2. Our Current Environment
Introduction
2.1 Tax policy must be developed with an understanding of how the economy operates and what motivates people and businesses. Maintaining this knowledge becomes more challenging as enterprises grow more sophisticated, businesses continue to expand globally, and national economies become more interconnected.
2.2 The global landscape is changing quickly. Current events show how swiftly capital markets can change and influence industrial and commercial activity, and how adaptable Canadian companies need to be in response. Within the past 16 months, the ways in which financial market participants evaluate credit, liquidity and market risk have shifted dramatically amid unprecedented intervention by governments and central banks. The Panel acknowledges that the current situation is worrisome and that similar events could occur in the future. With this in mind, we have taken a long-term view in developing our recommendations.
2.3 As a relatively small trading nation, Canada has traditionally pursued an open economy. Canada’s system of international taxation has historically reflected this pursuit.
2.4 This chapter highlights some of the important elements influencing the development of international tax policy in Canada.
Tax policy and cross-border investment
2.5 Domestic tax rates play an important role for Canadian companies investing abroad and in the overall attractiveness of Canada as a place to invest. As noted in paragraph 1.2, in its domestic tax policy, the Canadian government has taken action to improve the competitiveness of Canadian businesses with scheduled reductions to Canada’s domestic corporate tax rate. Currently, the combined federal-provincial corporate tax rate is scheduled to decrease from about 31.9 percent at the start of 2008 to 25 percent by 2012 (assuming a 10 percent provincial rate in 2012).
2.6 In our consultation paper, the Panel noted that foreign competitors of Canadian businesses are growing in strength and number, aided in many cases by the tax policies of their home countries. Some countries have already reduced their corporate taxes in their efforts to compete for capital, jobs and growth. For example, the average corporate tax rate of member countries of the Organisation for Economic Co-operation and Development (OECD) has dropped from 34.1 percent in 2000 to 26.7 percent in 2008.4
2.7 Foreign direct investment (FDI) has become a central feature of the world’s economy, and its importance for Canada and for other national economies has grown significantly in recent years.
2.8 Since 1980, the worldwide stock of FDI has increased substantially. Figure 2.1 shows how world stocks of outbound and inbound direct investment evolved between 1980 and 2006. Both stocks grew by about 900 percent in real terms over that period and are in excess of USD$12 trillion.
Figure 2.1
Stock of Total World Outbound and Inbound Direct Investment
1980–2006 (billions of constant 2007 U.S. dollars)
Source: UNCTAD, Foreign Direct Investment Online Database.
2.9 Canadian direct investment abroad and foreign direct investment in Canada have grown significantly since 1980 and both now exceed $500 billion (see Figure 2.2). Canada’s direct investment abroad has exceeded inbound investment since 1997.
Figure 2.2
Stock of Direct Investment by Canadians Abroad and by Foreigners in Canada
1980–2007 (millions of 2007 constant Canadian dollars)
Source: Statistics Canada, CANSIM Table 376-0037.
Benefits of foreign inbound and outbound direct investment to Canada
2.10 The rising importance of FDI for the Canadian economy is a positive development.5 The Competition Policy Review Panel made the following observation:
With our small domestic market, Canada must look outward. To that end, the (Competition) Panel has been mandated to investigate how best to encourage outward investment by Canadian firms.
…(T)he government has a significant role to play in establishing the conditions that will assure Canada’s position as an attractive destination for investment, both by Canadians and those from abroad.6
Outbound direct investment
“As a country with a wealth of resources and ideas, but a relatively small market and consumer base, our prosperity is built on our openness to international trade and investment.”
- Foreign Affairs and International Trade Canada web page, “Seizing Global Advantage: A Global Commerce Strategy for Securing Canada’s Growth and Prosperity” (www.international.gc.ca, February 15, 2008).
