Abstract
Selected Issues
Taxing Business in a Changing World1
This paper reviews, and suggests possible improvements to, Canada’s system of business taxation—focusing particularly on the implications of wider developments in the global tax environment. Section 1 provides an overview of current arrangements,2 and identifies some sources of concern. Section 2 describes and considers the likely impact on Canada of recent developments in, and pressures on, the international tax order, including the landmark reform (known as the Tax Cuts and Jobs Act, TCJA) in the United States. Section 3 sets out some options for reform.
A. Taking Stock
This section reviews core features of the taxation of business income in Canada.
Revenue and Rates
1. Revenue from the corporate income tax (CIT) in Canada3 is relatively high. While fluctuating quite widely, revenue from the CIT (federal, provincial and in the territories) has consistently accounted for a larger share of GDP in Canada than in most other G7 countries (Figure 1). It generates around 10 percent of total tax revenue, also above the G7 average. For the provinces, their CIT accounts for about 15 percent of their total own-source revenue. Revenue from the CIT has held up despite a large reduction in the combined (federal plus provincial) average rate since 2000 (Figure 2). While the reasons for this robustness remain unclear, among the possible explanations is tax-induced migration from business operation as sole proprietor or in partnership to the corporate form, 4 reflecting the substantial gaps between the top marginal rate of personal income taxation (PIT) and statutory rates of CIT5 (combined with provincial legal and regulatory changes that have allowed many regulated professionals to earn income through a corporate structure).
CIT Revenue in G7, 2016
Citation: IMF Staff Country Reports 2018, 222; 10.5089/9781484368398.002.A001
Source: OECD Tax Revenue DatabaseNote: Data on Japan refer to the year 2015.CIT Rate by Government Levels
Citation: IMF Staff Country Reports 2018, 222; 10.5089/9781484368398.002.A001
Source: University of Calgary School of Public Policy Tax Database2. At about 27 percent, the combined average rate of CIT (federal plus provincial) is towards the lower end of the G7 norm—but post-TCJA is now virtually the same as, rather than substantially below, the comparable average rate for the U.S.6 (Figure 3). Behind the averages, however, variation in rates across the U.S. states is more marked than it is across the provinces, making the comparison of these averages especially misleading. Post-TCJA, the highest all-in rate in the U.S. is still 6.5 percentage points above the lowest rate in Canada, while the lowest U.S. rate (21 percent, in the six states that have no CIT7) is now 10 points below the highest in Canada. A full comparison also needs to consider taxes other than the CIT: four of the U.S. states without a CIT levy a gross receipts tax,8 for instance, while some provinces in Canada also levy a capital tax on financial institutions.9
Statutory CIT Rates
Citation: IMF Staff Country Reports 2018, 222; 10.5089/9781484368398.002.A001
Note: Box height represents inter-quartile [25th to 75th percentile], the bars indicate minimum and maximum, and the dot represents outlier(s).‘Small’ Companies
3. Preferential rates of CIT are available to Canadian-Controlled Private Corporations (CCPCs). The first CAN$500,000 of profit is taxed at reduced rates of 10 percent at federal level (falling to 9 percent in 2019) and 0–7 percent at provincial level—implying a very large gap, of around 39 points, relative to the top rate of PIT.10 The benefit of the reduced rate is phased out at higher levels of taxable capital (between $10–15 million at federal level).
4. The case for this favorable treatment is questionable. Experience11 is that small companies as such are commonly not key drivers of growth and innovation, that the high effective marginal rates associated with withdrawal of the benefit of the reduced rate can discourage growth, and that reduced rates provide opportunities for the wealthy to avoid tax that are hard to deal with. The avoidance opportunities open to private corporations in Canada—which include, for instance, the advantage of generating passive income from lightly taxed income within the company rather than, say, from salary income—were recently the focus of a major and controversial consultation12 and action announced in October 2017 and February 2018. They remain a source of considerable complexity, and the distortions and inequities associated with the small company tax rate are unlikely to have been reduced by its recent further reduction. In so far as smaller companies face particular difficulties accessing credit, this is best dealt with directly rather than by further distorting the tax system. And if the concern is to ease the distortions caused by the non-refundability of tax payments in the event of bankruptcy (which is more common for smaller firms), an alternative response is to provide a reduced rate up to some cumulative level of profits over time (though experience shows this can bring administrative difficulty). A stronger case can perhaps be made for supporting start-ups and young entrepreneurs, though this can be difficult to implement without creating its own avoidance opportunities.
The Tax Base
5. The central elements of the CIT base are closely aligned between federal and provincial13 governments. Provinces that have entered into a Tax Collection Agreement14 agree to adopt the federal base, with relatively minor differences, in return for collection of the tax virtually free of charge, by the Canada Revenue Agency (CRA). Features of the common base that are central to the issues addressed here are:
Depreciation allowances are likely somewhat accelerated relative to true economic depreciation. Such acceleration is common international practice, and is explicit policy in relation to machinery and equipment used for manufacturing and processing, for instance, which is depreciated at 50 percent declining balance, compared, for example, to an estimated economic depreciation of 17 percent for industrial machinery.15
Interest is fully deductible, subject only to a thin capitalization rule on payments to related parties abroad. Even that rule appears weak: interest payments to third parties on debt that is guaranteed by the parent company are excluded from its application and the rule does not cover the financing element of financing leases.
Only 50 percent of capital gains realized by corporations are included in the CIT base, a feature returned to below.
Other than the reduced rate for small businesses, the capital gains exclusion and an R&D credit that is quite generous by international standards, corporate tax incentives appear to be modest. They are mainly at provincial level,16 and of limited scope; they are not examined here.
International Aspects of the CIT
6. Canada operates a de facto territorial form of international taxation for active income, with four key elements:
Subject to Canada’s Foreign Accrual Property Income (FAPI)rules,17 distributions from subsidiaries in jurisdictions with which Canada has a tax treaty or Tax Information Exchange Agreement (TIEA) are untaxed (‘exempt surplus’). Since Canada has treaties or TIEAs with 116 jurisdictions, this provides considerable scope for tax-free repatriation, routed to minimize withholding taxes. There is believed to be some stock of unrepatriated earnings accumulated abroad that would be liable to tax in Canada; it would be useful to quantify their scale, which appears to be unknown.18
The FAPI rules bring certain types of passive income earned abroad immediately into tax in Canada. The difference between the exempt surplus rules and the CFC rules is, respectively, full exemption irrespective of the level of foreign tax paid vs. full taxation on a current basis (with a credit-type mechanism for foreign taxes paid). This places extreme pressure on the definitional rules of the CFC regime.
Canada has a full range of withholding taxes on outbound payments which are reduced, but often not eliminated under tax treaties. Under the treaty with the U.S., interest and royalties on copyright, patents and software are not subject to withholding, while dividends (on shareholdings of more than 10 percent) are withheld at 5 percent.
Canada has little in the way of rules that allocate interest and other expenses between domestic and foreign source income, which risks excessive allocation of expenses to Canada.
Personal Income Tax—Key Features
7. The progressivity of the PIT rate structure is marked by current international standards: the top (federal plus provincial) marginal rate is in the order of 53–54 percent (in New Brunswick, Nova Scotia, Ontario, and Quebec) and sets in at a relatively modest level of income. Three specific features are particularly important for the taxation of business activity.
8. The first key feature is the widespread availability of savings schemes that in effect exclude the normal return from tax,19 (Such schemes are less readily available to business owners, but individuals disposing of qualified small business shares have a lifetime capital gains exemption of around $850,000 in 2018). The alternative to direct investment in business is thus in many cases a PIT-free return. Boadway (2017) reports that if full advantage were taken of the opportunities for PIT-free saving, about 70 percent of all capital income of Canadian taxpayers could be in some way excluded from tax. The system thus has important elements of expenditure tax treatment.
