3. Taxation of Inbound Direct Investment
3.1 Direct investment in Canada by foreign businesses is important to Canada’s economic well-being. Inbound foreign direct investment generates economic activity and employment in Canada. It contributes to the growth and productivity of the Canadian economy by fostering competition and facilitating the transfer of new technology into Canada.
3.2 The taxation of inbound direct investment should aim to balance two objectives. First, Canada’s tax system should, to the extent appropriate, seek to treat foreign investors and domestic investors equally. Second, foreign entities doing business in Canada should pay Canadian tax on what is properly considered Canadian-source income.
3.3 The government recently implemented several changes to make Canada a more attractive place to conduct business. Significant corporate tax rate reductions have been legislated that will bring the federal rate to 15 percent in 2012 from 20.5 percent in 2008. The government eliminated the withholding tax on interest paid to unrelated foreign lenders effective January 1, 2008. The withholding tax on interest to U.S. related lenders will be eliminated over a three-year period under the revised Canada–U.S. tax treaty.
3.4 One guiding principle regarding inbound tax policy is to ensure the proper measurement and taxation of business income generated from Canadian sources. A policy of keeping Canada’s corporate tax rate low complements this approach by helping attract investment, reducing the incentive to shift income out of Canada, and easing pressure on the rules designed to properly measure Canadian-source business income.
3.5 The following sections consider two important aspects of the taxation of inbound direct investment in Canada. The first section considers the tax treatment of interest expense incurred by Canadian corporations with debts owing to certain non-resident persons and discusses whether the current treatment is appropriate vis-à-vis the two objectives stated above. The next section examines the accessibility of foreign investors to Canada’s tax treaty network. Canada’s withholding tax regime is addressed in Chapter 4. While withholding taxes affect both inbound and outbound investment, changes to further reduce or eliminate them may put additional pressure on some inbound rules such as thin capitalization.
Tax Treatment of Interest Expense Incurred by Foreign-owned Canadian Corporations
Current Rules
3.6 Interest costs incurred in Canada by Canadian subsidiaries of foreign businesses are generally tax deductible under the same rules that apply to other Canadian corporations.
3.7 Canada’s so-called “thin capitalization” rules, which apply to Canadian corporations that have incurred debts to certain non-resident persons (foreign shareholders with a significant interest and non-resident persons that do not deal at arm’s length with significant shareholders), are a notable exception to this general tax treatment.6 Under these rules, interest paid by a Canadian corporation on loans received from those non-resident persons is not deductible to the extent that such loans exceed twice the equity (which is subject to special computational rules) of those Canadian corporations. In 2000, Canada reduced the maximum debt-to-equity ratio allowable under the thin capitalization rules from 3:1 to 2:1.
3.8 These rules generally do not apply to loans received from third-party lenders, whether Canadian or foreign. Interest expense denied under these rules cannot be carried forward for use in future years.
Issues under the Current Rules
3.9 The deductibility of bona fide business costs incurred by Canadian subsidiaries of foreign companies, including interest, is appropriate from a tax policy perspective. Canada’s corporate income tax for the most part is a tax on net income, and the deductibility of business costs offers relief for expenses incurred to earn income. While the deductibility of interest expense reduces the government’s revenue from corporate income taxes, it also lowers the cost of capital for foreign businesses that wish to invest in Canada. The fiscal cost to the government of granting interest deductibility must be balanced against the economic benefits that inbound direct investment brings to the Canadian economy.
3.10 In some cases, the unrestricted deductibility of interest expense incurred by foreign-owned Canadian corporations may not be appropriate. It is reasonable to review whether Canada’s thin capitalization rules are effective in dealing with these situations.
3.11 The thin capitalization rules were adopted because foreign businesses are typically able to choose between debt and equity in financing their Canadian subsidiaries, allowing them to optimize their capital structure from a tax perspective. The current maximum debt-to-equity ratio is 2:1 and, as noted, includes only debt from certain non-resident persons. An issue that arises is whether this ratio is a good approximation of the amount of related-party debt a foreign-owned Canadian corporation should be allowed to incur in Canada. In the absence of a principle defining an appropriate level of related-party debt, there may be no clear way to resolve this issue.
3.12 The current rules do not apply to borrowings of foreign-owned Canadian corporations from third-party Canadian or foreign lenders. A foreign business may have an incentive for its Canadian subsidiaries to borrow if the tax deduction claimed in Canada by the subsidiary is worth more than the same deduction claimed in the foreign parent’s home country. This incentive will diminish as Canada’s corporate tax rate drops.
