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1992 Report of the Auditor General of Canada

Main Points

2.2 The Other Audit Observations chapter fulfils a special role in the annual Report. Other chapters normally describe the findings of the comprehensive audits we perform in particular departments; or they report on audits and studies of issues that relate to operations of the government as a whole. The Other Audit Observations chapter is used to report individual matters that have come to our attention during our financial and compliance audits of the Public Accounts of Canada, Crown corporations or other entities. It is also used to report some specific matters that have come to our attention during our comprehensive audits.

2.3 The chapter contains a wide range of observations on departmental operations. The issues addressed generally concern failure to comply with authorities, poor cash management practices, inadequate control over revenue and the expenditure of money without due regard to economy.

2.4 Although the individual audit notes report matters of significance, they should not be used as a basis for drawing wider conclusions about matters we did not examine.

Introduction

2.6 Section 7(2) of the Auditor General Act requires the Auditor General to call to the attention of the House of Commons any significant cases where he has observed that:

• accounts have not been faithfully and properly maintained or public money has not been fully accounted for or paid, where so required by law, into the Consolidated Revenue Fund;
• essential records have not been maintained or the rules and procedures applied have been insufficient to safeguard and control public property, to secure an effective check on the assessment, collection and proper allocation of the revenue and to ensure that expenditures have been made only as authorized;
• money has been expended other than for purposes for which it was appropriated by Parliament;
• money has been expended without due regard to economy or efficiency; or
• satisfactory procedures have not been established to measure and report the effectiveness of programs, where such procedures could appropriately and reasonably be implemented.

Observations on Departmental Operations

The Government of Canada

Inappropriate use of section 5 of the Department of Agriculture Act as authority to spend $17.3 million on forestry matters and failure to correctly report the expenditure to Parliament

2.8 Background. In 1987 and again in 1989, our Office reported on the erosion of accountability and of parliamentary control resulting from the Department of Agriculture's use of section 5 of the Department of Agriculture Act and Governor in Council authority to create new programs. Section 5 provides that the "Governor in Council may assign any other power or duty to the Minister". In the case of another department, we reported that a section with words similar to section 5 was interpreted as providing the power to re-assign existing powers and duties, but not the power to create new ones.

2.9 Regardless, the Department has made frequent use of this section to set up new programs and spend billions of dollars. By 1989, the Department had spent over $3 billion based on the use of section 5. Since then, an additional $900 million has been spent under this authority. As noted in the Auditor General's 1989 Report, Parliament has little opportunity to debate the programs that section 5 authorizes, and little basis for scrutinizing them even though it is being asked to vote moneys to fund them.

2.10 Until 1992 the expenditures that have come to our attention have been restricted to agricultural matters. However, in 1992 the government used section 5 of the Department of Agriculture Act as its authority to spend $17.3 million to assist the Province of Manitoba with costs incurred as a result of its 1989 forest fires. In our view, the current Department of Agriculture Act does not provide any authority for forestry matters. However, section 9 of the Department of Forestry Act and section 3(c) of the Forestry Act are quite specific in allowing the Minister of Forestry to conclude agreements with the provinces for the purposes of forest protection.

2.11 The following comprises a brief account of the key events that led the Department of Agriculture to pay for the costs incurred as a result of forest fires:

• In November 1988, the Canadian Crop Drought Assistance Program was announced in response to the severe drought experienced by producers in various regions of Canada. Subsequently, the participating provinces agreed to share 25 percent of the program's cost. As of October 1990, the Province of Manitoba was the only participating province that had not signed a Canadian Crop Drought Assistance Program agreement with the Government of Canada.
• In the spring and summer of 1989, the Province of Manitoba experienced severe forest fires, resulting in the evacuation of almost 24,000 people and expenditures exceeding $63 million.
• According to Department of Agriculture officials, the province, in its endeavour to recover approximately $30 million of its 1989 forest fire costs, delayed signing a Canadian Crop Drought Assistance Program agreement and, hence, effectively forestalled its $37.7 million contribution.
• In March 1992, the Government of Canada agreed to assist the Province of Manitoba for up to $30 million of the Province's costs resulting from the 1989 forest fires. The quid pro quo was that the Province of Manitoba would sign a Canadian Crop Drought Assistance Program agreement and pay Canada the $37.7 million that it owed.
• Under the authority of section 5 of the Department of Agriculture Act, $17.3 million was to be paid for costs incurred as a result of the forest fires. The remainder was paid out appropriately by two other federal departments for the amounts of $1.3 million and $11.4 million, under their respective legislation.
• The Department of Agriculture's amount was offset against the $37.7 million due to Canada under the Canadian Crop Drought Assistance Program. The outstanding balance of $20.4 million was to be paid by the Province of Manitoba in instalments.
• Order-in-council approval was given using section 5 of the Department of Agriculture Act, to enter into an agreement to effect the $17.3 million transaction.

2.13 In accounting for this transaction the Department of Agriculture netted the forest fire costs against the recovery of the expenditure under the Canadian Crop Drought Assistance Program, thereby failing to correctly report the $17.3 million expenditure and understating by that amount the amount spent under Vote 15 - Grants and Contributions. The Department's non-tax revenue is understated by the same amount. The transaction was thus carried out without proper authority, and was not properly recorded in the accounts.

2.14 Conclusion. In our opinion, the expenditure could have been properly made and disclosed if two separate agreements had been implemented: the first between the Province of Manitoba and the federal Minister of Forestry for $17.3 million, and a second agreement with the federal Minister of Agriculture for the provincial contribution of $37.7 million under the Canadian Crop Drought Assistance Program.

Department's response: The Department of Agriculture concurs with the facts as presented above. However, as in the past, the Department continues to disagree with the Auditor General's interpretation on the use of section 5 of the Department of Agriculture Act. Legal counsel for Agriculture Canada supports the departmental position that the use of section 5 in this instance was appropriate.

Department of Agriculture

Lack of adequate controls over payments made to the Farm Credit Corporation for Farm Debt Review Fund Concessions

2.15 Background. The Farm Debt Review Act was enacted in June 1986 to facilitate financial arrangements between farmers and creditors. The Act established a Farm Debt Review Board (FDRB) in each province. The Boards were to provide mediation services to assist farmers who were in financial difficulty or insolvent to reach agreements with their creditors. The FDRBs are managed and funded by the Department of Agriculture.

2.16 The Farm Credit Corporation (FCC) is a wholly owned federal Crown corporation and a major holder of farm mortgages, which formed a significant portion of troubled farm debt when the FDRBs were created. In December 1986, the Farm Debt Review Fund was established by an order-in-council pursuant to section 5 of the Department of Agriculture Act. It authorized the Minister of Agriculture to reimburse the FCC for certain types of concessions to farmers, arising from FDRB-mediated negotiations. The reimbursement would be in the form of a payment to the FCC from the Fund on behalf of the farmer. Total expenditures from the Fund were initially approved at $30 million and, in April 1988, the amount was increased by $300 million.

2.17 The order-in-council set out the conditions that a concession had to meet to be reimbursed from the Fund. First, the FCC had to satisfy itself that the farmer had demonstrated management ability, and a satisfactory plan of operations that indicated the future viability of the farming operation. Second, FCC concessions to farmers that were proportionately greater than those given by other secured creditors were not reimbursable. The Fund was available only to the FCC.

2.18 The Department approved reimbursements to the FCC from the Fund based on a listing submitted by the FCC of concessions made to each farmer. Accordingly, when the reimbursements were authorized, the Department did not know whether the concessions met the conditions for reimbursement. Making payments before obtaining evidence of compliance with governing authorities is acceptable, provided that it is followed soon by a post-audit of the organization to whom the payments were made, to assess compliance with the terms and conditions establishing eligibility. The order-in-council assigned the Department the duty to do just that. However, for a reasonable basis for post-audit, it is essential that the Department ensure that the terms and conditions establishing eligibility are clearly defined; that these definitions are understood and agreed to by the recipient organization, along with agreement on requirements for documentation to provide sufficient and appropriate evidence that the eligibility criteria have been met; and that the post-audits are timely to ensure that problems are identified and resolved early.

2.19 In June 1989, the Department's internal audit division reported that post-audits of payments made by the Department to the FCC had not been done and recommended that the Department undertake to do them. We also raised this with the Department in a management letter in connection with our audit of the summary financial statements of Canada for the year ended 31 March 1989, and in 1990 and 1991 as well. The Department agreed with our observation and stated its intention to undertake post-audits in June 1990, designed to provide the Department with assurance as to the validity of claims paid and an assessment of the FCC's internal controls and procedures over such claims.

2.20 The results of the first post-audit were not reported until March 1991, some five years after the first payments were made from the Fund and after the Department had authorized payments for $120 million, to 31 March 1991. In our opinion, the Department was unreasonably slow in implementing post-audits to assess whether the reimbursements made from the Fund were warranted. The delay in implementing post-audits is surprising, as there is evidence in departmental records as early as 1988 raising concerns that some of the claims made by the FCC might not be in accordance with the viability criteria set out in the order-in-council.

2.21 The Department made further payments for some $40 million from 1 April 1991 to 31 March 1992 after receiving independent evidence from post audits in March 1991 and again in December 1991 that raised concerns as to whether what it had already paid had been in compliance with the order-in-council.

2.22 To assess whether the concessions were in compliance with the order-in-council, the independent auditors engaged by the Department to carry out the post audits established audit criteria that among other things, expected the FCC concession files to contain clear documentation demonstrating management ability; and to also contain adequate financial statements and a satisfactory plan of operations demonstrating future viability of the farming unit. They also expected the plan of operations to include an analysis of the net effect of the proposed concession(s) on the borrower's cash flow and profitability. Finally, they did not believe that the criterion of proportionality could be met if other secured creditors did not participate in the FDRB process or grant a concession to the borrower. In December 1991, the auditors reported that:

• most of the FCC concession files tested did not contain documentation to determine if the management ability criterion had been met;
• many of the FCC concession files tested did not contain sufficient and appropriate documentation to determine if the future viability of operations criterion had been met; and
• over half of the FCC concession files tested did not meet the proportionality criterion.

