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.

5 comments

  • This disgusts me. The banks, the loopholes, the backing away from good policy, and the handouts banks are getting from the feds. Am sickened by it all.

  • If you are disgusted by this, send a letter to your MP and tell them. For added impact, send it to the PM and cc the other party leaders.

  • Thanks for sounding the alarm about this important issue. I was on top of foreign-affiliate interest-deductibility in the months following Budget 2007, drafting a letter and an op-ed as well as appearing before the House Finance Committee. It seems that Flaherty just waited until (almost) everyone was diverted by the passage of time and far larger fiscal issues.

    To me, the issue is not so much the two tax deductions (one Canadian and one foreign) for the same loan. The foreign deduction is ultimately the foreign country’s business and does not cost Canada anything. The problem is that Canada is handing out tax deductions for loans to finance business activity that we will never tax.

    You are correct about the Liberals. They not only ignored the loophole while in office, but also led the charge against the Budget 2007 proposal to stop foreign-affiliate interest-deductibility.

  • Great work.

    And yes I agree with Erin, it is a tool that the banks and their friends can develop out of country assets and write them off on the tax system.

    Nice.

    This goes back to the point that the banking system has risen above the nation state. When you are as large as they are in Canada, and control as many assets as they do, you can easily get what you want from the ruling party.

    And to think that the largest capitalist state in the history of time recently looked north of their border with envy at our banking system.

    So much for capitalism. This is by no means is a market oriented banking system. It is about as intrusive and dictatorial as an institution can get within a modern economy, regardless of the stripe: actually existing communist, capitalist or somewhere in between.

  • I had a a very interesting conversation today with an insurance insider who is none to happy that the banks have monopoly access to th BOC and also apparently to 200 billion in liquidity which gives them a doubly unfair competitive advantage in the FIRE sector. My insider also made the very interesting point that the private banks access to the BOC is prima facie grounds for constructing a huge firewall around their capacity to expand beyond “banking.” This issue is going to heat up in the coming months. “Regulatory capture” is going to be the frame.

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