6. Non-Resident Withholding Taxes
Canada’s approach
6.1 Non-resident investors 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”, because it must be withheld by Canadian residents making such payments to non-resident investors.
6.2 Canada’s tax treaties provide for lower withholding tax rates, typically reducing the rate to 10 percent for interest and royalties and to five percent for dividends paid by a Canadian subsidiary to a foreign shareholder who holds a substantial interest in the Canadian subsidiary (“direct dividends”). Dividends derived from portfolio investments are taxed at a reduced rate of 15 percent.
6.3 Several exemptions from withholding tax are available under Canada’s domestic law and tax treaties. A new exemption for interest paid to unrelated foreign creditors (arm’s-length interest) took effect on January 1, 2008. Now when Canadian corporations owe amounts to unrelated foreign creditors, the creditors are no longer subject to Canadian withholding tax on interest.
6.4 Additionally, withholding tax on interest paid to related U.S. creditors (non-arm’s-length interest) will be phased out over three years under the fifth protocol to the Canada-U.S. tax treaty. Once this change is fully implemented, no Canadian withholding tax will apply, for example, when a Canadian subsidiary pays interest on money borrowed from its U.S. parent corporation. Non-arm’s-length interest paid to non-U.S. corporations will remain subject to withholding.
Evaluating the case for further reducing Canada’s withholding taxes
6.5 In its 1998 report, the Technical Committee on Business Taxation expressed the following view:
(T)he present Canadian position with respect to the level of withholding taxes under bilateral tax treaties is consistent with international norms, strikes an acceptable balance between the competing goals of global neutrality and protection of the Canadian revenue base, and, accordingly, requires no modification at the present time.103
6.6 Since 1998, significant developments have occurred that suggest revisiting this conclusion. First, since 1997, Canada has been a net capital exporter of foreign direct investment. Second, and perhaps more importantly, many countries have moved to reduce or eliminate withholding taxes. For example, EU countries have agreed to eliminate all withholding taxes on certain payments between associated EU companies.104 The United States has also agreed with some of its trading partners — beginning with the United Kingdom in July 2001 — to eliminate withholding tax on direct dividends.105 Australia has negotiated similar exemptions with the United Kingdom, France, Finland, Japan and Norway.
6.7 The Panel observed a consensus among companies and industry groups that Canada should adjust its policies to conform to these recent developments and eliminate withholding taxes. In particular, there were calls for Canada to renegotiate its tax treaties to eliminate the withholding tax on direct dividends.
6.8 The Panel believes that further reducing withholding taxes, especially on direct dividends, would benefit Canada economically. Eliminating withholding taxes between Canada and the United States, for example, would remove an obstacle to cross-border flows of income and capital and help Canadian businesses, including small businesses, to expand in the United States and potentially elsewhere. Eliminating withholding taxes on interest and dividends could also reduce the cost of foreign capital for Canadian businesses. Reducing withholding taxes on royalties could lower the cost of importing foreign technologies, helping to improve the productivity of Canadian businesses.
6.9 The magnitude of the potential economic benefits from eliminating withholding taxes needs to be fully assessed. Research commissioned by the Panel shows that eliminating withholding taxes on interest and dividends could greatly reduce the cost of investing in Canada for certain foreign firms.106
6.10 A portion of the withholding taxes collected in Canada on interest and direct dividends, which could potentially be significant, can be credited abroad.107 To that extent, reducing withholding taxes in Canada may not attract significant additional investment to Canada; it would merely transfer tax revenues to foreign governments. The portion of withholding taxes credited abroad could rise further if the United States maintains its relatively high corporate income tax rate. However, this portion could drop if any of the United States, the United Kingdom or Japan were to replace its foreign tax credit system with a territorial system for direct dividends because, as is the case for Canada, it is unlikely foreign withholding taxes on exempt dividends would then be creditable.
