Proposed amendments to the Income Tax Act restricting the deductibility of interest and other expenses

March 5, 2004

On March 5, 2004, Tax Executives Institute submitted the following comments to the Department of Finance relating to proposed legislation that would restrict the deductibility of interest and other expenses. The Institute’s comments were developed by the Canadian Income Tax Committee, whose chair is Monika M. Siegmund of Shell Canada Limited. Numerous members of the Committee participated in the development of the comments. Contributing substantially as the principal drafter of the comments was John M. Allinotte of Dofasco, Inc.

On behalf of Tax Executives Institute (TEI), I am writing to express TEI’s concerns regarding proposed amendments to the Income Tax Act (hereinafter “the ITA” or “the Act”), relating to the deductibility of interest and other expenses.


Tax Executives Institute is the preeminent international association of business tax executives. The Institute’s 5,400 professionals manage the tax affairs of 2,800 of the leading companies in Canada, the United States, and Europe. Canadians constitute 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 eight geographic regions, and must contend daily with the planning and compliance aspects of Canada’s business tax laws. Our non-Canadian members (including those in Europe) work for companies with substantial activities in Canada. 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 letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

TEI concerns itself with important 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 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 of government.

Summary of TEI’s Comments

On October 31, 2003, the Department of Finance released for public comment draft amendments to section 3.1 of the Act. The draft proposals follow-up on concerns expressed in the February 18, 2003, federal budget message that “recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest expenses, in computing income from a business or property for purposes of the Income Tax Act.” (1) The Department’s objectives are to clarify that (1) “income” for purposes of the Act is “net” income, in accordance with the generally accepted understanding of the Act prior to the Supreme Court of Canada’s decision in Ludco Enterprises Ltd. v. Canada, (2) and (2) “net income” excludes “capital gains and losses.” In addition, the Department believes that draft subsection 3.1(1) should be introduced in order to institute a statutory “reasonable expectation of profit” (REOP) test. A statutory test would replace the common law REOP rule, as recently interpreted by the Supreme Court of Canada in Brian J. Stewart v. The Queen.

Although the Department’s goals are clear and seemingly circumscribed, the proposed amendment to subsection 3.1(1), relating to limits on losses, is far broader than necessary to achieve those goals. The emphasis of the proposed legislation on establishing a “cumulative profit” and requiring taxpayers to link expenditures to a “source” of business or property income in order to ensure their deductibility raises a number of administrative and policy concerns. Specifically, the proposed changes modify the longstanding treatment of interest and other commercial expenses that taxpayers and Canada Revenue Agency (CRA) have long considered fully deductible. Indeed, the proposals go substantially beyond restoring the Act to the pre-Ludco status quo for the treatment of such expenses. In addition, the commercial, or “profit,” purposes of large corporations’ investment and business activities are rarely, if ever, questioned by the CRA, but the proposed changes could trigger unwarranted and unnecessary audit scrutiny of such issues. As important, TEI believes the Stewart decision enunciates a clear and rational tax policy basis for distinguishing commercial activities from personal and hobby-related expenditures. Moreover, the generally accepted understanding of the Act pre-Ludco was that income is “net” income and that “net income” is synonymous with “profit” for determining a “source of income.” Thus, the draft legislation poses a substantial risk of creating confusion and ambiguity and imposing unwarranted restrictions on the ability of commercial enterprises, especially large-file taxpayers, to deduct the costs of producing their “net” income. In summary, we believe the proposed changes will have a broad and adverse effect on the administration of the Act. We encourage the Department to withdraw the proposed legislation and craft narrower rules that will not create unnecessary restrictions on deductions claimed by commercial enterprises.

Conceptual Changes to the Act

Proposed new subsection 3.1(1) provides that a taxpayer will be considered to have a deductible loss from a source that is a business or property only if, in that taxation year, it is reasonable to assume that the taxpayer will realize a cumulative profit during the time the taxpayer has carried on, or can reasonably be expected to carry on, the business or has held, or can reasonably be expected to hold, the property. The proposed legislation thus creates a continuing requirement to test–in respect of each source that is a business or property in each taxation year that the income source generates a loss–whether the taxpayer has a reasonable expectation of profit (REOP). Specifically, the deductibility of each expenditure must be evaluated from a narrow statutory tax perspective and perhaps even in isolation from the taxpayer’s overarching business objectives and marketing strategy. Such microanalysis of business operations on an annual basis would be burdensome, expensive, time-consuming, and not value added.

