Although new substantive legislative measures were introduced at a relatively modest pace for most of 2003, the last quarter of the year saw a flurry of legislative proposals, including draft legislation addressing expense deductibility and proposals dealing with the taxation of non-competition payments. By contrast, the only substantive legislative initiatives prior to October emanated from the February 18, 2003 federal budget, which introduced a handful of new legislative measures, including proposals relating to federal capital tax, small business corporations and the resource sector, all of which have already been enacted.

The Department of Finance devoted considerable time in 2003 responding to concerns raised by taxpayers and their advisors about ongoing legislative initiatives that have not yet coalesced into final legislative form. Most prominent among these initiatives is the proposed regime that would apply in respect of non-resident trusts ("NRTs") and foreign investment entities ("FIEs"). No less than four different versions of the NRT and FIE legislation have been released since the regime was first announced in 1999. The most recent version of the legislation was released on October 30, 2003 and is applicable retroactively to taxation years commencing after 2002. Other legislative initiatives expected in the near future include revisions to the technical amendments issued on December 20, 2002. More difficult to predict is when the Department will release promised new legislation relating to cross-border share-for-share exchanges.

Elimination of Federal Capital Tax

Of significant interest to corporate taxpayers in 2003 was the scheduled elimination of federal capital (large corporations) tax ("LCT") over a five year period. This key change was first proposed in the 2003 federal budget. It is no doubt a welcome development, which promises to increase Canada's international competitiveness by repealing a tax that has been widely criticized for creating a disincentive for capital investment in Canada. Formerly, the LCT was levied at a rate of 0.225% of a corporation's taxable capital employed in Canada in excess of a base capital deduction of $10 million (which is shared among members of a corporate group). Amendments enacted in June now result in the base capital deduction rising to $50 million. The LCT rate is scheduled to fall in stages from 0.225% in 2003, to 0.2% in 2004, 0.175% in 2005, 0.125% in 2006, and 0.0625% in 2007, with full elimination arriving in 2008 (although the federal capital tax applicable to large financial institutions has not been reduced). By comparison, some provinces continue to levy corporate capital taxes, and provincial initiatives aimed at reducing such taxes (in Quebec and Ontario, for example) have been slowed or derailed.

New Resource Tax Regime

The past year witnessed a substantial overhaul of the regime governing the taxation of resource income. The new measures were first announced in the 2003 federal budget and were articulated further in a technical paper issued by the Department of Finance in March. The legislation, initially tabled in the House of Commons in June, was enacted in November. Ongoing discussions between the Department of Finance and the resource sector concerning resource tax reform intensified following the announcement by the federal government in 2000 that, although the general federal corporate tax rate would be reduced from 28% to 21% by 2004, the resource sector would be excluded from the benefit of the proposed rate reductions in respect of resource income. The stated justification for the exclusion, at the time, was that significant resource industry incentives were already in place, including the federal resource allowance. Broadly stated, this allowance is a deduction based on a stipulated percentage of resource profits. The industry and its advisors, however, generally view the allowance not as a tax incentive, but as recompense for the restriction that prevents resource firms from deducting provincial and other Crown charges in computing income from mining and oil and gas activities.

The new resource tax regime is, perhaps unsurprisingly, complicated in its implementation, particularly with respect to the transitional period between the old resource allowance regime and the new regime. Key aspects of the legislation include a reduction in the general corporate income tax rate applicable to resource income from 28% to 21% over a five-year period commencing on January 1, 2003. Over the same five-year period, a deduction for provincial and other Crown charges would be phased in and the resource allowance mechanism would be gradually eliminated. The proposed legislation also introduces a new tax credit for corporations in respect of qualifying mineral exploration expenditures, which would be phased in at the rate of 5% for 2003, 7% for 2004 and 10% thereafter.

Small Business Corporations

The 2003 federal budget also led to the passage of amendments targeted at small business corporations and their investors. First, the small business limit - which is the amount of a Canadian-controlled private corporation's income that is eligible for a reduced basic federal corporate tax rate of 12% - will now increase from $200,000 in 2002 to $300,000 by 2006, in increments of $25,000 per year. Second, enhancements have been made to the capital gains rollover that allows individuals to defer recognition of some or all of any capital gains arising on the disposition of shares of eligible small business corporations when the proceeds are reinvested in replacement shares of eligible small business corporations. No longer does a $2 million limit apply to the amount of the original investment in respect of which a rollover is available. The $2 million dollar limit for replacement shares has also been eliminated. Further, the time period for acquiring replacement shares and benefiting from the rollover has been extended.