2.24 Issue. In our opinion, post-audit control did not provide a meaningful financial management control because the Department did not clarify the terms and conditions of the order-in-council (such as future viability and proportionality); did not communicate to the FCC its requirements for sufficient and appropriate evidence to demonstrate compliance with the order-in-council; and did not carry out the audits on a timely basis.

2.25 In May 1992, with less than one year left for approving payments from the Fund, the Department and the FCC agreed on criteria to support viability based on a proposal put forth by the Department. The Department did not do any research and analyses in developing this proposal to the FCC. Authoritative research in this field indicates that the agreed upon criteria are excessively optimistic as they do not give adequate consideration to, among other things, an adequate reserve for unexpected expenses and equipment replacement, or the capacity to absorb even small adverse trends in harvests or markets.

2.26 In June 1992, the Department requested and received order-in-council approval redefining proportionality. The revised order-in-council requires the FCC to act as any other responsible creditor in similar circumstances given its relative and net security position.

2.27 Conclusion. In our opinion, the Department needs to improve its systems and procedures to ensure that the terms and conditions that form the basis of payments, and the documentation required as evidence thereof, are clearly defined and built into the design of its programs; and to ensure that these requirements are clearly communicated and understood by all participating organizations. Further, the Department should implement timely ongoing post-audit compliance procedures for all programs under which payments are subject to this form of financial management control - normally within one year of the start of a new program. We noted similar concerns about the effectiveness of post-audit compliance procedures in our 1992 value-for-money audit of the farm income support programs.

Department of Agriculture's response: The Department agrees with the general thrust of these observations. However, the Department believes that its approach to this contribution arrangement is consistent with dealing with another federal government agency reporting to the same Minister in that it relied on FCC's knowledge and expertise to manage the Fund. When inconsistencies were discovered by the Department's audit, corrective action was taken to address the identified problems.

Department of Finance

Tax arrangements for foreign affiliates are costing Canada hundreds of millions of dollars in lost tax revenues

2.28 Background. In our 1986 Report (Chapter 4, Income Tax Expenditures) we noted our concerns about tax avoidance mechanisms. We pointed out that it is both legitimate and advisable for taxpayers to seek expert advice on how to minimize their tax costs. However, although such advice can produce tax savings for them, it may subvert or greatly reduce the effectiveness of taxation provisions. Unlike tax expenditures, which give tax relief to taxpayers who have fulfilled conditions that further the government's specific economic and social objectives, tax avoidance mechanisms do not. They do not relate to any specific legislative objectives and may usually be seen as frustrating the general intent of tax legislation.

2.29 Avoidance mechanisms also have a negative effect on the equity and integrity of the tax system and on public attitudes toward voluntary compliance. Access to such mechanisms is usually limited to those who can afford expensive advice. Those who cannot, therefore, may be denied equitable or even-handed treatment.

2.30 Recognizing that it is virtually impossible to anticipate every tax avoidance mechanism, we recommended in 1986 that, when they are identified, the government act to eliminate them.

2.31 The Standing Committee on Public Accounts, in its Report of 20 December 1989 dealing with a federal sales tax avoidance problem, recommended that the Department of Finance ensure that tax avoidance be closely monitored, and that it put forward proposals for dealing as soon as possible with significant revenue losses when those losses become apparent.

2.32 The Income Tax Act provisions dealing with the foreign affiliate rules and foreign source income are complex, as are the arrangements for foreign affiliates. It is our intention to explain the situation fairly and without undue complexity. Our concern is with transactions that can be structured to circumvent the intent of the law.

2.33 Issues. In 1987 the Department of Finance announced that it would review the tax rules on interest deductibility, foreign-source income and foreign affiliates. The reviews have not been completed.

2.34 Tax arrangements for foreign affiliates are a concern for the Department of National Revenue - Taxation (NRT). On a number of occasions, NRT has advised the Department of Finance about concerns it has with existing legislation.

2.35 Interest deductibility. In very general terms, the law allows a Canadian-resident corporation to deduct interest on funds it borrows for the purpose of investing in a foreign affiliate. It is not necessary to match the interest expense for that investment with the income it generates.

2.36 When a Canadian company carries on business outside Canada through a foreign affiliate, the interest expense associated with its investment in the foreign affiliate can be deducted in Canada, while the related income is reported in the foreign jurisdiction. The Department of Finance has advised us that this treatment is in accordance with that of other countries and that it is designed to encourage international competitiveness.

2.37 That deduction of interest reduces Canada's tax revenue and, at the same time, the related income is not necessarily subject to tax in Canada - it may be received as a tax exempt dividend and may never appear in the Canadian tax base. This exemption was intended as a proxy for a Canadian system of foreign tax credits.

2.38 Even if dividends from their foreign affiliates in high-tax countries were included in the income of Canadian corporations, any Canadian tax payable would be offset by the Canadian tax credits given for the underlying foreign taxes, paid by the foreign affiliates. This would produce no tax for Canada (to do otherwise would result in double taxation), but the corporations could deduct any related interest from their income in Canada.

2.39 If the exemption system were repealed, there would still be the issue of deferral. In other words, the interest cost to the Canadian corporation would be deductible in the current year, but dividends from its foreign affiliates would be included in income only as they were received.

2.40 If Canada's tax rates are higher than those of other jurisdictions there is an incentive to incur and deduct interest in Canada.

2.41 In 1990 the Department of Finance advised us that the issue of matching interest expense with related income had already been "the subject of extensive review with a view to arriving at a proper tax policy".

2.42 Tax exempt dividends from foreign affiliates. The rules on foreign affiliates enable a Canadian corporation to receive, tax free, active business income earned by its qualified foreign affiliates. Such a foreign affiliate must be resident in one of the countries designated in the Income Tax Regulations (see Exhibit 2.1 ), and the active business income must be earned in a country so designated, or in Canada. The dividends are not subject to Canadian tax, on the basis that the underlying income has been taxed by a foreign state at a rate that approximates Canadian rates. As previously mentioned, exempting dividends from tax was intended as a proxy for a Canadian system of foreign tax credits.

2.43 As Exhibit 2.1 shows, a number of the designated countries have low tax rates or are tax havens, and certain types of income earned in them thus may not be subject to tax at a rate that approximates Canadian rates.

2.44 Also, a foreign affiliate in a tax haven country that is not designated may technically be resident in a designated country; dividends from it can then be passed on to its Canadian affiliate without being subject to Canadian tax, even though the underlying income has not been subject to foreign tax at a rate that approximates Canadian rates. The Department of National Revenue - Taxation is aware of a number of taxpayers who have used this scheme to be in a position to move $500 million into Canada tax free.

2.45 Determining residency is a complex matter and is a question of fact.

2.46 The system was intended to ensure that income entering Canada would be taxed by Canada if it had not been previously taxed by a foreign state at a rate that approximated Canadian rates. This is not what is happening in many situations.

2.47 To further complicate matters, low-taxed or tax-free offshore income of a Canadian corporation carries the same federal and provincial tax credits for Canadian shareholders, on dividends paid to them, as taxed income from a Canadian source. Income earned in a tax haven may thus receive preferential treatment over income earned in Canada and subjected to Canadian tax. In our view, this provides an incentive to maximize the income of a foreign affiliate. In 1990 the Department of Finance advised us that the amounts claimed as tax credits in such cases are "not likely to be of significant magnitude to warrant legislative action".

2.48 Taxable dividends from foreign affiliates. Dividends received from non-qualified foreign affiliates (those resident in a country not designated in the Income Tax Regulations), and dividends received from income other than active business income of qualified foreign affiliates, are considered to be paid out of taxable surplus. These dividends are taxable on entering Canada, with a credit given to the Canadian corporation for the underlying foreign tax paid by the foreign affiliate. Consequently, there is an incentive to defer such distributions, or to disguise them, when the foreign affiliate's income is subject to foreign tax rates that are lower than Canadian tax rates.

2.49 A number of schemes have been devised that often are referred to as "surplus stripping" schemes. These involve the conversion of taxable surplus into tax-exempt surplus. It is also possible to use an "upstream loan" scheme to disguise a distribution into Canada - a foreign affiliate distributes money to a Canadian parent or affiliate by way of a loan or share purchase.

2.50 Other related problems. A number of other problems have been identified. We comment on one below.

2.51 Foreign Accrual Property Income (FAPI). The FAPI rules are a key anti-avoidance element of the current system. Their purpose is to eliminate the tax advantage of earning passive investment income, such as interest in a controlled foreign affiliate. This is done by attributing the passive investment income earned by the foreign affiliate to the Canadian shareholders.

2.52 A key concern is the fact that the Income Tax Act does not define active or passive income in the context of the FAPI rules. The absence of a definition is of concern to the Department of National Revenue - Taxation. It makes the law difficult to administer and difficult for taxpayers to comply with. The limited case law indicates that the meaning of active business income for purposes of FAPI rules may be derived from the case law dealing with the pre-1979 meaning of active business income in the context of the small business deduction rules. That case law gives a very broad meaning to active business income. The meaning of active business income for purposes of the small business deduction rules was subsequently altered by specific amendments to the Income Tax Act. These amendments were not extended to the FAPI rules. Accordingly, the meaning of passive income for the FAPI rules may be very narrow. As a result, there is no reasonable assurance that the rules will apply in all circumstances where they should.

2.53 The General Anti-Avoidance Rule (GAAR) was enacted in September 1988, subsequent to the tax arrangements for foreign affiliates referred to in paragraph 2.56. The General Anti-Avoidance Rule will apply to tax arrangements which result in a misuse of the provisions of the Income Tax Act or an abuse, having regard to the Act read as a whole.