The concept of “net income” has been a part of the Act for many years and is generally synonymous with “profit.” The concept of determining a “cumulative profit” or annual testing of whether a cumulative profit is reasonably likely, however, has never implicitly or explicitly been part of the Act. As important, there has never been a requirement to link an expense to a particular source in order to ensure the deductibility of the expense. The implementation of this concept in the Act is unnecessary and is likely to spawn significant controversy and litigation about its scope and meaning.

In taxation years in which a loss occurs, all the business decisions, ventures, and operations that affect–or may have ever affected–the determination of the taxpayer’s loss must be justified or re-justified. No such requirement has ever existed under the Act and it is unclear what recordkeeping procedures or accounting systems would be necessary–or can reasonably be developed–to prove the required linkage between the source, the deductions, and a taxpayer’s REOP. In addition, since the provision applies solely to disallow losses, the draft legislation would encourage CRA auditors to use hindsight to challenge the taxpayer’s legitimate business judgments. In other words, because of the delay between a taxpayer’s filing of its returns and the CRA’s audit, the CRA will be able to point to events subsequent to the loss year as evidence that the taxpayer lacked a REOP.

The Stewart case is highly instructive in respect of permissible losses from a business or property under the Act. In Stewart, the Supreme Court commented, as follows:

It is undisputed that the concept

of a “source of income”

is fundamental to the Canadian

tax system; however,

any test which assesses the

existence of a source must

be firmly based on the words

and scheme of the Act. As

such, in order to determine

whether a particular activity

constitutes a source of

income, the taxpayer must

show that he or she intends

to carry on that activity in

pursuit of profit and support

that intention with evidence.

The purpose of this test is to

distinguish between commercial

and personal activities

and where there is no

personal or hobby element to

a venture undertaken with

a view to a profit, the activity

is commercial, and the

taxpayer’s pursuit of profit is

established. (3)

The court elaborated that “[w]here the activity contains no personal element and is clearly commercial, no further inquiry is necessary.” (4) From these comments, it is clear that the source of income concept has but one overriding objective: to distinguish personal and commercial activities. Absent a personal element, which is highly unlikely in the case of a large business enterprise, it is clear that a large business enterprise’s expenditures will relate to a business source of income or, in limited cases, give rise to income from property. In either case, the enterprise will have a “source” of income that permits full deductibilty. Accordingly, proposed draft subsection 3.1(1) will introduce changes to the Act that are beyond the stated objectives.

To highlight issues and areas of concern, TEI offers the following comments and recommendations on specific provisions of the draft legislation as well as their interaction with other provisions of the Act. Even if the Department addresses these specific issues, however, the provisions will likely reach far beyond the Department’s stated objectives. As a result, the provisions will impose significant administrative burdens on compliant taxpayers, i.e., those for which there is little or no risk of noncompliance that would justify the expenditure of CRA’s limited audit resources. (5)

Heightened Emphasis on the “Source” of Income is Misplaced

The proposed legislation heightens the emphasis on determining a “source” of income, but no definition is provided for this key term. Depending upon how broadly or narrowly a source of income is ultimately determined to be, large business enterprises could have numerous sources of income. Sources of income for a large business may consist of (1) separate divisions (or product or service lines) within a single entity, (2) separate businesses (or product or service lines) housed in separate corporate or partnership entities, or (3) a single business (or multiple businesses) spread across multiple legal entities. As a result, depending on how the business is structured and the assets are held, the new rules may well produce inconsistent tax results among taxpayers in similar businesses with similar financial accounting results. (6) In addition, management will frequently reorganize loss-generating activities in order to minimize the business losses or maximize the utilization of tax losses within a corporate group. Thus, over several years–and as a result of amalgamations, windings-up, transfers among entities, etc., among members of a corporate group–separate individual “sources” may be commingled together or new, multiple sources may emerge from what was once a single source. As the number of sources expands or contracts, there will be correspondingly greater administrative burdens on taxpayers to track the sources and their related expenses in order to establish whether a “reasonable expectation of profit” exists on a cumulative basis with respect to each.