Interest Deductibility

While the 2003 budget contained no specific proposals to amend the provisions of the Income Tax Act (Canada) (the "Act") governing interest deductibility, the supplementary material tabled with the budget made it clear that the Department of Finance was reviewing the deductibility of interest and other expenses. The budget materials indicated that the Department of Finance was dissatisfied with recent court decisions in this area that, it believed, could lead to "inappropriate tax results". While no specific cases were identified, the discussion strongly suggested that the decisions of the Supreme Court of Canada in Ludco, Stewart and Walls were troubling the Department. Under Ludco, absent mere window dressing, a taxpayer need only demonstrate that borrowed money was used for the purposes of earning gross (rather than net) income in order for interest on the borrowed money to be deductible. Under Stewart and Walls, where an activity contains no personal element, it is not necessary for a taxpayer to prove that there is a reasonable expectation of profit in connection with the activity in order for losses from the activity to be deductible. The budget materials indicated that legislative amendments would be considered, in order to "restore continuity with the expected [tax] consequences before these recent court decisions".

In October, the Department announced proposed amendments to the Act that would limit the ability of taxpayers to recognize losses from business or property, for taxation years beginning after 2004. The proposed legislation would allow a taxpayer to recognize losses from business or property in a taxation year only if, in that year, it is reasonable to expect that the taxpayer will realize a cumulative profit from the business or property over the total period during which the taxpayer has carried on, and can reasonably be expected to carry on, the business or has held, and can reasonably be expected to hold, the property. It is intended that profit for this purpose would be determined in accordance with generally accepted commercial principles but without reference to capital gains or capital losses. In a press release accompanying the proposed amendments, the Department suggested that the proposed amendments should be read in light of the interpretation bulletin on interest deductibility that was released at the same time by the Canada Customs and Revenue Agency ("CCRA"), IT-533, "Interest Deductibility and Related Issues" ("IT-533"). The release of IT-533 followed a comprehensive review by the CCRA of its administrative position on interest deductibility. IT-533, however, expressly states that it does not take into account the proposed amendments.

While IT-533 is a welcome development, the apparent simplicity of the proposed amendments conceals a number of potential problems, including in areas where deductibility was widely thought to be unproblematic. For example, IT-533 confirms that the CCRA "normally" considers interest expenses in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the shareholder will eventually receive dividends. Nevertheless, despite apparent assurances to the contrary from the Department of Finance, the proposed amendments seem to call into question the deductibility of such interest (or more precisely, the ability to deduct a loss that arises from such deduction). Based on informal discussions with the CCRA, it is the authors' understanding that the CCRA would be prepared to apply its administrative policy in a manner that ordinarily would not deny losses that result from the deduction of such interest expenses. However, it is not clear how, as a matter of law, this position regarding loans to acquire common shares could be reconciled with what would appear to be the CCRA's position regarding loans to acquire other assets.

Non-Competition Payments

One of the more striking judgments of 2003 was the decision of the Federal Court of Appeal in Manrell, where the Court held that a payment received as consideration for entering into a non-competition agreement in connection with a sale of shares was not proceeds from a disposition of property and that the payment was therefore a non-taxable capital receipt. Previously, in Fortino, the Federal Court of Appeal had concluded that non-competition payments received by a selling shareholder were neither income from a source nor eligible capital amounts under section 14, but the issue of whether the payments could be considered proceeds of disposition had not been addressed. The issue in Manrell, therefore, was whether the "right to compete" fell within the definition of "property" in the Act and, if so, whether the taxpayer had disposed of that right. The Court held that the term "property" in the Act did not encompass the non-exclusive, commonly held right to carry on a business. If what the taxpayer in Manrell gave up was a right, the Court concluded, it did not fall within the definition of "property" in the Act. The Court deferred to Parliament as to whether this conclusion was appropriate as a matter of tax policy.

In October, the Minister of Finance responded to Manrell by announcing his intention to propose amendments to the Act that would treat amounts received for granting such a restrictive covenant as income for tax purposes, subject to certain exceptions that would allow treatment on capital account, if the restrictive covenant was granted in the context of the sale of a business or a sale of shares or partnership interests. Conversely, the payor would be able to treat such payments as an eligible capital expenditure (in the case of a sale of assets and goodwill) or include such payments in the cost of the shares or partnership interests acquired. The amendments would apply to amounts received or receivable after October 7, 2003, other than amounts received before 2005 pursuant to a written agreement made on or before October 7, 2003.