2.54 We are unable to provide Parliament with reasonable assurance that GAAR will have any significant impact on the problems identified in this note. Tax arrangements for foreign affiliates continue to be of concern to the Department of National Revenue - Taxation and in September 1990, it again advised the Department of Finance of its concerns. As of September 1992 no reassessments have been issued under GAAR.

2.55 How taxpayers use the rules. These tax rules are being used to:

• transfer foreign subsidiaries' losses to their Canadian parents;
• move Canadian corporations' income offshore; and
• convert income of Canadian corporations into tax-free income.

• A Netherlands Antilles subsidiary (under Canadian tax law the company is a resident of Switzerland but under Swiss law it is not considered to be a resident of Switzerland) of a Canadian company had assets of $865 million and income of $92 million not subject to the FAPI rules. Although the income of the foreign subsidiary has not been taxed at a rate that approximates Canadian rates, it can be transferred to the Canadian parent as tax-free dividends. The offshore income is not taxed on entering Canada, but it carries with it federal and provincial tax credits on dividends paid out to Canadian shareholders. The Canadian parent incurred the financing costs for its investment in the subsidiary and reported a tax loss in Canada of $29 million.
• A Canadian company transferred $318 million in investments to its Barbados subsidiary, which generated income of $37 million, not subject to the FAPI rules, in six months. Although the income of the subsidiary has not been taxed at a rate that approximates Canadian rates, it can be transferred to the Canadian parent as tax-free dividends. The offshore income is not taxed on entering Canada, but it carries federal and provincial tax credits on dividends paid to Canadian shareholders. The Canadian parent incurred the financing costs for its investment in the Barbados subsidiary and reported a tax loss in Canada.
• A Canadian company's U.S. affiliate has $684 million in cash and short-term deposits, which originated in the Canadian company. Investment income earned by the U.S. affiliate was used to absorb its U.S. tax losses. The related interest expense for the investment in the U.S. subsidiary is deducted in Canada. Although the Department of National Revenue - Taxation deemed that the investment income was subject to withholding tax, this scheme had the effect of transferring U.S. tax losses to Canada.
• Another Canadian company's U.S. affiliate has $672 million in cash and short-term deposits, which originated in the Canadian company. Investment income earned by the U.S. affiliate was used to absorb its U.S. tax losses. The related interest expense for the investment in the U.S. subsidiary is deducted in Canada. This scheme effectively transferred U.S. tax losses to Canada.
• A Canadian company's Hong Kong affiliate has $62.4 million in cash and short-term deposits, which originated in the Canadian company. Investment income earned by the Hong Kong affiliate was used to absorb its Hong Kong tax losses. The related interest expense for the investment in the Hong Kong subsidiary is deducted in Canada. This scheme effectively transferred Hong Kong tax losses to Canada. The Department of National Revenue - Taxation's tax avoidance unit has been reviewing this case since 1990.
• A Canadian company has $1.6 billion in interest-free advances and a $133 million investment in its Netherlands' foreign affiliate. This investment generated $130 million in income not subject to the FAPI rules for the foreign affiliate. Although the income of the foreign affiliate was not taxed at a rate that approximates Canadian rates, the $130 million can come to the Canadian company tax free. This offshore income is not taxed on entering Canada, but it carries federal and provincial tax credits on dividends paid out to Canadian shareholders. The Canadian company reported a tax loss.

• We analyzed National Revenue - Taxation's 1990 information return (T106) database. We found that at that time Canadian corporate taxpayers had "invested" $92 billion ($42 billion in loans and $50 billion in equity) in non-resident companies that they were not dealing with at arms' length and, in 1990, they had received over $4.2 billion in dividends from them.
• Of this total amount of $92 billion:
  • $5.2 billion was "invested" in companies in Barbados, a tax haven. In 1990 Canadian companies received over $400 million in dividends from companies in Barbados. Active business income earned in Barbados can enter Canada tax free. This income carries federal and provincial tax credits on dividends paid out to Canadian shareholders.
  • $10.9 billion was "invested" in companies in Cyprus, Ireland, Liberia, the Netherlands and Switzerland, all considered tax havens. In 1990 Canadian companies received over $200 million in dividends from companies in these countries. Active business income earned in these countries can enter Canada tax free. This income carries federal and provincial tax credits on dividends paid out to Canadian shareholders.
• The information returns do not indicate the full extent of the financial activity between parties in Canada and in foreign states. They disclose only transactions that are technically defined as not arms' length. For example, a Canadian company that has a 50 percent interest in a company resident in a designated tax haven country and that, in 1990, received over $17.5 million in dividends from the non-resident, was not required to file the T106 information return.

2.59 In the view of the Department of Finance, it is not possible to quantify how much tax revenue is being lost under the existing regime or to predict whether changing the existing regime would result in any increase in tax revenue. Further, any change in tax legislation would be accompanied by behavioral changes on the part of taxpayers. In their view, taxpayers would attempt to structure transactions in order to avoid any additional tax and, where this was not possible, they could refrain from entering into transactions in the first place. In either case, the Department believes that it is not clear to what extent changing the rules would result in any added tax revenue to the government.

2.60 However, the tax rules on foreign source income and foreign affiliates have now been in place for about sixteen years. We recognize that these problems are complex and that they are not unique to Canada. Nevertheless, the tax base is vulnerable and losses will continue until the issues are resolved.

2.61 It is important that the reviews of interest deductibility, foreign source income and foreign affiliates previously announced be completed. When amendments are presented to Parliament, a statement of legislative intent should accompany them to ensure that the government can subsequently be held accountable.

Department's response: The audit note alleges a number of concerns with respect to the taxation of foreign affiliates and foreign source income. In particular, the Auditor General claims that hundreds of millions of dollars in tax revenue are being lost. This claim is unsubstantiated. The existing foreign affiliate regime accurately reflects the policy intention of Parliament and provides for the taxation of all income that is intended to be subject to Canadian income tax. Moreover, any theoretical revenue gains that might be realized by amending the Income Tax Act would be largely offset as a result of behavioral changes on the part of taxpayers. Specifically, any significant change in the existing rules would likely result in large numbers of businesses moving completely offshore. This would weaken the Canadian economy without generating any additional tax revenue.

Notwithstanding the fact that the foreign affiliate rules do not result in the revenue loss that the Auditor General claims, in many instances the concerns he raises are ones that are shared by the Department of Finance and that have been the subject of extensive analysis and remedial action over the last several years. This area is, however, one of the most complicated in the Income Tax Act and while it often appears to produce results that are questionable, these results are necessitated by fundamental policy considerations. Accordingly, before commenting specifically on the Auditor General's concerns, it is important to elaborate on some of the basic considerations that must be taken into account in designing a system for the taxation of foreign source income.

Background. Canada has had to struggle with two conflicting goals. The goal of economic efficiency argues for a system which preserves capital export neutrality. This is achieved when foreign source income is subject to the same effective tax rate as domestic source income, leaving taxpayers indifferent, at least from a tax perspective, as to whether they invest inside or outside of Canada. Conversely, the goal of competitiveness argues for capital import neutrality. This requires that a Canadian investing in a foreign country be subject to tax at the same effective rate as a resident of that country. From a tax perspective, this ensures a level playing field between Canadian and non-Canadian businesses operating internationally.

In a world where countries maintain different tax systems, it is impossible to achieve both capital import and capital export neutrality. Accordingly, Canada has opted for a system that ensures capital export neutrality with respect to certain types of income and capital import neutrality with respect to other types of income. Specifically, in the case of passive income (i.e., investment income such as interest, dividends and rent) the tax policy concern is that taxpayers will attempt to shelter income in tax haven countries in order to defer the payment of Canadian tax. As a result of this concern, the Income Tax Act contains what are commonly referred to as the Foreign Accrual Property Income (FAPI) rules. The FAPI rules are intended to ensure that passive income earned by certain foreign affiliates is accrued and subject to Canadian tax on a current basis (i.e., annually), thereby eliminating the potential for deferral and hence the tax incentive to shift income offshore.

Conversely, in order to preserve the international competitiveness of Canadian businesses, active business income that is earned offshore by a foreign affiliate is not required to be accrued and is subject to tax only in the foreign jurisdiction. Furthermore, where such income is earned in a "listed country" (basically countries with which Canada has entered into a tax treaty) it may be repatriated (i.e., paid back as a dividend) to Canada on a tax-free basis. The ability to receive dividends from a foreign affiliate on a tax-free basis is intended, at least in part, as a proxy for the foreign tax credit that would have been available to the Canadian company if it had carried on its business through a foreign branch rather than a subsidiary. It also helps to ensure that there is no tax impediment to corporations re-investing their foreign earnings in their Canadian operations.

Finally, in formulating our policy with respect to the taxation of foreign source income, it was necessary to recognize that there are substantial costs inherent in implementing a system that deviates substantially from international norms. As is noted later, such international norms are largely responsible for the policy not to specifically restrict the deductibility of interest on money borrowed to invest in a foreign affiliate. Ultimately, Canada finds itself in the position of having to balance tax theory with the economic realities of the international marketplace. To a large degree, international norms limit the range of options available to the Canadian government and, in this context, the government's policy has generally been to favour competitiveness concerns over those of revenue generation. Nonetheless, the Department of Finance continues to study those rules relating to the taxation of foreign source income, both in Canada and in other countries, with a view to ensuring that the Income Tax Act produces results that are fair overall and maintain a reasonable balance between competing policy objectives.

Tax avoidance. The audit note begins by making some general observations on the inappropriateness of tax avoidance, with the underlying implication that the problem of tax avoidance in the foreign affiliate area has not been properly addressed.

