TAX: An Introduction to Nationwide - Canada
Aird & Berlis LLP International Tax Measures Introduced in Canada’s Budget 2021
In the last year, Canada has demonstrated its commitment to international tax reform. Significant changes to cross-border tax rules were contemplated before COVID-19, and the growing cost of the pandemic has further motivated this pursuit. Canada’s first federal budget in more than two years (“Budget 2021”), proposed to introduce numerous international tax measures to better align legislation with global norms and to build upon the minimum standards set out in the Base Erosion and Profit Shifting (“BEPS”) Action Plan developed by the Organisation for Economic Co-operation and Development (“OECD”). The following proposed measures announced in Budget 2021 will have the greatest impact on multinational groups.
Transfer Pricing Consultation
In Budget 2021, the Government announced its intention to consult with stakeholders to improve Canada’s transfer pricing rules. Canada’s focus on the transfer pricing regime is largely in response to the Federal Court of Appeal decision in Canada v Cameco Corporation, 2020 FCA 112 (leave to appeal to the Supreme Court of Canada denied), which in the Government’s view brought to light the shortcomings of the transfer pricing provisions. The consultation paper is expected to lead to several changes to the legislation, including the codification of transfer pricing methodologies to better align with what is seen in other jurisdictions, an increase in audit powers and disclosure requirements, stronger specific anti-avoidance rules and recharacterization rules, and harsher penalties. The consultation paper has not been released as of this writing.
Hybrid Mismatch Arrangements
Hybrid mismatch arrangements arise in a cross-border context where the tax treatment of certain entities or financial instruments is different in the relevant countries resulting in inconsistent and beneficial tax treatment. Canada has proposed to introduce measures in two phases to address these arrangements, as recommended in the Action 2 Report of the BEPS Action Plan. Canada’s new measures would deny the deductibility of payments made by Canadian residents where the amount is not included in the ordinary income of the recipient or to the extent it gives rise to a further deduction in another country. Similarly, to the extent that interest paid by a non-resident entity was deductible for foreign income tax purposes, it will not be deductible in computing the income of a Canadian resident. To the extent that a payment to a Canadian by a non-resident entity is deductible by the non-resident for foreign income tax purposes, the Canadian recipient must include the amount in its income and the amount will not be available for a deduction. Draft legislation, which is expected to be mechanical and apply regardless of the relationship between the parties, has not been released as of this writing.
Consultation on Avoidance Rules
Canada reiterated a plan to launch a consultation and review of all specific and general anti-avoidance rules contained in the Income Tax Act (Canada). One of the motivations for this review is the failed attempt by the Canada Revenue Agency to apply the general anti-avoidance rule (the “GAAR”) to deny treaty benefits to taxpayers in certain transactions, as seen in the taxpayer’s recent success at the Supreme Court of Canada in Canada v Alta Energy Luxembourg S.A.R.L., 2021 SCC 49 [Alta Energy]. In Alta Energy, the majority of the Supreme Court of Canada held that treaty shopping is not inherently abusive and that Canada made deliberate choices in negotiating the Canada-Luxembourg tax treaty for the purpose of attracting foreign investment in Canada, implicitly accepting all the foreseeable circumstances that would or could arise as a result of the bargain it struck.
While the taxpayer’s success in Alta Energy is a welcome development, the impact of the decision must be considered in light of Canada’s adoption of the principal purpose test, amended pre-amble, minimum standard and certain other modifying provisions in the OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”).
Interest Barrier Rule
Canada has proposed an interest barrier to be consistent with the best practices recommended in the BEPS Action Plan and the interest barriers introduced by other members of the G7 and the European Union member states. The new rule will limit deductible net interest expense to a fixed ration of “tax EBITDA” (taxable income before interest expense, interest income, income tax, and deductions for depreciation and amortization). The interest barrier will be phased in, with the limit being 40% of tax EBITDA for taxation years beginning on or after January 1, 2023 and 30% of tax EBITDA for taxation years beginning on or after January 1, 2024.
Digital Services Tax
In Budget 2021, Canada proposed to implement a 3% Digital Services Tax (“DST”) on revenue from certain digital services which rely on data and content contributions from Canadian users. Certain revenue thresholds would need to be met for the DST to apply. This measure is set to come into force on January 1, 2024 (retroactive in respect of revenues earned as of January 1, 2022). However, the DST is only intended to be an interim measure pending the OECD settling on a more permanent solution as contemplated in the two-pillar approach to address the tax challenges that arise from the digitalization and globalization of the economy. Ambitiously, Pillar One is targeted to come into force in 2023, and a multilateral instrument to implement Pillar Two is expected to be released by mid-2022. Canada has said it intends to proceed with the DST until the OECD’s two-pillar approach is further developed and implemented.
Mandatory Disclosure Rules
In Budget 2021, Canada proposed to revamp its mandatory disclosure rules. The disclosure rules for reportable transactions will apply where one of the following hallmarks is present: (a) contingency fees; (b) confidential protection required by the promoter or tax advisor; and (c) contractual protection for the taxpayer such as insurance or an undertaking by the promoter or advisor (under the current rules, two hallmarks are required). There will also be a prescribed list of notifiable transactions that will require reporting regardless of whether the hallmarks listed are present. Canada has also proposed a new reporting regime for uncertain tax treatments in an entity’s income tax filings, which will target public corporations and private corporations that choose to prepare financial statements in accordance with IFRS, and that meet an asset threshold of CAD50 million. The revamped mandatory disclosure rules would apply to taxation years that begin after 2021. To the extent the proposed rule applies to transactions, the amendments would apply to transactions entered into on or after January 1, 2022.
Canada’s Budget 2021 proposes ambitious tax measures, which are subject to change following consultations with stakeholders, the parliamentary process and changing best practices around the world. Taxpayers that may be affected by any of these measures should watch the legal developments closely and seek guidance on how best to proceed in the evolving landscape.