdom the tax return is not due for up to 12 months following the close of the year; in the United States up to 9 months later; and in Germany, as much as 2 years may elapse until the return is filed. Hence, portions of the information currently requested on T1134 will simply be unavailable to taxpayers at the required time. We renew our recommendation that the government permit large-case taxpayers subject to the constant scrutiny of Revenue Canada to supply the information through the normal audit process.

In the event the six-month deadline for filing information reports in respect of foreign affiliates is retained, taxpayers should be permitted to (1) request an automatic extension of time within which to file the information or (2) submit the annual report based on the most recently completed accounts or tax returns for the foreign affiliate.

Finally, TEI seriously questions whether taxpayers should be compelled to supply information in respect of second-tier or lower foreign affiliates, particularly where there is no activity affecting Canadian tax liability. Financial statements in respect of lower-tier subsidiaries are often presented on a consolidated rather than a legal entity basis, especially where there are multiple entities within a single country. The need for relief from the draft reporting rules is particularly acute with respect to non-controlled foreign affiliates for which Canadian taxpayers may be able to supply little, if any, of the detailed information.

Volume and Details Requested

A. Adjusted Cost Base

The draft form and reporting requirements require Canadian taxpayers to determine the adjusted cost base (ACB) of shares of every reportable foreign affiliate. Such an under-taking is a time-consuming and daunting task with respect to shares in controlled affiliates and is typically deferred until the affiliate is sold, or otherwise participates in a group reorganization. Where there are tiers of foreign affiliates in a chain of ownership, each upper-tier affiliate will be required to determine the ACB of shares in lower-tier companies. Hence, the requirement to provide an annual update of ACB for each foreign affiliate, particularly in corporate groups with a large number of controlled and non-controlled affiliates, is especially onerous.

TEI questions whether the reporting of such information is relevant where there is no taxable event, such as a reorganization of the group involving the affiliate or a disposition of shares of the affiliate, that makes such computations necessary. In other words, what effect will the annual reporting of ACB of foreign affiliates have? Will taxpayers be precluded from reviewing their ACB records subsequently, for example upon disposition of the shares, in order to determine and report the proper gain or loss in respect of the shares? Presumably, Revenue Canada will also timely audit the annual ACB data. Having once reviewed the previously reported ACB information, will Revenue Canada be precluded from challenging a taxpayer’s calculation of gain or loss on disposition of the shares where that gain or loss is computed with reference to previously determined ACB figures? Since neither taxpayer nor government interests are affected by annual ACB information reports, we recommend that the reporting requirement be eliminated. The reporting of ACB of foreign affiliate shares should be required of Canadian taxpayers only where the determination of annual tax liability is affected.

B. Capital Gains

Form T1134 and the draft reporting requirements seemingly require a Canadian taxpayer to report separately every asset disposition by a foreign affiliate that gives rise to capital gains, regardless whether the gain arises from excluded or non-excluded property. This requirement will impose a substantial burden on taxpayers to review the existing records of all capital assets currently held by foreign affiliates. In some cases, however, the detailed records by individual property simply may not exist because (1) there has been no previous Canadian requirement to keep such detailed records or (2) the foreign jurisdiction permits accounts to be kept, as in Canada, on the basis of asset pools. Where asset records are maintained in pool accounts, the specific cost and depreciation reserve attributable to individual assets are either lost or may be recomputed only at substantial cost to the taxpayer. Further, we question whether such detailed property-by-property reporting is necessary since the disposition of excluded property affects only the surplus accounts and, with respect to non-excluded property, the reporting requirement duplicates reporting for foreign accrual property income. TEI recommends that the government consider limiting the proposed capital gain reporting requirement to property consisting of shares of foreign affiliates or interests in foreign partnerships.

C. Other Data

TEI questions whether much of the additional information with respect to controlled foreign affiliates is relevant. For example, the information with respect to number of full-time employees, composition of gross revenues by source, location of books and records, and the need for the annual reporting of such information from all controlled foreign affiliates seems unnecessary. We recommend that these requests be deleted.

Proposed Penalties

The draft legislation prescribes an “additional penalty” for failure to file a required information return. The penalty ranges from a minimum of $500 per month (to a total of 24 months) to a maximum of 10 percent of the filer’s cost of shares or debts issued by the foreign affiliate, less penalties otherwise determined.

