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Archived - Backgrounder
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International Tax Avoidance and "Tax Havens"
In a fair tax system, everyone must pay their fair share of tax. Low-tax offshore jurisdictions-the so-called "tax havens"-play a role in facilitating international tax avoidance. Some low-tax jurisdictions are also tax havens in a less neutral sense, in that they encourage illegal tax evasion. These are jurisdictions that not only have low or no income taxes for non-resident investors, but also have secrecy laws in place to prevent other countries, such as Canada, from verifying whether their residents have invested there. The increasing mobility of global capital and the instantaneous distribution of information bring great rewards to open economies like Canada's. They also present some challenges, including the challenge of ensuring that business income is appropriately taxed. Multinational corporate groups use complex structures, often spanning several countries, in order to minimize their overall tax burden.
Increasingly, governments are recognizing that they must either act to limit the erosion of their domestic tax bases by creative international tax planners, or increase the share of taxes borne by their citizens and small businesses.
The international tax measures in Budget 2007 address both international tax avoidance and international tax evasion. Certain proposals in particular respond to multinational groups' use of low-tax jurisdictions and other avoidance structures as a means of obtaining two deductions for the same financing expense. (See Figure 1.) Where the low-tax jurisdiction has a tax treaty with Canada, these "double dip" structures allow a deduction in Canada as well as one abroad, with no Canadian tax payable ever by the Canadian corporation on its foreign investment income (since it is treated as "exempt surplus"). Where the low-tax jurisdiction is not a treaty partner, the structures produce a deduction in Canada with the income qualifying for indefinite deferral-that is, the income will be taxed only if and when the group decides to repatriate that income by paying a dividend from the foreign affiliate to its shareholder in Canada (as it is treated as "taxable surplus").
The proposals also respond to certain structures that do not use a "tax haven" or other low-tax jurisdiction. For example, complex "tower" structures seek to arbitrage differences between Canadian and U.S. tax rules to obtain the same result as the double dip. (See Figure 2.)
In addition, Budget 2007 sets out important initiatives to deal with the second concern with "tax havens"-secrecy laws in other jurisdictions that facilitate tax evasion in Canada. To detect and deter the concealment of income, the Canada Revenue Agency needs information from foreign governments. Canada will conclude no new tax treaty, nor update an existing tax treaty, unless the treaty partner country agrees to abide by the highest international standards of tax information exchange. Canada will also invite jurisdictions that are not candidates for full-scale tax treaties to enter into bilateral tax information exchange agreements (TIEAs).
A jurisdiction that has a functioning TIEA with Canada will gain an important competitive advantage: income earned there by the foreign affiliates of Canadian companies will be eligible for Canada's exempt surplus system. Income earned in a jurisdiction that has not agreed to a TIEA, on the other hand, will be taxed in the hands of the Canadian parent company as the affiliate earns it. The scale of these consequences, both positive and negative, indicates how serious the Government of Canada is about dealing with international tax havens. Further evidence is the budget's significant enhancement of the resources of the Canada Revenue Agency specifically for international tax audit and enforcement.
The remainder of this backgrounder focuses on the budget proposals dealing with investments in foreign affiliates, as this is the most technically complex element of the international tax initiative. It should be kept in mind that those provisions are part of a larger package of international tax measures, which not only addresses international tax avoidance and evasion issues, but also simplifies and improves Canada's tax exemption for foreign-source business income and substantially reduces non-resident withholding taxes. Taken together, the package is a major advance in Canada's ongoing effort to balance competitiveness and fairness in the tax system.
International Taxation: The Canadian Experience
Since 1972, Canada has maintained a complex system for the taxation of the income that a corporation resident in Canada earns through a "foreign affiliate"-that is, through a non-resident corporation in which the resident person has a significant investment.
One aspect of this system is the tax exemption that Canada provides for dividends that a Canadian-resident corporation receives out of the active business income (for example, income from carrying on a manufacturing business) of its foreign affiliates in countries with which Canada has a tax treaty.