However, the note ignores the fact that numerous amendments to the foreign affiliate rules have been implemented over the last several years. As well, given the creativity of taxpayers in devising new avoidance transactions, it is frequently impossible either to anticipate a particular avoidance scheme or to specifically legislate against it. It was against this background that the General Anti-Avoidance Rule (GAAR) was introduced into the Income Tax Act - effective for 1988 - in order to provide Revenue Canada with the legislative tool necessary to deal with unanticipated tax avoidance. While GAAR is still relatively new, it is anticipated that Revenue Canada will apply it on a regular basis in those cases which involve abusive tax avoidance. Rather than attempting to attack each avoidance scheme, a general anti-avoidance rule is a much more useful tool to deal with avoidance transactions. In the short time since its introduction the professional community has found it to be a matter that must be taken into consideration in any tax planning format.

Interest deductibility. The principal concern raised in the note is that a Canadian resident who borrows money in order to acquire shares in a foreign affiliate will, subject to the general rules regarding interest deductibility, be able to deduct the interest on the borrowed money as an expense, even though the income earned by the foreign affiliate may not be subject to Canadian tax on a current basis and, in many cases, may be repatriated to Canada tax-free.

While this clearly gives rise to a mismatching of income and expenses, it is important to note that, at least historically, it also represents the international norm. Departing from this norm (i.e., denying Canadians a deduction for interest when, in similar circumstances, other countries would permit an interest deduction for their residents) would have a significant impact on Canada's international competitiveness and, ultimately, could result in a considerable number of Canadian businesses either moving offshore or being forced out of foreign markets. Moreover, it is not always appropriate that the expenses related to a particular investment be deductible only against the income from that investment. For example, where an investment generates losses, such a narrow approach would have the effect of denying taxpayers a deduction for legitimate business expenses and would represent a significant disincentive for Canadians to invest in new ventures. Finally, the ability to repatriate certain income on a tax-free basis is intended both as a substitute for allowing a foreign tax credit in respect of the foreign source income and to eliminate any tax impediment to corporations reinvesting their foreign earnings in their Canadian operations.

Consequently, while the government continues to monitor developments in other countries, it has refrained from making changes that would have the potential to damage Canada's international competitiveness. As was indicated earlier, the exact balance to be struck between capital export and capital import neutrality is not easily achieved. In this regard, Canada - in keeping with most industrialized countries - has chosen to encourage international competitiveness at the expense of revenue generation. Where, however, technical anomalies with the existing rules are identified, they are dealt with on an ongoing basis.

Exempt dividends from foreign affiliates. The audit note criticizes the fact that dividends from Canadian corporations qualify for the dividend tax credit even when they are paid out of foreign source income that has not been subject to either Canadian or, in many cases, foreign income tax. The note also observes that although the ability to receive dividends on a tax-free basis ("exempt dividends") was intended as a substitute for a foreign tax credit system, exempt dividends may be received from a foreign affiliate even where the affiliate is based in a tax haven country and therefore is effectively not subject to any foreign tax. In this regard, the Auditor General has provided a number of examples of ostensibly abusive transactions and concludes that hundreds of millions of dollars in tax revenue are being lost.

The availability of the dividend tax credit is fundamental to the elimination of double taxation. This goal is equally appropriate in the context of Canadian as well as foreign source income. The ability of foreign affiliates to pay out exempt dividends also represents a strong incentive for other countries to enter into treaty negotiations with Canada, further contributing to the elimination of double taxation generally.

Furthermore, the dividend tax credit is as much an inducement to invest in the equity of Canadian companies as it is a credit for taxes paid at the corporate level. Given this, the precise composition of a corporation's income is irrelevant. Under the Canadian tax system, earnings are not segregated by source. Rather, funds are co-mingled and the dividend tax credit is available in respect of all earnings, regardless of the amount of underlying tax which may have been paid by the corporation. On a practical level, eliminating the dividend tax credit for dividends paid out of foreign source earnings would simply result in corporations paying dividends only out of their Canadian source earnings. Moreover, based on the examples in the note, there is no indication of the extent, if any, to which exempt dividends received from foreign affiliates are flowed out to Canadian taxpayers, who are eligible for the dividend tax credit. Accordingly, there is no evidence that the availability of the dividend tax credit in respect of foreign source income represents a serious problem.

With respect to the ability of corporations to receive exempt dividends from foreign affiliates based in "designated countries" that are tax havens, historically Canada's policy was to designate countries once we had entered into tax treaty negotiations with them. In some instances, although negotiations were commenced, no treaty was ratified. Notwithstanding this, certain countries continued to be designated in the expectation that a tax treaty would be entered into at a future date. Since the early 1980s, however, Canada has had a general policy of neither designating, nor entering into tax treaties with, countries that are considered to be tax havens. Difficulties arise, however, where a country introduces tax preferences into its law only after it has concluded a treaty with Canada. In this respect many countries that introduce such tax preferences are really no different from Canada, which also offers limited tax preferences in order to stimulate certain sectors of the economy.

The Department of Finance is, however, currently considering a number of proposals to address these issues. In particular, the list of designated countries is continually under review as a result of changes to our treaty network, with a view to adding new countries with which tax treaties have been entered into and removing countries with which tax treaties are not in effect. In addition to this, the Income Tax Act and Regulations contain several provisions to ensure that income earned in tax haven countries cannot generally be brought back to Canada tax-free. Where there is a concern that a foreign affiliate based in a tax haven country has attempted to circumvent these rules, the arrangement should be attacked by Revenue Canada on the basis of either the specific rules in the Income Tax Act or GAAR.

Taxable dividends from foreign affiliates. The audit note observes that even where a foreign affiliate is not able to pay exempt dividends, an incentive may exist to defer distributing income in order to postpone paying Canadian tax. The note also provides a number of examples of instances in which the foreign affiliate rules may have been circumvented.

Once again, the appropriate policy response to the issue of deferral necessitates weighing the desirability of capital export neutrality against that of capital import neutrality. Thus, in those situations where it is reasonable to conclude that the principal reason for earning or retaining income in a foreign affiliate is to avoid Canadian tax, the FAPI rules are intended to ensure that the income is accrued and subject to tax on a current basis in Canada. Where, however, there are legitimate business reasons for the income being earned or retained offshore, competitiveness concerns dictate that it should be taxed only when it is brought back to Canada.

Other related problems. The FAPI rules, which are designed to prevent taxpayers from sheltering investment income offshore, drive off the distinction between active and passive income (with only the latter being subject to tax on an accrual basis). The audit note criticizes the lack of any definition as to what constitutes active and passive income. The audit note also puts forth a list of examples to demonstrate the apparent ease with which tax avoidance occurs.

Although the Income Tax Act does not define active and passive income, the policy underlying these concepts is well understood by the business community. The terms have also been commented on extensively by the courts and the principles underlying their characterization are well established. Given this, there is little foundation for the Auditor General's comment that "there is no reasonable assurance that the rules will apply in circumstances where they should".

The examples cited by the note are misleading. In many instances the income involved would appear to constitute FAPI and, as such, would be accrued and subject to tax in Canada on a current basis. In addition to this, many of these examples would also seem to involve transactions which could be attacked by Revenue Canada, under either the specific anti-avoidance provisions of the Income Tax Act or GAAR. Consequently, the claim that hundreds of millions of dollars in tax revenue are being lost is not supported by the examples and is unfounded.

Conclusion. While the Auditor General has identified a number of concerns with respect to the operation of the foreign affiliate rules, he has failed to indicate that most of these concerns are the result of conscious policy decisions on the part of the government and reflect a desire to promote the goal of international competitiveness. Moreover, he has also overstated the impact of the rules on revenue collection while understating the degree to which any problems have already been addressed by existing legislation. It would not be prudent to implement a system for the taxation of foreign source income which deviates substantially from international norms and fails to properly address the issue of competitiveness. In this regard, the economic costs inherent in amending the income tax legislation to accommodate the Auditor General's ostensible concerns would far exceed any marginal revenue gains that might be realized thereby.

Department of Industry, Science and Technology

Non-compliance with Government Contracts Regulations and payment to an operating agency resulted in avoidance of a lapsing of funds

Non-compliance with Government Contracts Regulations

2.63 Further, the government's policy on procurement contracting states that "contracting shall be conducted in a manner that will "stand the test of public scrutiny in matters of prudence and probity, encourage competition and reflect fairness in the spending of public funds".

2.64 The competitive bidding process applies to all contracts unless the circumstances meet one of four criteria:

• the need for the services is one of pressing emergency in which delay would be injurious to the public interest;
• the estimated expenditure must be less than $30,000;
• the nature of the work is such that it would not be in the public interest to solicit bids; or
• only one person or firm is capable of performing the contract.

2.66 Issue. On 24 May 1991 Treasury Board approved the creation of an interim Prosperity Secretariat to pursue Cabinet consideration of the proposed Prosperity Agenda and timetable. It has a two-year budget of $21.6 million. One of its objectives is to improve Canadian competitiveness domestically and internationally.

2.67 The Prosperity Initiative was publicly launched on 29 October 1991. Among other things, the aim of the initiative was to conduct about 200 public consultation meetings at the community and regional levels (the "Community and Regional Talks") starting in fall 1991. To conduct this and other work the Prosperity Secretariat verbally entered into 22 non-competitive contracts ranging in value from $35,000 to $743,000, for a total of $3.3 million. These legally binding verbal contracts were subsequently confirmed by the Department of Supply and Services in written contract form.

2.68 In entering into these 22 non-competitive contracts, the Prosperity Secretariat did not follow the Government Contracts Regulations. The Treasury Board Manual interpretation of the regulations permitting non-competitive contracts states, "Emergencies are normally unavoidable and require immediate action which would preclude the solicitation of formal bids. An emergency may be an actual or imminent life-threatening situation, a disaster which endangers the quality of life or has resulted in the loss of life, or one that may result in significant loss or damage to Crown property." None of the Prosperity Secretariat's contracts for public consultations entailed an "emergency" as defined by the Treasury Board Manual. The three other exception criteria in the regulations also were not met. All 22 contracts were in excess of the $30,000 exception limit and were for work directly related to public consultation and communication conducted by a number of different persons and firms.