CRA’s scrutiny of the “source” of profit within large corporate groups has to date generally been minimal. In other words, the “source” to which deductions relates has been assumed to be for a commercial purpose and taxpayers have not been required to justify each business unit’s profitability either on an annual or cumulative basis. Under the proposed legislation, the assumption would be upended and CRA would seemingly be required to review such questions. There may, however, be numerous legitimate business reasons why a “source” of income within a corporate group will not, standing alone, generate a cumulative profit. For example, a company may make strategic investments in a losing enterprise in order to (1) pre-empt competitors from offering a product or service or from entering a particular geographic market; (2) provide a full range of products or services to customers; (3) comply with regulatory requirements; or (4) minimize the overall cost of producing the goods or services.

In addition, the capital investments necessary to produce a desired level of product may exceed initial projections. In such a case, it is unclear whether the cumulative profit requirement would be measured against the original or the increased investment. (7) Also, companies are increasingly providing a global scope of products or services for customers even though particular entities or enterprises in particular geographic areas–standing alone–generate a net loss. Finally, the anticipated cost savings or market opportunities that are expected from an acquisition of a business may not materialize, either because of subsequent events or faulty underlying assumptions at the time of an acquisition.

Although the Department may have intended that the draft proposals would require the same level of CRA audit review and resources as before the Stewart case, we believe that the current draft legislation will permit–even require–CRA to undertake a microanalysis of each taxpayer’s sources. More important, it may encourage CRA auditors to reclassify expenditures and separate them from their income streams in an attempt to deny loss deductions under the REOP test. We believe this would be an unfair and unintended result.

The potential for CRA to interpret the legislation in a fashion that creates inequitable and unintended results is illustrated by a recent technical interpretation where CRA stated, as follows:

Where a timber tenure holder

may be required to continue

to satisfy silviculture obligations

in respect of areas that

are taken by the Province of

British Columbia from the

timber tenure holder and

in which the timber tenure

holder no longer has an interest,

it is arguable that there

is no longer a “source” from

which expenditures in satisfaction

of the silviculture

obligations may be deducted

or that there is no property to

which the costs of satisfying

the obligation may be added.

Notwithstanding the foregoing,

in these circumstances

we are generally prepared to

accept that, depending on the

result of the determination

referred to in the preceding

paragraph, the expenditures

will be deductible by the timber

tenure holder or they are

to be given treatment, in the

form of a capital loss and/or

terminal loss, that, absent

timing considerations, provides

a net result that is

consistent with the result

that would have occurred had

the disposition of the particular

property not taken place

prior to the expenditures being


The foregoing does not take

account of proposed legislation,

contained in Department

of Finance News Release 2003-055

(October 31, 2003) entitled

“Proposed amendments to the

Income Tax Act related to the

deductibility of interest and

other expenses related to a

source.” The proposed legislation,

if and when passed, could

alter the positions described. (8)

Although the scope and effect of CRA’s comments are unclear, the Agency seems to be saying that its administrative practice with respect to the treatment of the cost of silviculture obligations may change–to the taxpayer’s detriment–if proposed section 3.1 is enacted. Moreover, although the Department of Finance has publicly affirmed that the draft legislation is not intended to change the meaning of the recently released Interpretation Bulletin IT-533, Interest Deductibility and Related Issues, CRA highlighted the issuance of the proposed legislation as a caveat in another technical interpretation relating to margin account interest. (9)

