Sunday, April 15, 2007

Budgets and Conservative Pseudo Protectionism

Over coffee this morning, my father asked a question about the changes to the interest deductability rules in the March 19 budget.

I must admit to having not paid much attention to this most recent budget - at least not in the kind of detail to identify and understand the implications of some of the more subtle changes like this. (Yes, I do have a life, and it's been rather busier than would allow me the time to dissect a large piece of legalese in detail - especially when it hasn't caught my immediate interest)

So, I went digging around for some analysis, and found a rather nice article on the subject here, which summarizes the interest deduction rules as follows:

The budget proposes a significant reversal in tax policy in this area. If the budget proposals are enacted, interest expense incurred to acquire shares of a foreign affiliate generally will not be deductible unless and until those shares generate income that is taxed in Canada.

The Notice sets out the details of this proposal. The Notice provides that "interest relating to an investment in a foreign affiliate" (as specifically and quite broadly defined) will generally go into a taxpayer's "disallowed interest pool." Amounts in the pool (which will include both interest and other borrowing costs) will be deductible only to the extent the taxpayer recognizes taxable income from shares or debt of the foreign affiliate or net taxable capital gains from disposing of shares or debt of the foreign affiliate. The determination of such taxable income will be made only after deducting (x) any deductions relating to the receipt of dividends from such foreign affiliate, (y) deductions available where a dividend is paid out of previously taxed "foreign accrual property income" (FAPI), and (z) deductions relating to foreign accrual taxes on previously taxed FAPI. In effect, this means that such interest expense can only be deducted to the extent the taxpayer realizes income from the foreign affiliate that is taxed in Canada (or sheltered by other losses or deductions).

It would appear that the "disallowed interest pool" is defined for each particular foreign affiliate of a taxpayer. The Notice contains no provisions for carryover of such amounts to successors in the case of mergers, amalgamations or similar transactions. However, it is understood that the Department of Finance will include appropriate continuity rules in the definitive legislation enacting these provisions.

The Notice provides for a specific anti-avoidance rule by defining "interest relating to an investment in a foreign affiliate" to include interest or borrowing costs that may reasonably be considered to be in connection with a transaction or series "a main purpose of which was to avoid the application" of these rules.

Along with some other changes that the Blake article points out, this starts to look like the Conservatives are implementing a bizarre, and somewhat incomprehensible version of the kind of protectionism that the United States Republicans have so often pushed in legislation (all the while talking about reducing government and "open markets").

This looks a little like an attempt to "keep capital investment at home", but it creates a unique problem for Canadian companies. Canada is a fairly small market overall, which means that a company that is growing significantly is going to have to "go abroad" sooner or later in order to continue growing. By constraining this ability as significantly as the Conservatives are, there is a very real danger of inverting the problem, and finding that Canadian companies will become takeover targets themselves - hamstrung by legal and taxation environments that would make it difficult for Canadian companies to remain Canadian.

There is a perverse irony to this, since we have a party who talks gamely about "open markets" and their supremacy and is in fact not only bungling their attempts to be protectionist (in the model of the Republicans they so admire), but worse will turn Canada's economy into one controlled not by Canadian interests, but by foreign ownership. (Anyone skeptical of this needs look no further than the gradual incursion of Kinder Morgan Inc. into the Canadian resource industries in a way that echoes of some attempts by Enron to manipulate our energy markets)

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