NAFTA Tax Law and Policy: Resolving the Clash between Economic and Sovereignty Interests 9781442683822

Table of contents :
Contents
Tables
Preface
CHAPTER 1. Introduction
PART I. THE CURRENT REGIME
CHAPTER 2. Background Issues
CHAPTER 3. The Tax Systems
CHAPTER 4. Tax Coordination
PART II. THE ECONOMIC STAKES
CHAPTER 5. Taxes and Cross-Border Investments
CHAPTER 6. The Impact of U.S. Dividend Tax Reform
PART III. SOVEREIGNTY CONCERNS
CHAPTER 7. Lessons from Europe
CHAPTER 8. E-Commerce Tax Policy
PART IV. DEVELOPING AN INTERNATIONAL TAX POLICY FOR NAFTA
CHAPTER 9. Balancing Economic and Sovereignty Interests
CHAPTER 10. Modelling NAFTA Tax Competition
CHAPTER 11. Recommendations
CHAPTER 12. Conclusion
Notes
Select Bibliography
Index

Citation preview

NAFTA TAX LAW AND POLICY: RESOLVING THE CLASH BETWEEN ECONOMIC AND SOVEREIGNTY INTERESTS

Under the North American Free Trade Agreement (NAFTA), Canada, the United States, and Mexico continue to maintain their own distinct tax regimes, jealously guarding their sovereign right to do so. At times, these different tax systems harm the economic welfare of the trade bloc by imposing barriers to cross-border flows of capital. In NAFTA Tax Law and Policy, Arthur J. Cockfield analyses these different tax systems and proposes a number of recommendations to reduce the harm caused by these barriers. Cockfield argues that it is unrealistic to expect the NAFTA countries to negotiate comprehensive reform efforts such as full-fledged tax harmonization. Rather, a strategy of heightened multilateral tax coordination is the appropriate solution as it permits the countries to maintain national tax differences, while addressing many of the problems created by the interaction of the tax regimes. The NAFTA countries should promote binding arbitration for transfer pricing disputes, multilateral tax treaty negotiations, the elimination of parent/subsidiary dividend withholding taxes, and enhanced administrative cooperation to reduce tax compliance costs for multinational firms. Only then can NAFTA function in the way it was designed to. arthur j. cockfield is an associate professor in the Faculty of Law at Queen’s University.

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NAFTA Tax Law and Policy Resolving the Clash between Economic and Sovereignty Interests

ARTHUR J. COCKFIELD

UNIVERSITY OF TORONTO PRESS Toronto Buffalo London

© University of Toronto Press Incorporated 2005 Toronto Buffalo London Printed in Canada ISBN 0-8020-3581-7

Printed on acid-free paper

Library and Archives Canada Cataloguing in Publication Cockfield, Arthur J. NAFTA tax law and policy : resolving the clash between economic and sovereignty interests / Arthur J. Cockfield. Includes bibliographical references and index. ISBN 0-8020-3581-7 1. Taxation – Law and legislation – North America. 2. Fiscal policy – North America. 3. Double taxation – North America – Treaties. 4. North America – Economic integration. 5. Free trade – North America. I. Title. KDZ911.C62 2005

343.705’26

C2004-906361-8

This book has been published with the help of a grant from the Canadian Federation for the Humanities and Social Sciences, through the Aid to Scholarly Publications Programme, using funds provided by the Social Sciences and Humanities Research Council of Canada. University of Toronto Press acknowledges the financial assistance to its publishing program of the Canada Council for the Arts and the Ontario Arts Council. University of Toronto Press acknowledges the financial support for its publishing activities of the Government of Canada through the Book Publishing Industry Development Program (BPIDP).

Contents

tables

xiii

preface

xv

1 Introduction 1 The Clash between Economic and Sovereignty Interests 2 Increasing Cooperation on Tax Coordination 3 Regulatory Emulation in Three-Player Game 4 Outline of the Book

3 4 5 5 6

PART I. THE CURRENT REGIME 2 Background Issues 1 Introduction 2 Economic Concerns 2.1 Background 2.1.1 Emphasis and Scope of Study: Broad Review of Cross-Border Investment Patterns 2.1.2 Trade and Investment within North America 2.2 Tax Distortions 2.3 Tax Competition 2.4 Tax Discrimination 2.5 Tax Arbitrage and Transfer Pricing 2.6 International Double Taxation 3 Political Concerns 3.1 Tax Sovereignty 3.2 Tax and Domestic Policy Goals