Retrospective Effect of the Proposed Legislation

The proposed amendments will apply to taxation years beginning after 2004 with no exemption or grandfathering for transactions entered into or investments made prior to 2005. Applying the REOP test to losses arising from long-term investments made prior to the effective date will likely impose a significant financial hardship on many taxpayers. Taxpayers may have made good faith investments many years ago for which they had, in accord with the Stewart decision, a reasonable expectation of profit at the time the investment was made. Market events, such as an increase in interest rates or a decline in commodity prices, subsequent to the date the investment was made may have made the investment, viewed in isolation from the rest of a taxpayer’s business, unprofitable on a cumulative basis. In addition, taxpayers frequently finance long-term investments by incurring long-term indebtedness. In many cases, taxpayers will be unable to restructure or prepay that debt without incurring a significant financial penalty. Introducing legislation that potentially denies a deduction for expenses incurred after 2004 for transactions entered into prior to the effective date, or forcing a taxpayer to choose between incurring a financial penalty or a disallowed tax loss, is unfair. That taxpayers might incur such detriments underscores our belief that the scope of the draft amendments is far broader than necessary and goes beyond restoring the Act to its pre-Ludco status quo. At a minimum, the legislation should exempt or otherwise grandfather transactions entered into prior to the date of the release of the draft legislation–October 31, 2003.

Denied Losses Do Not Carryforward

Where a loss is disallowed under the proposed REOP test of draft subsection 3.1(1), the loss is permanently disallowed and no carryforward is permitted. In other words, the entire gain on the investment will be taxed with no relief for the denied losses–even in the determination of the investment’s adjusted cost base on disposition of the asset or business. Without a carryforward provision or a cost base adjustment to permit recovery of the loss, double taxation will result. This is contrary to the policy of taxing only the “net” income of business enterprises and contrasts with the treatment of disallowed losses under the “at risk” rules for limited partnerships, which provide a carryover of denied losses. TEI recommends that the draft legislation be revised in order to permit a loss denied under draft subsection 3.1(1) to be carried forward and applied against future year’s income from the business or property source or be deducted on disposition of the source.

Unlimited Scope of Legislation

The 2003 Budget pronouncement and the press release accompanying the draft legislation state that the proposal is designed to affect the deduction of interest and other costs. Thus, for example, even a simple Capital Cost Allowance (CCA) claim for a business enterprise that engenders business losses could be denied under draft subsection 3.1(1).

In Stewart, the Supreme Court of Canada observed that the common law REOP test is a flexible, even amorphous, standard that courts apply based on all the facts and circumstances. Regrettably, this creates uncertainty for taxpayers, which the Supreme Court summarized, as follows:

The reasonable expectation of profit test is imprecise, causing an unfortunate degree of uncertainty for taxpayers. As well, the nature of the test has encouraged a hindsight assessment of the business judgment of taxpayers in order to deny losses incurred in bona fide, albeit unsuccessful, commercial ventures.

The proposed statutory formulation of the REOP test is no more precise because it depends on all the facts and circumstances of the taxpayer’s case. The scope of the proposed statutory test though is far broader than the common law rule and will apply to far more cases and many new situations. As a result, the proposed rules significantly depart from the Act’s pre-Ludco status quo.

Moreover, since the REOP must be applied in each taxation year in which a loss results rather than when the initial investment is made, the provision will impose substantial burdens on taxpayers and have a deleterious effect on tax administration. Specifically, in any year a loss is incurred, the REOP test requires a taxpayer to prove its expectation of profit many years after the initial investment by providing records for the entire holding period for the source. Indeed, there seems to be no statute of limitations in respect of the records that taxpayers would be required to retain in order to comply with the REOP test. In effect, the cumulative profit test compels taxpayers to retain all of their annual accounting records permanently for each source. Such a record retention requirement would impose a significant burden on taxpayers. In addition, the taxpayer’s reasonable expectation of profit can be challenged anew each and every year a loss is incurred regardless of whether or how the issue was resolved in a prior year’s audit. Expending taxpayer and CRA resources to resolve the identical issue in a recurring dispute over the same source of income without a final resolution is unproductive and wasteful for the government and taxpayers alike.

In addition, since the proposed REOP test requires an annual determination, timing differences between years in which income and expenses are realized could result in a permanent disallowance of a loss in a particular taxation year even where the taxpayer can prove a reasonable expectation of profit on a cumulative basis. As important, the determination of the time period over which the REOP test must be satisfied (i.e., the “profitability time period” in the explanatory notes) is a highly subjective judgment that will lead to frequent disputes between the CRA and taxpayers. Indeed, as noted, top management frequently reorganizes business in a fashion that will cause “sources” to disappear or merge with other old or new sources or give rise to new “sources.” Addressing such shifts and changes in sources will likely spawn frequent and unnecessary disputes.