9. Second, the federal and provincial governments provide non-refundable20 dividend tax credits that largely reflect a presumption that the underlying profits have been fully taxed at the domestic corporate tax rate. However, the availability and extent of this credit is based on notional, not actual, Canadian CIT paid, the most extreme example being that full credits are granted with respect to redistributed foreign dividends paid from exempt surplus. While the intention of the credit is to integrate corporate and personal level taxation, it is subject to some criticism in its current form:
The rationale for giving the credit when no Canadian tax—and, especially, when little or no tax at all—has been paid is unclear. Reluctance to give credit for foreign taxes was a primary reason, for instance, why, given European Court of Justice decisions that not to do so in respect of other member states would be discriminatory, EU countries21 moved away from similar dividend tax credit systems.
In a small open economy, dividend tax credits may have limited impact on domestic investment, and may forego an efficient source of revenue.22 For an economy that is small in world capital markets, a reasonable benchmark assumption is that the after-corporate tax return on investments is fixed exogenously on those markets. Measures that reduce or offset taxes paid at corporate level then have no impact on the level of domestic investment. And to the extent that tax bears on the normal return to capital, the effect of the CIT is to reduce investment while leaving the after-tax return to capital unchanged: the real incidence of the tax then falls on immobile factors (whose productivity is reduced by the lower capital stock), not on shareholders. To the extent, on the other hand that the CIT bears on rents,23 the credit merely dissipates tax revenue of a particularly efficient kind.
10. Third, only 50 percent of realized capital gains are included in the PIT base. This opens up large and potentially problematic wedges between the top rates of tax on returns received as ordinary income or as dividends and those received on the disposal of shares, creating tax mitigation opportunities (and distortions) by tax-favoring the retention of profits within the company.
Distortions to Investment
Marginal effective tax rates (METRs)24 have fallen substantially in the U.S., on average, to around the same level as those in Canada. (Figure 4; see also Mintz (2018)).25 This is so when the comparison takes account not only of CIT parameters but of unrecovered sales taxes on business purchases—which, given the prevalence of value added tax treatment under the Goods and Services Tax (GST) in Canada, is noticeably more prevalent in the U.S.
Marginal Effective Tax Rates
Citation: IMF Staff Country Reports 2018, 222; 10.5089/9781484368398.002.A001
Source: IMF Staff calculations11. Care is needed, however, in drawing conclusions from comparisons of average METRs. All METR calculations need to be interpreted with great caution. Their sensitivity to a variety of underlying assumptions means that they should be interpreted as no more than indicative, with little significance attached to small differences. Beyond this, however, it should be stressed that:
Measures that stimulate investment in the U.S. do not necessarily reduce investment in Canada or elsewhere, a point taken up below.
Investment decisions may also be independently affected by the statutory rate since, all else equal, multinationals prefer to base their businesses in locations that will tax their profits least heavily. For example, two countries might both offer rent taxes (as discussed later) levied at different rates but both providing an METR26 of zero: a multinational faced with the discrete choice of where to locate would then be expected to choose that with the lower tax rate.
Averages conceal significant variations not only across provinces and states, but across both assets and source of finance: The METR on debt-financed investments in plant and machinery, for instance, is commonly negative, implying that at the margin (and all else equal) the tax system induces such investments to take place even though, in the absence of tax, they would be unprofitable. On the other hand, for equity-financed investments the METR is generally positive, ranging within Canada from 10 percent for plant and machinery to 40 percent for buildings. Taking account of the variation in statutory CIT rates across the provinces, the debt-financed METR for plant and machinery in Nova Scotia is -75 percent, whereas for retention-financed investment in buildings in Newfoundland and Labrador the METR is 31 percent. There is variation in the U.S. too, of course, including as a consequence of the ‘FDII’ provision touched on below (and not reflected in the calculations above). Dispersion in METRs signals distortions to the composition and financing of investment decisions that is a distinct source of efficiency loss in itself.
Any positive METR implies a tax disincentive to investment in real assets.
Distortions to Financing
12. For larger corporations, there is likely a strong incentive to use debt finance. This is so in two respects:
As one means of profit shifting.27 With few effective limits on interest deduction, there is potential to use interest payments to reallocate taxable income from high rate jurisdictions to low, both internationally and within Canada.28 The primary policy concern with such ‘debt shifting’ is that it erodes revenue.
As inherently tax-preferred to equity. In many contexts—corporate groups that finance themselves in global markets, or whose shareholders are effectively tax exempt on their capital income (pension funds, and those saving in tax-advantaged forms, being prominent instances)—the deductibility of interest but not of the return to equity creates a distinct CIT advantage to debt finance. Apart from the distortion to firms’ operations and governance mechanisms that this implies, the excess leverage induced by such ‘debt bias’ potentially amplifies risks to financial stability.
13. There appears to be no direct evidence for Canada, and the severity of these issues is unclear. The ratio of corporate debt to GDP in Canada has risen markedly since 2012, and is now at an all-time high; but it is broadly in line with international norms; and the ratio of corporate debt to equity and assets has not increased markedly.29 A substantial body of evidence from other countries, however, does suggest that both debt shifting and debt bias can be substantial.30
14. For high income owners of CCPCs, on the other hand, the primary distortion is likely to be towards retention finance, as a consequence of the very low CIT rate (making debt less attractive) and light taxation of capital gains (with significant taxation of dividends remaining, for higher rate payers, after the dividend tax credit).
Federal-provincial Interactions
15. The prominence of the provinces in corporate taxation is very marked31—and, for some, a cause for concern. It runs counter to the standard prescription for tax design in federations that the central government have control over taxes levied on bases that are mobile within the union, capital being a prime example. (This does not, of course, prevent some degree of revenue sharing). The underlying concern is that decentralizing powers over mobile tax bases will lead to excessively intense tax competition. While that incentive for ‘horizontal’ tax competition between the provinces exists in Canada, equalization arrangements counter this and imply (for recipient provinces) an incentive to set tax rates higher than would otherwise be the case, since the contraction in the provincial tax base that raising their rate would otherwise induce will be offset to some degree by increased receipt of transfers.32 There is indeed some evidence that provincial CIT rates are so high as to cause significant efficiency losses, and in several provinces may even be above the level at which they maximize provincial revenue.33 Some34 have thus suggested some degree of transfer of powers in corporate taxation to the federal government that can take a more complete view of the national interest.
16. What is critical, however—especially in these times of considerable uncertainty—is close coordination between federal and provincial governments. The record in this area is evidently good, with quite limited cross-province variation in either rate or base. And the provinces did not increase their own tax rates to take up room vacated by federal rate cuts in the early 2000s. Such cooperation is likely to be critical in shaping a coherent response to the pressure emerging from developments in international taxation beyond Canada, to which we now turn.
B. Changing Times
17. Canada is deeply exposed to developments in the wider international tax system. As an active and respected participant in the discussions underway in global forums, Canada will play its part in shaping the direction that the international tax order takes. At the same time, however, it must fashion its own response in a way which recognizes that it is both a very open economy and a relatively small player in world capital markets, and so needs to adapt to pressures created by current and prospective developments elsewhere. This applies to both cooperative programs in which Canada participates and unilateral measures adopted by others.