This "exempt surplus" treatment is a significant advantage for Canadian companies. Many other countries, including the United States, the United Kingdom and Japan, do not provide a comparable exemption. Instead, they tax their residents' foreign affiliate dividends, providing a credit for any foreign taxes paid on the underlying income. In any case where foreign tax rates are lower than home-country rates, Canada's exemption system is more generous than a credit-based system, since no Canadian tax is payable by the parent company when it receives the foreign earnings as dividends.
Canada also allows corporations to deduct, in computing for tax purposes their income from a business or a property, the expenses they have incurred to earn that income. Since shares are a source of property income (in the form of dividends), a corporation that buys shares with borrowed money can in most cases deduct the resulting interest expense. This includes shares that-because they are shares of a foreign affiliate in a tax-treaty country-may produce income that bears little or no tax overall, and no Canadian tax whatsoever in the hands of the affiliate's Canadian parent corporation.
The combination of Canada's tax exemption for foreign affiliate exempt surplus dividends, and the deductibility of interest expense on borrowed money used to acquire shares, thus creates a mismatch between income and expenses.
This mismatch offers distinct tax planning opportunities for multinational corporations. There has for many years been a question in tax policy circles as to the extent to which those opportunities are a legitimate and even necessary part of Canada's international competitiveness, and the extent to which they are an invitation to tax avoidance.
That question has no simple answer. Many would agree, though, that some of the tax planning structures that have been developed in response to Canada's international tax rules are inappropriate.
For example, many "double dip" structures have been used by multinationals to finance their investments abroad. Figure 1 shows a simplified example.
The interest deduction in Canada offsets the group's Canadian-source income, while another deduction, claimed in the country in which the business being financed is located (in the example, "country S"), shelters the structure from tax there. Taking advantage of another feature of Canada's rules, the group recharacterizes the resulting investment income as active business income, allowing it to be returned to Canada as exempt surplus dividends (and sometimes paid in turn to a foreign parent company). As a result, the group enjoys two deductions for what is economically the same expense. The extra deduction allows it to shelter other, Canadian-source income from Canadian tax.
Another class of tax avoidance techniques is generically known as "tower structures". Like double dips, these are chains of holding entities that are used to reduce or eliminate tax on investments from one country into another. The distinctive aspect of a tower structure is its exploitation of hybrid entities. A hybrid entity is one that is treated differently under the tax systems of two or more countries. For example, some entities that Canada recognizes as corporations are seen by the United States as partnerships, and vice versa. Because corporations are subject to tax, while partnerships ordinarily are not (instead, their investors are generally taxed directly), a hybrid entity can allow a tax planner to ensure mismatching tax treatment as between the two countries. Figure 2 shows a simplified tower structure.
Both the double dip and the tower structure make investment outside Canada less costly than investment in Canada. Other things being equal, the mismatch between the interest deduction in Canada and the non-taxability of foreign-source earnings acts as an incentive to Canadian business to locate new operations-and the jobs they provide-in other countries, rather than in Canada.
Put differently, the "tax shield" provided by the extra deduction reduces the cost to a Canadian corporation of acquiring and operating foreign subsidiaries. Through that deduction Canada is in effect subsidizing the expansion of multinational corporations, both foreign-owned and Canadian-owned, from bases in Canada.
Some could argue that these effects are desirable. Some might accept that these structures are inappropriate but nonetheless contend that Canada must tolerate them to help Canadian multinationals be internationally competitive. Canada's New Government disagrees.
To evaluate this contention, two points need to be considered: the extent to which other developed countries tolerate international tax avoidance by their residents; and the overall competitive position of the Canadian economy, including but not limited to its tax aspects.