6.11 If withholding taxes were eliminated, foreign companies that could not credit them abroad might be encouraged to increase their investments in Canada. How much weight Canadian withholding taxes carry in the investment decisions of foreign companies is unknown. Empirical studies have suggested that lower corporate income taxes generate more inbound direct investment.108 However, available studies on the impact of dividend withholding taxes found that they have little influence on how much capital companies will invest in a given country.109 This finding may indicate that where dividend withholding taxes cannot be credited abroad, they act as cash-flow taxes rather than taxes on capital investment. Cash-flow taxes are not believed to affect the long-term investment decisions of international enterprises.110
6.12 The possible benefits of further reducing withholding taxes on royalties are also unknown. Canada has negotiated exemptions with its various treaty partners for royalties paid for the use in Canada of patents, know-how and software, which are the principal intangible assets used in industrial production.111 Payments in respect of the use of intangible property that do not now qualify for a withholding tax exemption include trademarks and trade names, movies, cultural works (in certain circumstances), data and information, and unpatented knowledge other than know-how.
6.13 Canadian businesses may pay withholding tax on the interest, dividends and royalties they derive from investments in other countries. Reducing withholding taxes bilaterally could greatly benefit Canadian businesses to the extent their foreign withholding taxes paid are not currently creditable in Canada. The change would remove an impediment to repatriating foreign profits to Canada. Further, reduced foreign withholding taxes would produce a net income gain for Canada; the magnitude of this gain is unknown due to a lack of data on the amount of foreign withholding taxes paid by Canadian businesses.
Fiscal cost of reducing Canadian withholding taxes
6.14 The Panel acknowledges that eliminating withholding tax on direct dividends and interest and royalty payments that are not already exempt would come at a significant fiscal cost. In 2005, the government collected $4.3 billion in withholding taxes, half of which ($2.1 billion) was withheld on dividends paid to non-residents (see Table 6.1).
6.15 If withholding taxes were eliminated bilaterally, the net revenue cost would be lower because the government would no longer have to grant foreign tax credits in Canada for foreign withholding taxes paid by Canadian businesses. However, this offset is not expected to be significant. Foreign withholding taxes paid by Canadian corporations on exempt dividends from their foreign affiliates are not creditable in Canada, and receipts by Canadians of foreign-source interest and rents and royalties that are likely to be subject to foreign withholding tax are relatively small.112
6.16 The above discussion does not consider how eliminating withholding taxes could change taxpayer behaviour. Concerns arise that exempting all interest and royalty payments from withholding tax could put Canada’s corporate income tax base at risk by increasing incentives for foreign businesses to pay out larger shares of their Canadian-source profits as deductible interest and royalties. Additionally, eliminating withholding taxes on direct dividends would provide an incentive for foreign-owned Canadian corporations to borrow in Canada to pay dividends to their foreign parents.
Table 6.1
Withholding Taxes Collected on Payments to Non-Residents
2000–2005 (millions of dollars)
|
2000 |
2001 |
2002 |
2003 |
2004 |
2005 |
|
|
Direct dividends |
713 |
739 |
790 |
690 |
778 |
1,362 |
|
Other dividends |
448 |
467 |
468 |
501 |
678 |
739 |
|
Interest |
492 |
617 |
514 |
549 |
676 |
717 |
|
Rents and royalties |
562 |
615 |
676 |
730 |
733 |
730 |
|
Other payments* |
295 |
324 |
390 |
411 |
378 |
734 |
|
Total |
2,510 |
2,762 |
2,838 |
2,881 |
3,242 |
4,283 |
* Includes withholding tax on social security benefits, pension income, and other types of income.
Source: Canada Revenue Agency, NR4 Return. Totals may not add up due to rounding.
Withholding tax reductions versus lower corporate income tax rates
6.17 The government could reduce the immediate fiscal cost of eliminating withholding taxes by phasing them out over a number of years. Some of the lost tax revenues would be recouped through the greater economic activity in Canada generated by eliminating withholding taxes.
6.18 The same arguments can be made in favour of reducing other taxes. In the current fiscal framework, the government must assess which of the array of options to further reduce taxes would create the greatest economic benefit for Canadians per dollar of tax revenue foregone. The government must decide whether reducing withholding taxes is preferable to other beneficial tax reduction options, such as further reducing Canada’s statutory corporate income tax rate.
6.19 During our consultations, the Panel posed this question directly, and most companies and organizations recommended lower corporate tax rates over lower withholding taxes. The reason for this preference may be that reducing the corporate tax rate would benefit all Canadian companies (including small and medium-sized businesses) and help improve the competitiveness of the Canadian economy more broadly. Another possible reason is that a large share of the withholding tax collected in Canada on payments to non-residents may be credited abroad and does not increase the tax burden of non-residents investing in Canada.