Undefined Terms

The application of the draft rules depends on the meaning of key terms such as “source,” “profit” and “realize,” which are not defined in the draft legislation or in the ITA. The proposed legislation depends on Canadian jurisprudence to supply the definition of source, but the cases and rulings are inconsistent or sometimes unclear about the meaning and application of the amorphous term. The new rules also specify that “profit” excludes capital gains and capital losses, but otherwise provide no guidance on how “profit” is to be determined. According to the explanatory notes, “profit” is intended to mean profits determined in accordance with generally accepted commercial principles–a concept that is open to interpretation and that has been the subject of litigation over the years.

“Cumulative Profit” Test

In taxation years in which a business source has a loss, the proposed rules require an annual evaluation of the expected cumulative profit for the entire period during which the taxpayer can reasonably be expected to carry on the business or hold the property. The cumulative profit test will introduce significant uncertainty for taxpayers and increase administrative and compliance costs for taxpayers and the CRA.

A. The provision interferes with rational, incremental business decisionmaking. A fundamental principle of financial decisionmaking is that “sunk” costs (i.e., costs already incurred) are ignored when evaluating investment decisions. The “cumulative profit” test, however, ignores this principle and, thus, potentially encourages commercial enterprises to make decisions based on an arbitrary tax result rather than sound business practice. Since most decisions are made “at the margin,” or in respect of incremental changes to, or effects on, the business, the prospect of generating prospective, incremental cash inflows (or minimizing incremental cash outflows) is the driving factor in a decision rather than whether a “cumulative profit,” including recovery of sunk costs, will be engendered by a particular business activity. For example, a taxpayer may, after incurring several years of losses, conclude that a business venture is unlikely to produce a cumulative net profit. Nonetheless, if the taxpayer’s variable costs of production are less than the selling price of the goods or services, the taxpayer may continue the business because the absorption of fixed overhead expenses borne by that business may result in a marginal contribution to overall net profit. (In other words, other product lines or businesses may be marginally more profitable because fixed overhead costs are allocated to and absorbed by a business that is cash-flow positive but produces accounting losses.) The denial of a loss in such cases is harsh where the taxpayer continues the business for a period of time in an effort to recoup some, but not necessarily all, of its past losses.

B. The requirement of an annual evaluation of the prospect of realizing a cumulative profit potentially restricts losses arising from adverse, unanticipated events. The cumulative profit test must be applied each year. Thus, even though a taxpayer and CRA conclude that a business or property produces a deductible loss in one year, a loss arising from that same business or property in a later year may subsequently be disallowed even if the change in the prospects for a cumulative profit is attributable to circumstances beyond the taxpayer’s control. For example, a business might, after a string of loss years from ordinary business operations, incur an extraordinary or catastrophic, uninsured loss (e.g., as a result of an explosion or a toxic emission) that eliminates all possibility of a cumulative profit. The extraordinary loss (and all subsequent losses incurred to remedy the situation) may be nondeductible. Such a result is clearly contrary to the interpretation of the Act prior to Ludco.

C. The requirement of an annual evaluation of the prospect of a cumulative profit potentially penalizes entrepreneurial activity as well as poor business decisions. Many new ventures incur start-up losses. Management continually evaluates the prospects of start-up businesses against long and short-range business plans and trends. After operating a start-up business at a loss for several years, management may conclude that its initial decisions were based on faulty information or flawed analysis. Alternatively, changes in technology or in the market for the product or service may render the initial decisions questionable. If a decision is made to discontinue the business, a loss for that year, for subsequent years until the business or property is sold or wound up, and for years prior to the decision to discontinue the business that are open for audit may be disallowed even though the taxpayer had a reasonable expectation of profit at the time it started the business. The disallowance of a business loss as a result of a decision to discontinue a business would clearly be at odds with taxpayers’ expectations under the prevailing understanding of the Act prior to the Ludco decision.

