The positives in the International Tax Fairness Initiative outweigh the negatives, says Corrado Cardarelli in Investment Dealers' Digest

April 02, 2007

Near the end of March, Canadian Finance Minister Jim Flaherty outlined a 2007 federal budget with various proposed tax changes that could have major implications for cross-border M&A and private equity.

The most significant proposal is the International Tax Fairness Initiative. It would alter the tax code to prevent Canadian multinationals from borrowing funds in Canada to finance foreign operations.

"It is a practice that has resulted in Canadian taxpayers indirectly subsidizing the foreign operations of multinational corporations, and paying the price in reduced business activity and job losses in Canada," Flaherty said in a speech introducing the budget. "No more. The interest expense on debt incurred to acquire shares of a foreign affiliate will no longer be deductible."

Some experts fear that the initiative could impair the ability of Canada's largest companies to expand abroad and inhibit large multinational businesses outside of Canada from investing in the country.

The Canadian government's concern is companies that employ "double dip" loan structures that allow businesses to make interest deductions in both Canada and foreign jurisdictions. The proposal will eliminate double dipping, but make international expansion more costly for Canadian companies.

However, Canada's private equity industry considers as a positive the recognition of U.S.-based limited liability companies (LLCs) under Canadian tax law, and the development of the "Recognized Stock Exchange" concept, which will allow Canadian businesses to list shares on AIM. The first initiative is the result of an amendment to the Canada-U.S. tax treaty that will also eliminate a 10% withholding tax on cross-border interest payments, a tax change that itself has drawn applause from many dealmakers. Traditionally, the exclusion of LLCs under Canadian tax law hurt smaller private equity players, particularly venture capitalists.

Other changes in the 2007 federal budget that could affect M&A is an apparent green initiative that will accelerate capital cost allowance (CCA) for clean energy businesses, such as wind or tidal energy equipment makers, or solar energy outfits. This initiative comes alongside a phaseout of accelerated CCA for oil sands projects, a field that has drawn a number of large multinational oil and gas companies.

The International Tax Fairness Initiative became effective on new loans immediately and will go into effect on existing loans in 2009. Meanwhile, the agreement that was reached on the new Canada-U.S. tax treaty, which will recognize LLCs under Canadian tax law, is expected to be signed by Flaherty and U.S. Treasury Secretary Henry Paulson in about three months.

Corrado Cardarelli says that while it may be close, the positives outweigh the negatives. "On the one hand, you never like to see a useful tool being taken away," he says, referring to the double-dipping loophole. "On the other, the new budget is eliminating the withholding tax and the nuisance of being an LLC, and in a lot of cases, those will be more important to M&A."

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