6.20 On balance, the Panel believes that further reducing withholding taxes is desirable for Canada. The Panel recommends that the government continue to reduce or eliminate withholding taxes in future tax treaties and protocols to those treaties. However, in recognition of the significant fiscal cost to the government and of the widely-shared preference among businesses for lower corporate income tax rates over lower withholding taxes, future reductions should be implemented as the government’s fiscal framework permits, taking into account the government’s currently planned reductions in the federal corporate tax rate. The government should also continue to monitor global trends and assess the desirability of eliminating withholding tax bilaterally on a case-by-case basis.
|
Recommendation 6.1: Consider further reducing withholding taxes bilaterally in future tax treaties and protocols to the extent permitted by the government’s fiscal framework and its agenda regarding additional corporate tax rate reductions. |
103 Report of the Technical Committee on Business Taxation, at p. 6.25.
104 Interest and royalties paid between associated EU companies are exempt from withholding tax following the entry into force of the Interest and Royalty Directive (2003/49/EC, June 3, 2003) in 2004. Dividends paid by EU subsidiaries to their EU parents have been exempt from withholding tax since 1992 under the Parent-Subsidiary Directive (90/435/EEC, July 23, 1990).
105 The following U.S. tax treaties now provide for a zero withholding tax rate on direct dividends (year signed or amended in parentheses): the United Kingdom (2001), Australia (2001), Mexico (2002), Japan (2003), the Netherlands (2004), Sweden (2005), Denmark (2006), Finland (2006), Germany (2006), and Belgium (2006). However, the revised U.S. Model Income Tax Convention released in late 2006 still provides for a five percent withholding tax on direct dividends.
106 Kenneth J. McKenzie, An Analysis of the Economic Effects of Withholding Taxes on Cross-Border Income Flows for Canada (September 2008), research report prepared for the Advisory Panel on Canada’s System of International Taxation.
107 On average, about 75 percent of the tax collected by Canada on direct dividends was withheld on dividends paid to investors in the United States, the United Kingdom and Japan. Each of these countries provides a credit for foreign withholding taxes paid on foreign-source dividends, although the credit that can be claimed is generally subject to various types of limitations.
108 For a review of the existing literature, see Ruud A. de Mooij and Sjef Ederveen, “Taxation and Foreign Direct Investment — A Synthesis of Empirical Research”, International Tax and Public Finance, vol. 10(6) (November 2003) at pp. 673-693. See also OECD, Tax Effects on Foreign Direct Investment — Recent Evidence and Policy Analysis, OECD Tax Policy Studies no. 17 (Paris: OECD, 2007), at pp. 45-66.
109 See Harry Grubert, “Taxes and the Division of Foreign Operating Income Among Royalties, Interest, Dividends and Retained Earnings”, Journal of Public Economics, vol. 68(2) (May 1998), at pp. 269-290; Bruce A. Blonigen and Ronald B. Davies, “The Effects of Bilateral Tax Treaties on U.S. FDI Activity”, International Tax and Public Finance, vol. 11(5), at pp. 614-615 (September 2004); and Ronald B. Davies, “Tax Treaties and Foreign Direct Investment: Potential versus Performance”, International Tax and Public Finance, vol. 11(6) (November 2004), starting at p. 785.
110 See David G. Hartman, “Tax Policy and Foreign Direct Investment”, Journal of Public Economics, vol. 26 (February 1985), at pp. 107-121. See also Parthasarathi Shome and Christian Schutte, “Cash-Flow Tax”, IMF Staff Papers, vol. 40(3) (1993), at pp. 638-662.
111 Such exemptions were negotiated with Algeria (software and patent only), Australia (software only), Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Ireland, Kyrgyzstan, Luxembourg, the Netherlands, Norway, Oman, Russia, Sweden, Switzerland, Ukraine (software only), the United Arab Emirates, the United Kingdom, and the United States.
112 According to data from Statistics Canada, receipts of non-arm’s-length interest payments from countries other than the United States were $650 million on average per year between 2000 and 2007. Average receipts of royalties for the use of trademarks, franchises and copyrights were $450 million between 2000 and 2006. An unidentified portion of such receipts would not be subject to foreign withholding taxes due to applicable exemptions. Source: Statistics Canada, CANSIM tables 376-0033 and 376-0062 and special request.