Cross-border tax regime still problematic: C.D. Howe

Although Canada has done much to increase its tax competiveness on cross-border investing, a new report released Tuesday from the C.D. Howe Institute says there is still a lot of work that needs to be done by the federal government to create a tax regime that attracts investment.

The report, entitled Finding Silver Linings in the Storm: An Evaluation of Recent Canada–U.S. Crossborder Tax Developments, says the fifth protocol, a bilateral tax treaty between Canada and the United States signed last September, would make Canada’s cross-border tax regime more competitive by eliminating withholding taxes on cross-border interest payments.

The author of the report, Arthur J. Cockfield, associate professor of law at Queen’s University, says that under the current tax system, a payment of cross-border interest made to a nonresident individual or firm results in a 10% gross withholding tax on the payment. In addition, the payer of the interest is required to remit the withheld amount to the relevant tax authority, either the Canada Revenue Agency (CRA) or the U.S. Internal Revenue Service (IRS).

“For example, if a Canadian parent company loans money to its U.S. subsidiary, which then makes an interest payment of $100, the subsidiary is required to withhold $10 and remit that amount to the IRS, and the parent corporation receives the remaining amount,” Cockfield writes. “

Cockfield notes that for interest paid between non-arm’s-length parties — such as a parent corporation and its wholly owned subsidiary — the new protocol proposes to reduce the interest withholding tax from 10% to 7% in the first year, 4% in the second year, and to eliminate the withholding tax completely in the third year after the protocol enters into force.

In addition, the fifth protocol will immediately abolish cross-border interest payments between arm’s-length taxpayers. Cockfield says this means Canadian corporations that invest in U.S. government bonds would no longer have to pay withholding tax on any interest the U.S. government paid on the bonds.

Cockfield highlights that even if the protocol comes into force — which is not certain at this point since the U.S. has not ratified it — problems will still remain with the Canadian cross-border taxes.

He says Canadian policy-makers could further enhance cross-border taxation by reducing tax discrimination that favours domestic investment over U.S. investment and by abolishing withholding taxes for cross-border parent/subsidiary dividends.

Cockfield says Canada uses discriminatory tax policies that favour Canadian tax interests over those of U.S. and foreign investors. Canada has agreed to extend national, nondiscriminatory tax treatment only to permanent establishments of U.S. residents in some circumstances, whereas the United States extends national treatment to U.S. corporations owned or controlled by Canadians.

Canada discriminates in favour of corporations that have been incorporated in Canada, and such corporations are eligible for tax-deferred rollovers or amalgamations, while foreign corporations often cannot take advantage of this, Cockfield says.

Also, Cockfield says certain payments, such as those for cross-border services are subject to a 15% withholding tax when paid to nonresident corporations while the same payments to a Canadian corporation do not attract the withholding tax. He says this might create a tax disincentive for non-resident service providers to operate in Canada to the extent that they cannot obtain a waiver or foreign tax credit for the withholding tax.

According to the report, Canada also negotiated to retain its right to put withholding taxes on dividends paid by subsidiary corporations to their parent corporations, which creates a revenue stream of nearly $1 billion for the Canadian government. This type of taxation has been eliminated in the European Union, the U.K. and the U.S. By retaining this form of tax, Canadian-based companies are at a disadvantage to their international counterparts, Cockfield says.

“A withholding tax on direct dividends with other nations might have been appropriate when Canada was a “small, capital-importing country,” but it is no longer appropriate given Canada’s current status as a larger, net-capital-exporting country,” Cockfield writes. “The end result is that Canadian companies might increasingly be at a tax disadvantage relative to companies in countries that have eliminated the tax. Moreover, the maintenance of such a tax is, like other areas of discriminatory tax treatment, incompatible with attempts to tie together the economic interests of Canada and the United States in a highly integrated free trade area.”

Canada could also create a more foreign-investment-friendly tax regime by allowing for loss deductions within multi-national corporations. Currently, under Canadian tax laws, a corporation cannot deduct the losses of an underperforming subsidiary against the profits of other ones. The report says U.S.-based corporations are able to file consolidated tax returns when ownership equals or exceeds 80% of common shares, allowing them to offset losses within the corporate structure.

“The denial of loss deductions thus discourages cross-border entrepreneurial activity and risk taking, as governments fully tax any profits when a business succeeds but deny loss deductions when a business fails,” Cockfield writes. “Currently, Canadian tax laws do not permit the filing of consolidated tax returns for groups of related companies. As a general rule, losses incurred by one corporation within a corporate group cannot be offset against the profits of corporations within the same group (with an exception in the case of certain corporate reorganizations, such as the liquidation of a subsidiary into a parent corporation). As a result, for certain corporations, these losses may be forever “trapped” within the corporation.”

The complete report from the C.D. Howe Institute can be accessed here.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(09/02/08)