3.13 Whether or not Canada’s thin capitalization rules apply depends on how leveraged a foreign-owned Canadian corporation is, and not on how the amounts borrowed are used. Accordingly, the Canadian subsidiary of a foreign business could incur debt in Canada — within the limit of the thin capitalization rules if they apply — and use the borrowed funds to invest outside Canada. Using Canada as a platform to finance investment made outside Canada is tax-effective if the debt in Canada allows the foreign business to lower its overall tax burden and/or if Canada’s taxation of the income derived from the investment in the third country is more generous than the tax regime that applies if the foreign business invests in the third country directly.
Options for Consideration
3.14 If Canada’s thin capitalization rules need further revisions, different approaches are available. The maximum allowable debt-to-equity ratio could be adjusted or extended to cover third-party borrowings guaranteed by a related foreign corporation. On the other hand, one view is that thin capitalization rules should apply only where shareholders are indifferent to whether they finance their subsidiaries with debt or equity, since it is in those circumstances that shareholders can use excess debt to achieve a particular tax result. This view suggests that the appropriate ratio and the scope of shareholders or non-arm’s-length creditors subject to the rules should be reviewed, but that the thin capitalization regime should not be extended to third-party borrowings. Other technical changes could also be made, notably extending the application of the thin capitalization rules to non-corporate entities such as trusts and partnerships.
3.15 A different approach, which is in place in the United Kingdom and many other European countries, is based on the so-called “arm’s length principle” that has been developed in a transfer pricing context. Under this approach, interest paid by a corporation to a related-party lender is deductible if a comparable corporation could have borrowed the same amount from an unrelated lender. Conceptually, a benefit of this approach is that the maximum debt a corporation can borrow is determined relative to that corporation’s particular situation, avoiding the arbitrariness of limits set by reference to some industry or economy-wide averages. However, this approach can be burdensome to apply in practice and may create uncertainty for taxpayers over how much interest expense can be deducted.
3.16 Some countries have adopted broad thin capitalization rules that apply to all companies, rather than only to domestic companies under foreign control. Adopting such an approach involves resolving a number of difficult issues, including the complex task of determining the appropriate debt-to-equity ratio (keeping in mind differences among various sectors of the economy) and appropriate components of the calculation.
3.17 Another possibility is to adopt a so-called “earnings stripping” rule. Such an approach limits the amount of interest deductions that a foreign-owned corporation can claim by reference to that corporation’s ability to borrow (generally determined by reference to the corporation’s earnings before tax, interest, depreciation and amortization). The U.S., Germany, Italy and France have adopted this approach (in addition to thin capitalization rules in some of these countries). Examples of the application of the thin capitalization and earnings stripping approaches are shown in the accompanying box.
Restricting Interest Deductibility: Thin Capitalization Versus Earnings Stripping Rules |
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Two alternative approaches can be used to limit the amount of deductible interest expense incurred by the Canadian subsidiary (“CanSub”) of a foreign business (“ForCo”). Basic facts
Thin Capitalization Rules Countries with thin capitalization rules disallow the deductibility of interest paid on debt that exceeds some fixed ratio. For example, in Canada, interest paid to a related foreign shareholder on debt that is more than twice the amount of equity contributed by this shareholder is not deductible. Under these rules, the interest paid by CanSub to ForCo under Scenario A in respect of the $4 million loan is fully deductible in Canada, as the loan is smaller than twice the equity invested by ForCo ($4 million < 2 x $6 million = $12 million). Under Scenario B, the loan from ForCo to CanSub exceeds the maximum allowed under the thin capitalization rules by $1 million ($7 million > 2 x $3 million = $6 million), such that one-seventh of the interest paid by CanSub to ForCo (1/7 x $7 million x 10% = $100 000) is not deductible. Earnings Stripping Rules Countries with earnings stripping rules disallow the deductibility of interest paid on debt where the interest paid exceeds some fraction of the borrower’s earnings (generally, earnings before tax, interest, depreciation and amortization). For example, assuming Canada would limit the amount of interest deductible to 50 percent of CanSub’s earnings, CanSub is not subject to the limitation under Scenario A, as its interest expense ($4 million x 10% = $400 000) is less than half of its earnings ($1 million x 50% = $500 000). Under Scenario B, its interest expense ($7 million x 10% = $700 000) exceeds the limitation by $200 000, and this amount is therefore not deductible. |
Questions on Tax Treatment of Interest Expense Incurred by Foreign-owned Canadian Corporations
- Does the use of debt by foreign-owned Canadian corporations raise any concern from a tax policy perspective?
- Should any of the specific transactions and tax planning structures used by foreign businesses to finance their Canadian subsidiaries be considered inappropriate from a tax policy perspective?
- Should Canada’s current thin capitalization rules be modified? Should Canada pursue another approach?