11 11 11 11 11 13 15 16 16 16 17 18 18 18

vi Contents

3.3 International Tax Policy Principles and Goals 4 Conclusion

20 21

3 The Tax Systems 1 Introduction 2 Difference in the Tax System 2.1 Tax Reform Efforts 2.2 Differences in Tax Provisions 2.2.1 Taxation of Individuals 2.2.2 Taxation of Corporations 2.3 Tax Incentives 3 Subnational Taxation 4 International Aspects 4.1 Double Taxation Relief 4.2 Transfer Pricing 4.3 Anti-Avoidance Rules 4.3.1 Thin Capitalization Rules 4.3.2 Controlled Foreign Corporation (CFC) Rules 4.4 International Consumption Taxes 5 Conclusion

22 22 22 22 23 28 29 33 34 37 37 39 41 42 43 44 45

4 Tax Coordination 1 Introduction 2 NAFTA and Taxation 2.1 Tax Treatment of Goods 2.2 Taxes on Services 2.3 Conditional Tax Benefits 2.4 NAFTA and Tax Treaties 3 Tax Treaties in North America 3.1 The Purpose of Tax Treaties 3.2 Historical Review of Tax Coordination in North America 3.2.1 Canada-United States Tax Coordination 3.2.2 Tax Coordination with Mexico 3.3 Comparative Review of Tax Treaties 3.3.1 Taxes Covered 3.3.2 Residence 3.3.3 Business Profits 3.3.4 Permanent Establishment 3.3.5 Dividends 3.3.6 Interest

46 46 46 46 47 48 49 49 49 50 50 51 52 52 52 53 54 55 56

Contents vii

3.3.7 Royalties 3.3.8 Capital Gains and Corporate Reorganizations 3.3.9 Anti-Treaty Shopping Provisions 3.3.10 Anti-Discrimination Provision 3.3.11 Mutual Agreement 3.3.12 Exchange of Information 3.3.13 Enforcement of Tax Claims 3.4 The Limitation of Tax Treaties 4 Conclusion

57 57 58 59 59 60 60 61 65

PART II. THE ECONOMIC STAKES 5 Taxes and Cross-Border Investments 1 Introduction 2 The Importance of Foreign Investment within North America 2.1 Investment Flows and the NAFTA Countries 2.2 Competition for Investment and NAFTA Rules of Origin 3 Does Tax Influence the Movement of Foreign Direct Investment? 3.1 FDI Is Influenced by a Number of Non-Tax Factors 3.2 Taxes and FDI Movements 4 Measuring the Influence of Taxes on Investment Decisions 4.1 Why Use Taxes on Marginal Investments? 4.2 The Theory of Effective Tax Rates 4.3 Calculating the Effective Tax Rate 4.4 Problems with Marginal Effective Tax Rate Studies 5 Studies of the NAFTA Tax Systems 5.1 Marginal Effective Tax Rate Studies of Canada and the United States 5.2 Marginal Effective Tax Rate Studies for All NAFTA Countries 5.3 Capital Risk Analysis Study Involving Canada and the United States 6 Conclusion 6 The Impact of U.S. Dividend Tax Reform 1 Introduction 2 Capital Market Integration between Canada and the United States

69 69 69 69 72 73 74 74 75 75 76 77 77 80 80 82 84 85 87 87 87

viii Contents

3 Dividend Tax Reform in the United States 3.1 Background: U.S. Anti-Tax Sentiments and Sources of Tax Revenues 3.2 The Jobs and Growth Reconciliation Act of 2003 4 The Impact of U.S. Dividend Tax Reform on Canada 4.1 The Effect of Previous U.S. Tax Reform Efforts 4.2 Impact of Tax Reform on Canadian FDI Flows 4.2.1 Comparing the Tax Burdens after the Reform Efforts 4.2.2 Mitigating Factors 4.2.3 The Impact on Canadian Direct Investment Flows 4.3 Impact on Financial Strategies 4.3.1 Increasing Dividend Distributions 4.3.2 Debt Financing of Canadian Affiliates 4.3.3 Manipulation of Transfer Prices 5 Canadian Reaction to U.S. Dividend Tax Reform 5.1 Economic Integration and Canadian Tax Reform 5.2 Matching and Undercutting U.S. Tax Changes 6 Conclusion

88 88 90 92 92 92 92 94 96 96 97 97 98 99 99 100 101

PART III. SOVEREIGNTY CONCERNS 7 Lessons from Europe 1 Introduction 2 European Economic Integration and Tax Harmonization 2.1 The Movement towards Political and Economic Integration in Europe 2.2 Tax Harmonization in Europe 2.2.1 Harmonization of Direct Taxes 2.2.2 The Establishment of the Ruding Committee 2.2.3 Recent Developments: Harmful Tax Competition, Corporate Tax Base Consolidation, and European Court of Justice Decisions 2.2.4 Harmonization of Indirect Taxes 2.2.4.1 Legislative Impetus for Harmonizing Indirect Taxes 2.2.4.2 Abolition of Barriers to Trade Caused by the VAT 3 The Drive towards Economic Integration under NAFTA 3.1 Why Have Free Trade within North America? 3.2 The Institutional Structure of NAFTA