18. Policy choices must recognize the current unprecedented fluidity and uncertainty in international tax matters, with even the basic elements of the system under challenge. Key contributing factors here are:
‘BEPS’ implementation: Canada is a member of the OECD Inclusive Framework on BEPS (Base Erosion and Profit Shifting) and so is committed to implement the four minimum standards35 that emerged among the outcomes of the G20-OECD BEPS project. This creates few issues in itself— Canada is committed to and in the process of fulfilling its obligations36—but there are more general concerns as to whether the broader implementation process will, for example, result in more extensive cross-national tax disputes (IMF and OECD (2017)).
Digitalization: There are strong differences of opinion as to whether current international tax norms deal appropriately with business practices that involve substantial activity with little if any physical presence and which exploit information acquired from users—or whether, on the other hand, these now call from some element of profit taxation in the ‘market country’ (that in which purchasers/users of the product are located). This latter view points to far-reaching changes in the century-old norms of international taxation. In its recent interim report, the OECD (2018) remained agnostic on the need for a new approach. The European Commission, in contrast, has proposed a turnover tax on selected services37 as a temporary response while arguing for an expanded notion of permanent establishment as a longer-term solution;38 this seems far, however, from having the necessary unanimous support among the member states. Responding to a request from the Canadian House of Commons Standing Committee on International Trade, the government has stressed its commitment to multilateral discussions on possible updates to international tax norms to reflect new digital business models.39
Unilateral reforms elsewhere… The global trend towards lower statutory rates of CIT continues. Belgium, for instance, has recently reduced its rate, while Australia and France have expressed the intention to reduce from 30 to 25 percent and from 33.33 to 25 percent respectively. It may be that as BEPS implementation succeeds in reducing the scope of tax avoidance, so pressures for governments to compete though rates and other devices increases (Keen, 2018). At the same time, significant structural measures to curb perceived avoidance have been taken unilaterally, such as the adoption of a diverted profits tax40 by both the UK and Australia. And, related, a number of actions have as noted above been adopted and more proposed in relation to digitalization.
…especially the recent tax reform in the United States. The TCJA is a major and in many respects novel reform with the potential to fundamentally reshape international tax norms. Proximity and a largely integrated North American market make it especially germane for Canada: more than half of all foreign direct investment in Canada, for instance, is U.S.-owned.
19. There is considerable uncertainty as to the impact of the TCJA, not only in Canada but more generally. Many of the international provisions (discussed below) remain to be fully described; their novelty and complexity are such that practitioners are still assessing their implications; several provisions are projected to change significantly over time; questions have been raised as to the consistency of some provisions with WTO rules, tax treaties, and the minimum standard on harmful tax practices of the G20-OECD project on Base Erosion and Profit Shifting; and some observers have stressed that the legislation lacked bipartisan support. The discussion here focuses on broad features of the TCJA, and is necessarily speculative.
20. The sharp reduction in the federal CIT rate in the U.S. substantially reduces Canada’s relative appeal for mobile investments and increases its exposure to the shifting of profits to the U.S…. Including average state and provincial CIT rates, what was a substantial advantage for Canada in the difference in statutory CIT rates has now turned into broad equality (Figure 2).41 This matters for two reasons.42 The first is a potential impact on real investment: to the extent that companies (both Canadian and U.S.) serve effectively the same market wherever they locate, they have an incentive to locate wherever their profits will be more lightly taxed. The second is a potential impact on profit shifting, as companies have an incentive to take deductions—such as interest paid and purchases of goods and services—where statutory rates are high and take their receipts where taxes are low. Prior to the TCJA, this generally pointed to shifting profits out of the U.S. and into Canada—to the benefit of tax revenue in Canada. Now that incentive is weakened, and may be reversed. Provincial and state taxes begin to matter, in a way that simple averages may conceal. For instance, the gap in statutory rates between British Columbia and neighboring Washington state is 12 percentage points, and that between Manitoba and North Dakota is about 4 points.43
21. …while also, combined with the move to immediate expensing, substantially eroding the gap in METRs between the U.S. and Canada. As noted, while a reduction in METRs in the U.S. can be expected to increase investment there, that does not necessarily imply any effect on investment in Canada, which depends most directly on METRs in Canada. Indeed, in the simple model upon which derivation of METRs commonly relies, with firms operating in competitive markets and unconstrained in their ability to raise capital, one might not expect the METR in the U.S. to affect investment in Canada at all. More realistically, however, if companies are constrained in the total amount of investment they can undertake, or can effectively serve and are able to derive some rent from the same market wherever they locate, then a reduction in the U.S. METR might indeed reduce investment in Canada.
22. While subject to many caveats, an empirical analysis summarized in Appendix 1 suggests that the reaction of U.S. multinationals to the reduction in the U.S. statutory rate and average METR could well include significant reductions in their real investment in, and profit shifting into, Canada. Using a short panel of aggregate data on foreign multinationals’ assets held in Canada, in the preferred point estimates reported there:
Real assets held in Canada by U.S. multinationals are projected to fall, in the long run, by 6 percent,
Reduced profit shifting into Canada by U.S. multinationals is estimated to reduce the profits they report in Canada by around 15 percent, …
…which together imply a reduction in the CIT paid by U.S. multinationals in Canada (currently about 15 percent of all CIT revenue) of close to one quarter.
23. These results need to be interpreted with great caution. Among the many caveats, for example, is that the sample does not contain any change in the U.S. rate, nor is it long enough to meaningfully capture rate changes in Canada. Nonetheless, the results are not out of line with the wider literature on these issues. For instance, Beer and others (2018), using firm-level data covering many other countries (but not Canada), suggests a loss of CIT revenue attributable to the TCJA, arising from reduction in both real investment and reported profits, of around 1.58 percent of total MNC tax revenue (with the highest percentile of 6 percent).
24. Investment and profit shifting responses can also be expected from non-U.S. businesses. Canadian companies exporting to the U.S. may now find it advantageous to produce there; and perhaps even to produce there for sale into Canada (especially given the FDII provision discussed below). They may also incline towards more equity- and less debt-financing of U.S. subsidiaries, shifting tax revenue from Canada to the US. These concerns have been highlighted by business44 and some commentators.45 They remain unquantified, but are evidently a significant cause for concern.
Three Novel International Provisions of the TCJA 1/
Foreign Derived Intangible Income (FDII). Domestic corporations receive a 37.5 percent deduction from the corporate tax base for FDII, which is calculated as the income of the corporation in excess of 10 percent of qualified business asset investment multiplied by the share of foreign-derived income to total income (all calculated on a consolidated group basis). This effectively reduces the CIT rate for such income from 21 to 13.125 percent. Questions have been raised on the consistency of this provision with WTO rules and the BEPS minimum standard on harmful tax practices.46
Global Intangible Low Taxed Income (GILTI). As an important qualification of the move to territoriality, the TCJA imposes a minimum tax on overseas income that is in excess of 10 percent of the return on tangible assets. Specifically, it taxes at the standard U.S. CIT rate, and on accrual, the income of U.S. CFC’s earned in all foreign jurisdictions that exceeds 10 percent of qualified business asset investment (i.e., the depreciated value of tangible fixed assets of those controlled foreign corporations)—but with a deduction for 50 percent of that income. Credit is also given for 80 percent of the foreign tax paid on such income. The effect is to impose a minimum rate on GILTI income of 10.5 percent on such income (when no tax is paid abroad) with the U.S. liability wholly eliminated if the average foreign tax rate paid is at least 13.125 percent.
