Download Fiscal Fact No. 334: Canada’s Experience with Territorial Taxation
This is the first case study in a series on territorial taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. systems in other countries. The intent of the study is to see what lessons the U.S. can learn from other countries’ experiences and to evaluate the validity of some of the fears critics express when discussing what would result if the U.S. were to move to a territorial system.
“It is important to ensure that Canada’s system of international taxation continues to promote the competitiveness of Canadian businesses internationally and to attract new foreign investment to Canada.”—Advisory Panel on Canada’s System of International Taxation, 2008
Canada generally exempted all foreign source income from tax until 1976,[1] when it adopted foreign affiliate rules that exist, though modified, to this day. These rules fully exempt from tax all dividends derived from active income earned by an affiliate if the affiliate resides in a country with which Canada maintains a tax treaty.[2] Because the treaty network now encompasses 91 countries and all major trading partners, the Canadian system is, in practice, a territorial system. It is often referred to as a “hybrid system,” however, because income earned in non-treaty countries is taxed on a current basis.[3]
All passive income is treated as Foreign Accrued Property Income (FAPI), which is a classification modeled after U.S. Subpart F. As the primary base-erosion measure, FAPI rules classify interest, royalties, rent, other passive investment income, and income of unincorporated foreign branches as taxable.[4] Regardless of whether the profits are repatriated, FAPI income is taxed on a current basis, in order to mitigate the tax advantage of shifting domestic income to low-tax jurisdictions.[5] The other major anti-erosion measures are the typical limits on the deductibility of interest paid by a Canadian corporation to foreign affiliates and transfer pricing rules.[6]
Despite its very competitive system, Canada has not slowed its efforts to continually improve its tax competitiveness. Since 1998, its combined corporate tax rate has been lowered from 42.9 percent to 26.1 percent.[7] In 2007, it adopted rules to apply the dividend exemption to affiliates in countries with a bilateral Tax Information Exchange Agreement (TIEA),[8] and the government’s 2008 “Advisory Panel on Canada’s System of International Taxation” recommended that the existing exemption system be expanded further to cover all active foreign business income.[9] Further, recognizing that foreign investment yields benefits to the home economy, Canadian officials actively facilitate foreign investment by Canadian companies.[10]
Data
In spite of fears that foreign investment displaces domestic investment to the detriment of the home economy, the case of Canada demonstrates that foreign engagement, territorial taxation, and competitive tax rates can promote better economic performance. Canada’s economy has grown at an average real rate of 2.61 percent since 1995, which is 0.2 points stronger than the U.S. average and 0.4 point stronger than the OECD average.[11]
This has translated into more jobs in the Canadian economy. Unemployment has trended downward since the 1980s, and the Canadian labor force was not as affected by the global recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. as was the U.S. labor force. As of 2011, the unemployment rate in Canada sat 1.5 points below the U.S. rate (Figure 1, above).
The most remarkable lesson from Canada is that territorial systems are capable of yielding substantial and consistent tax revenues, even through periods of recurring tax cuts (Figure 2, above). Canada has lowered its tax rate from 42 percent to 26.1 percent since 2000, yet corporate tax revenues have tended to grow faster than GDP. The Canadian territorial system has consistently out-collected the U.S. worldwide system despite higher tax rates in the U.S.
[1] The rules were adopted in 1972 but were not implemented until 1976. See Advisory Panel on Canada’s System of International Taxation, Enhancing Canada’s International Tax Advantage, at 13, http://www.apcsit-gcrcfi.ca/07/cp-dc/pdf/finalReport_eng.pdf.
[2] Under new legislation, the exemption also applies to affiliates residing in a country with which Canada shares a Tax Information Exchange Agreement (TIEA). See Advisory Panel on Canada’s System of International Taxation, Enhancing Canada’s International Tax Advantage, at 13-14, http://www.apcsit-gcrcfi.ca/07/cp-dc/pdf/finalReport_eng.pdf.
[3] Michael Smart, RepatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. taxes and foreign direct investment: Evidence from tax treaties, at 2, http://www.sbs.ox.ac.uk/CENTRES/TAX/SYMPOSIA/Documents/2010/05%20Smart.pdf.
[4] Foreign branches are not separate legal entities from the domestic parent company and in many systems, foreign branch income is treated as domestic income. Foreign branch arrangements are less common than parent-subsidiary relationships.
[5] Natural Resources Canada, Canadian International Income Tax Rules, http://www.nrcan.gc.ca/minerals-metals/business-market/3854.
[6] Joint Committee on Taxation, Background and Selected Issues Related to the U.S. International Tax System and Systems that Exempt Foreign Business Income (May 20, 2011), at 19, http://www.jct.gov/publications.html?func=startdown&id=2793.
[7] OECD, Basic (non-targeted) corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rates (2011), www.oecd.org/dataoecd/26/56/33717459.xls.
[8] As of January 2012, there were 15 TIEAs in effect, bringing the number of countries subject to territorial treatment up to 106. See Kevin Fritz & Deepti Asthana, Canadian Tax Treaty and TIEA Update, Wildeboer Dellelce LLP Tax Law Update (Jan. 2012), http://www.wildlaw.ca/resources/contentfiles/wildeboerdellelce/websitecontent/publications/canadian-tax-treaty-and-tiea-update/downloadableversion/Tax%20Law%20Update%20-%202012%20January.pdf.
[9] Advisory Panel on Canada’s System of International Taxation, Enhancing Canada’s International Tax Advantage, at 16, http://www.apcsit-gcrcfi.ca/07/cp-dc/pdf/finalReport_eng.pdf.
[10] Conference Board of Canada, Direct Investment Abroad: A Strategic Tool for Canada (Jan. 2011), at 2, http://www.conferenceboard.ca/e-Library/abstract.aspx?did=3958.
[11] Author’s calculations. Data from OECD Statistics, http://www.oecd.org/statistics/.
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