D. The requirement to evaluate the prospect of a cumulative profit must be made annually, but it is unclear when during the year the evaluation is to be made. The proposed draft rules do not state when the taxpayer’s expectation of cumulative profit is to be determined. Is it at the beginning, middle, or end of each year (or quarter)? Alternatively, may taxpayers undertake multiple valuations during a particular year in order to develop an analysis that demonstrates a reasonable expectation of cumulative profit?

E. The requirement to evaluate the expectation of a cumulative profit evaluation on a property-by-property and business-by-business basis will place undue emphasis on the allocation of expenses among business units of a multi-business operation or among different activities that are part of a single, integrated business. The proposed REOP test ultimately depends on a source-by-source allocation of expenses, but the requirement to allocate expenses, such as general corporate overhead or research expenditures that benefit multiple business product lines, to each business and property source will engender new and significant disputes between tax-payers and the CRA because auditors may attempt to reallocate expenses in order to produce or increase non-deductible losses. Finally, requiring taxpayers to fully allocate all costs to each business source will impose a significant burden on taxpayers to implement and refine their cost and financial accounting systems.

Interest on Indebtedness to Purchase Common Shares

The press release accompanying the release of the draft legislation states:

These measures will reaffirm

many current practices that

support the deductibility of

interest, including those relating

to the deductibility of

interest on money borrowed

to purchase common shares.

The draft legislation, however, does not support this comment. Under the proposed rules, a taxpayer will be entitled to a loss deduction for a taxation year only where it has a reasonable expectation, in that year, of receiving sufficient dividends over the period that the taxpayer has held, and may reasonably be expected to hold, the common share investment. In most cases, however, the interest expense on leveraged investments in common shares will exceed the annual dividend yield as well as the cumulative dividends during the holding period of the debt and the investment. Unless the draft legislation is clarified to remove the potential restriction on the deductibility of shareholder interest expense, the cost of corporate capital will increase substantially and the competitiveness of Canadian companies in global capital markets will be adversely affected.

We understand that the statement in the press release is premised on the expectation that CRA would continue its administrative practice of permitting a deduction for the interest on money borrowed to purchase common shares. TEI does not believe that taxpayers, or the tax system itself, should depend on administrative concessions where, as here, there is a significant discrepancy between the Act and the administrative practice. The Auditor General of Canada occasionally criticises CRA for failing to administer the Act as written. Moreover, there is no assurance that CRA will continue its administrative practice. If the draft legislation is not withdrawn, it should be clarified to confirm that interest expense to purchase investments in common shares is fully deductible notwithstanding that a loss may be incurred on the shares as a source.

Finally, publicly traded companies increase shareholder value by managing their business operations and generally return only a portion of that value through dividends. The decision to pay dividends or to reinvest in operations for capital appreciation is a discretionary decision made solely by the management of the company, generally on a year-by-year basis. To limit the deductibility of interest for shareholder borrowings because of decisions made by a company’s management is unsound.

Conflict with Paragraph 20.1(1)(b) for a Disappearing Source

In the event that a shareholder disposes of shares purchased with borrowed funds, the draft legislation would likely deny the shareholder-taxpayer a deduction for the loss (interest expense) incurred prior to the disposal of the investment as well as any ongoing interest expense incurred after the common shares are sold. Thus, the anticipated result under the draft amendments seemingly conflicts with the “disappearing source” rules of section 20.1. Paragraph 20.1(1)(b) would likely permit a deduction for the ongoing interest expense, but proposed subsection 3.1(1) would seemingly deny the loss because there would no longer be a “source” and thus no reasonable expectation of generating a cumulative profit. If the REOP test is to apply to large commercial businesses, the draft legislation should, at a minimum, clarify that Paragraph 20.1(1)(b) provides the proper result for a disappearing source.