105 105 105 105 108 108 110

112 114 114 114 116 116 118

Contents ix

3.3 Comment on the Institutional Structure of NAFTA 4 The Loss of Sovereignty under NAFTA Tax Harmonization 4.1 Tax as a Policy Tool to Pursue Distinct Socio-Economic Objectives 4.2 Different Revenue Objectives within North America 4.3 The Need to Reform Non-Tax Laws 4.4 Tax Harmonization with a Big Player 5 Conclusion 8 E-Commerce Tax Policy 1 Introduction 2 Taxing Cross-Border E-Commerce Profits 2.1 Technology as a Catalyst for Economic Integration 2.2 Background Reform Efforts 2.3 Computer Servers as Permanent Establishments 2.4 Evaluating the New Rule 2.5 Towards an Economic Presence Test for Income Tax Purposes 3 Enforcing GST and VAT Rules on E-Commerce Sales 3.1 The GST and Collection Obligations 3.2 Revenue Losses and Lack of a Competitive Playing Field 3.3 Developing Economic Presence Tests for the GST 3.4 Tax Cooperation in a Free Trade Area 4 Using Internet Technologies for Tax Purposes 5 Conclusion

113 120 120 121 124 124 126 128 128 129 129 129 131 132 133 134 134 135 137 139 140 141

PART IV. DEVELOPING AN INTERNATIONAL TAX POLICY FOR NAFTA 9 Balancing Economic and Sovereignty Interests 1 Introduction 2 Economic Interests 2.1 Distortion of Direct Investment Flows 2.2 The Use of Tax Incentives 2.3 Transfer Pricing Issues 2.4 Trade Flows 2.5 Comment on the Economic Interest 3 The Sovereignty Interest 3.1 Sovereignty as a Driver of International Tax Developments

145 145 145 146 147 148 149 150 150 150

x Contents

3.2 Lessons from Europe Revisited 3.3 Sovereignty Concerns in North America 3.4 Tax Reform Initiatives under NAFTA 3.4.1 Do Nothing 3.4.2 Comprehensive Tax Reform Efforts 4 Towards Heightened Multilateral Coordination 5 Conclusion

151 152 153 154 155 157 158

10 Modelling NAFTA Tax Competition 1 Introduction 2 Tax Competition: Theory versus Reality 2.1 Tax Competition among Subnational Governments 2.2 Theories on International Tax Competition 2.3 Harmful versus Fair International Tax Competition 3 Regulatory Emulation 3.1 Tax Competition with One Big Player 3.2 The Canadian and Mexican Approach 3.3 The United States and Its ‘Go It Alone’ Approach 4 A Game Theory Perspective on NAFTA Tax Competition 4.1 General Observations 4.2 Modelling NAFTA Tax Competition 4.3 Lessons from the Model 4.4 Limitation with the Analysis 5 Conclusion

160 160 160 160 162 163 164 164 164 165 166 166 167 169 173 174

11 Recommendations 1 Introduction 2 Policy Recommendations 2.1 NAFTA Tax Working Group 2.2 Harmonize Treaty Policy 2.3 Arbitration Procedure for Transfer Pricing Disputes 2.4 Abolish Withholding Taxes on Parent/Subsidiary Dividends 2.5 Corporate Mergers and Reorganizations 2.6 Reduction of ‘Harmful’ Tax Competition 2.7 Multilateral Agreement on the GST and VAT 2.8 Improving Administrative Cooperation 3 Conclusion

