3. Principles for Guiding Canada’s International Tax Policy
Introduction
3.1 In setting any government policy, a clear and sound set of principles is invaluable. Principles offer guidance now and in the future in setting tax policy, and they can point the way when making decisions among different alternatives.
3.2 In this chapter, the Panel has distilled what it believes should be the principles that underpin Canada’s system of international taxation. In developing our recommendations, the Panel took direction from these principles.
3.3 The Panel acknowledges that setting international tax policy entails trade-offs and practical constraints. In the Panel’s view, Canadian international tax policy makers should be guided by the following principles:
| 1 | Canada’s international tax system for Canadian business investment abroad should be competitive when compared with the tax systems of our major trading partners. |
| 2 | Canada’s international tax system should seek to treat foreign investors in a way that is similar to domestic investors, while ensuring that Canadian-source income is properly measured and taxed. |
| 3 | Canada’s international tax system should include appropriate safeguards to protect the Canadian tax base. |
| 4 | Canada’s international tax rules should be straightforward to understand, comply with, administer and enforce, to the benefit of both taxpayers and the CRA. |
| 5 | Full consultation should precede any significant change to Canada’s international tax system. |
| 6 | Canada’s international tax system should be benchmarked regularly against the tax systems of our major trading partners. |
3.4 We believe that an international tax system that is consistent with these principles will be competitive, efficient and fair, and deliver predictable and certain results. The system will also be less costly for all businesses to comply with14 and easier for the CRA to administer and enforce.
Competitive tax system for Canadians investing abroad
3.5 The competitiveness of Canada’s outbound tax system has been a concern of the government since the system was put in place in the mid-1970s. Many features of the existing system were adopted with the goal of fostering the competitiveness of Canadian companies investing in foreign markets. In 1992, former Department of Finance Deputy Minister David Dodge made the following observation:
Canada’s approach to taxing foreign-source income…falls squarely within the international norms. What it seeks to do is to ensure that Canadian-based multinationals remain viable and competitive with those based in other countries…. At the same time, the specific anti-avoidance rules…seek to ensure the system is not open to abuse.15
3.6 To the Panel, this statement reflects how the system was viewed from its inception and the key policy goals needed to achieve a competitive tax system. The statement acknowledges that the system should be benchmarked globally and should protect the Canadian tax base.
“Governments must…evaluate policy, not in a domestic context, but in a global one. When examining legislation, setting policy and establishing regulations, governments need to consider how this positions Canada against our competitors and in the context of Canada’s links to the U.S. economy. It also means establishing a process where we continually review and refine our policies to reflect a fast evolving world and changing circumstances. Competitiveness begins at home, but it is measured internationally.”
- Competition Policy Review Panel, Compete to Win, June 2008, at p. 103.
3.7 In the Panel’s view, the overriding principle guiding Canada’s taxation of outbound direct investment should be to ensure that the Canadian tax treatment of foreign-source business income does not disadvantage Canadian businesses investing abroad when compared with their foreign competitors. Achieving this goal can be accomplished, in part, by not exposing Canadian businesses to costs in relation to their foreign business income that their foreign competitors are not required to incur.
3.8 Having companies that are internationally competitive is particularly crucial for Canada. As discussed in Chapter 2, access to foreign markets is key for Canadian firms to grow and achieve economies of scale. Because the Canadian market is relatively small, Canadian companies often need to engage in cross-border trade sooner than other companies that are based in countries with larger domestic markets.
3.9 Economists have identified three economic principles as possible guides to setting international tax policy. These principles are described in the accompanying box. Nevertheless, the Panel has highlighted competitiveness as a predominant principle. While competitiveness is not a well defined economic principle in the context of international taxation, the Panel firmly believes that it should be a fundamental consideration in developing Canadian tax policy. The Panel also believes that a focus on maintaining a globally competitive tax system is appropriate to a small, open economy such as Canada’s.
Economic Approaches to the Taxation of Foreign Direct Investment Income
Besides being fair and simple, a good tax system should be economically efficient: it should impose the least possible burden on the economy while generating its target revenue.
FDI refers to investments that give the investor a significant interest in the foreign entity, and thus influence over the management of its business activities. A tax imposed on income from FDI not only affects the competitiveness of multinationals but also may distort the investment and saving decisions of taxpayers and may affect the pattern of ownership of business assets among corporations. Economists have identified three possible objectives that countries might pursue to ensure neutrality in designing their systems for taxing income from FDI:
- “Capital Export Neutrality” (CEN): Where CEN is the chosen objective, a tax system is designed to be neutral regarding resident investor preference for investment at home or abroad, so the more profitable investments (on a pre-tax basis) are made first.