Non-Resident Trusts and Foreign Investment Entities

Like the three drafts that preceded it, the October 30, 2003 release of revised proposals dealing with NRTs and FIEs is an enormously complicated and exhausting maze of interconnected definitions, inclusions, exemptions and supporting rules. While the complexity and basic statutory scheme of the proposals remains unchanged from the previous drafts of the legislation, the latest proposals have altered the rules in a number of significant respects, and not all of these modifications are relieving in nature. Some of the changes expand the reach of the legislation as compared with the three previous drafts, a fact that may make the retroactive effect of the legislation seem unduly harsh for taxpayers who had structured their affairs in reliance on previous versions of the proposed legislation.

Non-Resident Trusts
Subject to limited exceptions, the basic thrust of the proposed legislation is that a NRT is deemed to be resident in Canada and subject to tax on its worldwide income where a Canadian resident is considered to have made a direct or indirect contribution to the NRT or in certain other circumstances where the NRT has a Canadian resident beneficiary. The NRT, the contributor and certain beneficiaries are generally jointly and severally liable for any Canadian tax that arises as a result of the application of the rules. Significant changes under the revised proposals include the extension of the NRT regime to offshore foundations and the potential imposition of Canadian non-resident withholding tax on certain amounts paid by a NRT to non-resident persons (including interest and distributions of foreign source income to offshore beneficiaries). The revised proposals also seek to clarify the circumstances under which offshore pension or employment benefit trusts are exempt from the NRT regime.

The scope of the NRT rules is exceptionally broad and can potentially apply to many commercial trust structures. Importantly, a NRT that qualifies as an "exempt foreign trust" is excluded from the reach of the proposed regime and will instead be potentially subject to the FIE regime. Offshore investment trusts will generally qualify as exempt foreign trusts if certain requirements are satisfied with respect to the distribution of the trust's units which are intended to ensure that the trust is a widely held, or if other criteria are satisfied, including the ongoing filing of certain information with the Canadian tax authorities.

Foreign Investment Entities
Under the proposed FIE rules, a taxpayer that holds a "participating interest" (other than an exempt interest) in a FIE will be required to include an amount in income annually, calculated in accordance with the rules, regardless of whether the taxpayer actually receives any income from the FIE. A participating interest includes any share of a non-resident corporation, certain specified interests in an offshore trust, or an interest in any other non-resident entity, as well as other property that gives the holder a right to acquire an interest in a non-resident entity or the value of which is determinable by reference to such an interest. An important change made in the revised proposals is to clarify that derivative contracts that are computed by reference to an interest in a non-resident entity, but which can only be "cash settled", are not subject to the FIE regime.

A FIE is any non-resident entity unless the entity satisfies prescribed conditions. In broad terms, if more that half of the carrying value of the property of a non-resident entity is represented by "investment property" or if the principal business of the non-resident is an investment business, the non-resident entity will be a FIE. Supporting rules dealing with the use of consolidated and non-consolidated financial statements in making this determination have, to some degree, been relaxed under the revised proposals.

The concept of an "exempt interest" is intended to provide a safe-harbour for investments in foreign entities that, from a policy perspective, should not be subject to the FIE regime. One notable example is, generally, an interest in a non-resident entity held by a taxpayer where the taxpayer has no tax avoidance motive in respect of the interest and where the entity satisfies prescribed conditions that are intended to demonstrate, among other things, that the interests held by the taxpayer are widely held and, in certain cases, publicly-traded, and that the entity is either resident in a country in which there is a prescribed stock exchange or resident in and governed by, and formed under, the laws of a country with which Canada has a tax treaty. The revised proposals have eliminated or clarified some aspects of this exemption, although significant uncertainty remains in the application of the exemption to many transactions.

