Appendix C Taxation of Foreign-source Income — Revisiting the Other Alternatives
C.1 As noted in Chapter 4, broadly speaking, countries have three principal choices in how they tax foreign income earned through foreign entities:
- Accrual or Worldwide Basis of Taxation
- Deferral with Credit (the Credit Method)
- Full Exemption Method
The key elements of these methods were also described in Chapter 4.
C.2 In our consultation paper, the Panel suggested that our consultations and review of Canada’s system of outbound taxation should focus on the scope of the exemption for foreign active business income. However, the Panel also considered it important to revisit and assess the relative merit of the alternative methods. The Panel’s findings and conclusions in this area are discussed below.
Accrual or Worldwide Basis of Taxation
C.3 If Canada were to adopt the Accrual Method, all foreign-source income earned directly or indirectly through foreign affiliates would be taxable in Canada on a current basis, with a credit given for any applicable foreign tax.
C.4 In theory, this method is attractive for several reasons:
- early advocates of this method considered it to be a necessary element of a progressive taxation system based on a taxpayer’s ability to pay,
- the method ensures that domestic and foreign-source income is taxed currently at comparable rates,
- as a practical matter, this method eliminates any need to distinguish between active and passive income, and
- under this method, similarly-situated taxpayers perceive that they are being taxed on an equal basis whether they do business in Canada or abroad, which arguably upholds the morale of taxpayers and induces them to comply with their legal obligation to self-assess their income.145
C.5 Although many OECD and EU countries employ this system for taxing passive income earned indirectly through certain foreign corporations, none employs this system in its purest sense for taxing foreign business income. New Zealand comes close, but it still maintains exceptions for foreign corporations located in countries included on a grey list. Additionally, following its own consultations, New Zealand recently introduced legislation to move closer to a full exemption system for taxing foreign business income.
C.6 A consultation paper issued by the New Zealand government details the drawbacks of using the Accrual Method for active business income. The Panel found this discussion to be of special interest, given the country’s eventual decision to change to a broader exemption system.146
C.7 In particular, the New Zealand paper notes that the Accrual Method eliminates the incentive for corporations to invest abroad in favour of investment domestically. Thus, for countries with relatively small domestic economies, the Accrual Method limits opportunities for its domestic companies to grow and compete internationally. The Panel believes these to be compelling arguments that apply equally to Canada.
C.8 Use of the Accrual Method would eliminate a policy feature of Canada’s system for taxing foreign business income that actually predates the current foreign affiliate rules, namely, the deferral of Canadian taxation of such income until it is repatriated.
C.9 More importantly, use of the Accrual Method would contradict Canada’s outbound taxation policy by putting Canadian businesses operating globally at a major disadvantage with respect to businesses based in all of Canada’s major competitors, none of which have adopted this approach.
C.10 For the above reasons, the Panel has concluded that the Accrual Method is not a viable alternative for Canada, except with respect to the taxation of passive income, as discussed more fully starting at paragraph 4.79.
Credit Method
C.11 If Canada were to adopt the Credit Method, the taxation of foreign business income earned indirectly through foreign corporations would be deferred until such income is repatriated to domestic shareholders, and a tax credit would be available to offset the foreign income tax paid on the income.
C.12 The Technical Committee on Business Taxation rejected this approach in 1998, largely because of the enormous complexity inherent in such a system. The Panel agrees that a move by Canada to this alternative would be undesirable.
C.13 The Panel sees no clear justification for the Credit Method. Conceptually, it is closer to the Accrual Method as it is intended to tax active business income on repatriation subject to credit for underlying foreign tax.147 However, the ability to defer the taxation of foreign business income under this method indefinitely imparts an exemption element. Under the Credit Method system currently in place in the United States, the exemption element is at least equal to, and in some respects perhaps greater than, that of the Canadian system.148
C.14 On the other hand, the Credit Method discourages the repatriation of foreign-source income because the income then becomes subject to tax, potentially impeding the ability of home country firms to access capital efficiently so they can compete effectively with others.
C.15 The Panel also notes that major countries that employ this method, including the United Kingdom, Japan and the United States,149 are considering moving to an exemption system for taxing foreign active business income.
C.16 For the above reasons, the Panel has concluded that the Credit Method is not a viable alternative for Canada.
145 See Arthur J. Cockfield, Examining Policy Options for the Taxation of Outbound Direct Investment (September 2008), research report prepared for the Advisory Panel on Canada’s System of International Taxation, at section 2.3.
146 New Zealand, Inland Revenue Department, Policy Advice Division, New Zealand’s International Tax Review: A Direction for Change, op. cit., at pp. 8-14.
147 As is the case where countries employ an exemption system, passive income earned directly or indirectly through certain foreign entities would be taxed under the accrual method.
148 In particular, cross-crediting under the U.S. system effectively allows U.S. corporations to avoid U.S. taxation on certain foreign-source royalties, interest and other passive income earned directly, and U.S. Treasury studies show that a move to exemption would increase taxes.
149 The United Kingdom is more advanced in this regard; the UK government issued a discussion paper in June 2007 stating, among other things, its desire to move to an exemption system as early as 2009. In August 2008, Japan’s Ministry of Economy, Trade and Industry published a report entitled “Proposal for Boosting Repatriation of Foreign Subsidiaries’ Profits — Towards Introduction of Foreign Dividends Exclusion System” outlining a proposal to move to a dividend exemption system. The proposal was subsequently reflected in the Tax Reform Request for fiscal year 2009. The debate in the United States in recent years has centred on various studies that advocate a change to a full exemption system, including studies by the Joint Committee on Taxation and the 2005 President’s Advisory Panel on Federal Tax Reform.