Base Erosion and Anti-Abuse Tax (BEAT). The TCJA applies a base erosion provision to large multinational companies47 (annual gross receipts over US$500 million in the preceding 3 years) that make certain cross-border payments to affiliates that exceed 3 percent of their total deductible expenses. The payments targeted are those (such as interest, royalties, and management fees) that are commonly associated with profit shifting, but the provision does not apply to items characterized as cost of goods sold. Specifically, the BEAT imposes a minimum tax that is a fixed percentage48 of a concept of “modified” taxable income that adds back into income the deductions claimed for these categories of cross-border payments to affiliates. Questions have been raised as to the consistency of this provision with tax treaties.
1/ These descriptions are much simplified: for instance, the allocation of domestic expenses to foreign earnings can mean that U.S. tax is payable under GILTI even when the foreign tax rate exceeds 13.125 percent.25. The international provisions of the TCJA, especially some of the more novel, may also come to have a substantial impact on Canada.49 The move towards territoriality (qualified by the GILTI provisions) means that earnings repatriated to the U.S. will no longer be subject to taxation there (with credit for Canadian taxes paid). To the extent that earnings were indeed repatriated, this implies a reduction in the effective tax rate on, and so might encourage, such investments. Tending in the opposite direction, however, the U.S. change also suggests a removal of a lock in effect. Once the profits were derived in Canada there was an incentive to keep those profits under Canadian control. Now it is easier to withdraw profits from Canada, so reinvestment may be less. Experience with the movements to territoriality in the UK and Japan has been an increase in outward investment in lower tax countries:50 But the effects at work in the present context seem likely to be relatively muted given the ease with which repatriation could be and in many cases was deferred. The transition tax that now brings unrepatriated earnings into tax (at reduced rates) in the U.S. over the next eight years is a one-off that seems unlikely to have significant impact even in the short term.51 The distinctive measures summarized in Box 1, however, may prove to have, to varying degrees substantive implications for Canada:
FDII may amplify the tax advantage of serving Canada from the U.S. that is created by the reduction in the statutory rate: for producers able to achieve a return on tangible assets located in the U.S. over 10 percent, that part of the return is taxed at the still lower rate of 13.125 percent.52 Transactions costs are likely to limit the shifting of tangible assets back to the U.S. But for companies already producing for export in the U.S., the implied tax advantage of producing in the U.S. for export to Canada may already be in play for a range of companies. And the effect could be significant: had FDII been in effect in 2014, one estimate is that around 9 percent of all U.S. companies and 13 percent of multinationals would have been eligible for FDII, with a particularly heavy concentration in manufacturing.53
At the same time, however, FDII can also encourage the location of tangible assets outside the U.S., so as to increase the return on tangible assets in the U.S. and thereby increase the likelihood of the reduced rate coming into play.
GILTI creates an incentive to locate tangible assets outside the U.S., including in relatively high tax countries such as Canada. This is because doing so increases the ‘deemed’ tangible income outside the U.S., and so reduces the amount of GILTI subject to tax. (Hence, bearing in mind FDII too, the international provisions of the TCJA are sometimes caricatured as encouraging the location of intangible assets in the U.S., and the location of tangible assets outside).
One wider effect of the GILTI provisions may be to induce changes in the business models of some low tax jurisdictions (since those low rates may no longer be so effective in attracting highly mobile income). If so, a consequent reduced exposure to profit shifting towards such jurisdictions will be an indirect source of benefit for Canada and other relatively high tax countries.
The impact on Canada of the BEAT seems likely to be limited. Since the reversal of the differential in statutory rates for larger companies largely eliminates any incentive to shift profits directly from the U.S. to Canada, the BEAT may have little direct bite, though there may be an indirect effect for Canadian operations financing their U.S. operations through low tax jurisdictions.
26. The generous treatment of small businesses in Canada means that they may be less affected by the TCJA. For large corporations, several aspects of the reform tend to switch the balance of advantage away from Canada and towards the U.S. Even with the rate reduction and FDII for C-corporations, however, and the top federal marginal rate for eligible pass throughs in the U.S. of 29.6 percent,54 the low CIT rates in Canada for small corporations combined with the dividend tax credit and 50 percent exclusion of capital gains will often preserve more favorable treatment in Canada.55
27. The balance of risks to Canada from the TCJA (to investment, activity and tax revenue) is firmly to the downside and focused on larger corporations—but the extent of the risk remains very unclear. Practitioners are still grappling to understand provisions that are complex, still incompletely defined and whose continuation into the medium term is not universally regarded as assured.
C. Looking Forward
28. The Canadian tax system has considerable coherence, but the strategy it embodies is coming under increasing pressure. Key elements of that strategy include: what is by international standards heavy reliance on a sharply progressive PIT rate structure (with a weighted average top marginal rate of about 52 percent), and beginning at a relatively low level of income—around one-third of that in the U.S.); a significant degree of integration with the corporate tax (in a form that is now quite rare);56 particularly favorable treatment of small businesses; consumption tax treatment for a broad range of savings; and relatively modest reliance on the GST as a source of revenue (accounting for about 23 percent of total taxation, compared with the OECD (unweighted) average of 33.3 percent). The most evident pressures for change come from the large differential between the top rate of PIT and the rate of CIT, averaging around 25 points (and around 39 points for small businesses): the highest in the G-7 countries and 9 points above the OECD average). Responses therefore need to consider coherence of the wider system. Reducing the overall rate of CIT, for instance, risks exacerbating the difficulty of distinguishing between income taxable immediately at high marginal rates (such as employment income) and income that may be sheltered behind the corporate tax rate, at least until distribution. More generally, as it becomes increasingly hard to sustain such high rates of tax on capital income, the wider question arises as to the sustainability of the current tax strategy.
29. There are some ways in which coherence could be improved, but the wider pressures at work mean the time is ripe for a fundamental and independent review of the Canadian tax system. Box 2, drawing on parts of the discussion above, sets out some changes that could enhance the effectiveness of the tax system within its own terms and without unduly prejudging possible wider reforms. More is needed, however, to address the systemic issues. There have been a number of reviews of key aspects of the Canadian tax system, including the 1997 Technical Committee on Business Taxation and the 2008 Godsoe Report on international taxation. 57 Given however the interlinkages between all parts of the tax system, and the substantial changes in the tax environment over recent decades, there is a strong case for a holistic and independent review—the first since the Carter Review of 1966.58 This could provide an opportunity to reassess not only corporate taxation but the wide architecture of the system: whether there is a case, for instance, for a more schedular approach to the treatment of capital and labor income (as in many Nordic countries), for some shift in the balance from direct to indirect taxation, and for the allocation of taxing powers between provinces and federal governments. While these issues go far beyond the scope of the paper, the considerations raised above can help frame the closer analysis needed.
Improving the Coherence of the Current System
Excluding 50 percent of the capital gain on inter-corporate shareholdings sits uneasily with exemption of inter-corporate dividend payments., both being ways of transferring value along the corporate chain. This creates a prima facie case for exempting corporate gains on the disposal of shares while, consistent with the logic of imputation, fully taxing other gains.
For the reasons in Section A, there is a strong case to reconsider the purpose and role of the small business rate.
Rebalance the tax treatment between small business taxed to individuals on a transparent basis and small business taxed as a company. The current differential in the tax treatment of business profit retention is a substantial distortion. There might be consideration, for instance, of whether small companies could be taxed on a transparent basis or sole proprietorships and partnerships taxed like companies.
Review dividend tax credit arrangements with a view to their restructuring and reduction, for reasons outlined in Section B. The treatment of distributions out of exempt surplus seems overly-generous and potentially distorting; at a minimum, consideration should be given to limiting it to distributions from subsidiaries in countries that have a full tax treaty with Canada (and not simply a TIEA). More fundamentally, however, it is not clear that these arrangements enhance either efficiency or fairness.
