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Toronto's Bay Street financial district.

Fred Lum/The Globe and Mail

Ottawa is moving to end a long-standing practice of "debt-dumping" that has allowed foreign companies to avoid paying hundreds of millions of dollars a year in taxes in Canada.

Under a loophole in Canadian tax law, foreign multinationals have been allowed to loan money to their Canadian subsidiaries, which they would use to buy shares in another foreign affiliate of the parent company. The Canadian subsidiary was then allowed to deduct the interest payments on the debt from its parent - and reduce its taxable income - while the dividends it received from investing the borrowed money in the foreign affiliates was exempt from taxation.

"Such transactions provide a mechanism for foreign parent corporations to extract earnings from their Canadian subsidiaries free of Canadian dividend withholding tax," the budget says of the loophole, first identified in 2008 by an advisory panel on Canada's international taxation system. "Immediate action is being taken to discourage such transactions from being undertaken in the future."

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The government said it will reap $1.3 billion in tax revenues over the next five years by ending the loophole.

Under the new rules, foreign-controlled Canadian subsidiaries will be subject to a "bona fide purpose" test by the Canada Revenue Agency to determine if the actions that reduce its taxes serve a legitimate business purpose or are merely part of a large-scale tax reduction scheme by the foreign parent. If they fail the test, the investment made by the Canadian subsidiary will be considered a dividend paid to the foreign parent - and subject to Canadian withholding taxes.

Gabriel Hayos, vice president, taxation with the Canadian Institute of Chartered Accountants, warned the changes as worded in the budget "may have unintended changes" by discouraging legitimate investments abroad by the foreign-controlled companies. "It's so subjective that it's almost at the discretion of the CRA to see if firms are onside or more. You want to see more objective tests. If not, you'll either have a lot of court cases or it may discourage companies from investing abroad," he said. "It needs further work."

The government said it is inviting stakeholders to submit comments about its proposed business test by June 1. In addition, Mr. Hayos said the CICA will organize discussions to ensure affected companies have a say on the new rules.

Ottawa is also proposing to close personal taxation loopholes related to employee group sickness or accident insurance plans and employee profit sharing plans. Those changes are expected to save a combined $570 million in total over the next five years.

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