July 30, 2007

Mr. James Flaherty
Department of Finance
Ottawa, Canada

Dear Mr. Flaherty:

Re:      FIE Proposals

I am writing to you from Maui, where I spend a good chunk of the summer.  I work in the mornings and then take advantage of the six hour time difference from Toronto to spend most afternoons windsurfing.  This regimen has a way of putting things in perspective, including – believe it or not – our country’s international tax policy.  Actually, that’s why I’m writing.  I would like to invite you come to my windsurfing beach - maybe you might pick up some pointers.

I’m sure you’re wondering, what in the world does windsurfing have to do with international tax policy?  You see, Mr. Flaherty (may I call you Jim?) most people on my windsurfing beach are barely aware that Canada exists.  There are only a few of us here, dwarfed by legions of Japanese, Europeans, and of course US’rs.  Worse still, I’m in constant peril of being bumped into by one of the Japanese windsurfers – they’re very competitive and aggressive.  So here’s my point: Just like on my windsurfing beach, international business can be tough competition for Canadian businesspeople - they need all the help they can get!  A smallish country like Canada should be structuring its international tax laws to encourage Canadian competition abroad.

Jim, I’d like to bend your ear about one pretty flagrant example: the FIE (foreign investment entity) proposals in Bill C-33, which passed through the House of Commons last month with only minor changes.  My impression is that not many tax advisors have had an opportunity to go into the proposals in detail; so you probably haven’t received many letters on them.  But I have seen enough of them to realize that they are a morass of complexity that may seriously hamper international investment by Canadian businesses. 

After numerous rounds of revisions, the FIE proposals are top-heavy with complexity often bordering on the nonsensical.  Here’s an irony: a major rationale for the rules was to deal with offshore mutual funds and the like.   As the original legislation featured a hard-to-enforce test as to whether there was a tax-avoidance motivation for making the investment, the complex new rules were introduced.  Several rounds of revisions later we found that the similar motivation tests were reinstated for many or most of these sorts of investments – along with page after page of fine print, having nothing to do with offshore funds and everything to do with legitimate international investment. 

The rules are structured so that unless an investment in a foreign entity fits specifically into an exemption, it’s a FIE, with the typical result that there is a deemed income based on prescribed interest rates as applied to the “designated cost” of the FIE.  While a major exemption is available for controlled foreign affiliates[1] (in most cases) anything else - most “co-ventures”, for example, must be scrutinized carefully - even if they are active-business related, and therefore might fit into the major exemptions offered for this type of investment[2].  In this respect, I believe there may be major issues where there are layers of FIEs.  Look-through rules are limited by accounting practice: consolidated financial statements in according with Canadian or similar GAAP may be required[3].  With the possible exception of a controlled foreign affiliate, any substantial foreign investment, even if business-related, should be reviewed to make sure it is not caught by the rules.  The more complex the structure, the more likely it is that issues may arise.   

The various revisions to the FIE proposals have spawned virtual sub-regimes where special knowledge is required.  Somewhere along the way it became apparent that the rules could adversely affect Canadian beneficiaries of non-resident estates and trusts – in situations where the non-resident trust proposals themselves do not apply.  The latest revisions make it pretty clear that, unless the estate or trust is completely discretionary (no default clauses allowed), the rules are in play.  

Let me say it in plain words.  If you are a beneficiary of a non-resident estate or trust, the general rule is that you must pay tax based on the interest factor applied to the entire trust’s/estate’s assets, even though you may receive only pennies.  This makes sense?  Here’s another example: A person who has immigrated to Canada with a foreign life insurance policy will ultimately have to revalue the policy every year and pay tax on the increase[4].  C’mon, Jim.  Some poor schmuck comes into Canada and he has to do this?  How does he even go about it?

Let me be honest.  I doubt that you’re going to hop a plane to Hawaii.  So is there any chance that you might make some changes to these proposals?  I know, I know.  They’ve gone all the way through the House of Commons, not to mention your own Department.  But you have to admit it - a lot of this legislation is off the wall.  Instead of helping Canadian businesses compete abroad, the FIE rules and other elements of our international tax policy are structured as if we were a superpower[5]. 

Actually, this brings me to one last point.  Having gone through some examples, let me give you my overview, straight from the middle of the Pacific. I honestly think that there is something terribly wrong going on here, not only with the legislation itself, but with the legislative process in your own Department – and I think you should fix it.  These are not technical glitches I am talking about, they are stinkers.  And by the way, while the biggest stinkers lie in the international area, there are other stinkers too (the restrictive covenant proposals spring to mind). 

I know what you’re thinking.  If I’m carping about competitiveness, why haven’t I carped about the double dip/tower proposals, which (speaking of harming competitiveness) replaced the restricted interest proposals in the March 2007 federal budget.  You’re probably getting so many letters from my colleagues down the street at King and Bay, I don’t see the point.

Aloha