Canada has an important role to play in in the international dialogue seeking a coordinated way forward to address the BEPS-identified risk of substantial market penetration without taxation. It will be important too to reflect on whether Canada might ultimately move towards greater taxation of profits in order to ensure that Canadian enterprises competing at home are not disadvantaged.
Navigating the International Tax Environment
30. The current unprecedented uncertainty in international tax matters argues for a cautious approach to CIT reform… Fragmentation of policy responses to the international tax consequences of digitalization for instance, risk undermining—to comparatively modest national gain—the progress that has been made under the BEPS project in strengthening tax cooperation. With the OECD aiming to arrive at consensus approach by 2020, or perhaps 2019, there is a strong case against immediate action.
31. …including in any response to the U.S. tax reform. While the risks to Canada are clear, their extent will not become clear for some time: hasty action could overshoot the appropriate response. There are, nonetheless, some guidelines for navigating through a system in some flux is such a way as to improve efficiency and limit risks of profit shifting.
32. Since the most immediate risk is of enhanced profit shifting out of Canada, the adequacy of anti-base erosion protections merits close attention. Possibilities for consideration here include:
Extend thin capitalization rules to borrowing from unrelated parties, and perhaps to domestic transactions too. Policing a distinction between related and third parties is inherently problematic, and deduction of internally generated group debt that is not reflected in group third party debt is a continuing problem. Moreover, substantive problems of debt shifting can arise domestically between the provinces, and debt bias concerns arise predominantly from borrowing outside the corporate group. Thin capitalization rules, nonetheless, are an inherently blunt instrument and do not address the fundamental problem of a fundamental tax distortion towards debt finance.
Consider similar anti-base erosion measures for other types of deductible payments that are subject to minimal or limited withholding tax. This is particularly the case with rents and royalties, but service fees are another problematic area. An extreme response would consider the coordination of anti-base erosion measures for all types of relevant deductible payments.
Address the risk of inappropriate allocation of expenses to Canada. Deduction against domestic income of expenses related to foreign source income is potentially a significant form of base erosion. This is especially so for interest expense incurred in deriving exempt foreign dividends. A lack of prescriptive allocation rules facilitates stuffing foreign low-tax subsidiaries with profits and loading Canadian parents with expenses. Addressing this may require more prescriptive rules in allocating expenses between domestic and foreign activities. In relation to foreign branches of Canadian companies, allowing the deduction of foreign losses effectively allows foreign expenses to reduce domestic source income; this merits reconsideration.
33. There are many instruments—perhaps some as yet unthought of—by which investment in Canada can be encouraged and profit shifting discouraged, each with strengths and costs. Now being a time in which countries are showing ingenuity in international tax policies, there may be scope for novel measures which, while consistent with international obligations, are tailored to Canada’s particular circumstances. More obvious are responses through the statutory rate and/or the treatment of investment:
Reductions in the statutory rate are best targeted to discouraging profit shifting—but can be expensive because they confer a windfall benefit to past investments. There may well be further pressures to reduce the rate for large businesses: one estimate is that the rate reduction in the U.S. many eventually spur reductions elsewhere in the order of 4 or so percentage points.59 As discussed above, there is likely to be less pressure on the small business rate; indeed there remains a strong case for moderately increasing it. And it will be important too to preserve effective taxation of location-specific rents, most obviously in the natural resource sector.
Revenue concerns can be mitigated to some degree by phasing any necessary reduction in the rate., as has been the case in the past. Phasing brings its own distortions, creating incentives to bring investment forward (so as to take investment-related deductions when the tax rate is high and profits when it is low) and, by the same token, to exploit timing opportunities to bring expenses forward and shift profits into the future. It may also add complexity to the dividend tax credit during the transition period, though experience is that these difficulties have proved manageable. These are likely to be prices worth paying, however, to limit a loss of revenue that simply conveys a windfall benefit on companies’ owners.
Close coordination between federal and provincial governments, which appears to be well-established, would be needed to consider how best to share any reduction in the combined rates between the two levels of government. Given the narrowing of the rate differential between Canada and the U.S. and the absence of corporate taxes in some states, there may be increased pressure for rate harmonization across the provinces. It is of considerable benefit to Canada (in terms of consistency, predictability and mobility within Canada) that there is greater uniformity of rates and bases of taxation across provinces than there is, for instance, across U.S. States. However, increasing provincial uniformity is a continuing worthwhile goal.
Increased generosity of investment allowances is most directly targeted at supporting real investment. Movement towards immediate expensing of a wide class of assets would directly follow developments in the U.S. This too can be expensive, though the issue here, while significant, is essentially one of timing: immediate expensing implies a narrower tax base than deprecation when the investment is undertaken, but—since in either event the asset is fully written off over time—a broader one later. Here too there would be a need for coordination with the provinces as the provinces would also suffer a front-loaded revenue loss to the extent their tax base reflects the federal corporate tax base.
More generous treatment of investment may need to be accompanied by tighter limits on interest deductibility to avoid exacerbating a marginal corporate tax subsidy to investment. This would need to apply to all interest, not just borrowing from related parties—and it would also recoup some of the revenue loss from enhanced investment allowances.
Structural Corporate Tax Reform
34. A central issue for any broad review of the tax system is the case for moving towards some form of rent taxation at corporate level. This would in principle eliminate any corporate level distortion to investment and remove the bias towards debt finance, resetting the corporate-level METRs for all investments to zero.
35. There are two leading candidate forms of corporate rent taxation, and experience, to varying degrees, with both:
Allowance for Corporate Equity (ACE)/Capital (ACC). Under an ACE, interest deductibility is retained but a deduction is also allowed for a notional return on equity; under an ACC, a common notional rate is applied to debt as well as equity. No restriction is placed on the schedule of depreciation allowances. Potential concerns include biases that may arise from setting the notional rate inappropriately (though whether the potential cost exceeds those of the distortions under the current system is unclear), and the revenue loss from a narrowing of the corporate tax base (though this can be mitigated by, for instance, providing the equity deduction only for equity added after introduction of the tax). ACE-type schemes have been adopted in several countries. While these experiences60 have pointed to the risk of creating new avoidance opportunities, that in Italy in particular is widely regarded as having been positive, especially in alleviating debt bias.
Cash flow taxation (CFT). This means giving full expensing for all investment while (since that provides full allowance for the costs of investment) denying any deduction for interest (or of equity finance). Ensuring full neutrality requires that this be accompanied by full loss offset, or carrying forward of losses at interest. While there is quite wide experience with full expensing, particularly for smaller firms, there is almost no international experience of that accompanied by complete denial of interest deductions.61 In revenue terms, while full expensing reduces the present value of receipts (by bringing depreciation allowances forward, the extent to which this is offset by denying interest deductions will be context-specific.