175 175 175 175 177 178 179 180 181 182 182 183

12 Conclusion

185

Contents xi

notes

191

select bibliography

231

index

245

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Tables

3.1 Differences in tax provisions

24

4.1 Withholding tax rates

62

5.1 Total foreign direct investment

70

5.2 NAFTA direct investment positions

71

5.3 NAFTA direct investment flows

72

5.4 NAFTA marginal effective tax rates (METR)

84

6.1 Sources for total tax revenues (2001)

90

6.2 Canada-U.S. corporate income tax rate comparisons

93

7.1 NAFTA country comparisons (2001)

122

7.2 Fiscal figures for the NAFTA countries (2001)

123

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Preface

The North American Free Trade Agreement (NAFTA) generally permits Canada, the United States, and Mexico to develop and maintain any tax system they wish. Under NAFTA, these countries continue to control their own tax destinies to meet domestic economic and social goals, despite a growing belief that national tax differences are harming the ability of North America to reach its full economic potential, particularly with respect to cross-border investment flows. The purpose of this book is to offer a first comprehensive attempt to determine an appropriate international tax policy approach under NAFTA, taking into account the current regime, the economic stakes, and sovereignty concerns. The road to publication was a long one. It began when I worked as a lawyer in Toronto in the early 1990s. During this period, I gained an appreciation of how taxes can impede investments between Canada and the United States. The fact that tax differences can deter or distort crossborder investment flows seemed odd in light of the free trade agreement struck between these two countries. With the announcement of an expanded deal that included Mexico, I decided to concentrate on this issue through doctoral studies at Stanford University, which were completed in 1998. Many thanks must go to my dissertation committee: Tom Heller and Joe Bankman from Stanford and Jack McNulty from the University of California, Berkeley. I am also grateful for the financial support provided by a Stanford University Littlefield Graduate Fellowship and an Organization of American States Training Fellowship. The writing of this book involved a significant revision of the dissertation and the addition of three new chapters. The book also reflects my research efforts as a law professor at Thomas Jefferson School of Law in San Diego from 1998 to 2001: I benefited from the fact that San Diego

xvi Preface

borders Mexico, bringing me into contact with Mexican tax scholars and lawyers. In recent years, my research has been supported by discussions with Canadian colleagues and policy makers. I would like to thank Walter Hellerstein, Robin Boadway, Tim Edgar, Charles McLure, Jr, Jinyan Li, Mitchell Kane, Brian Arnold and an anonymous referee for comments on chapters from earlier drafts. Responsibility for any errors remains with the author. Finally, many thanks must go to my spouse, Mariah, for her love and support, as well as thanks for the joy derived from our sons, Arthur, Jack, and William.

NAFTA TAX LAW AND POLICY: RESOLVING THE CLASH BETWEEN ECONOMIC AND SOVEREIGNTY INTERESTS

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CHAPTER 1

Introduction

The proprietor of stock is necessarily a citizen of the world ... He would be apt to abandon the country in which he was exposed to a vexatious inquisition, and would remove his stock to some other country where he could either carry on his business, or enjoy his fortune more at his ease ... A tax which tended to drive away stock from any particular country, would so far tend to dry up every source of revenue, both to the sovereign and to the society. Adam Smith, Wealth of Nations (1776)1 Capital markets in OECD countries are increasingly integrated as Member countries have removed controls on international investment and foreign exchange regulations. At the same time, the proportion of international activities accounted for by large multinational enterprises has increased ... Differences in the taxation of corporate profits may now be one of the few remaining potential barriers to a better international allocation of capital. OECD, Taxing Profits in a Global Economy (1991)2

These warnings carry a message of great importance to countries participating in regional economic integration. On 1 January 1994, Canada, the United States, and Mexico implemented the North American Free Trade Agreement (NAFTA) – creating the largest regionally integrated trade and investment area in the world – to promote their economic interests by lowering barriers to international trade and investment.3 NAFTA strives in part to create an integrated North American capital market where individuals and firms can invest in the most productive businesses. However, as noted in the two excerpts reproduced above,

4 NAFTA Tax Law and Policy

national tax differences are thought to harm or inhibit cross-border investment flows. Sometimes companies in North America decide not to invest in another NAFTA state because the tax cost is prohibitively high. At other times, tax influences business people to invest in unproductive cross-border activities. Consider a hypothetical tax incentive to encourage investment in Florida swamp land: a Canadian investor might undertake this investment for tax reasons rather than any real economic rationales. In addition, firms are sometimes taxed twice by governments on the same cross-border profits, creating international double taxation and discouraging such ventures. The most straightforward way to resolve the problem would be for the NAFTA countries to agree to adopt the same tax systems: tax laws would need to be altered to unify the different North American tax rates and tax bases – a process referred to as ‘tax harmonization.’ Yet the NAFTA deal is almost silent with respect to taxation measures. For the most part, the tax treatment of cross-border flows remains governed by bilateral tax treaties negotiated between the NAFTA states. This occurs despite a growing belief that tax differences inhibit the ability of North Americans to reap the full economic benefits of regional integration. 1 The Clash between Economic and Sovereignty Interests Why does NAFTA permit national tax differences to remain a barrier to cross-border trade investment flows? The answer lies in the unique place that tax policy plays in a nation’s fortunes: taxation is intensely political. The citizens and governments of each NAFTA state have different views on how much tax should be collected to pay for government services such as schools, roads, and the military. Tax regimes also promote different social and economic agendas, like wealth redistribution.4 Governments jealously protect their sovereign right to maintain tax differences despite the growing economic cost of doing so, creating a clash between economic and sovereignty interests. This clash reflects the dynamic tension inherent in globalization. In 1944, the economic historian Karl Polanyi wrote that a ‘double movement’ propels modern society.5 On the one hand, governments seek to better the lives of their citizens by increasing economic prosperity through heightened ties with other countries. On the other hand, as market forces expand they constrain governmental policy making and people demand that their governments protect them from the socially disruptive effects of these market forces.