International Tax Avoidance in Other Countries
Most of Canada's multinational corporations compete for international business with corporations that are resident in other major developed economies. A measure of a country's significance in this regard is the scale of its outward foreign direct investment (FDI): the amount of capital its resident firms invest in subsidiaries abroad. Countries with large outbound FDI include the United States, Germany, Japan, France and the United Kingdom.
These countries have tax systems that differ in important ways from Canada's and from one another. Nonetheless, all have in various ways attempted to control the extent to which international structures and operations can be used to shelter their income from domestic tax. The following outlines some of these initiatives.
United States: The U.S. has a number of rules that target tax avoidance strategies that generate double dips, including "dual consolidated loss" rules that prevent the same loss from being claimed in two jurisdictions, anti-hybrid rules that target certain structures used by foreign companies making U.S. acquisitions, and "limitation on benefit" provisions contained in many U.S. tax treaties.
Germany: As a substitute for limiting interest deductibility, the percentage of foreign business income that is exempt from tax is limited to 95 per cent. Proposed rules would limit total interest deductions (whether or not the interest was incurred to finance foreign direct investments) to 30 per cent of taxable income before interest.
Japan: In certain circumstances, special "tax haven" rules apply to recharacterize as Japanese-source income-and thus tax immediately-the income of a controlled foreign affiliate, if the affiliate's foreign tax rate is 25 per cent or less. As well, no credit for foreign taxes paid by a foreign affiliate is provided to the extent that foreign-source income exceeds 90 per cent of total income.
France: "Anti-tax-haven" rules specify that foreign business income will not be exempt when earned in a jurisdiction with a preferential tax treatment (i.e., a jurisdiction which imposes tax at less than two thirds the rate of tax in France). This would prevent firms from routing investments in third countries through a tax haven in order to achieve a double dip of interest expense.
United Kingdom: The UK has recently enacted anti-hybrid legislation which is aimed at "engineered" tax avoidance structures. This prevents firms from using structures that, for example, generate a deduction in a foreign jurisdiction, but no income inclusion for UK tax purposes. The UK is also considering a revision of its international tax system.
Overall Competitiveness: The Canadian Advantage
As noted above, a key argument advanced for tolerating double dips, tower structures and other forms of international tax avoidance is that Canada must compromise tax fairness in order to preserve the competitiveness of Canadian businesses. This supposes that a single factor, such as the ability to obtain double dip financing, can determine whether a company, or even an entire economy, is able to compete globally.
The Canadian Tax Advantage
International competitiveness is a function not of particular isolated aspects of a country's business environment, but of the economy as a whole. This is equally true of tax competitiveness: it can be assessed only by examining the overall impact of the tax system on business, investment, labour and quality of life, and comparing those to the equivalent impacts of tax systems elsewhere.
Competitiveness is central to this government's agenda. Last fall, the Government presented Canadians with Advantage Canada, a comprehensive plan to improve Canada's competitiveness. Advantage Canada makes clear that an overall business tax advantage is a vital part of this government's economic strategy.
The business tax advantage involves first, building an internationally competitive corporate tax system to attract and retain business investment; and second, eliminating tax-based distortions to business decision-making.
Since taking office, the Government has improved the competitiveness of the system in a number of ways, including:
Before the 2006 Budget, Canada's marginal effective tax rate (METR) was the third highest in the Group of Seven (G7). Taking into account the changes made to date, it will be the third lowest by 2011. The Government's objective, as stated in Advantage Canada, is to achieve the lowest METR in the G7.
The Anti-Tax-Haven Initiative will help maintain Canada's leading position, without sacrificing the principles of tax fairness that are also cornerstones of the Canadian approach. Tax fairness additionally ensures that overall tax rates can be lowered to benefit all Canadians.