36. Each form of rent tax has its merits and drawback, both in general and in the Canadian context.62 The ACE approach is better suited to dealing with financial institutions, for instance: it simply retains interest deductibility, while their appropriate treatment under a cash flow system requires the unfamiliar device of in effect taxing all inflows, and providing deductions, of principal as well as interest. Application to smaller businesses, on the other hand, is likely to be simpler under a cash flow approach. Transition issues appear manageable in either case: the U.S. is to some degree showing the way for movement towards a CFT, and transition issues may be even less under the ACE, since there is no issue of handling pre-existing debt and no need to change deprecation arrangements. The cash flow approach, on the other hand, has closer similarities with the direction of reform across the border under the TCJA. And neither approach resolves potential problems of profit shifting.63
37. In each case, taxation of the normal return to capital would need to be shifted to the personal level. Moving towards a rent tax would mean that the CIT is focused on raising revenue, rather than withholding against personal income tax.64 One approach, for example, would be to impute to corporate owners a normal return on assets subject to the rent tax and bringing that into tax at personal level. The latter might involve for instance, applying some notional return to the capital value of assets subject to the tax (irrespective of actual dividends and capital gains);65 that return could then be taxed at a flat rate or, aggregated across assets, by a progressive schedule.66
38. Rent taxation, at an unchanged statutory rate, could involve some loss of corporate level tax revenue. Absent behavioral responses, this is clear under the ACE, movement to which is unambiguously base-narrowing; it is less clear-cut for CFT, given at least some offset through the elimination of interest deductions. For either form, there would be some revenue gain from the increase in investment to the extent that a positive METR means that some investments yielding an infra-marginal profit are not undertaken, and from the dissipation of the base through excess leverage. But these effects are unlikely to offset the first order loss of revenue. That loss, moreover, cannot be recouped by raising the statutory rate without exacerbating problems of profit shifting. Attention must thus shift to other revenue sources: Boadway and Tremblay (2014) argue, for instance, that the revenue costs of an ACE would be amply covered by elimination of the dividend tax credit.
Dealing with the Revenue Consequences of Corporate Tax Reform
39. The pressures are evidently towards a reduction in CIT revenues, and there is some scope to mitigate this by base broadening within the CIT… The tighter limitation on interest deductions suggested above is one such measure. Some possible measures that have been raised, however, risk amplifying the distortions that it should be the objective of policy to reduce: restricting loss carry forward and carry back, for instance, would act in the direction of increasing METRs.
40. …but ultimately other sources of revenue may need to be tapped more fully. With the strongly progressive personal income taxation, among the questions for any wider review must be the case for heavier reliance on indirect taxation, and notably the GST. As a ready reckoner, a loss of revenue of one percent of GDP would be recouped, roughly speaking by a 1.2 percentage point increase in the federation wide rate of GST.
Appendix I. Estimating the Potential Impact of the U.S. Tax Reform on Canada
This appendix outlines the derivation of the empirical results reported in Section B.
Data
1. The main dataset used is the Inward Foreign Affiliate Statistics (FATS), which provides information on economic and financial activities of foreign majority-owned affiliates in Canada (FMOCAs) during 2010–2015. This is merged with data on country-level statutory CIT rates, METRs and key macro variables (including GDP, GDP per-capita, unemployment rate). This produces an unbalanced panel of FMOCAs from 34 countries, including their assets, revenues, profits1, and corporate tax rates.
Investment Effects
2. In a competitive world with markets segmented between countries and companies unconstrained in the amount of capital they can mobilize, the METR in one country would not be expected to directly affect investment in others. Such effects can arise, however, if companies’ access to capital is constrained or they serve integrated markets in which they have some degree of market power. In either case, statutory tax rates in both countries also have an effect (in the latter model, to an extent that reflect relative levels of production in the two countries). Allowing for these possibilities, a dynamic gravity-like panel specification relating the assets of foreign corporations in Canada to these tax variables and a range of controls is estimated in the basic form:2
where CIT_Diffjt is the difference in the statutory CIT rate between country j and Canada, Rj is the share of all sales revenue of non-Canadian multinationals in Canada earned by those from country j (averaged over the sample period). METRjt is the METR in country; at time t, and controls Xjt include the natural logarithm of GDP (lnGDPjt) and GDP per-capita (lnGDPPCjt), exchange rate relative to USD (Xratejt), unemployment rate (Unempljt), and an index for current account openness (Openjt) in country j in year t.3 By including country and year fixed effects (αj – and ηt), the regression exploits the within-country time variation in the CIT/METR to identify the effects of taxes.
3. Results are reported in Table A1. Taking as preferred results those in Column (4) (estimated by instrumental variable estimation and including both country and time effects) suggest that the effects of both the METR in the country of the originating parent company and the differential between the Canadian and originating statutory rates, weighted by revenue share, to be significant at 5 and 10 percent respectively.
Effects of Corporate Taxes on MNC Investment in Canada
Effects of Corporate Taxes on MNC Investment in Canada
| OLS | IV | GMM | |||
|---|---|---|---|---|---|
| (1) | (2) | (3) | (4) | (5) | |
| Panel A: | |||||
| CIT_Diff | 0.052** (0.023) |
0.037* (0.020) |
0.150** (0.060) |
0.095 (0.071) |
0.033 (0.061) |
| CIT_Diff × R | 0.553* (0.314) |
0.564* (0.308) |
0.478* (0.270) |
0.634** (0.314) |
|
| METR | 0.084** (0.036) |
0.072*** (0.026) |
|||
| METR × R | –0.564 (0.931) |
0.106 (0.713) |
|||
| L.Total assets | –0.002 (0.001) |
–0.001 (0.001) |
–0.002 (0.003) |
–0.002 (0.002) |
–0.002 (0.002) |
| Panel B: Long-Run Effect | |||||
| CIT_Diff | 0.052** (0.023) |
0.036* (0.020) |
0.15** (0.060) |
0.095 (0.071) |
0.033 (0.061) |
| CIT_Diff × R | 0.553* (0.314) |
0.562* (0.307) |
0.477* (0.269) |
0.633** (0.312) |
|
| METR | 0.084** (0.036) |
0.072*** (0.026) |
|||
| METR × R | –0.562 (0.929) |
–23.239 (647.799) |
|||
| Panel C: Test Statistics | |||||
| Cragg-Donald Wald F Statistics | 6.00 | 6.48 | |||
| Hansen J p-value | 0.52 | 0.36 | 0.20 | ||
| AR1 p-value | 0.23 | ||||
| AR2 p-value | 0.21 | ||||
| Parent Country Controls | Y | Y | Y | Y | Y |
| R2 | 0.986 | 0.986 | 0.286 | 0.333 | |
| N | 116 | 114 | 57 | 52 | 37 |
Effects of Corporate Taxes on MNC Investment in Canada
| OLS | IV | GMM | |||
|---|---|---|---|---|---|
| (1) | (2) | (3) | (4) | (5) | |
| Panel A: | |||||
| CIT_Diff | 0.052** (0.023) |
0.037* (0.020) |
0.150** (0.060) |
0.095 (0.071) |
0.033 (0.061) |
| CIT_Diff × R | 0.553* (0.314) |
0.564* (0.308) |
0.478* (0.270) |
0.634** (0.314) |
|
| METR | 0.084** (0.036) |
0.072*** (0.026) |
|||
| METR × R | –0.564 (0.931) |
0.106 (0.713) |
|||
| L.Total assets | –0.002 (0.001) |
–0.001 (0.001) |
–0.002 (0.003) |
–0.002 (0.002) |
–0.002 (0.002) |
| Panel B: Long-Run Effect | |||||
| CIT_Diff | 0.052** (0.023) |
0.036* (0.020) |
0.15** (0.060) |
0.095 (0.071) |
0.033 (0.061) |
| CIT_Diff × R | 0.553* (0.314) |
0.562* (0.307) |
0.477* (0.269) |
0.633** (0.312) |
|
| METR | 0.084** (0.036) |
0.072*** (0.026) |
|||
| METR × R | –0.562 (0.929) |
–23.239 (647.799) |
|||
| Panel C: Test Statistics | |||||
| Cragg-Donald Wald F Statistics | 6.00 | 6.48 | |||
| Hansen J p-value | 0.52 | 0.36 | 0.20 | ||
| AR1 p-value | 0.23 | ||||
| AR2 p-value | 0.21 | ||||
| Parent Country Controls | Y | Y | Y | Y | Y |
| R2 | 0.986 | 0.986 | 0.286 | 0.333 | |
| N | 116 | 114 | 57 | 52 | 37 |
Applying in the estimated equation both a 14-point reduction in the statutory rate differential (weighted by the revenue share of U.S. companies) and a 13-point reduction in the U.S. METR, the implied long run reduction in U.S. companies’ assets held in Canada is around 6 percent (with a 95 percent confidence interval of between 0.4 and 14 percent), which is equivalent to about 3 percent of GDP.
