The 18.2 Overture: An Evasive Tax Symphony

It has to be the single most successful lobbying effort in a long time. And no one will notice or care.  In Budget 2007, the Conservatives did something courageous and which tax experts had long called for : they proposed measures that would have denied firms a tax deduction on money borrowed in Canada, invested it abroad, and used to claim two tax deductions — one here in Canada, and another somewhere else.

This can get really technical really fast but the key to understanding this issue is that Canada defines two categories of foreign income, namely exempt surplus and taxable surplus. If a company’s foreign operations are in a country with which Canada has a tax treaty, Canadian firms can : (1) borrow in Canada; (2) deduct the interest costs; (3) invest abroad; and (4) repatriate the resulting earnings as tax-free dividends because they are considered to be paid out of exempt surplus, a designation that reflects the presumption that Canada only signs tax treaties with countries that impose tax rates roughly in line with our own.

If a company’s foreign operations are in a non tax treaty country, on the other hand, earnings are considered taxable surplus and companies have to pay normal Canadian taxes (less any taxes they paid in the non-tax treaty country) on an accrual basis, i.e., as the earnings arise.

What sometimes happens is that companies are able to effectively claim two deductions on the same borrowing by setting up a shell company in a Canada approved tax treaty country (A) which then lends the borrowed money (from Canada) to another affiliate in a non-tax treaty country (B).  A second deduction ensues in country A.  Dividends from the non-tax treaty country (B) flow to (A) which then flows the dividends back to Canada tax free.  Voila.  Two tax deductions.  Almost no tax paid anywhere. Certainly not in Canada.

In the Conservative proposal to limit the incentives for this practice (basically disallowing the initial deduction in Canada), there was another proposal that would have made the pill a little easier to swallow, namely granting exempt surplus status to a Canadian company operating in any non-tax treaty country that signed an information-sharing agreement with Canada.  Information-sharing is a much less onerous hurdle to climb than a tax treaty.  This measure was a gift and would have likely, eventually, led to tax losses, although the precise extent of the loss is difficult to measure. .

And here, finally, is the point: Bill C-10 does away with 18.2 (the bitter pill to swallow) BUT introduces a lot of the promised sugary sweatness.  That’s right : the Budget Implementation Act 2009 effectively introduces regulations that would extend exempt surplus status to any company operating in any country that agrees to sign an information-sharing agreement with Canada.

Bottom line: Not only has the government backed away from a proposal that would have tightened up Canada’s foreign taxation policy, it’s introduced a hole that will cost the treasury untold millions dollars in foregone tax revenue in the long run.  The Liberals are no better in any of this : for years, they ignored advice from the Auditor General and their own tax experts (the Mintz report of the mid 1990s) that suggested the government close these loopholes (and certainly not extend new ones). Don’t expect a peep from them.

And who is behind all this fine maneouvering? Why, the banks of course.  Or at least their courtiers, those authors of the report which urged the federal government to reverse course on 18.2, extend exempt surplus status everywhere, and generally do away with taxation of foreign income everywhere.  Their entirely predictable report is available here.

Meanwhile, the 18.2 overture plays on. Democracy is silent. Tax changes are, I guess, just too complicated and boring for anyone to care.