The view of economic and business competitiveness is necessarily broader than the specific comparison of particular tax measures. In Canada, the Government has a standing commitment to an integrated, coherent approach to ensuring that the country's business environment ranks among the best in the world. This engagement was set out in the 2006 Advantage Canada plan. It includes a tax advantage. Even in terms of tax alone, the Canadian advantage goes well beyond the accommodation of specific tax planning structures.The international tax measures in Budget 2007 enhance both the fairness and the competitiveness of Canada's international tax rules. An important aspect of these proposals is that they address the tax avoidance structures described above. The Government also commits to use the revenues generated through the Anti-Tax-Haven Initiative to further reduce business taxes and increase competitiveness in Canada.
Details of the Budget Proposal
The Government is committed to shutting down inappropriate tax avoidance structures. At the same time, the modern economy does require that Canadian businesses be internationally competitive. To sustain competitiveness, Canada must have a tax system that, in its overall impact, is generally in step with the systems of major competing jurisdictions.
This need to balance tax fairness with competitiveness is reflected in the specific mechanism that is proposed to implement this part of Budget 2007's international tax package-a mechanism to prevent companies from obtaining two or more tax deductions for the same expense.
In broad terms, it is proposed that a deduction not be allowed in Canada in respect of interest relating to investments in foreign affiliates in those situations where the corporate group in question is entitled to deduct the same or an equivalent expense elsewhere. This addresses the double dip structure depicted in Figure 1 and resolves some other forms of tax avoidance such as the tower structure depicted in Figure 2.
An indicator of the duplication of a deductible expense is the recharacterization of the passive income of a foreign affiliate of the taxpayer, or of a foreign affiliate of a related person, as active business income, such that it can be returned to Canada as exempt surplus (or taxable surplus, if it was earned in a non-treaty country).
More specifically, it is proposed that interest on borrowed funds that a corporation resident in Canada uses to finance a foreign affiliate be non-deductible to the extent that any foreign affiliate that is a member of the same corporate group has interest income that has been recharacterized as active business income and that is traceable to the Canadian interest. Where the recharacterized income has borne foreign tax, the interest will be deductible in proportion to the foreign tax rate. That is, a grossed-up amount of the tax, representing the amount of income that would have generated that amount of tax had the foreign jurisdiction applied a Canadian tax rate, will continue to support deductibility in Canada.
The Government recognizes that this is a complex area of taxation. To ensure a comprehensive consideration of the factors involved and a smooth implementation, a Technical Roundtable of tax experts, chaired by the Department of Finance, will be created to provide input in the development of the enabling legislation. Tax professionals will be invited to work with government officials at a technical level to ensure that the proposal functions as it is intended. This Roundtable is a short-term, specific project that will operate independently of the Expert Panel.
The attached description sets out the operation of this proposal in more detail.
The Government proposes to make the measures described here applicable to interest payable on or after January 1, 2012.
No distinctions will be made under the transitional relief to transactions on or about Budget day, or based on arm's length versus non-arm's length debt. The transitional relief will thus provide almost five years for Canadian businesses to adjust to the new rules.
Canada's international tax regime has important implications for Canadian-based businesses, as well as for the fairness and competitiveness of the tax system as a whole. These measures take important steps toward improving the international tax rules. But in a world where international business and investment are increasingly complex and rapidly evolving, it is essential that Canada's system keep pace. That is why the proposals include plans for an advisory panel of experts to undertake further study and consultations, with a view to building on the measures in the March 2007 budget, and identifying additional measures to improve the fairness and competitiveness of Canada's system of international taxation. The panel will be asked to produce an interim report by the end of 2007 and a final report in 2008.
An announcement will be made soon outlining the mandate and composition of the panel.
Technical Description of Mechanism to Implement the Anti-Tax-Haven Initiative to Constrain Inappropriate Tax Planning Structures to Finance Foreign Affiliates
It is proposed that the following mechanism, to implement the March 19, 2007, budget proposals concerning the deductibility of interest expense on debt used to finance foreign affiliates, replace the mechanism set out in paragraphs (24) to (29) of the Notice of Ways and Means Motion to Amend the Income Tax Act that was tabled with that budget.