Profit Shifting
4. The estimating equation used to assess this relates the profits reported in Canada by multinationals in each originating country to the difference between the CIT rate there and in Canada,4 allowing for both (a) asymmetries in respect of inward- and outward shifting and (b) threshold effects by which profit shifting is concentrated in countries for which the absolute tax differential relative to Canada is particularly large. Specifically, in the most complete specification reported:
where the CIT difference in absolute value (|CIT_Diffjt|) is interacted with a dummy indicator (Lowj) that takes the value of 1 for countries j with a lower CIT rate than Canada throughout the sample period, and with a dummy indicator (Highj) taking the value of 1 for countries with a higher CIT rate than Canada throughout, respectively; the dummy indicator Ilow takes the value of 1 for a CIT differential larger than 5.1 percent in low-tax countries, and above 12.8 percent in high-tax countries.5
5. The results in Table A2 point to large outward profit shifting to low tax countries, but—most relevant here—to no inward profit shifting from high-tax countries except those with a CIT rate at least 12.8 percentage point higher than the Canadian rate: that is (in the sample used) from Japan and the US.6
Effects of Corporate Taxes on Foreign Multinational’s Profits in Canada
Effects of Corporate Taxes on Foreign Multinational’s Profits in Canada
| Pooled Regressions | Within Group | |||||
|---|---|---|---|---|---|---|
| (1) | (2) | (3) | (4) | (5) | (6) | |
| CIT_Diff | 0.301*** (0.105) |
0.339** (0.143) |
0.027** (0.011) |
|||
| CIT_Diff x Low | –0.012 (0.010) |
–0.295* (0.176) |
–0.159* (0.088) |
|||
| CIT_Diff x High | 0.080*** (0.030) |
0.136 (0.112) |
0.069 (0.073) |
|||
| CIT_Diff x Low x Ilow | –0.143*** (0.030) |
|||||
| CIT_Diff x High x IHlgh | 0.382*** (0.022) |
|||||
| Total assets (USD Billion) | 0.022*** (0.007) |
0.024*** (0.007) |
0.052*** (0.011) |
0.050*** (0.004) |
||
| No. of employees (thousands) | 0.019*** (0.006) |
0.017*** (0.006) |
0.037 (0.033) |
0.002 (0.016) |
||
| Parent Country Characteristics | N | Y | Y | Y | Y | Y |
| Country FE | N | N | N | N | Y | Y |
| Y | Y | Y | Y | Y | Y | |
| R2 | 0.217 | 0.986 | 0.990 | 0.991 | 0.996 | 0.997 |
| N | 157 | 140 | 133 | 133 | 162 | 162 |
Effects of Corporate Taxes on Foreign Multinational’s Profits in Canada
| Pooled Regressions | Within Group | |||||
|---|---|---|---|---|---|---|
| (1) | (2) | (3) | (4) | (5) | (6) | |
| CIT_Diff | 0.301*** (0.105) |
0.339** (0.143) |
0.027** (0.011) |
|||
| CIT_Diff x Low | –0.012 (0.010) |
–0.295* (0.176) |
–0.159* (0.088) |
|||
| CIT_Diff x High | 0.080*** (0.030) |
0.136 (0.112) |
0.069 (0.073) |
|||
| CIT_Diff x Low x Ilow | –0.143*** (0.030) |
|||||
| CIT_Diff x High x IHlgh | 0.382*** (0.022) |
|||||
| Total assets (USD Billion) | 0.022*** (0.007) |
0.024*** (0.007) |
0.052*** (0.011) |
0.050*** (0.004) |
||
| No. of employees (thousands) | 0.019*** (0.006) |
0.017*** (0.006) |
0.037 (0.033) |
0.002 (0.016) |
||
| Parent Country Characteristics | N | Y | Y | Y | Y | Y |
| Country FE | N | N | N | N | Y | Y |
| Y | Y | Y | Y | Y | Y | |
| R2 | 0.217 | 0.986 | 0.990 | 0.991 | 0.996 | 0.997 |
| N | 157 | 140 | 133 | 133 | 162 | 162 |
Applying a 14-point reduction in the statutory rate in the U.S., the results in Column (6) of Table A2 imply a reduction of around 15 percent of total profits of U.S. multinationals reported in Canada, which is around 0.31 percent of GDP.
Revenue Implications
6. Relative to assets, the effective tax rate paid in Canada by U.S. corporations is about one percent. Applying this to the estimated reduction in U.S. assets in Canada of 0.3 points of GDP gives a reduction in CIT revenue of around 0.03 percent, which is about 6 percent of CIT currently paid in Canada by U.S. corporations.7
7. At a combined statutory rate of 26.9 percent, the estimated reduction in annual reported profits in Canada of U.S. corporations of 0.31 percent of GDP would reduce total CIT revenue by about 0.08 percent, which is approximately 17 percent of all current CIT revenue from US multinationals. Overall, the long run loss in CIT revenue from U.S. corporations is thus estimated to be about 23 percent of their current payments, with a 95 percent confidence interval of between 0.16 to 0.31 percent.
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Prepared by Michael Keen, Li Liu (both FAD); and Peter Harris (University of Cambridge).
The paper does not address sector-specific issues, for example in relation to natural resources.
Figures for CIT revenue do not include receipts from resource royalties.
As suggested, for instance, Department of Finance (2017).
The gaps between the top PIT rate and the general (respectively, small business) CIT rate rose from about 3 percentage points in 2000 to 26 now (from 26 to 37 points).
The rates here are those generally applicable to domestic earnings of large corporations, and so do not reflect, for instance, the small business rate in Canada or the reduced FDII rate in the U.S. (both discussed later).
These are Wyoming, South Dakota, Washington State, Nevada, Ohio and Texas.
Washington State, Nevada, Ohio and Texas (ranging to a top rate of 1.5, 0.33, 0.26 and 2 percent respectively).
Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia, Prince Edward Island, and Saskatchewan, at rates of 4–6 percent.
Department of Finance (2017, p.12) increased by 1.5 points for the 2019 reduction in the federal rate.
As reviewed, for instance, in International Tax Dialogue (2012). Chen and Mintz (2011) provide a powerful critique of the small business tax regime in Canada.
Including throughout the paper, the territories.
Quebec administers its own CIT and personal income taxes; Alberta administers its CIT but participates in the federal- provincial collection scheme for the personal income tax.
Statistics Canada (2015), Table 11.
These usually take the form of investment tax credits that reduce provincial liability.
These are a form of what are referred to more generally as Controlled Foreign Corporation (CFC) rules.
Smart (2010, p.9) reports that as of 2009 around 7 percent of Canadian FDI was in non-treaty/TIEA jurisdictions.
Notably the Registered Pension Plan and Registered Retirement Savings Plan (under each of which contributions are deductible and withdrawals fully taxable), and Tax-free Savings Accounts (under which capital income is exempt).
Excess credits (which may arise, for example, when the taxpayer has a low marginal tax rate or has expenses associated with dividends) may, however, be set against tax imposed on other income.