Introduction 5

2 Increasing Cooperation on Tax Coordination This book seeks to explain how the tensions inherent in globalization play out with respect to potential tax reform efforts in a regionally integrated free trade area. My analysis suggests that an arrangement for freer trade and investment ought to be complemented by a policy of heightened multilateral tax coordination to reduce the harmful effects of maintaining tax differences. In the short term, the NAFTA governments should alleviate many tax barriers faced by highly integrated North American firms by promoting, among other things, binding arbitration for transfer pricing disputes, multilateral tax treaty negotiations, the elimination of parent/subsidiary dividend withholding taxes, and mechanisms to reduce tax compliance costs. The longer term strategy involves the creation of a NAFTA Tax Working Group to study how tax differentials are harming the economic welfare of NAFTA and to consider reform measures to address these concerns. None of these proposals would place undue restrictions on the tax autonomy of the NAFTA states, and they would provide an important starting point for addressing the problems created by the interaction of the NAFTA tax regimes. In addition to sovereignty concerns, a number of other factors support the view that an incremental approach towards enhanced multilateral tax coordination is the appropriate international tax policy position for the NAFTA countries. The current similarity in tax burdens on North American cross-border investment flows suggests that these flows are not being unduly distorted by tax measures; there is no evidence that tax competition is leading to reduced tax revenues; no empirical studies have tried to quantify the welfare losses associated with maintaining national tax differences; the NAFTA countries are relatively inexperienced with respect to regional integration, in contrast to regions like the European Union; and the federal systems of Canada and the United States grant constitutional rights to provinces and states to develop their own distinct tax polices, which would frustrate efforts to harmonize at the national level. 3 Regulatory Emulation in a Three-Player Game Beyond these concerns, formal mechanisms like tax harmonization may be inappropriate for NAFTA at this time: in 2002, the United States contributed roughly 86 per cent of North American gross domestic

6 NAFTA Tax Law and Policy

product (GDP), while Canada and Mexico made up 8 per cent and 6 per cent, respectively.6 NAFTA is thus a three-player game in which the tax policy of the one big player exerts a disproportionate economic impact on the two relatively smaller players. In such an environment, the two smaller players pursue a policy of regulatory emulation in many circumstances, amending their tax legislation to follow U.S. tax developments with respect to taxes on highly mobile cross-border factors like capital. In particular, Canada and Mexico strive to ensure they get their fair share of tax revenues from international transactions while maintaining a favourable tax climate for inward investment. These voluntary changes to tax legislation create a situation of de facto tax harmonization in certain circumstances. This follow-the-leader approach may be the most effective response to the tax challenges facing the NAFTA countries. It does not necessitate the development of tax rules that might require an overly bureaucratic and costly centralized structure. Moreover, regulatory emulation, along with the suggested policy of heightened multilateral tax coordination, permits the NAFTA countries to control their tax destinies to the greatest extent possible. Finally, this approach permits Canada and Mexico to choose lower tax burdens on capital in comparison to the burdens imposed by the United States. They are thus presented with an opportunity to engage in limited tax competition without the fear of triggering retaliation by the big player, which is generally oblivious or indifferent to the tax reform efforts by the two smaller economies. This competition will not lead to a so-called race to the bottom, in which tax burdens are reduced to the point where nations have difficulty in raising revenues to pay for public goods and services. As economic interdependency increases among the NAFTA countries a delicate tax policy balance is needed to adapt domestic tax systems to the social, economic, and institutional needs of each country while ensuring that the tax system does not harm the ability to compete for cross-border investments. This is the challenge for the NAFTA countries. 4 Outline of the Book The book is organized as follows. Part I reviews the main concerns that arise from the interaction of the North American tax systems. Chapter 2 thus expands on the scope and focus of the book and highlights the issues under scrutiny; chapter 3 discusses the different tax laws employed

Introduction 7

by the North American governments, and chapter 4 analyses tax coordination under the NAFTA agreement and the three bilateral tax treaties. Part II concentrates on economic concerns. Chapter 5 reviews studies that attempt to measure the potential impact of taxation on cross-border investment decision making, while chapter 6 analyses the potential for tax reform initiated in one country – U.S. dividend tax reform – to promote harmful economic consequences in another. Part III focuses on the tax sovereignty challenges facing the NAFTA countries. Chapter 7 contrasts European struggles to overcome tax sovereignty concerns with the situation under NAFTA; chapter 8 sets out the sovereignty challenges presented by an environment of increased cross-border flows resulting from e-commerce developments. Part IV synthesizes the analysis of previous chapters. Chapter 9 proposes a strategy of heightened multilateral tax coordination as the most appropriate policy response to the economic and sovereignty challenges facing the NAFTA countries; chapter 10 presents a simple game theory model of NAFTA tax competition to demonstrate why comprehensive mechanisms such as tax harmonization are not appropriate for North America; and chapter 11 presents recommendations to promote enhanced tax coordination among the NAFTA countries. The main conclusions are then set out in chapter 12.