Inbound Treaty Shopping
Current Rules
3.18 A tax treaty is an agreement entered into between two or more countries, the purpose of which is to avoid international double taxation and to prevent fiscal evasion with respect to taxes imposed on income and capital. Tax treaties are essentially relieving in nature, that is, they do not impose new or additional taxes, but provide relief from taxes otherwise applicable under the domestic tax law of the treaty partners. As such, tax treaties can provide important tax benefits to investors, such as lower withholding taxes on cross-border payments, reduced taxation of capital gains in the countries where these gains arise, and double tax relief in their home countries for taxes imposed abroad.
3.19 The term “treaty shopping” refers to the situation where a person, who is resident in a given country (the home country) and who derives income or capital gains from another country (the source country), is able to gain access to a tax treaty in place between the source country and a third country that offers a more generous tax treatment than the tax treatment otherwise applicable. This situation could arise if the person is resident in a country that does not have a tax treaty with the source country, or if the tax treaty between the source country and the person’s home country offers less generous tax treatment than the tax treaty between the source country and the third country.7
3.20 Canada generally provides access to reduced withholding tax rates under its tax treaties to the “beneficial owners” of the payments subject to withholding tax. Until very recently, Canada’s position has been that it is preferable to rely on general anti-avoidance rules to counter treaty-shopping transactions than to include detailed anti-treaty-shopping provisions in its tax treaties, as the U.S. does. Canada recently agreed to include such a detailed provision in the revised Canada–U.S. tax treaty that was signed on September 21, 2007.8 It is unclear whether such a provision will be included in future tax treaties negotiated by Canada.
Issues under the Current Rules
3.21 Tax treaties signed by Canada differ in many respects. This may create opportunities for arbitrage through treaty shopping, especially as Canada has signed treaties with a number of countries that have extended treaty networks of their own and that are either low-tax jurisdictions or have preferential tax regimes.
3.22 Differences among Canada’s treaty withholding tax rates may be due to the long period of time required before a given treaty policy change can be implemented. Certain differences seem to reflect deliberate tax policy choices. For example, Canada has negotiated specific exemptions from withholding tax, usually with a few important treaty partners. In particular, once the revised Canada–U.S. tax treaty is ratified, the U.S. will be the only country with which Canada has agreed to eliminate withholding tax on interest paid to related-party lenders (see Chapter 4). Canada has also agreed with a number of countries to eliminate withholding tax on software, patent and know-how royalties.
Options for Consideration
3.23 As noted above, certain treaty benefits are afforded to “beneficial owners” who are resident in a treaty country. The CRA has challenged some structures on the basis that the person resident in the treaty country who is receiving the payment is not the beneficial owner, and so the treaty benefits should be denied. One option is to define the term “beneficial owner” in Canada’s domestic tax law, specifying the criteria that a person must meet to be considered the beneficial owner of a stream of income. This approach could add some clarity and certainty for taxpayers and the CRA alike. Another option is for Canada to update each of its tax treaties to include a specific, detailed anti-treaty-shopping rule, similar to the rules in most U.S. tax treaties. Alternatively, such an anti-treaty-shopping rule could be adopted in Canada’s domestic tax law, although this may raise issues regarding the possible override of existing tax treaties.
3.24 In assessing these options, it is important to consider how to ensure a proper balance between the existing risk (if any) to the Canadian income tax base, the additional compliance burden that could be imposed on foreign investors and Canadians under some of these options, and the need for Canada to remain attractive to foreign investment. To the extent that some of these options would apply on a reciprocal basis, it is also important to consider the possible implications for Canadian companies with outbound direct investments.
Questions on Inbound Treaty Shopping
- Is Canada’s income tax base at risk because of treaty-shopping transactions?
- Which treaty provisions are more likely to encourage treaty-shopping behaviours?
- Should Canada consider additional rules in its tax treaties or its domestic tax law to discourage treaty-shopping transactions?
Questions on Other Inbound Matters
- Does investment into Canada by sovereign wealth funds and other tax-exempt foreign entities raise any issues?
- Are there other issues or options related to inbound investment that should be reviewed and considered?
6 While the scope of these rules is broad and can apply in situations where a Canadian corporation does not have a foreign shareholder, this paper focuses on situations where a significant foreign shareholder is present. For the purposes of this paper, those Canadian corporations are referred to as “foreign-owned Canadian corporations.”
7 The most common way for a person resident in a given country to access the benefits under a tax treaty between a source country and a third country is to set up a corporation in the third country through which the income or capital gains will be channelled. For example, an investor may lend money to a foreign borrower by setting up a corporation in a third country through which the funds will be channelled. Such a triangular structure is tax-efficient, provided that the tax treaty between the source country and the third country allows for a lower withholding tax rate than the rate that would apply if the interest were paid directly from the borrower to the lender, and provided that the interest income is not subject to any significant taxation in the third country.
8 Such a provision has been part of the existing Canada–U.S. tax treaty since 1995, but it currently applies for U.S. tax purposes only.