8. Looking Ahead
Introduction
8.1 In this report, the Panel sets out our views on the current state of Canada’s system of international taxation and offers an integrated package of recommendations for improving it.
8.2 In the course of the Panel’s work, other important tax policy choices became apparent that may influence the competitiveness of Canadian businesses and of the Canadian economy in the future. Consistent with the principle that Canada’s system of international taxation should be benchmarked regularly against the systems of our major trading partners, this chapter highlights issues that the government should monitor as international tax norms evolve. These issues are source-based taxation, neutrality among substitutable economic returns, and tax consolidation.
Source-based taxation
8.3 Tax systems require “source” rules to determine where income is earned. These rules emerge from legislation, jurisprudence and tax treaties, and they consider both the place from which income arises and the activities that generate it. Income from a business is usually earned where “the operations take place from which the profits in substance arise”.140
8.4 Canada’s source rules — like those of other countries — face challenges due to globalization facilitated by electronic commerce and the increased mobility of capital and labour.
8.5 When business operations require physically fixed establishments to carry on, there is little doubt about the place from which profits arise. Electronic commerce does not require physically fixed structures for its operations: all it may need, for example, are information technology support, call centres, server farms, telecommunications infrastructure, goods, services or intangible products, and a market — all of which could be located anywhere. Thus, it is difficult to pinpoint from where “profits in substance arise”.
8.6 In addition, income from services is usually earned where the services are provided. Since services are mobile, there is a risk that income from services can be diverted for tax reasons from one place to another. Income from financial instruments is generally said to arise where the issuer of the underlying debt or security resides. However, because the issuer has flexibility in where it locates, there may be little economic connection between the location of the issuer and the economic benefits of the financing.
8.7 A consequence of these challenges is that the source rules are increasingly difficult to apply and are open to planning. Monitoring developments in this area is important to ensure Canada remains in step with international tax norms.
Neutrality among substitutable economic returns
Other returns from foreign affiliates
8.8 For many years, Canada’s international tax policy has been to exempt foreign active business income earned by a foreign affiliate where certain conditions were met. In practice, Canada’s international tax system has partly reflected that shareholders are often indifferent as to whether they receive their returns from their outbound business investments as dividends, interest, rents or royalties.
8.9 A Canadian shareholder can capitalize its foreign affiliates with either debt or equity, or rent or license property (tangible or intangible) to the affiliates. The tax effects of using equity, debt or other capital investments are quite different: interest, rents and royalties received by a shareholder are subject to full Canadian tax, whereas most dividends from foreign active business income are exempt from Canadian tax.
8.10 Equity, debt and other capital investments held by a Canadian shareholder in a foreign affiliate are often substitutable. Therefore, absent tax considerations, it could make no difference to a shareholder whether its returns are received in the form of dividends, interest, royalties or any combination of such income.
8.11 Arguably, an integrated tax policy should treat all foreign-source active business income similarly. If Canada’s international tax policy were to exempt foreign active business income earned by a foreign affiliate from Canadian tax, the policy should perhaps also apply regardless of whether the return received by the Canadian shareholder were to take the form of dividends, interest, rents or royalties.
8.12 This view may appear counter-intuitive as interest, rents and royalties paid by a foreign affiliate are usually deductible (reducing foreign taxable income) while dividends are not. However, whether a payment is deductible in a foreign country should not necessarily influence the Canadian tax treatment of that amount. For example, if foreign thin capitalization rules operate to deny an interest deduction abroad, the denial does not affect the Canadian tax treatment of the amount.
8.13 In addition, Canada’s international tax policy allows Canadian businesses the flexibility to structure their affairs to reduce their total foreign tax cost on interest and royalties by creating foreign financing, leasing and licensing companies.
8.14 While this policy allows Canadian businesses to reduce foreign tax costs without reducing Canadian tax otherwise payable, it encourages Canadian companies to establish complicated structures in other countries, incurring the costs and administrative burden of setting up and maintaining companies or branches, hiring and managing employees, and engaging and paying professional advisors.
8.15 Accordingly, rather than carrying out financing, leasing or licensing functions in a foreign jurisdiction, consideration could be given to encouraging Canadian companies to carry out these functions in Canada, along with any related research and development. Potential benefits of this approach include:
- increased investment in research and development activity in Canada by both Canadian and foreign multinational corporations,
- increased repatriation of intellectual property to Canada for further development and licensing, and
- increased commercialization of intellectual property in Canada.
8.16 These results might be achieved by exempting this income from Canadian tax or taxing it at a preferential rate, as is done (or is being considered) by certain countries.141
Allowance for corporate equity
8.17 Nearly all countries that tax corporate income allow a deduction for interest paid on debt, but not for dividends paid to shareholders. This asymmetric tax treatment is often seen as creating a bias in favour of debt financing over equity financing, creating the need for rules to limit the deductibility of interest paid by foreign-owned businesses.
8.18 Many options could be considered by the government to ensure a more neutral tax treatment between debt and equity financing. One option would be to allow corporations to deduct an imputed cost for their corporate equity by claiming an allowance for corporate equity (ACE) when computing their income for tax purposes. Two countries, Belgium and Brazil, currently have some form of an ACE system, while Austria, Croatia and Italy have experimented with this approach.
8.19 An ACE system could reduce the need for thin capitalization rules and other forms of interest deductibility limitations by enhancing neutrality between debt and equity financing. Such a system could also reduce existing distortions on real investment caused by the taxation of capital income at the corporate level. However, implementing an ACE system might require increasing the statutory corporate tax rate to make up for any revenue shortfall, which could, among other drawbacks, cause highly profitable firms to relocate abroad.
Tax consolidation
8.20 In the Canadian tax system, each corporation is taxed as a separate entity. Unlike most other developed countries, Canada does not permit consolidation for tax purposes nor does it have explicit rules to permit corporations to transfer losses within a group. Rather, all members of the same corporate group compute their tax liabilities and file their tax returns separately.
8.21 The Canadian government previously considered the advantages of group reporting systems including consolidation.142 However, tax consolidation raises provincial tax issues involving income and loss allocation and their effect on provincial government revenues.
8.22 Given the prevalence of consolidation in other countries, the federal and provincial governments should work together to consider how a tax consolidation system could operate in Canada.
140 FL Smidth and Company v. F Greenwood, (Surveyor of Taxes), [1921] 3 K.B. 583 at p. 593, quoted in Gurd’s Products Co. v. R., 1985 CarswellNat 310.
141 See discussion in OECD, Tax Effects on Foreign Direct Investment — Recent Evidence and Policy Analysis, OECD Tax Policy Studies no. 17, 2007, at pp. 15, 21-22, 104-106 and 116. See also Department of Treasury, Office of Tax Policy, Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century (December 2007) at p. 62 and the discussion of planning used to reduce U.S. taxes on foreign royalties at pp. 45-46.
142 Department of Finance Canada, “A Corporate Loss Transfer System for Canada”, Discussion Paper (Ottawa: Department of Finance Canada, May 1985).