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PART I

The Current Regime

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CHAPTER 2

Background Issues

1 Introduction The purpose of this chapter is to discuss the principal economic and political issues that provide the context for this study. The first part reviews the main economic concerns that arise from the interaction of the different tax regimes in the environment of increased economic integration promoted by NAFTA. Attention then turns to the political hurdles that would need to be overcome to address many of these concerns. The chapter concludes with a review of traditional international tax policy principles that often serve as a guide for reform efforts. The main theme of this study, as framed in this chapter, can be succinctly described as follows: countries engaged in regional economic integration must strike a balance between resolving and constraining economic concerns while maintaining tax autonomy to the extent dictated by political reality. 2 Economic Concerns 2.1 Background 2.1.1 Emphasis and Scope of Study: Broad Review of Cross-Border Investment Patterns Under NAFTA, the economic and institutional barriers to cross-border trade and investment flows continue to decline. For example, all tariffs on goods traded among the NAFTA countries will be eliminated by 2008.1 Further, NAFTA contains a number of provisions designed to enhance cross-border investment, including principles of national treat-

12 The Current Regime

ment (that is, non-discrimination with respect to foreign investments) and most-favoured-nation treatment (that is, offering the same investment benefits to a NAFTA country extended to another NAFTA partner).2 As a result, mobile economic factors such as capital, goods, and services move more freely across borders. International investment flows will become increasingly sensitive to barriers created by the different tax rules of the NAFTA countries. There is less concern about the ability of these tax systems to create incentives for labour to migrate from one NAFTA country to another, because NAFTA and immigration laws make it difficult for workers, in contrast to capital or goods and services,3 to easily relocate within North America. As a result, the study focuses on the potential for tax policy to harm investment patterns in North America as a whole rather than reviewing in detail potential labour issues such as the ‘brain drain’ (these issues are briefly addressed in chapter 3). In addition, international trade patterns can be distorted by discriminatory tax measures. The tax regimes of the NAFTA countries distort trade flows through tax subsidies granted to a variety of businesses, including subsidies to companies that export goods, as well as to selected domestic industries.4 Apart from this type of trade distortion, the crossborder tax treatment of goods and services is currently not a major area of concern. Economists generally assert that exchange rates offset the impact of taxes on goods and services, such as Mexico’s value-added tax (VAT) or Canada’s goods and services tax (GST), which are imposed on a destination basis (that is, taxes are placed on imported goods while exports leave the country tax free).5 Both NAFTA and tax treaties contain anti-discrimination provisions which ensure that national and, at times, subnational taxes placed on goods and services do not discriminate against foreign goods and services (see chapter 4). Moreover, as a free trade area, rather than a European-style customs union, NAFTA does not strive to create a truly free flow of goods across borders. Under NAFTA rules, customs officials often stop goods at the border to ensure that they are properly marked as originating from a NAFTA country. Accordingly, there is currently no impetus to remove border tax adjustments in North America. For these reasons, the main emphasis of this study is the impact of taxation on North American crossborder investment patterns. The discussion of the tax treatment of these patterns is, for the most part, general in nature. The tax systems of the NAFTA countries are extremely complex. Tax legislation in Canada and the United States now

Background Issues 13

runs on for literally thousands of pages, and the Mexican tax system is becoming increasingly complex due to tax reform efforts initiated in the 1980s. Myriad tax rules determine the appropriate cross-border tax treatment of different investment strategies and their impact on different assets, industries, and financing alternatives. An entire book, for example, could be written on the cross-border tax treatment of the oil and gas industry in North America. This study also does not take into account, in other than a generalized manner, the sophisticated international tax-planning opportunities available to multinational firms within North America, used to lower corporate income tax burdens by taking advantage of tax differences among the NAFTA countries. The purpose of this first book on NAFTA tax policy is to provide a bird’s-eye view of the main interests and concerns with respect to the interaction of the different North American tax regimes. A drawback of this approach is that the details and complexities involved in the interaction of these regimes are, at times, overlooked. 2.1.2 Trade and Investment within North America The ability of differing national tax systems to wreak economic havoc has received serious attention in Europe for several decades (see chapter 7). Attention is less evident in North America, presumably because of the relative newness of the deal as well as the less ambitious political/social integration agenda set out in NAFTA as compared to the Treaty of Rome. Yet the stakes appear to be high in North America, at least in terms of the size of trade and investment flows among the NAFTA countries. These flows take place within the largest regionally integrated economic bloc in the world, consisting of more than 406 million people who produce over $11 trillion in goods and services.6 Canada is the largest trade partner of the United States, with 2002 exports of US$211 billion and imports of US$161 billion.7 Over 80 per cent of Canadian exports in goods end up in the United States.8 Mexico is the second largest trade partner of the United States, with 2002 exports of US$134 billion and US$98 billion in imports.9 Mexico exports roughly 85 per cent of its goods and services to the United States. Trade between Canada and Mexico has increased roughly threefold from 1994 to 2001: Mexico is Canada’s largest trade partner in Latin America, and Canada has become Mexico’s second-largest export market after the United States. In 2001, Canada exported over Can$6 billion in goods and services while total trade between the two countries exceeded $18 billion.10 To facilitate cross-border trade between Canada