The revised FIE legislation now provides three different methods for calculating the annual income inclusion of a taxpayer subject to the regime. The default approach requires a taxpayer to include an amount in income that is determined by applying a prescribed interest rate to the taxpayer's designated cost of the investment in the FIE. If, however, the investment has a readily obtainable fair market value, the taxpayer may elect to be taxed instead on a mark-to-market basis, which requires the taxpayer to reflect in computing income (either as ordinary income or loss or, in certain circumstances, as capital gain or loss) an amount based upon the annual change in value of the investment in the FIE. Alternatively, the revised legislation reintroduces a third income computation method which allows a taxpayer to elect in certain cases to be taxed on the taxpayer's proportionate share of the income of the FIE determined in accordance with certain modified Canadian tax rules. However, in order for this third method to be available, the taxpayer must have access to detailed information relating to the FIE that is necessary to allow the income of the FIE to be computed for Canadian tax purposes. It is likely, however, that many FIEs will be unwilling to provide this information to Canadian investors and the third method is therefore expected to have only limited application. Finally, the revised proposals also introduce a set of "true up" rules that, in broad terms, are intended to reconcile, upon a disposition of a FIE interest, the actual economic return realized by a taxpayer from the investment with the amount included in the taxpayer's income under the FIE regime.



Selected Canadian Cases of Interest

Interest Deductibility
The impact of the Supreme Court of Canada decisions in Singleton and Ludco continued to be felt in 2003, particularly in the context of tax avoidance. In order for interest on borrowed money to be deductible under the Act, the borrowed money must be used for the purpose of earning income from a business or property. Under Singleton, it appears that the motivation for the borrowing is irrelevant, so long as the borrowed money has been used for an income-earning purpose. In 2003, in Novopharm, the Federal Court of Appeal considered this requirement, in the context of a series of transactions that was carried out for no purpose other than tax avoidance and that effectively enabled a profitable corporation to acquire the losses of an unrelated corporation. The transactions included borrowing money, which was used to purchase shares that were subsequently redeemed, resulting in a deemed dividend. The Tax Court of Canada denied the interest deduction in respect of this borrowing, on the basis that the series of transactions to which the share purchase belonged had no purpose other than tax avoidance. On appeal, the Federal Court of Appeal considered whether, in applying the income earning purpose test, it was necessary to regard all of the transactions as a series of connected transactions (as the Tax Court of Canada had done, thereby denying the deduction) or as independent transactions. If the latter was correct, then the deduction would be allowed, as the borrowed money had been used directly for the income-earning purpose of purchasing shares from which a dividend could be expected and a deemed dividend was received. The Court concluded that Singleton decided this question in favour of the latter approach. The direct use of the borrowed money was the purchase of shares to earn dividend income. To treat the individual transactions as a series of connected transactions, the Court held, would be to ignore this fact. The interest deductibility provisions of the Act do not contemplate treating individual transactions as a series of transactions, according to the Court. Ultimately, the Court ruled against the taxpayer on other grounds. The Supreme Court of Canada has refused leave to appeal the Federal Court of Appeal's decision.

GAAR and Corporate Tax Planning
Novopharm is also relevant to the application of the general anti-avoidance rule ("GAAR"). GAAR does not apply to an avoidance transaction that does not result, directly or indirectly, in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole. Under OSFC Holdings, in applying this rule, it is necessary to identify a clear and unambiguous policy behind the relevant provisions of the Act or the Act as a whole, and then to determine whether the avoidance transaction in question constitutes a misuse or abuse in light of that policy. Although Novopharm did not involve GAAR, the Court commented on the policy behind the interest deductibility provision in the course of applying an anti-avoidance rule that is no longer in the Act. The Court stated that there is no doubt that the object of the provision is to permit the deduction of interest to encourage the accumulation of capital which would then produce taxable income. This policy may be tested in 2004, as it appears to assume that interest is a capital expense, which is a question currently before the Supreme Court of Canada in Gifford.

The importance of identifying a clear and unambiguous policy in the context of applying the misuse or abuse test under GAAR was underscored in Loyens, where the inability to identify a clear and unambiguous policy led the Tax Court of Canada to allow the taxpayers' appeal. Loyens involved the transfer by the taxpayers of real property inventory to a partnership on a tax-deferred basis, followed by the transfer of the partnership interests to a corporation with losses on a tax-deferred basis. Following the dissolution of the partnership, the corporation sold its interest in the property and used its losses to offset the income realized on the sale. Unlike section 85, which deals with tax-deferred transfers to corporations, the tax-deferred rollover applicable in the context of a partnership does not exclude real property inventory from property that is eligible for the rollover. In considering whether GAAR would apply to deny the tax benefit arising from the use of the losses, the Court concluded that the policy behind the restriction on transferring real property inventory on a tax-deferred basis under section 85 was to prevent the conversion of income into capital gains by a real property trader. As the gains on the transactions in question had been reported as income, that policy was not contravened. With respect to whether there was a misuse of the Act as a whole, the Court held that the policy against loss trading identified in OSFC Holdings did not extend to a policy against trading profits.