“Fears about FDI, rooted in protectionist thinking from the 1970s, do not reflect the new realities of global trade and investment. The idea that foreign-controlled companies operating in Canada will turn us into a ‘branch plant’ economy is entirely outmoded. With globalization and open markets, production processes have been decentralized and disaggregated among different locations. Supply chains now criss-cross borders. Canada’s challenge is to ensure that we maintain and enhance our position within global supply chains — and this, in turn, requires attracting inward foreign direct investment and investing heavily abroad.”
- The Conference Board of Canada, The Benefits of Foreign Direct Investment - How Investment in Both Directions Drives Our Economy, March 2006, at p.1.
2.11 Outbound direct investment is associated with efficiency gains and greater productivity. Such benefits may arise from the ability to achieve scale economies and greater specialization, set up global supply chains, and access foreign technologies.7
2.12 Because of these efficiency gains, outbound direct investment can generate positive benefits for the Canadian economy. Canadian companies with international operations undertake high-value-added headquarters activities in Canada. Their domestic suppliers may also benefit through indirect technology transfers.8
Inbound direct investment
2.13 Investment by foreign businesses in Canada does not displace domestic economic activity. In fact, it adds to the stock of capital invested in Canada, resulting in faster growth, greater employment, higher living standards, and additional tax revenues for governments in Canada.9 Inbound direct investment can encourage more competition in Canadian markets, leading to greater productivity.
2.14 Inbound direct investment is also a channel through which Canada can gain access to new foreign technologies.10 By interacting with foreign-owned companies in Canada, domestic companies can benefit from the transfer of these new technologies and knowledge. In addition, foreign-owned Canadian companies perform a significant amount of research and development (R&D) in Canada.11
An increasingly competitive international environment
2.15 The competition that Canada faces now for investment within and outside Canada is expected to accelerate. New competitors are emerging, notably from developing economies. Some of these new competitors are aggressively seeking capital, while others have substantial amounts of capital to invest. Canadian businesses need to be able to compete with them for investment on both the outbound and inbound fronts.
Figure 2.3
Canada’s Share of Total World Stock of Outbound and Inbound Direct Investment, 1980–2006
Source: UNCTAD, Foreign Direct Investment Online Database.
“Canada’s share of outward global FDI has slipped relative to OECD countries such as France, Germany, the UK, Sweden, and Australia. Canadian firms continue to face real competitive challenges as they seek to expand their market presence globally.”
- Submission of the Conference Board of Canada, at p. 3.
“(W)hile the current system is conceptually attractive, its lack of conformity with international taxing norms puts pressure on the New Zealand tax system. There is a concern that it inhibits the internationalisation of New Zealand business. The current system risks inducing New Zealand businesses with significant international operations to migrate, and it could inhibit the development of multinational enterprises based in New Zealand.”
- New Zealand Inland Revenue Department, New Zealand’s International Tax Review - A Direction for Change, December 2006, at p. 14.
2.16 Canada’s share of the total world stock of inbound and outbound foreign direct investment has been decreasing for a number of years (Figure 2.3). On the inbound side, foreign direct investment decreased from nearly 10 percent of the world stock of FDI in the early 1980s to 3.2 percent in 2006. On the outbound side, Canadian direct investment abroad fell from a high of 5.9 percent in 1984 to 3.6 percent in 2006. Canada’s average annual growth rate in the stock of outbound direct investment from 1990–2006 of just over 10 percent is the second-lowest among G7 countries.12
Looking forward
2.17 The above data demonstrate that Canada’s relative share of inbound and outbound investment has fallen. There are many possible explanations for this decline, including new competition from emerging economies, and most of these explanations have little to do with tax. To the Panel, however, Canada’s declining FDI share reinforces the competitive nature of the world economy and highlights the need to consider carefully any international tax changes that impede the ability of Canadian businesses to compete. Other countries are moving in a similar direction; for example, New Zealand has acknowledged that one of the key reasons its outbound direct investment could be hindered is its uncompetitive outbound international tax rules.13
2.18 In summary, inbound investment and outbound investment are important to the Canadian economy, and the competition for this investment is increasing. The principles and the specific recommendations that follow attempt to strike a balance between protecting the Canadian tax base and ensuring that Canada’s international tax system does not impede cross-border business investment.