- “Capital Import Neutrality” (CIN): Where CIN is chosen, investors from different countries face the same level of tax when doing business in a given country, so there is neutrality with respect to the investment decisions made by residents of different countries.
- “Capital Ownership Neutrality” (CON): If CON is the objective, a tax system is designed to be neutral as to which corporations own and exploit capital assets, so the corporations that exploit a given asset most efficiently are willing to pay the most to own that asset.
Different countries, however, tax income from FDI at different rates, so fulfilling the three neutrality standards with a single set of tax rules is impossible. For example, taxing foreign business income on an accrual basis with a credit for foreign taxes paid on that income would conform with the CEN standard but not with CIN or CON. Conversely, providing an exemption for foreign business income could conform with CIN and CON but not with CEN, as it could create a bias in favour of foreign investment.
Of course, countries will consider many other factors beyond neutrality in designing their tax systems, including competitiveness.
3.10 While striving to meet its other objectives, the outbound international tax system needs to protect the Canadian tax base. A competitive international tax system includes robust rules for taxing foreign passive income. Rules to properly measure and tax transactions that involve Canadians’ selling or buying goods and services to or from foreign persons are also critical. These rules also should be benchmarked against similar regimes in other countries.
3.11 Some observers worry that a competitive outbound tax system will cause a preference for foreign investment over domestic investment and lead to a loss of jobs within Canada. The government itself expressed this concern when Canada’s outbound international tax system was being developed. The White Paper of 1969, in which the government presented its proposals that led to the 1972 tax reform, commented as follows:
For the foreseeable future Canada’s capital requirements will continue to exceed available domestic savings…. In these circumstances it would clearly be inappropriate to encourage the export of investment capital needed domestically.
On the other hand, Canadian business is often required to go abroad to seek foreign sources of supply and to develop foreign markets. Going international is frequently necessary to enable Canadian companies to achieve the economies of scale which are otherwise denied them by the relatively small size of the Canadian domestic market. Such companies would find it hard to compete on the international scene if they were subject to more onerous taxes than those which apply to their competitors….16
3.12 Despite these concerns, existing Canadian studies suggest that Canadian direct investment abroad does not significantly affect domestic capital formation.17 Rather than shifting capital abroad, recent international evidence (based mainly on firm-level data) indicates that outbound direct investment more likely has a beneficial effect on the domestic stock of capital.18
3.13 A more common worry among some Canadians is how Canadian direct investment abroad affects Canadian employment. The Panel found no clear evidence that direct investment abroad leads to an export of jobs or increases unemployment in a capital-exporting country like Canada.19 Rather, outbound direct investment appears to move employment away from low-value-added jobs and toward higher-value-added work.20
3.14 A 2004 report by the C.D. Howe Institute21 summarizes the state of research on these issues:
While the decision to outsource certain activities is quite independent of ownership, there is a commonly held view that Canadian direct investment abroad (CDIA) may transfer production facilities from Canada to foreign locations and reduce Canadian employment levels. As Gunderson and Verma (1994) point out, however, this argument comes back to the classic “lump of labour fallacy”, according to which there is a fixed number of jobs in an economy so that investing in another country becomes the equivalent of exporting jobs. This concern rests largely on unstated premises that CDIA substitutes for exports and domestic capital formation. As shown, these premises are false.
In a long-term perspective, the employment-loss argument loses much of its force. In the long run, CDIA generates investment income, as well as contributing to exports and increased efficiency within the home economy. In fact, direct investment abroad leads to a change in the employment structure of the home country, away from low-value-added employment and toward higher-value-added work. Higher-value-added jobs reflect Canada’s comparative advantage in knowledge-intensive occupations….
“British businesses and the Government will…look at the long-term challenges facing the UK tax system and ensure competitiveness remains at the heart of any future reforms…. In his speech, the Chancellor said…‘Tax is one element of the strong business environment which makes the UK competitive at a global level.’”
- HM Treasury press release, April 29, 2008.
3.15 Accordingly, the Panel believes the risk that a competitive outbound tax system will result in a loss of economic activity in Canada is less than the risk of losing business because our system is not competitive. Other countries acknowledge that systems that deviate too much from international norms carry a steep cost. For example, a number of companies moved their parent corporation out of the United States in order to achieve tax savings, notably with respect to their foreign business income.22 Following a series of corporate migrations out of the United Kingdom,23 the Chancellor of the Exchequer announced a new project to review the UK taxation system in April 2008, saying that competitiveness would be a central focus of any changes arising from the review.24
3.16 These examples show the importance for Canada of benchmarking its outbound tax system with the systems in place in other developed countries to ensure Canada’s system does not disadvantage Canadian businesses. Of course, achieving a competitive outbound tax system does not mean Canada should take part in an unsustainable and potentially harmful race to the bottom with other countries. A competitive tax policy for outbound investment does not need to place the Canadian tax base at risk, and robust rules to tax foreign passive and other mobile income are important. In the Panel’s view, a tax policy that is attuned to competitiveness is one that reflects strategic choices regarding key design features.