In Canada Trustco, the GAAR reassessment similarly faltered for lack of a clear and unambiguous policy against the transactions. Canada Trustco involved the purchase of trailers by the taxpayer that were indirectly leased back to the vendor. As a result of the transactions, the taxpayer bore no economic risk in respect of the purchase and lease of the trailers or the loan used to finance such purchase, but sought to deduct interest on the loan and capital cost allowance ("CCA") on the trailers from other leasing income. The Tax Court of Canada considered whether GAAR could be applied to deny the tax benefit arising from the deduction of CCA. The Court stated that the transaction did not lend itself to an analysis that would proceed by comparing the transaction with its "tax-untainted" counterpart, for purposes of identifying the tax benefit. Accordingly, the Court identified the tax benefit by comparison with the taxpayer's position prior to the transaction. The Court also noted that the threshold for identifying an avoidance transaction was low and observed that the emphasis in a GAAR case was properly placed on misuse or abuse. In applying the misuse and abuse test, the Court examined the object and spirit behind the rules preventing the deduction of CCA by lessors in respect of leased property in an amount in excess of leasing income. The Court concluded that the policy is "to limit the generous CCA treatment in lease financing arrangements to a recognition of money invested to acquire property leased for operational purposes, and for which CCA reasonably approximates actual depreciation, to the extent that such property is consumed in an income-earning process, such consumption limited to deductions against leasing income". The transactions in this case, the Court held, were not so dissimilar from "ordinary" sale-leaseback transactions as to fall outside of this policy. The Court concluded that there was no abuse of the Act as a whole and that the misuse inquiry was effectively inseparable from the abuse inquiry once the relevant policy was identified. Despite tweaking the nose upward on a "smell test", the Court concluded that the transactions were not subject to GAAR. The Minister has appealed this decision.

Capital Gains Stripping
The Act provides that what would otherwise be a tax-free intercorporate dividend may be recharacterized as a capital gain in certain circumstances. Where a deemed dividend is received as part of a transaction or event, or series of transactions or events, one of the results of which is to effect a significant reduction in the capital gain that, but for the dividend, would have been realized on the sale of a share, the rule may apply. The rule does not apply to the extent that the dividend is subject to Part IV tax that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of "the series". In CanUtilities Holdings, the Tax Court of Canada considered whether this exception applied in the context of an acquisition transaction that was structured to include an amalgamation, pursuant to which two corporate shareholders received redeemable shares that were subsequently redeemed. The resulting deemed dividends reduced the capital gains that would otherwise have been realized on the disposition of the shares, but the corporate shareholders were subject to Part IV tax on the dividends. The corporate shareholders subsequently paid sufficient ordinary course dividends to obtain refunds of the applicable Part IV tax. The issue was whether the Part IV tax exception in subsection 55(2) of the Act applied. The Court concluded that it did, because the Part IV tax was not refunded as part of the same series of transactions or events in which the deemed dividends were received by the shareholders.

The Federal Court of Appeal also dealt with the capital gains stripping rules in Kruco, in considering how to calculate the "safe income" (that is, income earned or realized after 1971, subject to certain adjustments) to which the capital gain is attributable. The issue was whether safe income should be adjusted to exclude so-called "phantom income", or income for tax purposes that is not associated with any corresponding cash inflow. In rejecting the proposed adjustments, the Court distinguished the computation of income from a subsequent inquiry into whether the income was on hand or disposable to fund the payment of the dividend. The Court indicated that the latter inquiry involved extracting cash outflows, such as taxes or dividends paid, in order to assess the degree to which the capital gain on a notional sale of the shares could be attributed to safe income. For computation purposes, the relevant income was deemed to be the income of the corporation, as computed for the purposes of the Act, subject only to specific exceptions identified in the Act. The Court held that this deeming rule precluded inquiring, at the computation stage, into whether amounts included in income were ever on hand or disposable and, accordingly, the proposed adjustments were rejected.



Conclusion

One wonders whether the flood of proposals, amendments and revisions introduced in the past year will result, in time, in legislative fatigue. The Department of Finance appears to have a full dance card for 2003, and cases such as Gifford and Hayes (which threatens to redefine the meaning of "property" in structured transactions) may spur further initiatives. As taxpayers and their advisors bring increasingly sophisticated litigation and tax planning strategies to bear on the Act, the role of the Minister will no doubt continue to loom large in corporate tax developments for the upcoming year.