Federal finance minis-ter Jim Flaherty attempted to present an olive branch to corporate Canada in May, when he announced a proposal to narrow a 2007 federal budget crackdown on the financing of Canadian foreign affiliates. But tax advisors are responding to the announcement as if it were a wilted rose.

The new measures are meant to shut down tax arrangements commonly used by Canadian corporations to enable investing in their foreign affiliates.

“It will increase the cost of capital,” says Trent Henry, leader of international tax services with Ernst & Young LLP in Toronto. Ultimately, he adds, it will adversely affect investors in Canadian multinationals when the markets discount the impact of the new rules, which are scheduled to come into effect in five years. During that time, however, it’s expected that corporate Canada will lobby Ottawa to back off.

Under present tax rules, income earned by a Canadian foreign affiliate is taxed in the jurisdiction in which the income is earned. If Canada has a tax treaty with that country, the income is exempt from Canadian tax when earned and when it is “repatriated,” for example, as a dividend paid from the affiliate to the Canadian parent.

A “mismatch” arises when foreign affiliates are in non-treaty countries: their profits are taxed in Canada when they are repatriated. But if the income is not repatriated, depending on the jurisdiction, it may never be taxed. However, Ottawa gives a deduction to all Canadian companies on interest arising from financing used to invest in their foreign affiliates — even if the foreign-earned income is not repatriated.

The 2007 federal budget contained a proposal to resolve this mismatch. The budget characterized the interest deduction as a “subsidy” encouraging Canadian multinationals to locate debt at home while earning income abroad.

The Finance Department promised to cast a wide net on the type of foreign-affiliate financing that could be denied an interest deduction. The result was a cry of protest from business that its ability to compete globally would be handicapped.

The revised measures are more narrowly focused. Ottawa will allow Canadian corporations to use what are known as “single-dip” tax transactions; instead, it will target “double-dip” transactions that involve foreign affiliates in so-called “tax havens.”

A single-dip transaction involves the Canadian company borrowing to invest in a foreign affiliate and getting an interest deduction on the financing cost, “providing a significant benefit to Canadian companies investing abroad” and giving them “a competitive edge,” says Flaherty.

Meanwhile, the Canada Revenue Agency will target “double-dipping” through the use of a tax haven country. For example, a Canadian company borrows money to invest in a foreign affiliate in a country considered to be a tax haven, and that affiliate lends the funds to another of the Canadian company’s affiliates in a non-tax haven country.

The loan, with interest, is repaid to the company in the tax haven, but there are little or no taxes. Then, the Canadian company and the second affiliate claim interest deductions for their financing costs. Two deductions based on this type of transactions will not be allowed.

Under the new measures, companies will be able to decrease the amount of Canadian taxes they pay in proportion to taxes they pay in foreign jurisdictions. Therefore, they should structure foreign financing in more highly taxed jurisdictions. Ottawa is encouraging Canadian firms to pay more foreign taxes in order to get a deduction at home, says Henry: “No other countries have implemented this type of measure, focusing on the foreign taxes.”

Meanwhile, one of the key problems tax experts have with the new initiative is that it doesn’t define what constitutes a tax haven. “It’s not clear what Flaherty means by ‘tax havens’ — jurisdictions with lower tax rates?” asks Sandra Slaats, an international tax partner with Deloitte & Touche LLP in Toronto.

According to Nick Pantaleo, a partner in PricewaterhouseCoopers LLP’s international tax services group in Toronto, tax havens should be characterized as countries that have laws that would prevent the CRA from carrying out its audit role. This includes countries targeted by the Organization for Economic Co-operation and Development because they lack transparent tax systems and bank secrecy laws, such as Andorra, Liberia and Liechtenstein.

Bermuda and the Cayman Is-lands, says Pantaleo, “have no rate of tax, but they have transparent laws.” Both countries have been used to facilitate international corporate and tax transactions for years and are not on the OECD list.

@page_break@Ottawa is also giving tax experts and corporations until 2012 before it starts denying the targeted interest deductions. The transition period in the budget was only two years. IE