2.69 Conclusion. In our opinion, the Prosperity Secretariat did not meet any of the criteria for entering into non-competitive contracts as stated in the Government Contracts Regulations, and an exception to the regulations was not obtained by means of an order-in-council.

Payment to an Operating Agency resulted in avoidance of a lapsing of funds

2.71 The advertising campaign did not take place until the following fiscal year. Industry, Science and Technology's rationale for payment in 1991-92 was contained in a handwritten addendum to the agreement, stating "the funds are required immediately so that media space can be purchased now in order to secure significant discounts".

2.72 Issue. The Department of Industry, Science and Technology's agreement with CCG stated that the costs involved were for fiscal year 1992-93 and that the Department agreed to be invoiced immediately for payment in fiscal year 1991-92. In our opinion, the payment in 1991-92 was in advance of need. The Department's rationale was that significant discounts in the purchase of media space would result. The agreement with CCG, however, was for the production of several television commercials and printed material in tabloid format. It did not involve purchase of media space except for one television contract. We found that no discounts were obtained on the contracts for either production or media space.

2.73 The Financial Administration Act permits advance payments to be made if such an advance is stipulated in the contract. In our opinion, however, there was no need for such a stipulation in this agreement since CCG did not make any advance payments to the suppliers in fiscal year 1991-92 and no discounts were obtained.

2.74 Conclusion. In our opinion, Industry, Science and Technology's payment from a lapsing vote to a non-lapsing Supply Revolving Fund of DSS resulted in avoidance of a lapsing of 1991-92 funds. The $2.5 million payment did not involve any discount and, consequently, there was no saving to the Crown.

Department of Industry, Science and Technology's response: Non-Compliance with Government Contracts Regulations. The Prosperity Secretariat was established on 14 June 1991 on an interim basis for the 1991-92 and 1992-93 fiscal years. The Secretariat was tasked to organize and carry out a comprehensive consultative process, including community consultations which were held in 186 rural and urban centres across Canada, a series of national consultations with Canadian opinion leaders in the business, labour, academic, aboriginal and social action communities, as well as discussions with other federal government departments and agencies and provincial governments.

A detailed operational plan was developed to ensure that this consultative process would fit within the timeframe established by the government to produce, by the fall of 1992, an Action Plan on the future prosperity of Canada. It was recognized from the start that the operational plan would require continuous updating and that the Secretariat would have to retain flexibility in its operations to meet last minute changes. Consequently, it was not always possible to enter into a competitive bidding process in contracting out certain of its workload and still meet the deadlines to produce results which would be both useful and timely.

Transfer of Funds to an Operating Agency Resulted in an Avoidance of a Lapsing of funds. During the contract negotiations, the Department received a written confirmation from CCG that advance payments would facilitate their negotiating of discount prices on media buys. Subsequently, we entered into a contract with CCG which stipulated that an advance payment be made. We then executed the contract in accordance with its terms and conditions.

Department of Supply and Services' response: The transition of the Canada Communications Group to a Special Operating Agency has afforded the opportunity to review business and accounting practices so that both probity and profitability are effectively accommodated. Clearly the situation referred to by the Auditor General arose as a result of a misunderstanding, which the review of business practices will endeavour to ensure does not occur again.

Department of National Health and Welfare

Failure of management controls over project contracting

2.75 Background. Paragraphs 2.114 to 2.125 of our 1991 Report described an instance where certain managers in the Department of National Health and Welfare (NHW) acted beyond their authority and breached numerous policies and directives that were in place to control the management of cash, contracting, travel and financial-reporting practices. Our observations were based on the results of a departmental internal audit.

2.76 The instance involved the Income Security Programs (ISP) redesign project. This is a multi-year undertaking to plan, define and implement a new integrated client delivery system for the Old Age Security, Canada Pension Plan and Family Allowances programs. The ISP redesign project will extend to 1997 at a total estimated cost of $258 million.

2.77 The Deputy Minister of National Health and Welfare requested that a second internal audit be carried out to review contract administration generally, within the ISP redesign project. The audit scope included all service contracts over $10,000 that had been entered into during the planning phase of the project. These contracts, totalling $5.6 million, were reviewed for compliance with Treasury Board and Department policies on contracting and other financial management practices. The audit was completed in January 1992 and the report was dated May 1992.

2.78 Our observations below are based on the findings contained in the second internal audit report. As required for purposes of reliance, we completed a review of the supporting audit files and satisfied ourselves that the work was carried out in accordance with appropriate professional standards. We are reporting the results of this internal audit because of the extent and seriousness of the breaches of control, and also because of the size and importance of the overall ISP redesign project.

2.79 Issue. The internal audit found that 22 contracts out of the 23 examined were not managed in full accordance with all applicable legislative and other requirements. There was repeated disregard for the Financial Administration Act, Government Contracts Regulations, Treasury Board policies and directives and the Department's own policies and procedures. In short, there was a general and widespread breakdown of management controls, including fundamental parliamentary controls, during the planning phase of the ISP redesign project.

2.80 The timing of these actions raises another serious concern. In responding to the earlier internal audit, referenced in our 1991 Report, senior ISP Branch management stated that steps had been taken in the fall of 1990 to strengthen the contract review process. However, the second internal audit found that breaches of contracting and other financial controls were occurring well into 1991. Clearly, any initial steps taken to correct the situation were ineffective.

2.81 Parliament has assigned responsibility for the control and spending of public money to ministers and deputy heads through appropriation acts, the Financial Administration Act (FAA) and regulations made under that Act, such as the Government Contracts Regulations. Through the written delegation of financial signing authorities, these responsibilities are delegated by ministers and deputy heads to appropriate managers in departments. The intent is to delegate to managers who can execute the responsibility most effectively, and where accountability for results can best be exercised. Some examples of where and how this control framework failed follow.

2.82 The second internal audit found that on numerous occasions ISP redesign project managers exceeded their expenditure initiation authority, either directly or through contract splitting. Contract splitting kept the value of individual contracts within the delegated signing authority limit and, in some cases, below the Department's limit on sole-source contracting set by Treasury Board. These practices do not comply with the Government Contracts Regulations.

2.83 One instance involved an arrangement in early 1990 to acquire training services which provided for a payment of more than $350,000. The amount exceeded both the project managers' and the Department's overall authority for expenditure initiation. It also exceeded the limit beyond which the Department of Supply and Services must be involved in the contracting process. There was no evidence that bids from other suppliers were solicited and no sole-source justification document was prepared. Although no contract was prepared for this arrangement, payment was made.

2.84 Another important control is the certification of contract performance and price - FAA section 34. Managers with delegated authority certify that goods and services have been delivered in accordance with contractual terms and conditions. The internal audit found that ISP redesign project managers requested certain suppliers to submit invoices before year end for work that had not been completed. These invoices were then improperly certified by project managers pursuant to the FAA section 34, and payment authority, FAA section 33, was later granted by the Department's Accounting Operations Division. The audit concluded that, contrary to FAA Section 37, the funds had been prepaid to avoid their lapsing at 31 March.

2.85 In all, invoices totalling $446,000 were discovered to have been pre-billed at the request of ISP redesign project managers, and paid before the work was completed. The contracts did not call for advance payments, the advanced funds did not earn interest for the Crown and the funds were not protected by performance bonds. The audit also reported that invoices had been paid even though the rates charged were not in accordance with the written contracts.

2.86 Conclusion. The internal audit report reveals serious deficiencies in contracting and payment for services related to the planning phase of the ISP redesign project. The numerous instances of non-compliance show a disregard by managers for the controls that are in place to safeguard public funds, and demonstrate a lack of due regard to prudence and probity.

2.87 The ISP redesign project is still in its early stages. In our view, the repeated disregard for fundamental controls shown by the project managers and, more important, the failure of the Department's program and financial managers to correct these activities during the planning phase, indicate the need for a much stronger management control framework as the project progresses.

Department's response: The problems described by the Auditor General were recognized by ISP Branch management over a year ago. A new management control framework was in place by October 1991 with specific emphasis on strengthened contracting processes. Branch management is not aware of any serious deficiencies since that time.

The weaknesses in contracting practices occurred primarily in the ISP redesign project office. The work by departmental internal auditors provided more details about the exact nature of the failures in the contracting process and their report has been referred to the Royal Canadian Mounted Police for consideration. Therefore, the Department cannot comment on any of the details.

Department of National Health and Welfare

Payment of benefits to recipients who are no longer eligible results in significant overpayments in the Canada Pension Plan Disability Program

2.88 Background. The Department of National Health and Welfare (NHW) administers the Canada Pension Plan (CPP) program through its Income Security Programs Branch. The CPP Act provides for the payment of disability pensions to eligible CPP contributors and for the payment of benefits to their dependent children. A disability benefit is made up of a flat-rate portion plus 75 percent of the amount of the contributor's retirement benefit. The maximum monthly payment in 1992 was $784. During 1991-92, almost 224,000 disabled beneficiaries and 70,000 dependent children received payments totalling $1.8 billion.

2.89 To be eligible for a disability pension, an applicant must be disabled according to the terms of the CPP Act. The Act requires that an individual "have a severe and prolonged mental or physical disability". Severe is defined as "incapable regularly of pursuing any substantially gainful occupation"; only earnings income affects eligibility. Prolonged means that "the disability is likely to be long continued and of indefinite duration or is likely to result in death".

2.90 The CPP Regulations include a provision for the reassessment of eligibility for disability benefits; specifically, that it may be required "from time to time". The Department defines reassessment as a regular and pre-planned review of recipients' ongoing eligibility. The objective is to identify and stop payment on accounts where beneficiaries no longer meet the eligibility criteria.

2.91 We became aware of problems associated with the reassessment of eligibility for disability benefits during our regular CPP audit work, and pursued the issue concurrent with our audit of NHW seniors' programs (to be reported in 1993). The disability portion of the CPP is not seniors-related as benefits are paid only to those under 65 years of age. We are reporting this matter now because of the need for prompt action to address the ongoing high level of overpayment.

