Flaherty Forced To Backpedal On Interest Tax Deductibility

by Mike Godfrey, Tax-News.com, Washington

11 May 2007

Amid a growing chorus of criticism of his proposal to withdraw interest tax deductibility on investments made by foreign affiliates of Canadian corporates, Finance Minister Jim Flaherty insists the plan is aimed only at firms exploiting offshore structures to 'double dip.'

"If one looks at what I've said, every time I've spoken on this topic, I've said the focus and target is on double-dipping, that is double interest deductions by corporations using tax havens," Flaherty told reporters earlier this week.

He also added that: "We are going to make illegal the use of double deductions and tax havens," he told reporters. "They will have the benefit of a single deduction."

"It's about tax fairness. This is a continuing issue in Canada that if we're going to lower taxes overall for individuals and for corporations then we must have tax fairness - that is everybody must pay their fair share and you don't pay your fair share if you're using a tax haven and taking a double dip."

Flaherty intends to outline how his proposals will work in practice during a speech in Toronto on Monday. He has suggested that a transitional phase could be put in place to ease the concerns of Canadian corporations who have expressed consternation at the new measures.

“We will have a transition period that I think will be fair and acceptable, but over the course of the next number of years we are going to make illegal the use of double deductions in tax havens,” he said. He added that contrary to popular belief, it was never his intention to eliminate all interest deductibility.

Flaherty announced in the March 19 budget that he would eliminate the deductibility of interest on debt taken on by companies to finance foreign affiliates to stop companies claiming deductions both in Canada and the country where they are making acquisitions. However, the proposal has provoked an outcry from businesses and tax experts, who warn that the move could severely hamper Canadian firms' ability to compete in both the international and domestic market place.

In a recent e-brief published published by the economic think tank the C.D. Howe Institute, Robert D. Brown, Chair of the Institute’s Tax Competitiveness Council and Finn Poschmann, Director of Research, warned that the introduction the non-deductibility of interest without thinking through the need for Canada to have lower and internationally competitive rates could be a "major mistake."

"Depending on the fine print of the new rules, it will cost Canadian businesses to rearrange their debt, and could have a profound effect on the structure and cost competitiveness of Canadian business," Brown and Poschmann cautioned.

In a letter to Flaherty in April, the Canadian Chamber of Commerce also warned against the proposals, telling the finance minister that the policy represents a "dramatic and negative change from Canada’s existing system, which the Department of Finance has historically defended."

"Current policy helps businesses in Canada to invest and expand globally. Canadian businesses use their foreign affiliates, established by foreign direct investment (FDI), to deliver more services internationally," the Chamber said.

"The Canadian Chamber believes that the proposal in Budget 2007 will increase the after-tax cost of borrowing to invest in foreign affiliates, thus serving as a disincentive to invest abroad, thereby eroding the competitiveness of Canadian resident corporations. Moreover, in a small, open economy such as Canada’s, if a company has reached its capacity in the local market – i.e. reached a level where it cannot expand further in the Canadian marketplace – it will now be penalized for borrowing in Canada to expand abroad," the letter added.

Moreover, tax experts have noted uncertainty surrounding the proposed new deductibility rules is already hindering the ability of Canadian companies to expand, with several acquisitions deals said to have stalled in recent weeks.

"I think there are some transactions that have not proceeded. That's because some companies are waiting to see what happens," Heather Kerr, international tax partner at accounting firm Ernst & Young LLP, was quoted as observing by the Globe and Mail newspaper.

"People are trying to structure flexibly, but I think a lot of people are trying to hold off on decisions until they hear what the minister has to say," she added.

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