See Boadway and Bruce (1992), and on the possible welfare implications, Smart (2018).
That is, on the amount by which the return that the company earns exceeds the minimum required by investors.
The METR is the wedge between the pre- and post-tax return on an underlying investment which just yields the investor their required post-tax return (expressed as a proportion of the former). Since input taxes create such a wedge just as do features of the CIT, they are appropriately included in its calculation.
The calculations in Figure 4 apply statutory rates of sales taxation, and so will over-estimate their impact given the exemptions that in some cases apply to business purchases. (Those used to produce output subject to sales taxation, for instance, are in broad terms commonly exempt in the U.S.). The calculations also do not take into account, however, investment tax credits in Canada.
Taking account only of CIT.
There are of course also others, such as the payment of management fees and royalties.
The latter is relevant for firms that operate through separate but related entities in different provinces. See Mintz and Smart (2004).
Statistics Canada CANSIM Table 378–0122; and IMF Financial Soundness Indicators, available at: http://data.imf.org/?sk=51B096FA-2CD2-40C2-8D09-0699CC1764DA
See for instance Huizinga and others (2008) on debt-shifting and IMF (2016) on debt bias.
Though not unique: corporate taxation is a cantonal matter in Switzerland, and in Germany the local Gewerbesteuer accounts for a larger share of all corporate tax than do the provincial CITs in Canada.
Smart (1998). Broadly speaking, while the mechanics of the equalization arrangements can be expected to affect the level of provincial taxes they would not in themselves be expected to affect the responsiveness of provincial taxes to, for instance, changes in the federal rate or competing rates in the U.S.
Such as Boadway (2017).
These relate to: harmful tax practices, treaty abuse, country-by-country reporting and dispute resolution mechanisms.
The BEPS minimum standards are subject to peer review. So far Canada has been assessed as having no harmful tax regime, has the legal framework and exchange network in place for country-by-country reporting and its dispute resolution mechanisms have been reviewed. Canada awaits review of measures for preventing treaty abuse, but is a signatory to the Multilateral Instrument that will amend its tax treaties to incorporate the minimum standard in this respect.
Some countries, including India and Italy, have already adopted measures of this sort.
These measures are largely targeted at avoidance of taxable presence such as a permanent establishment and so arguably are also related to issues of digitalization.
For CCPCs, the lower rate of CIT continues to confer significant advantage. (See, however, Boidman (2018) on the complexities that arise in comparing the treatment of reinvested business profits in the U.S. and for CCPCs).
There is of course also a substantial benefit to Canadian owners of U.S. corporations.
It would of course be even more advantageous for US firms to shift profits to jurisdictions with lower tax rates than Canada, but there is evidence that physical presence in a country facilitates shifting profits there.
Ernst and Young (2018) report that more than half of 165 surveyed executives thought it likely they would shift revenue or risk functions to the U.S. following TJCA, and nearly one-third expected to reduce investment in Canada.
See for example Mintz (2018).
Academic views on this are divided: Kamin and others (2017) argue that the FDII regime “is likely an illegal export subsidy in violation of WTO agreements”; Sanchirico (2018) concludes that it is not clearly in breach.
This includes both U.S. companies and foreign companies with income effectively connected with a U.S. trade or business but does not cover individuals, S-corporations, regulated investment companies or real estate investment trusts.
The rate is set at 5 percent for 2018, 10 percent for 2019–2025, and 12.5 percent thereafter.
These are not captured in the empirical results just reported.
For example, investment in Europe by U.K. MNCs is estimated to have increased by 15.7 percent in countries with lower statutory CIT rates than the UK (Liu, 2018). And for Canada itself, Smart (2010) finds a significant increase in outward FDI from Canada associated with the expansion of the treaty/TIEA network and hence of exempt surplus treatment.
Other than reducing (perhaps substantially) the cost of repatriation of existing profits from Canada: Canadian dividend withholding tax will now be the only barrier for repatriation of existing retained profits.
On marginal effective tax rates under FDII, see Chalk and others (2018) and Beer and others (2018).
This is achieved by granting businesses a deduction equal to 20 percent of their income, capped by reference to the greater of 50 percent of certain wages paid, or 25 percent of those wages plus 2.5 percent of certain depreciable tangible property held by the business. This will of course be increased by applicable state taxes.
Except perhaps in the case of dividends paid to high income CCPC-owners.
Australia and New Zealand are the two main examples of OECD countries that still generally attempt to tax distributed corporate profits at shareholder marginal rates.
Department of Finance (1997, 2008 respectively). The Department also produces an annual report on tax expenditures. At provincial level, there has also been a recent review of the tax system in Quebec (Gouvernement du Québec, 2015).
Ernst and Young (2018) find considerable business support for such a review.
See for instance, see Klemm (2007), Zangari (2014) and Hebous and Ruf (2017); the later shows, for instance, that the ACE has been effective in addressing debt bias. Canada itself had a form of ACE in its 1916 business profits tax (Boadway, 2017).
Rent taxation of this kind has been applied in the extractive industries, for example in Norway. Of general applicability, Mexico operated a CFT (the Impuesto empresaria a tasa única, IETU) as a minimum CIT from 2008 to 2013. Issues have been raised about the creditability of CFT under tax treaties, but the movement towards territoriality in the advanced economies makes this much less of concern.
The case for movement to an ACE in Canada is made in detail by Boadway and Tremblay (2014, 2016).
Profit shifting problems may though take different forms from now: under neither an ACE/C nor a CFT, for instance, does borrowing create a net deduction (by simple exclusion under a CFT, because of an offsetting effect through a reduced future notional allowance for equity under the ACE). Issues of transfer pricing in relation to goods and services remain.
Boadway (2017) elaborates on and argues for such a change in the focus of Canadian CIT.
The Netherlands (in the ‘Box 3’ arrangement) takes an approach of this kind, applying a notional rate to the capital value of net assets (which is then subject to a flat rate of tax, though progressive taxation would also be possible).
There would be no efficiency grounds for giving a credit in respect of taxes charged on rents.
Profits in the FATS statistics are operating profits before interest and royalty payments, and thus exclude profit shifting arrangements through debt shifting or royalties. This suggests that analysis using the FATS profits may understate the extent of profit shifting.
More precisely, the latter model implies that for a multinational operating in countries A and B, its investment in A would depend on the difference between the statutory CIT rates in the two countries weighted by the proportion of its production that takes place in country A. Given data limitations, the latter is proxied by the sales revenue variable. Investment in A would also depend on the METR in A, and indirectly (though its exec on production levels) on that in B. Theory does not predict that the impact of the METR in A should vary with production shares, but from completeness we allow and test for this possibility in the estimation.
With the presence of a time effect, there is insufficient time variation in the Canadian METR over the sample period to meaningfully include it the regressions: doing so, and replacing the time effect with a time trend, its effect is insignificant.
While using macro-level data does not control for firm-specific heterogeneity, the direction of bias in estimated tax sensitivity can be in either direction; the macro estimate of profit shifting represents an average effect for all multinationals in Canada.
Estimated by grid search to minimize the sum of squared residuals.
The implied semi-elasticity of reported profits with respect to statutory CIT rate differential for US multinationals is around 1.2. This is comparable, though slightly smaller, to the average semi-elasticity of 1.4 reported in Dowd et al (2017) that uses micro U.S. tax return data over the period of 2002–2012, and the consensus semi-elasticity of 1.5 for the year 2015, as found in a recent meta-analysis by Beer et al (2018).
Total CIT revenue in Canada is about 3.2 percent of GDP, of which US MNCs pay about 15 percent.