2.92 Issue. We expected to find that the Department's policies and procedures would ensure that disability benefits were paid only to those who continued to be eligible due to a severe and prolonged disability. We found that this was not the case.

2.93 The Department describes its reassessment processes as cumbersome. There is a lack of EDP support, and some policies and procedures are not formalized. For example, there is no formal policy establishing the level of earnings that will result in cancellation of disability benefits. Furthermore, the current reassessment activities are neither consistent nor timely.

2.94 There is a reassessment questionnaire that can be mailed to disability beneficiaries (9,000 in 1991-92) for a variety of reasons. It includes questions on medical condition, on earnings and on other types of disability benefits received. There is a follow-up to ensure that all questionnaires are returned; a beneficiary's failure to do so may result in the immediate cancellation of benefits.

2.95 We were informed, however, that reassessments using the returned questionnaires are performed only as resources permit. In recent years, to cope with increases in the number of clients and demand for service, priority has been given to processing new applications. As a result, reassessments are carried out only when essential, such as when a beneficiary submits new information about employment.

2.96 In early 1988, a project was undertaken to identify disability recipients who have not disclosed significant employment earnings. All active disability accounts were compared to the CPP record-of-earnings file. This comparison identified 31,000 beneficiaries with post-entitlement earnings. Between March 1989 and March 1991, 4,600 of these accounts were selected for reassessment, and benefits were subsequently cancelled for one in ten. Of these, 360 were found to be no longer disabled, and overpayments of $8 million were recorded.

2.97 Project results also disclosed that 80 percent of the 4,600 cases had not been reassessed since being granted disability benefits, some going back to 1980-81. The project report concluded that ongoing maintenance of a reassessment program for accounts identified with earnings would prevent substantial mispayments to beneficiaries who are no longer eligible. Although there is now a quarterly earnings match carried out, we were told that resources have not been available to investigate these accounts.

2.98 In a 1991 Treasury Board submission, the Department projected savings of $1.2 billion over the nine-year period to 2000-01 related to the establishment of a new disability reassessment program. Recently, a two-year, $10 million project was established to develop and implement a new disability reassessment process. The scope of this project will include the reassessment function's organization, business processes, systems and procedures, and training of staff. One of the anticipated benefits of the project is reduced overpayments.

2.99 The Department has received a consultant's report that contains a more conservative projection of $730 million in savings over the same period. The preliminary data indicated that, with proper screening and pre-selection methods, benefits could cease in 30 to 35 percent of accounts reassessed. However, it is unlikely that significant benefits from the current project to develop new reassessment processes will be realized before 1994-95, representing two years slippage from the original plan. In the meantime, the high rate of overpayment to disability beneficiaries who are no longer eligible will continue, resulting in a sizable loss to the CPP account. Current annual overpayments are estimated by the Department to be up to $65 million.

2.100 Conclusion. Disability reassessment activities have been insufficient for many years now, although the Department has good evidence that large amounts of money are being paid to ineligible beneficiaries. In our view, the action taken to address this situation has been inadequate for both ongoing reassessment activities and timely development of improved assessment processes.

2.101 As administrator of the CPP, the Department has a responsibility to manage its operations, including disability reassessment, in the most cost-effective manner, to the benefit of the Plan's contributors and beneficiaries. The Department should take immediate steps to deal with the backlog of returned questionnaires and earnings information awaiting reassessment action. The new reassessment process under development should, in addition to developing reassessment selection criteria for new applicants, include measures to identify existing cases for high-priority reassessment.

Department's response: Although the development of revised reassessment processes has been slower than anticipated, improvements to questionnaires and other forms were introduced in January 1992. At the same time, the Department has recognized that disability reassessment processes need to be improved to cope with a significant increase in workload and is making substantial investment in this area as one of the components of the income security programs redesign project. This major Crown project is in its project definition phase. Other options for immediately targeting the reassessment backlog are being actively considered, within resource constraints.

Department of National Revenue - Taxation

Unauthorized tax exemption for interest earned by condominium corporations

2.102 Background. In an administrative arrangement not authorized by law, described in Information Circular No. 79-7 (which excludes Quebec), the Department of National - Taxation allows condominium corporations to earn tax-free interest on the money they set aside in operating and reserve funds to pay certain maintenance expenses. Condominium corporations regulate the use of the condominium property and provide repairs to the common areas and other services to the owners.

2.103 The only limitation is that the operating and reserve funds cannot be maintained at an "unreasonably high" level in relation to the purpose for which they were created. The Department, however, provides no interpretation of "unreasonably high".

2.104 Issue. The tax exemption for interest earned on a condominium corporation's operating and reserve funds indirectly benefits the condominium owners. Homeowners not living in condominiums must pay tax on any interest earned on funds set aside for maintaining their homes. This situation creates an inequity between homeowners who own condominiums and those who own other types of residential dwellings. Furthermore, because this assessing practice is not authorized by the Income Tax Act, it violates the fundamental principle that the right to tax rests with Parliament, through the legislative process.

Department's response: Condominiums are set up not to make a profit in the long run but to maintain the common elements of the condominium. Information Circular 79-7 was drafted to address issues raised by provincial laws which differed between provinces and were still developing.

The Department is studying the status of these condominium corporations in light of current provincial laws and will update its Information Circular accordingly.

Departments of National Revenue - Taxation and Finance

Excessive claims for Investment Tax Credits

2.105 Background. The Investment Tax Credit (ITC) is calculated as a percentage of the capital cost of specific qualifying assets - essentially new machinery - to be used in activities including farming, fishing, forestry, manufacturing, construction, producing oil and gas, and mining. These credits are fully deductible against tax otherwise payable. In the early 1980s, the Department of National Revenue - Taxation (NRT) identified a tax avoidance situation involving excessive claims for Investment Tax Credits. Taxpayers who were purchasing new equipment where a trade-in was involved were structuring the transactions to increase the capital cost of the purchased equipment, resulting in an ITC overallowance (see Exhibit 2.2) . Although Investment Tax Credits were significantly reduced after 1988, they are still earned on qualifying assets in the Maritimes and offshore regions, and on research and development expenditures throughout Canada.

2.106 Beginning in 1982, NRT took the following steps:

- A national audit project was undertaken with the support of the Department of Finance to determine the extent of the problem and any potential abuses of the ITC program.

- Over 1,400 cases involving ITC overallowances were identified, with a majority located in the western farming industry.

- NRT reassessed only those cases where the value of the trade-in equipment was inflated more than $30,000 above its fair market value.

- Over 700 cases were reassessed for the 1984 to 1986 taxation years.

2.107 A test case on these overallowances was taken to the Tax Court of Canada, but the decision, rendered on 23 April 1991, went against NRT (Zeiben v. Minister of National Revenue). Although the Department of Justice filed an appeal, it was discontinued four days later on instructions from NRT. It is unclear why the appeal was discontinued. The Department of National Revenue - Taxation has decided to apply the Tax Court decision for the benefit of all 700 taxpayers who were reassessed in respect of trade-in allowances on farm equipment. The Department obtained a remission order to return approximately $5 million dollars of federal income taxes, CPP contributions and interest paid by these taxpayers. Taxpayers who claimed the fair market value of their trade-ins for Investment Tax Credit purposes, in accordance with generally accepted accounting principles, will not benefit from the remission order.

2.108 Issue. An opportunity now exists for taxpayers to inflate the trade-in value of used equipment and thereby increase the capital cost of their new equipment purchases. This enables taxpayers to increase their Investment Tax Credits and avoid tax. This situation also creates an inequity between those taxpayers who buy equipment only with cash and those who buy with cash and a trade-in of their used equipment.

Department of National Revenue - Taxation's response: The Tax Court found that the contract of purchase and sale between the parties was the major item of evidence and it had not been discredited to warrant it being rejected. Although generally accepted accounting principles (GAAP) provide that the basis for the valuation of a new asset acquired in a trade-in transaction is the fair market value of the consideration given in exchange, the Court was not convinced that the jurisprudence regarding GAAP went as far as to reject the amounts agreed to by the parties in a bona fide contract.

It was decided not to appeal the decision on the basis of the facts of the particular case, which is limited in its application, and will, therefore, not impact the remaining investment tax credits, i.e. the regional and research and development tax credits. Also, since tax reform, there is a general anti-avoidance rule in place that will serve to prevent any abuse.

A number of cases in the same business sector with identical fact patterns were outstanding, pending the resolution of the case, and it was decided to accept those where appeals had been filed. In addition, there were a number of other cases in the same business sector who had not protected their rights by appealing. With respect to those cases, a remission order was recommended and approved.

Department of Public Works

Lack of due regard to economy in the lease-purchase agreement for the Louis St. Laurent Building

• DPW entered the lease-purchase agreement based on an unspecified term of requirement and without due regard to economy;
• DPW did not consider the income tax implications arising from the lease-purchase of the Louis St. Laurent Building; and
• the government's method of accounting for capital acquisitions may have contributed to a real property investment decision that was not economical.
• The last two findings have broader application to other real property investments undertaken by the government.

2.110 Construction of the building was substantially completed in 1985 at a cost of $41.5 million (including land), according to audited financial statements. It contains about 40,800 square metres of office and storage space, for which the gross annual rent was about $9.6 million under the original 1985 lease.

2.111 The building houses some 2,150 personnel from the Department of National Defence (DND), or 18 percent of the Department's headquarters staff. The Department of National Defence has been the sole tenant of the building since June 1985.

2.112 During the period December 1990 to May 1991, the landlord made a number of unsolicited proposals to DPW to renegotiate and extend the term of the existing lease, due to expire in May 1995. The proposals included options for a new lease with terms ranging from 10 to 25 years; the Department of Public Works rejected those proposals on the basis of price.

2.113 In May 1991, having been unsuccessful in negotiating a renewal of the lease with the landlord, DPW proposed a lease-purchase arrangement based on the appraised market value of the building. This approach culminated in a contract that was signed on 30 September 1991.