Level playing field for domestic business activity
“(B)eing an attractive destination for skilled immigrants and foreign investment will be a critical success factor for developed countries.”
- Competition Policy Review Panel, Compete to Win, at p. 8.
3.17 Foreign direct investment brings significant benefits to the Canadian economy. While competitiveness is an important feature of an outbound international tax system, domestic competition is also important to Canada’s inbound regime. Recognizing the importance of domestic competition, the government has taken action to ensure Canada remains an attractive destination for foreign investors. This action includes maintaining the scheduled federal corporate income tax reductions.
3.18 Canada’s tax treatment of inbound direct investment should contribute to the policy of attracting foreign investment. At the same time, Canada’s inbound tax system should, to the extent appropriate, seek to treat foreign investors and domestic investors similarly in taxing their income from Canadian sources.
3.19 A level playing field for the taxation of Canadian-source income is a key concern of Canadian businesses. Foreign entities doing business in our country should pay Canadian tax on what is properly considered Canadian-source income.
3.20 Although no playing field can ever be perfectly level, the Panel believes that creating the conditions to ensure that Canadian and foreign businesses investing in Canada compete on similar footing should be a key consideration of the government in setting Canada’s tax policies regarding inbound direct investment.
Protecting the tax base
3.21 Canada’s system of international taxation should include appropriate rules to properly measure and tax Canadian-source income. The Panel believes such rules should include robust anti-deferral regimes for foreign passive income, effective transfer pricing rules, and targeted anti-avoidance rules.
Straightforward tax rules
3.22 The tax system should be designed with a view to minimizing the compliance cost of taxpayers and facilitating its administration and enforcement by the CRA. The ability to achieve this objective is determined largely by the complexity of the tax laws.
3.23 International taxation is a complex subject, and some level of complexity in the tax rules is inevitable. Nonetheless, the Panel believes complexity in tax rules should be avoided where possible, provided tax policy objectives are not sacrificed. The CRA and businesses need unambiguous, readily understandable rules. The CRA also needs workable solutions for assessing data to determine whether the rules have been met.
3.24 General rules with broad application should be plainly drafted so that businesses, their advisors and the CRA can readily understand how to interpret and apply them. Particular areas of concern should be addressed with additional guidance from the CRA or anti-avoidance rules that target the problem directly without affecting a wider range of taxpayers than absolutely necessary. Though clear-cut rules can result in rough justice for taxpayers or the government in some cases, such instances must be weighed against the efficiencies and savings that greater simplicity will bring.
3.25 Predictability regarding future tax changes is just as important. New tax rules should be introduced and implemented in a timely fashion so that businesses can make decisions with a clear grasp of their tax implications.
Open consultation
3.26 Canada’s tax legislative process should be as open and transparent as possible to increase certainty for taxpayers while bearing in mind the potential market implications of budget proposals or other new measures. To increase certainty and avoid unintended consequences for Canadian businesses, consultations should be held regarding possible tax policy changes, with a reasonable period of time allowed for study and comment on the potential impact of a proposed rule before it takes effect.
Regular benchmarking
3.27 In our consultation paper, the Panel noted that Canadian businesses face increased international competition and that the tax policies of other countries are part of the reason for this increase. Many countries are considering or are already changing their tax systems to compete for capital, jobs and growth. Canada’s tax policy must anticipate continuous change in the global environment and retain the flexibility to adapt accordingly. Regular benchmarking can help ensure Canada’s system of international taxation stays in step with or ahead of international norms.
Implementing the principles
3.28 Canada’s international tax system, and its tax system generally, is largely dependent on self-assessment. Should self-assessment break down, the result would be an ineffective and inefficient tax system that would benefit no one.
3.29 Achieving an effective self-assessment system requires a culture of mutual responsibility and cooperation among businesses, their advisors and government.
Responsibility of businesses and their advisors: The Panel understands that every business will seek to organize its affairs in a way that minimizes the tax it pays. This long-standing principle should continue. However, there is a limit to reasonable tax minimization, and businesses and their advisors have a duty to respect the object and spirit of the tax law and to understand the legitimate need for government to protect Canada’s tax base.
Responsibility of government: Government must accept that most businesses seek to comply with the letter and spirit of the law and do not practise inappropriate tax minimization. An overly negative view from government would put at risk the goal of achieving a competitive, efficient and fair tax system.
