4. Withholding Taxes

Current Rules

4.1   Foreign investors and other non-residents must pay a 25-percent Canadian tax on interest, dividends, royalties, rents and certain other payments derived from Canada. This tax is commonly referred to as a “withholding tax,” as it must be withheld by Canadian residents making payments to foreign parties.

4.2   Tax treaties entered into by Canada generally provide for lower withholding tax rates. Most tax treaties concluded by Canada reduce the rate to 10 percent for interest and royalties and 5 percent for dividends paid by a Canadian subsidiary to a foreign shareholder who holds a substantial interest in the Canadian subsidiary. Dividends derived from portfolio investments are generally taxed at a reduced rate of 15 percent.

4.3   Canada’s domestic law provides exemptions from withholding tax for specific types of payments and for payments to or from certain persons. For example, there is no Canadian withholding tax on interest paid with respect to a debt obligation that is guaranteed by the Government of Canada and on certain royalties paid for the use of copyrighted artistic works. Exemptions can also be available under certain tax treaties, notably for royalties paid in respect of computer software, patents and know-how.

4.4   A new exemption for interest paid to unrelated foreign lenders (arm’s-length interest) took effect on January 1, 2008. As a result, a Canadian corporation can now borrow from an unrelated foreign person or financial institution and that foreign lender will no longer be subject to Canadian withholding tax.

4.5   Withholding tax on interest paid to related U.S. lenders (non-arm’s-length interest) will be phased out over a three-year period under the revised Canada–U.S. tax treaty. Thus, where a Canadian subsidiary pays interest on money borrowed from its U.S. parent corporation, no Canadian withholding tax will apply. This new exemption will apply to Canada–U.S. cross-border interest payments only, and interest paid to non-U.S. non-arm’s-length foreign lenders will remain subject to withholding tax.

Issues under the Current Rules

4.6   The imposition of a withholding tax can be justified on various grounds. Along with corporate income taxes, countries impose withholding taxes as a way of taxing the income that has its source within their borders. Withholding taxes can also play a role in reducing or mitigating the erosion of the corporate income tax base due to the deductibility of business costs such as interest, rents and royalties. Finally, withholding taxes on dividends paid to foreign portfolio shareholders can be viewed as proxies for personal income taxes that would be payable if these shareholders were residents in Canada.

4.7   Like other taxes, withholding taxes can be expected to adversely affect economic activity. This negative effect arises in part because withholding taxes are imposed on a gross basis and not on net income. Their impact is diminished, however, to the extent that foreign investors can credit those taxes against their home-country tax liabilities (leaving their overall tax rate unchanged) or can mitigate their withholding tax burden by substituting alternative transactions that are not subject to withholding taxes (such as financing a subsidiary with debt rather than equity to avoid the withholding tax on dividends).

4.8   Canadian companies with foreign investments may also be liable to pay foreign withholding taxes on the income derived from these investments. A further benefit of making agreements with other countries to reduce or eliminate withholding taxes may be the reduction of the tax burden of Canadian-based corporate groups, thereby increasing Canada’s national return on capital invested abroad by Canadian companies. Canadian companies are most likely to benefit if foreign withholding taxes on dividends are reduced or eliminated, as foreign withholding tax paid on dividends received by Canadian corporations from their foreign affiliates are usually not creditable in Canada.

4.9   From a cost-benefit perspective, in determining whether further reducing Canada’s withholding tax is an effective way of reducing taxes in Canada, these potential economic benefits must be weighed against the revenue loss that the government would incur. This loss would amount to the loss of revenues from the Canadian withholding tax reduction minus additional income tax revenues arising as Canadian companies claim less foreign tax credits in respect of foreign withholding taxes paid on their income from foreign investment. Additional tax revenues could also be collected to the extent that reducing or eliminating withholding taxes would generate positive economic spillovers for Canada. The table below, provided to us by the Department of Finance, reports withholding taxes collected by the federal government for the years 2000 through 2005, by type of payment subject to withholding tax.

Withholding Taxes Collected on Payments to Non-residents, 2000–2005 ($millions)
	Direct Dividends	Other Dividends	Interest	Rents and Royalties	Other*	Total
2000
U.S.	462	244	242	310	142	1 399
Other	251	204	250	252	153	1 110
Total	713	448	492	562	295	2 510
2001
U.S.	507	242	303	344	163	1 559
Other	232	225	314	272	161	1 203
Total	739	467	617	615	324	2 762
2002
U.S.	552	289	284	368	246	1 738
Other	238	179	231	308	145	1 101
Total	790	468	514	676	390	2 838
2003
U.S.	422	303	296	367	244	1 633
Other	268	198	253	363	167	1 249
Total	690	501	549	730	411	2 881
2004
U.S.	469	455	341	384	214	1 863
Other	309	222	335	349	164	1 379
Total	778	678	676	733	378	3 242
2005
U.S.	998	431	381	404	533	2 747
Other	364	309	336	326	202	1 537
Total	1 362	739	717	730	734	4 283

* Includes withholding tax on social security benefits, pension income and other types of income.

Source: Canada Revenue Agency, NR4 Return.

Options for Consideration

4.10   Non-arm’s-length interest: Withholding tax on interest paid to related lenders in the U.S. will be phased out over a three-year period under the revised Canada–U.S. tax treaty. Should Canada negotiate similar exemptions with countries other than the U.S.? Many developed countries, such as France, Germany, Norway and Sweden, exempt all interest payments to foreign parties from withholding tax. The U.S. and the United Kingdom have agreed to such an exemption with most of their tax treaty partners. Interest paid between associated EU companies is exempt from withholding tax by virtue of an EU directive that entered into force on January 1, 2004.

4.11   Dividends paid by affiliates to their foreign parents: Canada’s tax treaties generally provide for a maximum rate of withholding tax of 5 percent on dividends paid by Canadian affiliates to their foreign parent corporations that hold more than just a portfolio interest. One option is for Canada to negotiate bilateral exemptions for such dividends with its main economic partners. Intra-EU dividends paid from subsidiaries to their foreign parents have been exempt from withholding tax since 1992 by virtue of an EU directive. Some developed countries, including the U.S., the United Kingdom, Australia and Japan, have recently agreed to eliminate withholding tax on dividends paid by subsidiaries to their foreign parents under some of their tax treaties.

4.12   Royalties: Canada’s tax treaties generally provide for a maximum rate of withholding tax of 10 percent on royalties. Canada has also negotiated exemptions and lower rates for software, patent and/or know-how royalties in about one-third of its tax treaties. One option for Canada is to negotiate exemptions for other types of royalties (such as unpatented knowledge and technologies, payments for the use of trademarks and trade names, and copyright royalties that are not already exempt). A second option is to negotiate general exemptions for all types of royalties. The U.S. tax treaty policy is to exempt all royalties from withholding tax. Royalties paid between associated EU companies are also exempt from withholding tax by virtue of an EU directive that entered into force on January 1, 2004.

Questions on Withholding Taxes

1. Should Canada further reduce its withholding tax on payments to residents of other countries? If so, which additional types of payments should be exempt or taxed at a lower rate?
2. Should Canada implement any additional exemptions or rate reductions unilaterally by amending Canada’s tax law or bilaterally through changes to Canada’s tax treaties?
3. What other changes, if any, could be made to ensure that further reductions in Canada’s withholding tax do not erode Canada’s corporate income tax base?
4. Are there other issues or options related to withholding taxes that should be reviewed and considered?

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