Draft Legislation Creates Uncertainty for Issues Addressed in IT-533

The Department’s press release accompanying the draft legislation states that the legislation and CRA’s interpretation bulletin, IT-533 Interest Deductibility and Other Issues, “form a coordinated Government response on the deductibility of interest and other expenses.” Depending on whether the interpretation bulletin or the proposed legislation is applied to a particular set of facts and circumstances or transactions, however, divergent tax results can arise. The inconsistent results and the Department’s statement have thus created confusion and uncertainty for taxpayers and tax practitioners. Specific examples where divergent results can arise depending on whether the interpretation bulletin or the draft legislation is applied, include: (1) the effect of disappearing sources; (2) borrowed money used to make interest-free loans and contributions of capital (paragraph 25 of the IT); (3) notes issued to redeem shares (paragraph 29 of the IT); (4) borrowed money used to honour guarantees (paragraph 33 of the IT); and (5) money borrowed to purchase common shares unless the expected dividends exceed the interest expense during the time the shares are held. The interpretation bulletin was a product of substantial consultations between the CRA and taxpayers and satisfactorily resolved a number of issues. If the legislation is not withdrawn, it should be clarified to confirm that the result prescribed in the interpretation bulletin prevails.

Canadian Parent Borrowings to Fund Foreign Affiliates

The proposed legislation will impose a special burden on Canadian parent companies that borrow in order to invest in the common shares of foreign affiliates because there are special costs, such as foreign exchange fluctuations and withholding taxes, that raise the bar in respect of whether a taxpayer will be able to demonstrate a reasonable expectation of realizing a cumulative profit. The Act is generally neutral in respect of how investments in foreign affiliates should be funded. We do not believe that it should be amended in a fashion that indirectly compels Canadian businesses to fund their investments in foreign affiliates with equity.


The proposed statutory reasonable expectation of cumulative profit test will create significant uncertainty for business taxpayers. We do not believe this legislation is necessary, especially since all interest that is not incurred for personal purposes should be fully deductible. We urge the Department to consider withdrawing the proposed legislation or narrowing its scope to the intended targets.

TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments and recommendations.

TEI’s comments were prepared under the aegis of the Institute’s Canadian Income Tax Committee, whose chair is Monika M. Siegmund. If you should have any questions about the submission, please do not hesitate to call Ms. Siegmund at 403.691.3210, or Mario M. Tombari, TEI’s Vice President for Canadian Affairs, at 514.932.6161, ext. 2943.

(1) The Department of Finance is concerned about the Supreme Court of Canada’s decisions in Brian J. Stewart v. The Queen, 2002 S.C.C 46, The Queen v. Jack Walls and Robert Buvyer, 2002 S.C.C. 47, and Ludco Enterprises Ltd., et al. v. The Queen, 2001 S.C.C. 62. In the first two cases, the court concluded that the “reasonable expectation of profit” test did not apply where the taxpayers’ activities had no personal element. In the third case, the taxpayer incurred interest expense of $6 million in order to acquire shares on which dividends of $600,000 were paid. The court decided that, where the reasonable expectation of gross income (i.e., dividends on shares) is satisfied at the time the shares are acquired, the interest expense is fully deductible.

(2) 2001 S.C.C. 62.

(3) 2002 D.T.C. 6969, 6970 (emphasis added).

(4) Id. at 6981.

(5) The greatest shortcoming of the proposed REOP test is captured in the following statement in Stewart: “It would be … unacceptable to permit the Minister [to say] to the taxpayer … ‘The fact that you lost money … proves that you did not have a reasonable expectation of profit, but as soon as you earn some money, it proves that you now have such an expectation’.” Stewart v. The Queen, 2002 D.T.C. 6969, [paragraph] 60.

(6) Even within the same industry there is little uniformity in how business activities and operations are structured. Moreover, in order to minimize legal liability taxpayers routinely isolate high-risk activities, which standing alone may or may not be considered a source, in separate legal entities. For example, a taxpayer may isolate certain manufacturing or processing activities in a separate entity in order to shield the marketing and distribution activities from the effects of a catastrophic loss.

(7) Alternatively, when the increased investment is made, is a new “profitability time period” triggered?

(8) Document No. 2003-002044 (December 1, 2003) (emphasis added).

(9) Document No. 2003-002744 (January 12, 2004).

COPYRIGHT 2004 Tax Executives Institute, Inc.

COPYRIGHT 2004 Gale Group

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