4 KPMG International, KPMG’s Corporate and Indirect Tax Rate Survey 2008 (September 2008), at p. 15.
5 For general surveys of the literature on the benefits of foreign direct investment for Canada, see John R. Baldwin and Guy Gellatly, Multinationals in Canada: An Overview of Research at Statistics Canada (Ottawa: Statistics Canada, 2007); and Yvan Guillemette and Jack M. Mintz, A Capital Story: Exploding the Myths around Foreign Investments in Canada, C.D. Howe Institute Commentary no. 201 (Toronto: C.D. Howe Institute, 2004). See also Conference Board of Canada, The Benefits of Foreign Direct Investment — How Investment in Both Directions Drives Our Economy (Ottawa: Conference Board of Canada, 2006).
6 Competition Policy Review Panel, Sharpening Canada’s Competitive Edge (Ottawa: Public Works and Government Services Canada, October 2007), at p. 3.
7 Someshwar Rao, Marc Legault and Ashfaq Ahmad, “Canadian-Based Multinationals: An Analysis of Activities and Performance”, in Steven Globerman (ed.), Canadian-Based Multinationals, Industry Canada Research Series, vol. 4 (University of Calgary Press: 1994), at pp. 63-123; John R. Baldwin and Wulong Gu, Multinationals, Foreign Ownership and Productivity Growth in Canadian Manufacturing (Ottawa: Statistics Canada, December 2005).
8 Guillemette and Mintz, op. cit., at p. 19.
9 John Ries, “Foreign Investment, Trade and Industrial Performance: Review of Recent Literature”, in Someshwar Rao and Andrew Sharpe (eds.), Productivity Issues in Canada, Industry Canada Research Series, vol. 10, (University of Calgary Press: 2002), at pp. 571-594; Walid Hejazi and Peter Pauly, Foreign Direct Investment and Domestic Capital Formation, Industry Canada Research Publications Program, working paper no. 36 (2002); John R. Baldwin, The Dynamics of the Industrial Competition: A North American Perspective (Cambridge University Press: 1995).
10 Someshwar Rao and Jianmin Tang, Contribution of Transnational Corporations to Canada’s Competitiveness (Industry Canada, mimeo, 2004); Alla Lileeva, The Benefits to Domestically-Controlled Plants from Inward Direct Investment — The Role of Vertical Linkages (Ottawa: Statistics Canada, April 2006); John R. Baldwin and David Sabourin, The Effect of Changing Technology Use on Plant Performance in the Canadian Manufacturing Sector (Ottawa: Statistics Canada, 2004); Surenda Gera, Wulong Gu and Frank Lee, Foreign Direct Investment and Productivity Growth: The Canadian Host-Country Experience (Industry Canada Research Publications Program, working paper no. 30, 1999).
11 John R. Baldwin and Petr Hanel, Multinationals and the Canadian Innovation Process (Ottawa: Statistics Canada, June 2000); J.A.D. Holbrook and R.J. Squires, “Firm-Level Analysis of Determinants of Canadian Industrial R&D Performance”, Science and Public Policy, vol. 23(6) (December 1996), at pp. 369-374; Someshwar Rao and Jianmin Tang, R&D Propensity and Productivity Performance of Foreign-Controlled Firms in Canada (Industry Canada Research Publications Program, working paper no. 33, 2001).
12 Calculations based on data from UNCTAD, Foreign Direct Investment Online Database.
13 New Zealand, Inland Revenue Department, Policy Advice Division, New Zealand’s International Tax Review — A Direction for Change (Wellington: Inland Revenue Department, December 2006), at p. 16.