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CRA zeroes in on tax ‘treaty shopping’

A woman walks past the Google offices near the city centre in Dublin. Many international companies have offices in Ireland because of its low tax rates.


If you're lining up millions of dollars in corporate financing, you may want to ask your lawyer: Read any good Canada Revenue Agency interpretation bulletins lately?

At least one should make the list – it's all about how the taxman will treat your finance arrangements.

The CRA's bulletin IT-533, called Interest Deductibility and Related Issues, may not be riveting reading, and it's not even hot off the presses – it came out in October of 2003. But to corporate finance lawyers working with Canadian companies, it's as gripping as the latest bestseller.

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"We rely on it," says Alex Pankratz, a chartered accountant and taxation partner at Osler, Hoskin & Harcourt LLP in Toronto. "Even though it came out a decade ago, it's still extraordinarily useful."

The bulletin deals with a key issue that must be addressed in every finance deal, whether it involves borrowing or shares or a combination: When the deal is done, what will the tax people want from you and your company?

"It's a primary tax consideration in the context of financing, ensuring that the interest expense on the borrowed money is deductible," Mr. Pankratz explains.

It's not the only tax consideration. The CRA, and the revenue departments of most other governments, are sharpening their focus on the use of corporate tax havens.

In June, the Organization for Economic Co-operation and Development (OECD) proposed a crackdown on tax haven use by major companies, including Canadian firms. It announced its plan at the last Group of 20 Summit, held in Moscow last July, aimed not just at closing loopholes in exotic micro-nations, but also ones in countries such as Ireland, used by major corporations such as Apple.

"We're seeing a strong effort because of the large deficits so many countries are running. They're going after transactions that they didn't necessarily have the energy to go after before," says Alan Rautenberg, tax partner at Bennett Jones LLP in Calgary.

The OECD wants to come up with a plan in the next two years to prevent firms from using elaborate cross-border schemes, such as reporting taxable profit in a country that has low corporate taxes while deducting the interest costs in another country.

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One of the goals of these rules is to compel companies to disclose more information to regulators. It's complicated and will take time, but already the CRA is among the national tax agencies looking at controlling a sophisticated variant of tax haven use called "treaty shopping."

The federal Finance Department defines treaty shopping as those situations where "an enterprise not directly entitled to the benefits of a tax treaty with Canada uses an intermediary."

Canada has tax treaties with the United States and many other countries in which both countries agree to treat each other's businesses favourably.

When a company goes treaty shopping, it takes financing that would normally be taxed in Canada to a country that we have a tax treaty with, and lower taxes, even though the connection to that country might be tenuous. The big issue is whether to tighten up our own Income Tax Act or to add wording to the many bilateral tax treaties Canada has with other countries.

"To date, the Ministry of National Revenue has been largely unsuccessful in challenging treaty shopping in court," according to a Finance Department paper released in early September.

Meanwhile, Ottawa does have considerable experience in dealing with the basic question that affects corporate finance deals: determining when the interest on a corporate finance loan is deductible.

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The government has been closing loopholes since the early 1990s, Mr. Rautenberg says. "It seems that every time somebody comes up with a scheme they change the rules."

While obviously interest expenses on a loan are deductible – it's a cost of doing business – lawyers are kept busy because "interest" is not defined categorically in the Income Tax Act. The fine points of what can and can't be deducted are left to interpretation.

Companies that borrow money need to show that the funds are being put to "direct use" to help the company's business. It's up to the company, as taxpayer, to show the link.

Courts recognize that businesses need to be flexible, so they'll look at the current use of the money rather than the original reason it was borrowed. It has to be related to doing business, though – the courts spend a lot of time looking at individual cases.

One taxpayer-friendly method of financing, common in the resource sector, is the use of flow-through shares. Resource companies get tax credits for exploration; it is legal for them to "flow through" these credits to shareholders for their own tax bills, since the resource companies might not yet be profitable and pay no taxes anyway.

"We happen to be on a bit of a run in corporate financing transactions, certainly in the oil patch and in Calgary," says Will Osler, partner and co-head of capital markets and mergers and acquisitions at Bennett Jones in Calgary. "I would expect the same is true in Vancouver and also Toronto. Wherever there are concentrations of resource [share] issues, a number of issuers are going to market with flow-through share offerings."

In all cases, says Mr. Osler, it's important for a company to make sure it has done all it can to understand how its financing will be treated by the tax department.

"The implications of getting it wrong can be pretty severe. You don't get your deduction," he says.

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