3.30 To call for businesses to be reasonable in their tax planning and for tax administrators to be less suspicious may be perceived as naïve. The Panel believes that mutual responsibility and cooperation will help achieve real efficiency and simplicity within the tax system. The alternative would lead to more rules, aggressive tax planning, suspicion and litigation. The Panel believes the Canadian tax system could be made better. Applying the above principles, in a spirit of cooperation and mutual respect, would offer Canada an opportunity to distinguish itself from other countries and enhance its international tax advantage.
Our recommendations
3.31 The body of this report includes an integrated package of specific recommendations for improving Canada’s system of international taxation in various areas. These recommendations were developed with reference to the principles discussed above and support the Panel’s broader conclusions on the tax policy direction that the government should take to improve the competitiveness, efficiency and fairness of the system. As noted in paragraph 1.12, the Panel believes the current international tax system is a good one and requires only some improvements. The recommendations in this report reflect this view.
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Two key directives emerge from applying the Panel’s principles:
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3.32 The principles and the recommendations in this report aim to improve Canada’s international tax system by delivering predictable and more certain results while protecting the Canadian tax base.25
14 For example, the Canadian Federation for Independent Business estimates that the cost to Canadian businesses of tax compliance is about $12.6 billion annually. See Lucie Charron, George Chow and Janine Halbesman, The Hidden Tax Burden: A business perspective on the cost of complying with taxes, Canadian Federation of Independent Business Research Series: Report I (August 2008), at p. iv. Also see PricewaterhouseCoopers LLP, Total Tax Contribution, Canada’s tax regime: complexity and competitiveness (May 2008), at p. 23.
15 House of Commons, Standing Committee on Public Accounts, Minutes of Proceedings and Evidence, no. 37, December 8, 1992.
16 Department of Finance Canada, Proposals for Tax Reform (Ottawa: Queen’s Printer, 1969), at paragraphs 6.8-6.9.
17 Someshwar Rao, Marc Legault and Ashfaq Ahmad, “Canadian-Based Multinationals: An Analysis of Activities and Performance”, in Steven Globerman (ed.), op. cit., at pp. 63-123; Walid Hejazi and Peter Pauly, Foreign Direct Investment and Capital Formation Industry Canada Research Publications Program, working paper no. 36 (2002); Walid Hejazi and Peter Pauly, “Motivations for FDI and Domestic Capital Formation”, Journal of International Business Studies, vol. 34 (2003), at pp. 282-289.
18 Mihir A. Desai, C. Fritz Foley and James R. Hines Jr., “Foreign Direct Investment and the Domestic Capital Stock”, American Economic Review, vol. 95(2) (May 2005), at pp. 33-38; Mihir A. Desai, C. Fritz Foley and James R. Hines Jr., Foreign Direct Investment and Domestic Economic Activity, National Bureau of Economic Research working paper no. 11717 (October 2005); Isabel Faeth, Consequences of FDI Australia — Causal Links Between FDI, Domestic Investment, Economic Growth and Trade, Australian National University, Department of Economics Research Paper 977 (2006).
19 Morley Gunderson and Savita Verma, “Labour-Market Implications of Outward Foreign Direct Investment”, in Steven Globerman (ed.), op. cit., at pp. 179-213.
20 Margit Molnar, Nigel Pain and Daria Taglioni, The Internationalisation of Production, International Outsourcing and Employment in the OECD, OECD Economics Department working paper no. 561, July 2007; P.S. Andersen and P. Hainaut, Foreign Direct Investment and Employment in the Industrial Countries, Bank for International Settlements working paper no. 61 (1998).
21 Yvan Guillemette and Jack Mintz, op. cit., at pp. 18-20.
22 See Mihir A. Desai and James R. Hines Jr., “Expectations and Expatriations: Tracing the Causes and Consequences of Corporate Inversions”, National Tax Journal, vol. 55(3), September 2002, at pp. 409-440. See also New York State Bar Association Tax Section, “Outbound Inversion Transactions”, Tax Notes, July 1, 2002, at pp. 127-149, and U.S. Department of the Treasury, Corporate Inversion Transactions: Tax Policy Implications (May 2002).
23 In the past year, four high-profile UK companies have announced they are relocating their tax domicile to the Republic of Ireland (Shire plc, United Business Media plc, Henderson Group plc, and most recently WPP Group). In an October 6, 2008 interview, Martin Sorrell, chief executive of the WPP Group, told the Financial Times that more UK companies might decide to relocate their tax domicile if the UK government did not improve the competitiveness of its corporate tax regime (Tax Notes International, October 6, 2008, at p. 7 and October 13, 2008, at p. 116).
24 HM Treasury news release, “Chancellor announces new business-government forum on tax” (April 29, 2008).
25 The Panel’s recommendations are listed in Appendix A in the order in which they are discussed in the body of this report.