14 The Current Regime

and Mexico, the Canadian government opened a border-crossing office in Nuevo Laredo in 2001. The international investment flows in North America are generally broken down into two main categories: foreign portfolio flows and foreign direct investment (FDI). An example of foreign portfolio investment occurs when a Mexican investor invests in Canadian government bonds or shares in a Canadian company: this type of investment in foreign debt or equity holdings is often sensitive to interest rate fluctuations and can enter and leave a country with the push of a computer button. Alternatively, the Mexican investor can invest in Canada by way of FDI, which typically involves foreign control of the Canadian business entity and may involve the placement of physical assets. FDI tends to be less mobile than portfolio investments and is influenced by many nontax factors such as local infrastructure and management skills. During 2002, FDI inflows to North America totalled roughly US$65 billion.11 In 2001, the total FDI stock (inward plus outward) in North America was US$4.4 trillion.12 FDI flows among the NAFTA countries are becoming increasingly important.13 By 2002, investors within the United States accounted for roughly US$152 billion in FDI in Canada (or almost two-thirds of all of the inward FDI stock in Canada).14 Canadians had invested a total of roughly US$92 billion in U.S. FDI by 2002, an increase from US$72 billion in 1998. Canadian FDI in Mexico has tripled since 1994, reaching Can$3.3 billion in 2002.15 Canada is now the third-ranking foreign direct investor in Mexico. Mexicans invested Can$83 million in FDI in Canada in 2002.16 By 2002, U.S. investors maintained over US$58 billion in FDI within Mexico.17 Investors within the United States increased their annual FDI flows to Mexico to $3.7 billion in 2002. FDI outflows from Mexico to the United States reached US$1.3 billion in 2002, an increase of roughly $500 million from 1998. Due to its economic size, the United States, which constitutes roughly one-third of the world’s capital market,18 exercises a disproportionate role in influencing capital movements in North America through its fiscal policy. Taking these relationships into account, this study focuses at times on the impact of U.S. tax policy on its relatively smaller NAFTA partners instead of reviewing the North American market in its entirety. For example, chapter 6 reviews the impact that U.S. dividend tax reform could have on investment flows to Canada.

Background Issues 15

2.2 Tax Distortions One objective of this study is to estimate the potential economic harm created by distortions to investment flows arising out of the interaction of the different tax regimes of the NAFTA countries. As discussed in chapter 4, NAFTA generally permits member nations to develop and maintain any domestic tax system that they desire. There are notable differences among the NAFTA countries in terms of tax bases, tax rates, and liability for tax (see the discussion in chapter 3). In a closed economy, these differences would not matter because trade and investment would take place within each NAFTA country. In the reality of open economies, however, the national tax regimes interact as trade and investment activity crosses the borders of the NAFTA countries. Differing NAFTA tax regimes may distort investment patterns and reduce overall North American capital productivity. The tax systems of the NAFTA countries were designed, in part, to promote investments in selected activities deemed worthy of promotion by North American legislatures. For example, tax policy is often configured to promote investments in research and development by increasing after-tax returns on these activities. Such polices can cause inefficiency by artificially inflating rates of return on otherwise unprofitable activities. As a result, investment decisions are sometimes undertaken for tax reasons instead of purely economic ones. The different rates of return arising from the tax differentials can influence the amount and direction of the investment patterns within North America, including what types of asset investments are undertaken (for example, investments in machinery rather than buildings) and how these investments are financed (for example, debt instead of retained earnings), as well as which industry to choose from (for example, industrial manufacturing instead of services). This leads to tax distortion, as resources are allocated among the NAFTA countries in a manner that is not considered economically efficient. Such distortion of investment decision making can harm the economy of one NAFTA country by diverting resources to another NAFTA partner. In some cases, this diversion of resources reduces the capital productivity of NAFTA as a whole. Reduced productivity in turn lowers the overall economic welfare or living standards that might otherwise be enjoyed by the citizens of the NAFTA countries. Further, reduced capital productivity may harm the ability of the NAFTA countries to compete with other countries or regionally integrated trade blocs.

