Fear and Loathing on Bay Street

Budget 2007 made interest on funds borrowed in Canada to finance foreign business operations nondeductible from Canadian corporate taxes. Finance Canada suggested that this arcane reform would raise relatively little revenue and, initially, business barely seemed to notice.

More than a week after the budget, a Globe editorial and a Financial Post op-ed criticized the change as a huge ‘tax grab’ that would make Canadian-based corporations ‘uncompetitive’ in foreign markets. Since then, corporate Canada has begun to wage what Terence Corcoran calls “the Great Foreign-Affiliate Interest-Deductibility War.”

Opponents of reform note that, in many industrialized countries, interest on loans to finance foreign affiliates is tax-deductible. However, they consistently neglect to mention that, in many of these same nations (including the US, Japan, and Britain), corporations pay tax on the incomes of their foreign affiliates.

Theoretically, corporate tax applies to profit: income net of expenses incurred in earning the income. If a corporation borrows money to finance operations that generate income, then the associated interest cost should be deductible from this income for tax purposes. However, since Canada does not tax income generated by the foreign affiliates of Canadian corporations, it is unclear why costs incurred in generating this income should be deductible in Canada.

As Corcoran pointed out in Thursday’s Financial Post, the deductibility of this interest was a subsidy for corporations to borrow from Canadian banks and invest outside of Canada. Why would Canada give up tax revenue to create economic activity and tax revenue in other countries? Apparently, to increase the profits of Canadian banks.

The Canadian left should, at a minimum, support the elimination of foreign-affiliate interest-deductibility (as announced in Budget 2007). More ambitiously, we could propose that Canada tax Canadian corporations on a worldwide basis, including foreign-affiliate income, which would make interest deductibility legitimate. Given that the US, Japan, and Britain tax their corporations on a worldwide basis, proposing that Canada do so would not be overly radical.

Another interesting point is that Finance Canada appears to have understated the revenue that ending deductibility will yield. This factor reinforces the view that future federal surpluses may continue to be greater than projected.

Tax policy or bank subsidy?
Terence Corcoran
Financial Post
Thursday, April 12, 2007
 
Finance Minister Jim Flaherty seems to have a knack for getting into hot water over his good tax policy decisions and a free ride on bad tax policy. The free ride comes from his post-budget glide over his failure to deliver significant corporate and personal tax cuts. Instead, he’s getting a rough time for taking on tough tax issues that are worth taking on. His move to level the tax playing field between corporations and income trusts was the right one, as is his proposal to reform a relatively obscure corner of the corporate tax system known as foreign-affiliate taxation.

. . .

First, the Finance Department’s explanation for ending the deductibility of interest on money corporations borrow to finance foreign affiliates doesn’t seem totally crazy. The objective, it says, is to end a practice whereby Canadian companies can borrow money in Canada and deduct the interest cost as an expense against Canadian income so they can buy assets abroad that pay no Canadian tax. “In other words,” said the department, “the Canadian tax system recognizes the expense, but not the corresponding revenue.”

Put another way, Canadian taxpayers are subsidizing borrowing to finance foreign operations that other countries can tax. Why would we do that?

An illustration of the tax issues was usefully provided the other day by KPMG, the accounting giant also well schooled in the art of tax avoidance. It takes a little time to work through, but it highlights a couple of points that suggest Mr. Flaherty is on to something few Canadians knew existed.

Suppose Canco, a Canadian corporation, borrows $100-million to fund an affiliate in a European country. The cost of borrowing is 8% and the foreign affiliate has earnings of $10-million, or 10%. The corporate tax rate in the European country is 35%.

Before Mr. Flaherty’s budget, it all worked out well for the corporation. After paying tax on the $10-million, paying interest on the loan and getting a deduction for the interest payment from the government of Canada, Canco had $1.3-million in after-tax earnings on its foreign investment. (See the table below.) But after Mr. Flaherty’s budget, the interest deduction is gone and Canco shows a loss of $1.5-million.

The KPMG accountants portray this as a terrible development, a form of double taxation. Which it may be, to a degree. But why should Canada give up tax revenue of $2.8-million so that Canco can pay $3.5-million to a government in Europe? Canada is subsidizing job creation in a European country and boosting its tax base.

There is, of course, a simple solution. If Canco were to borrow the money in Europe on the books of its Euro affiliate, and offset the cost against its European income tax, Canco would come up even, and Canada would not lose tax revenue.

Good idea, right? Aha, not so fast. KPMG said that Canadian multinationals would be “compelled” to move their foreign financing activities “out of Canada” and into various foreign jurisdictions. That might be a better idea “in theory,” it said, but “much more difficult in practice.” Another difficulty, says KPMG, is that if Canadian multinationals were to borrow from foreign jurisdictions, “the shift in activity could also damage Canada’s domestic financial-services industries and capital markets.”

That would happen, one assumes, because companies like Camco that now borrow money from Canadian institutions to get the tax deduction in Canada would have to borrow in Europe to get the tax deduction in Europe. What that means, of course, is that the deductibility of interest costs to fund foreign affiliates actually acts as a tax subsidy for Canada’s banks.

For the full column, click here.