The Department of Finance releases new income tax proposals in respect of deductible expenditures

On March 16, 2011, the Department of Finance released draft income tax legislation for comment.  The Department of Finance is looking for comments from the public by April 15, 2011.

One of the proposals introduces new section 143.4 of the Act.  This new section is in direct response to a Federal Court of Appeal decision – Collins v. The Queen, 2010 FCA 12 that we blogged about on our February 2, 2010 blog.  The Federal Court of Appeal, reversing an earlier decision by the Tax Court of Canada, enabled two taxpayers to deduct accrued but unpaid interest expense even though they had an existing right to satisfy their interest obligations by electing to pay a substantially lower amount of interest.  Our firm’s view was that the decision of the Federal Court of Appeal was the correct decision.  However, the government obviously has a different point of view.  In its explanatory notes to the release of the draft legislation, the Department of Finance stated the following:

“In response, and in general terms, the Government proposes to clarify through amendments to the ITA that the amount of a taxpayer’s unpaid expenditure otherwise deductible for income tax purposes does not include an amount in respect of which the taxpayer, or a person that does not deal at arm’s length with the taxpayer, has a right to reduce or eliminate.  For greater certainty, this treatment will also apply where the right is contingent upon the happening of another event, or in any other way, if it is reasonable to conclude having regard to all the circumstances that the right will become exercisable.  In the Collins case, this would mean that the interest payable under the original obligation in excess of the lower amount that the taxpayer could elect to pay would not be deductible for income tax purposes unless and until it was actually paid.

This proposal is to apply in computing income for taxation years that end on or after Announcement Date”

Proposed section 143.4 consists of seven new proposed subsections.  In general, as the above quote indicates, a taxpayer will be restricted by the amount that they are able to deduct for an expenditure (or capitalize to an asset) for amounts that the taxpayer has a “right to reduce”.  To the extent that the taxpayer ultimately pays the “right to reduce” amount, the taxpayer will be able to deduct the payment at that time.  The new proposals also contain provisions that would require an income inclusion to the extent that a “right to reduce” an expenditure (that was previously deducted for in a previous taxation year) now exists and the new proposals would have applied to reduce the expenditure to the extent that the law had been in place.

These income tax proposals are controversial.  From many practitioners point of view, the decision in Collins was the correct one.  However, as earlier stated, the government obviously has a different point of view and wishes to “protect Canada’s tax base”.

To the extent that these provisions are passed into law, the new proposals are intended to apply in respect of taxation years ending on or after March 16, 2011.  Accordingly, friends and clients of our firm will need to ensure that, when calculating taxable income and/or computing appropriate amounts that are capitalized, they will need to review for “rights to reduce” amounts in order to carefully apply new proposed section 143.4.

For example, some of the various expenditures or arrangements that will need to be carefully looked at will be:

  1. Lease Agreements – do the agreements contain contractual provisions that offer the lessor certain options to reduce the cost?
  2. Debt Arrangements – similar to Collins, are there contractual arrangements that enable the debt holder to reduce their future carrying costs?
  3.  Earn-outs – many business acquisitions are arranged in such a way that future profits (or other amounts thereof) are paid to the vendor into the future.  Will these new proposals affect such arrangements?  Perhaps.  A close review of the business deal and the new proposals will need to be carried out.

The tax professionals at Moodys would be pleased to discuss these proposals with you.