2.114 The contract contains the following main provisions:

• The term runs for 25 years, starting 1 August 1991.
• Rental payments are based on a 25-year amortization of $73 million. For the first five years, annual payments are about $8.4 million. Future payments are based on the landlord's cost of refinancing the outstanding balance. The Crown retains the right to approve financing rates and terms.
• The Crown has an option to purchase the building at the end of the 25-year term for $15 million (estimated by DPW at $1 million in 1991 dollars).
• The Crown is responsible for all costs (estimated by DPW at about $3.4 million per year) of operating and maintaining the building, including structural repairs.
• The landlord will manage the building for 25 years for an annual fee, subject to indexing, of $89,500 plus $70,000 for salaries.

2.116 In summary, the total present value of the lease-purchase package in 1991 dollars is $74 million (the $73 million value on which rental payments are based plus the $1 million present value of the purchase option).

2.117 Issue - DPW entered the lease-purchase agreement based on an unspecified term of requirement. Paragraph 17.94 of the Auditor General's 1991 Report recommended that DPW improve its procedures associated with the planning and acquisition of leased accommodation; this case reinforces the need to act on that recommendation.

2.118 In January 1991, shortly after the landlord and DPW had begun to renegotiate and extend the term of the existing lease, DND said that it was interested in a "further long-term lease" for the building, without specifying the number of years. DPW justified entering into the lease-purchase agreement based on DND's request. According to DND officials, their interest in retaining the space was based on the need to minimize employee disruption until a long-term plan to consolidate their entire headquarters staff (preferably on DND-owned land) could be worked out.

2.119 In March 1992 (about six months after the agreement was signed), DND advised DPW that the Louis St. Laurent Building would become surplus to its needs over the next 10 to 15 years.

2.120 Conclusion. In our opinion, DPW's decision to acquire the Louis St. Laurent Building through this lease-purchase agreement was not consistent with DND's long-term accommodation planning. DND is planning to consolidate all headquarters staff at one location within 10 to 15 years, and has said that it will not need the space after that time. We also noted that the Louis St. Laurent Building was not part of DPW's leasing strategy for the National Capital Region.

2.121 Issue - DPW entered the lease-purchase agreement without due regard to economy. Construction of the building was completed in 1985 at a reported cost of $41.5 million (including land). According to Statistics Canada, the price index for commercial buildings in the National Capital Region during the period 1985 to 1991 increased by 28 percent. Applying this increase to the Louis St. Laurent Building, the estimated cost to replace it in 1991 would have been $53 million. In early July 1991, two appraisers estimated the building's replacement cost (including land) in the range of $48 million to $64 million. DPW did not explore other building alternatives (such as Crown construction or a lease-purchase agreement with other developers) even though the original lease would not expire until May 1995. This would have allowed about four years to construct a new building for between $48 million and $64 million in 1991 dollars, according to the appraisers' estimates.

2.122 The two appraisers estimated the building's market value at $62 million and $65 million respectively. These appraised values reflected the fact that the government's remaining contractual rent payable under the then existing lease was higher than the 1991 market rent by $6 million to $10 million.

2.123 DPW used the appraised market value of $65 million as the basis for negotiating, as officials believed it was the more defensible appraisal.

2.124 On 9 July 1991 DPW informed the landlord that appraisal reports had been completed, and made its initial lease-purchase offer at the appraised market value of $65 million. After negotiations, DPW agreed on a value of $74 million for the lease-purchase package.

2.125 DPW justified the discrepancy between the appraised market value of $65 million and the negotiated $74 million value on the basis of certain factors. These included the additional value of adjacent land ($1.1 million), painting and carpeting ($1.3 million), money saved through not having to relocate staff and call for tenders ($831,000), and the assumption that a 10 percent variance between the appraised value and the negotiated value was acceptable.

2.126 The $65 million was the appraised market value, whereas the $74 million figure represented DPW's estimate of the value to the Crown. In determining the $74 million figure, DPW included the $9.7 million unamortized value of leasehold fit-ups, which had already been paid for by the government as a condition of occupancy under the original lease.

2.127 The landlord advised us, on 30 September 1992, that, in his view, DPW concluded a reasonable long-term lease with a purchase option agreement for the Louis St. Laurent Building.

2.128 In our view, it is difficult to establish a true market value for office space in the National Capital Region when the government occupies approximately 40 to 55 percent of private sector office space. In this case, the difficulty was compounded by the fact that the government was, indeed, the only tenant for the building. One appraiser noted that the property's overall size, large floor plates and relatively isolated location meant that "the only possible tenancy for the Louis St. Laurent Building is the federal government." In effect, the market value evaluations are based on a market created by the government.

2.129 According to DPW officials, the investment options were limited by the government's policy of locating 75 percent of the public service on the Ontario side and 25 percent on the Quebec side of the National Capital Region. In their view, it was unrealistic to think that an alternative building could be found on the Quebec side or that the government would relocate DND employees to the Ontario side.

2.130 Conclusion. In our opinion, a number of factors contributed to DPW's weak bargaining position in entering into the lease-purchase agreement for the Louis St. Laurent Building.

• Although the government is the dominant landowner in the National Capital Region, no other available existing building in Hull could accommodate 2,150 public servants.
• DPW claimed that Crown purchase, although the most economical option, was not viable because the owner was unwilling to sell. Other options (Crown construction or a lease-purchase agreement with other developers) were not considered in detail and were not priced out. This was a significant deficiency, in our view, because estimates of replacement cost could have been useful in assessing the acceptability of the landlord's proposals. Instead, the Department did not investigate the cost of constructing a building, disregarded the appraisers' estimates of building replacement cost, and made its initial lease-purchase offer based on the market appraisal of $65 million, the "high end" of the range of estimated values. DPW's view is that the building's replacement cost was not relevant to the negotiations.
• DPW also claimed that a Crown-construct option was precluded by a lack of capital funds and the short lead time (about four years) to plan, get approval for, and construct a building.

2.132 In summary, bearing in mind the various estimates of the building's replacement cost and the projected weak market for office space in 1995, we conclude that DPW entered the lease-purchase agreement for the Louis St. Laurent Building without due regard to economy. In addition, as discussed in the following section, there is a possibility that the total cost to the Crown could be significantly higher depending on how the transaction is treated for tax purposes.

2.133 Issue - DPW does not consider the income tax implications of investments in real property. In commercial real estate transactions, tax implications are important to the parties involved. Usually it is in the landlord's interest to structure a lease-purchase in such a way that, for tax purposes, it is deemed a lease and not a sale. From the Crown's point of view, the tax revenue from a lease-type transaction is most often lower than it would be from a sale.

2.134 In this case, a deemed sale could have resulted in a gain of approximately $32.5 million to the landlord ($74 million less the original construction cost of $41.5 million). The gain could be subject to capital gains tax and would be fully taxed over a five-year period. Furthermore, there could be an additional tax liability resulting from the recapture of any capital cost allowance previously claimed by the landlord.

2.135 If the transaction were deemed a lease, the difference between the rental income and operating costs would be taxed as income over the term of the lease. However, under a lease, a higher capital cost allowance would usually be taken in the early years to defer the income to the later years.

2.136 According to DPW officials, tax implications are not considered when analyzing and evaluating investment alternatives such as long-term leases or lease-purchase agreements. In the case of the Louis St. Laurent Building, DPW officials said they did not conduct such an analysis.

2.137 Conclusion. In our view, to determine the total cost to the Crown of a real property investment decision, DPW should estimate and take into account the tax implications of various options. Such an analysis could be done using standard assumptions without interfering with the rights of individual taxpayers. Tax implications are particularly important in cases such as this one, in which large sums of money are involved and the transaction is not subject to a competitive bidding process through public tender. Taxation benefits can make a significant difference in tender offers made by developers in public bidding for the provision of space to the Crown.

2.138 Issue - The government's method of accounting for capital acquisitions may contribute to real property investment decisions that are not economical. The lease-purchase transaction demonstrates that the government's own practices may contribute to uneconomical decisions in the way office space is acquired. Under these practices, capital outlays are fully expensed in the year they are made, and added to the deficit of the current year. For lease-purchase agreements, however, the annual costs are added to the government's expenditures each year but only gradually to the accumulated deficit over the term of the lease; in this case, over 25 years.

2.139 Previous reports of the Auditor General have noted that lease-purchase is a costly method of acquiring office space. Paragraph 13.45 of the Auditor's General 1984 Report noted that a developer's borrowing rate is approximately 2 percentage points higher than the government's borrowing rate. Our 1988 Report (paragraph 19.42) noted that acquiring the Government of Canada building in Edmonton, Alberta, through lease-purchase cost almost 20 percent more than the alternative of Crown construction.

2.140 Conclusion. Rental rates are based on the costs of borrowing by the developer. For each percentage point of interest the developer pays above that paid by the government, rents increase by approximately 10 percent. Thus, if the government were to purchase a building outright and finance it at its own borrowing rate, substantial savings could be made.

Department's response: In situations of fiscal restraint and restricted capital for investment, the lease with option to purchase can provide a practical and advantageous solution to space requirements for the Crown. Historically, lease transactions with an option to purchase have proven to be most advantageous. Examples include the C.D. Howe Building, L'Esplanade Laurier Towers and Les Terrasses de la Chaudière.

Issue 1, the Department of Public Works entered the lease-purchase agreement based on an unspecified term of requirement. The Department of Public Works (DPW) is mandated to provide general purpose office space to all federal government departments. In fulfilling this mandate, DPW manages an inventory of space, not just a specific building. Space requirements change over time. To best satisfy the short- and long-term operational needs of clients in the most economical manner, DPW continually evaluates options to reduce and eliminate vacancies in facilities it manages.

The Department of National Defence (DND) indicated a long-term requirement for the space in the Louis St. Laurent Building. While DND subsequently defined its requirement to be for a period of 10 to 15 years, DPW is unaware of any funded plan to replace the space occupied by DND in the Louis St. Laurent Building. In any case, this space will be available to other tenants within the National Capital Region (NCR) in accordance with the NCR leasing strategy.