TEI acknowledges that the government has an interest in employing civil penalties to promote accurate self-assessment of tax liability and to ensure adherence to minimum standards of behavior. We submit, however, that a penalty that is disproportionate to either the taxpayer’s culpability or the nature of the act or omission cannot serve as a rational deterrent. In addition, the government has an obligation to assist taxpayers to determine their tax liability and a concomitant obligation to recognize that — notwithstanding a taxpayer’s best efforts — inadvertent errors may occur that should not give rise to a penalty. Moreover, where the standard of compliance is impossibly high or the threshold deviation from the standard triggering penalties is exceedingly low — or, worse, where a penalty is automatically imposed regardless of the taxpayer culpability or good faith efforts to comply — the penalties are abusive.

Thus, TEI believes that the proposed penalties for failing to supply within six months all of the information sought on the draft form are excessive. Given the volume and detail of information required to complete proposed Form T1134, and in many cases its limited relevance in determining or verifying the taxpayer’s reported tax liability, we seriously question the value of the penalty in assuring proper self-assessment. Moreover, in the case of non-controlled foreign affiliates and subsidiaries of non-controlled affiliates, it may be impossible for Canadian taxpayers to supply the detailed financial information on Form T1134 at any time, let alone within the six-month period prescribed by draft section 233.4. In addition, should a taxpayer subsequently discover that it has inadvertently failed to supply information in respect of an affiliate, the seemingly automatic imposition of the maximum range of the penalty will perversely encourage continued non-compliance. As well, the sanction for egregious and willful noncompliance is seemingly the same as for omitting minor schedules from the plethora of information required on the Form. Applying the same penalty for minor errors — i.e., for foot faults — as for more egregious and wilful noncompliance is contrary to sound tax policy In summary, TEI believes the penalty provision is unjustifiably harsh and recommends that it be substantially revised.


TEI believes that the government can achieve its stated objectives and improve taxpayer compliance by limiting draft section 233.4 — and the foreign reporting requirements generally — in the following fashion:

1. Apply the reporting requirements solely to controlled foreign affiliates (i.e., those that are more-than-50-percent owned directly or indirectly by Canadian shareholders) and then only to the extent that (1) the affiliate does not carry on an active business and (2) is not resident in a designated treaty country.

2. Furthermore, just as there are de minimis rules under draft section 233.3, limit the additional reporting in respect of controlled foreign affiliates (as defined in 1) to those whose income or assets exceed a minimum threshold of, say, $100,000 in-gross income or $100,000 in gross assets. Indeed, the government should consider whether a higher de minimis threshold would be proper for large-case taxpayers subject to continuous scrutiny by Revenue Canada.

3. Extend the filing deadline for the additional information sought on Form T1134 to a minimum of at least 12 months following the close of the year. Alternatively, permit taxpayers to request extensions of time within which to file the information and limit the specific data that must be filed within the six-month period following the close of the year to information readily available from the foreign affiliate at the time of filing. For example, where the commercial financial statements or tax return for a foreign affiliate for a reporting period corresponding with the Canadian taxpayer’s year is not available, permit the Canadian information report to be based on the most recently completed accounts or tax return for the foreign affiliate.

4. For administrative convenience, eliminate duplicate reporting where related Canadian companies directly hold an equity interest in the same foreign affiliate. In other words, permit taxpayers to designate a single Canadian taxpayer as their agent for reporting the data for all foreign affiliates and permit other Canadian taxpayers with interests in the affiliate to identify the designated reporting agent.

5. Eliminate the requirement to compute and report ACB annually. Modify the requirement to report capital gain details by property. Limit the requirement to compute the surplus accounts of foreign affiliates to situations where (1) a dividend is paid from the affiliate and (2) there is a reasonable question whether the dividend was paid from surplus other than exempt surplus.


TEI is pleased to have this opportunity to present its views in respect of the foreign affiliate reporting requirements. The comments were prepared under the aegis of the Institute’s Canadian Income Tax Committee, whose chair is Alan J. Wheable of Canada Trust. To underscore our commitment to work with the government in fleshing out the proper scope of additional reporting rules in respect of foreign affiliates, we wish to discuss our comments and concerns with representatives of the Department as soon as possible. Hence, J.A. (Drew) Glennie, TEI’s Vice President for Canadian Affairs, will contact the Director of the Tax Legislation Division, Len Farber, very soon to arrange a meeting to be held at the earliest convenience of the Department.

COPYRIGHT 1996 Tax Executives Institute, Inc.

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