Backtracking on Tax Deductions

Canada’s financial services sector generally – and Canada’s insurance industry in particular – is no doubt keeping a careful eye on where the federal finance ministry is going to go next with its Anti-Tax-Haven initiative.

You may recall Finance Minister Jim Flaherty’s 2007 budget speech on Mar. 19, 2007, in which he took a tough line on the issue of Canadian companies being able to claim tax deductions for the interest they paid on loans. Many such loans were arranged for the purpose of Canadian companies investing in their foreign affiliates.

“We’re putting an end to the practice of corporations borrowing in Canada to fund business operations abroad, then using the interest deductions to offset Canadian income,” Flaherty said at the time. “No more. The interest expense on debt incurred to acquire shares of a foreign affiliate will no longer be deductible.”

“Whoa,” you could almost hear insurers whispering in the background. Other jurisdictions offer tax credits to encourage non-Canadian insurers to borrow money to invest in their Canadian affiliates. Assume these investment tax deductions in other jurisdictions were disallowed and then ask yourself this: Would non-Canadian-based insurers, without these tax breaks, be as eager to invest in their Canadian operations?

Another thing to consider is this: Given the same tax breaks are offered in other jurisdictions, how is it not a disadvantage for Canadian-based insurers to have to pay tax on the investment payments they make on their loans to invest in affiliates outside Canada?

But Flaherty insisted until recently that there is no tax inequaltiy between nations, because “international competitiveness depends not on a particular isolated aspect of a country’s business environment, but on the economy as a whole. This is equally true of tax competitiveness, which depends on many factors including marginal effective tax rates, statutory tax rates, taxation of foreign-source income and interest deductibility.”

In other words, if your whole business is riding on a tax deduction, then tax deductions are probably the least of your company’s financial concerns.

But in mid-May Flaherty appeared to have an epiphany and changed course. In a recent speech, he said it was really “double-dipping” he was after. In other words, companies should not be allowed to deduct twice for what is, in effect, a single investment loan.

The country’s tax department presents the following example of what Flaherty is talking about: Canadian insurance company CanCo borrows money from a bank and invests the money – i.e. by buying shares – in its U.S. affiliate, USCo. USCo then uses the money to make an equity injection into HavenCo, an insurance company in a low-tax jurisdiction such as the Caymen Islands. CanCo claims an investment tax deduction for the interest paid on its original loan from the bank. Similarly, HavenCo claims an expense deduction for the interest payments it pays on the money it received from USCo.

“What we are talking about here is: one investment [i.e. CanCo to USCo], some transfer of funds [USCo to HavenCo] and two deductions,” Flaherty said. “The ‘double dip,’ seen here, is where we need to draw the line. It simply goes too far.”

But not as far, for example, as eliminating the tax deduction altogether, which seems to be what the government was first prepared to do. It would appear that based on the financial sector’s initial lobby, the government has pulled back from the precipice that would have eliminated the tax break altogether.

There remain a lot of questions as to how this legislation might affect the insurance industry in the future. The issue is much more complicated than presented here; no doubt, the legislation will be further refined as a proposed advisory panel of experts reviews the proposed new tax rules in the future.

Flaherty said he expects to have the Anti- Tax-Haven Initiative implemented by 2012. That’s time for Canadian insurers to ponder how the proposed new rules would affect them as an industry, if at all, going forward in the future.