Issue 2, the Department of Public Works entered the lease-purchase agreement without due regard to economy. The Department did enter into the lease with an option to purchase agreement for the Louis St. Laurent Building with all due regard for economy and did obtain the best possible agreement given the situation at that time.

Information available at the time indicated that the recession appeared to be ending, rental rates in Ottawa/Hull were stabilizing, and interest rates were bottoming out. Based on this information, it appeared prudent and practical to entertain the leasing of the Louis St. Laurent Building with the option to purchase in order to solve an outstanding space requirement.

In analyzing the situation, DPW concluded that this was an opportunity for the government to secure in the order of 40,000 square meters of rentable space at an attractive price. This space, which was available in a single block, was seen as a long-term space solution in the Outaouais. DND had expressed a long-term need for space in that quantity. As well, securing this lease with option to purchase enabled the government to maintain the percentages of employees at 25 percent on the Quebec side and 75 percent on the Ontario side of the NCR.

The Department therefore decided to respond to the overtures of the Lessor but first gave itself the advantage by obtaining the Lessor's agreement that the lease price would be based on the value of the property as established by independent appraisers chosen by the Crown.

Issue 3, the Department of Public Works does not consider the income tax implications of investments in real property. The Department is aware that generally there are tax implications in real property transactions. Although a federal government department, DPW is not privy to the specific tax implications of owners for real property transactions. This information is confidential and known only by the owner and Revenue Canada Taxation. The Department acts as any prudent investor does when transacting in real property and relies heavily on the market value of the property in question.

Issue 4, the government's method of accounting for capital acquisitions may contribute to real property investment decisions that are not economical. Capital funding restrictions resulting from an environment of fiscal restraint coupled with operational requirements have created the need to enter into lease and lease-with-option-to-purchase agreements.

The comparison of a lease-with-option-to-purchase agreement to a capital investment provides only one perspective on the merits of the lease with option to purchase. To provide a more balanced perspective, the lease with option to purchase must also be compared to the lease option. Under the lease option, DPW sacrifices the build-up of the equity available under the lease with option to purchase. The Department can share in the equity build-up of the property via the option to purchase at a favourable price. The government thus obtains equity and long range benefits for the taxpayers' dollars.

Department of Fisheries and Oceans

Fishing Vessel Insurance Plan

Background

2.142 The Plan is administered by a national headquarters in Ottawa (2.5 person-years) and six regional offices across Canada (38 person-years). Headquarters has functional authority over staff in the regions. At the end of fiscal year 1991-92, there were 6,224 fishing vessels insured, valued at $264 million.

Lack of management action on previous recommendations

Since 1965, numerous reviews and studies of FVIP have been done. Deficiencies in management practices have been noted repeatedly over the past 23 years. We identified many of these same deficiencies in our audit. Although the findings of these past studies were accepted by management and action promised, there was little evidence that the problems were subsequently resolved. In response to our 1977 audit, the Department stated "action has already been taken with respect to many of the observations ... the remainder will be resolved in conjunction with a major review of FVIP now being undertaken." Following a 1985 decision by the Minister against privatization, another study has just been completed and an action plan is now being developed.

2.144 As part of our 1991 follow-up to our 1988 audit, we reported: "The plan [being prepared in 1988 during our audit and in response to the Department's 1988 study] had not been implemented at the time of our follow-up." Accordingly, we decided, in 1992, to audit further to identify and report on the cumulative effect of the Department's lack of action and the continuing existence of many long-standing deficiencies.

2.145 During this audit, officials claimed that much action had been undertaken on the recommendations in the 1988 action plan. We reviewed the implementation of these recommendations, many of which were not new and had also been documented in the previous studies. We found that, although management had initiated action on many of the 32 recommendations, only 7 had been fully implemented. Management states that it now intends to resume implementation of most of the remainder.

2.146 Since 1988, no one individual has been given full-time, permanent responsibility for the management of FVIP. Management functions have been assigned to staff on a part-time and/or temporary basis. This lack of continuity has eroded the corporate memory and contributed to the Department's inability to follow through on its promises of action.

2.147 A major reason given by departmental officials for the continuing lack of corrective action is their view that the Plan's future has been uncertain. Resources had therefore been diverted to, among other tasks, privatization. The Department states that, in response to the government's consistent commitment to identifying agencies and programs for privatization, it has regularly considered FVIP as a candidate. Since 1984 a number of proposals have been made with a view to "privatizing" - or more accurately "winding up" - FVIP (see Exhibit 2.3 for a listing of key events).

2.148 Whatever their merit, these successive proposals to Ministers for a program wind-up have had the effect of diverting resources away from implementing action plans to solve the many known deficiencies.

Deterioration of performance since 1988

2.150 Each of these trends - a rapidly declining insurance base, rising deficits and declining efficiency - would be matters of grave concern to management of any insurance program, and we would have expected management to have a full understanding of their causes and to have plans to reverse them. However, management has not attempted to determine the causes of these trends. For example, management has no information on whether people leaving the Plan are doing so in order to buy insurance from the private sector, to become self-insured, or to leave the fishery. The Department is satisfied that its volume of business is decreasing, and accordingly no remedial action on this lack of information is planned. No attempts have been made to determine the future impacts of these trends on the Plan.

2.151 The Department responds that its operational philosophy is one of passive competition with other insurers and, accordingly, it would be pleased if it found that fishermen could be persuaded to insure their vessels with commercial insurers instead. However, as noted above, the Department does not know why the numbers have declined and hence cannot act to reverse them.

2.152 The situation of the Plan may become graver as a consequence of the recent moratorium on fishing the northern cod stocks. Although the Minister has announced his intention to assist fishermen with vessels' fixed costs (including gearing up, maintenance, insurance, etc), the Plan will possibly face a significantly increased moral hazard, and may need to develop new insurance policies to provide appropriate coverage for boats laid up as a result of the moratorium or face the loss of a significant portion of its business.

2.153 Service to fishermen. Although the Department does not monitor this, it has agreed that the turnaround time for processing claims is an important aspect of the service provided to FVIP clients. The Plan approves, on average, about 400 claims per year. In 1988 the Department found that one third of its claims took longer than six months to resolve, and concluded then that this was unsatisfactory.

2.154 We observed no action directed at improving this situation, and norms or standards for processing claims have yet to be set. Further, our analysis shows that, in the past three years, there has been no improvement in turnaround time.

2.155 We reviewed in detail those claims that took more than six months to process during 1990-91 and 1991-92. Our analysis showed that nearly half of the turnaround time consisted of delays that could have been avoided if management had a clear understanding of what FVIP's insurance policy covers, proper control and a pro-active approach to claims review. In one case, it took 18 months to pay the claim as headquarters and regional staff could not agree on whether FVIP's policy covered damage caused by lightning ( see Exhibit 2.4 ).

Significant weaknesses in management practices

2.157 Direction and guidance to regional staff. Following the 1988 action plan, headquarters management made a commitment to develop and implement a claims manual on a priority basis, followed by a comprehensive procedures manual. Further, because it was uncertain about the meaning of key areas of its current policies, it undertook to perform a legal review and to provide the regions with a list of approved policy variations.

2.158 Although a draft claims manual was developed it has not been completed or implemented. No work has been initiated to develop the comprehensive procedures manual. The legal review of current policies has not been completed. In practice, the policies do not appear to have successfully protected the Plan from legal challenge.

2.159 Furthermore, no training on vessel appraising and claims adjustment is provided to staff, and the FVIP Management Committee, composed of headquarters management and the six regional managers, has not met in the last two years. In short, little guidance or direction is provided to staff.

2.160 Although headquarters management has functional authority for the Plan, it has not defined performance targets; nor does it systematically monitor regional activities to ensure consistent quality in the conduct of business. Overall, we found that the Plan is not being run consistently. Among regions, we found considerable variation in the conduct of their activities. One of the consequences is that there is no assurance that the vessels insured with FVIP are not either over-insured or under-insured.

2.161 Review and approval of claims. Headquarters management is responsible for reviewing and approving claims regardless of their size or nature, in an attempt to ensure national uniformity in this area. Since June 1991, the Department has not staffed this function on a permanent full-time basis. On occasion, there has been no one assigned to this task. This has also contributed to delays in settling claims.

2.162 Claims are first reviewed and adjusted by field staff. Each claim is then fully reviewed by the Regional Manager and submitted to headquarters. Headquarters in turn reviews all claims submitted. Because of these levels of review on every claim, most regional managers believe that considerable duplication exists. Often issues arise during the review of claims that result in disagreement between regional and headquarters management. We observed that many of the issues tend to recur. Resolutions of disagreements are not communicated among staff in such a manner as to ensure that similar claims are quickly resolved in the future.

2.163 Furthermore, files sometimes lacked sufficient documentation to support the decisions to pay the claims; as a result, the basis for approving claims was not clear. See Exhibit 2.4 for cases demonstrating these deficiencies.

Solution being considered by the Department

2.165 The Department views the appointment of the General Manager as imperative prior to addressing other implementation issues. Two months after the announcement, the appointment of the General Manager had not taken place. The planned changes deal with structure and reporting relationships. At the time of our audit, draft plans did not address how the changes would resolve any of the specific deficiencies observed.

Conclusion

Department's response: The Department concurs that there are deficiencies in the management of the Plan and appropriate corrective actions have been identified but, as indicated in the Auditor General's note, their implementation has lagged. However, the Department now has clear direction that the Plan is to remain in the government sector because of its objective which is to ensure that all fishermen, irrespective of their location and type of vessel, have access to vessel insurance at reasonable rates. The focus of our efforts will now be towards improving the management of the Plan and the quality of services to our clients. In this vein, the Department announced that a General Manager of the Plan will be appointed with the responsibility to address those deficiencies identified above.