(1) That, notwithstanding the general rules applicable to the deductibility of interest, no deduction be allowed in computing the income of a corporation for a taxation year for interest relating to investments in foreign affiliates that is paid or payable in respect of a period that begins after 2011, to the extent of the corporation's double dip income for the taxation year.
(2) That a corporation's interest relating to investments in foreign affiliates include the amount, if any, by which
(a) interest (and other borrowing costs) in respect of
(i) borrowed money that is used to acquire a share or indebtedness of, is used to lend to or to contribute to the capital of, or is otherwise used, directly or indirectly, for the purpose of earning income from, a corporation that is a foreign affiliate of the corporation or of a person or partnership that does not deal at arm's length with the corporation,
(ii) borrowed money that may reasonably be considered (having regard to all the facts and circumstances) to have been used to assist, directly or indirectly, a particular person or partnership with whom the corporation does not deal at arm's length, to acquire a share or indebtedness of, to lend to or to contribute to the capital of, or otherwise to earn income from, another corporation that is a foreign affiliate of
(A) the particular person or partnership, or
(B) another person or partnership that is related to the particular person or partnership or does not deal at arm's length with the corporation, and
(iii) an amount payable for property that is a share or indebtedness of, or other interest in, another corporation that is a foreign affiliate of the corporation, or of a person or partnership that does not deal at arm's length with the corporation,
(b) interest received or receivable by the corporation in respect of indebtedness that is referred to in clause (a).
(3) That the "double dip income" of a corporation for a taxation year be the amount determined by the formula
A - B
A is the total of all amounts determined in respect of a share of the capital stock of a foreign affiliate that is owned by the corporation at any time in the taxation year each of which is a percentage of the recharacterized income of a foreign affiliate of the corporation, which percentage is equal to the share's participating percentage in respect of that foreign affiliate, and
B is the amount determined by the formula
C x D
C is the total of all amounts each of which is the amount of foreign income taxes that can reasonably be considered to have been paid in respect of an amount of recharacterized income of a foreign affiliate included in A, and
D is the corporation's relevant tax factor.
(4) That the "recharacterized income" of a foreign affiliate of a corporation be the total of all amounts each of which is that portion of an amount included under paragraph 95(2)(a) of the Act in computing the active business income of the foreign affiliate that is attributable to a specified debt owing to the foreign affiliate.
(5) That the "participating percentage" of a particular share owned by a corporation of the capital stock of another corporation in respect of a foreign affiliate of the corporation, in respect of the recharacterized income of the foreign affiliate, be determined in the same manner that the "participating percentage" of a particular share owned by the corporation of the capital stock of another corporation in respect of a controlled foreign affiliate of the corporation is, in respect of the foreign accrual property income of the controlled foreign affiliate, determined.
(6) That a "specified debt" owing to a foreign affiliate of a corporation be a debt owing to the foreign affiliate that arose as part of a series of transactions or events that included, and can reasonably be considered to have been funded by the proceeds of, indebtedness interest in respect of which is included in the interest relating to investments in foreign affiliates of the corporation or of a corporation that does not deal at arm's length with the corporation.
(7) That where, for any particular taxation year, the amount of a particular corporation's interest relating to investments in foreign affiliates exceeds the amount of the particular corporation's double dip income, and another corporation that was related to the particular corporation at any time in a taxation year of the other corporation that ends in the particular corporation's taxation year, has for that other corporation's taxation year double dip income that exceeds its interest relating to investments in foreign affiliates, the lesser of the other corporation's excess double dip income and the particular corporation's excess interest relating to investments in foreign affiliates be deemed to be double dip income of the particular corporation for the particular taxation year and not to be double dip income of the other corporation.
(8) That, where a non-resident corporation is considered to be a foreign affiliate of a partnership, the income of the partnership be determined in a manner consistent with the rules in paragraphs (1) to (7).- News Release 2007-041 -