16 The Current Regime

2.3 Tax Competition Tax competition occurs within North America to the extent that the NAFTA countries continue to develop their own distinct tax systems. It arises when a government uses its tax system to maximize a pay-off. For example, a NAFTA country could lower its corporate income tax rate to attract mobile economic factors such as capital away from another NAFTA country that imposes relatively less favourable tax treatment on these factors. A ‘race to the bottom’ may develop, as jurisdictions respond to competition by reducing capital income tax burdens in order to compete for foreign investment. Continued rate lowering might ultimately lead to a tax burden insufficient to fulfil the revenue needs of a NAFTA country. In part, the potential for tax competition led a committee of European tax experts to recommend that certain aspects of corporate income taxes be harmonized throughout the European Union (see chapter 7). In addition, beginning in 1997 the European Union and the Organization for Economic Cooperation and Development (OECD) began efforts to constrain so-called harmful tax competition (see chapter 10). 2.4 Tax Discrimination A nation’s tax system can also discriminate against foreign investment and favour domestic investment. For example, Canada offers partial shareholder relief on dividend taxation through a gross-up of dividends received from Canadian corporations along with a dividend tax credit against such shareholders’ federal tax liability. As a result, the Canadian corporate tax system is said to be ‘partially integrated’ in the sense that most corporate profits are only taxed once. Non-resident shareholders of Canadian companies, however, are not permitted the same level of tax relief as resident Canadian shareholders in most circumstances. In effect, the structure of the Canadian corporate tax system discriminates against these non-resident shareholders by increasing their tax burden relative to Canadian shareholders, which may ultimately influence investment decision making. Discriminatory tax treatment is inhibited in many circumstances by tax treaties and the NAFTA deal itself (see chapter 4). 2.5 Tax Arbitrage and Transfer Pricing Differences in tax systems among the NAFTA countries also encourage tax arbitrage when taxpayers attempt to gain tax benefits offered by one country without altering their economic activity in any ‘real’ sense. For

Background Issues 17

example, a company in one NAFTA country can try to increase the price of intercompany transfers on goods being shipped to a subsidiary in another NAFTA country with a heavier tax burden, thereby shifting its accounting profits to the low-tax country. The company’s profits are allocated for tax reasons through this income shifting and do not reflect true economic profitability. Artificial transfer pricing transactions undertaken in order to take advantage of tax differences are generally considered undesirable because they waste business resources and divert revenues away from the treasury of a NAFTA country where the valueadding economic activity took place. In addition, related companies sometimes employ financial strategies to shift income to relatively lower tax jurisdictions. For example, a nonresident company may try to increase interest expense deductions in high tax jurisdictions to reduce taxes payable on domestic source income. Tax rules can be developed to deny the non-resident’s interest deduction unless the expense is related to the production of the domestic source income which is subject to tax. In addition, countries sometimes legislate ‘thin capitalization’ rules to restrict the deductibility of interest payments made by companies to their non-resident shareholders when the payor’s debt-to-equity ratio exceeds a stipulated threshold. Transfer pricing strategies and related-party financial strategies are a particularly sensitive area because, due to a highly integrated business environment, most trade and investment in North America takes place within the same related companies. For example, roughly two-thirds of overall trade, or Can$166 billion, in related-party transactions in 1993 took place between Canada and the United States, while the Canadian government raised less than $20 billion from its corporate income tax system during that year.19 2.6 International Double Taxation As NAFTA multinational firms increase their operations within North America, the problem of taxing corporate activity that takes place in two countries is exacerbated. Each country, with its own tax rules for imposing tax liability, may claim a right to tax the same economic activity, giving rise to international double taxation. International double taxation discourages cross-border trade and investment by punishing economic activity: entrepreneurs will not invest in each others’ countries to the extent they fear the same cross-border activities will taxed by two countries without relief being granted by one of them. The tax treaties negotiated among the NAFTA countries strive to avoid or reduce the risk

18 The Current Regime

for international double taxation, although problems persist in some circumstances (see chapter 4). 3 Political Concerns 3.1 Tax Sovereignty The economic environment in North America, as well as previous initiatives such as the Canada–United States Free Trade Agreement,20 has changed under NAFTA. The current system of taxing cross-border activity, which has largely remained unchanged during this time, appears to be inconsistent with the trend towards the removal of barriers to the mobility of goods, services, and capital as well as increased global commercial competition. Why has North American tax policy not kept up with trade and investment liberalization? As mentioned in chapter 1, governments jealously protect their tax autonomy, since tax laws are viewed as an important policy tool to serve the distinct needs of the citizens of each NAFTA country. The desire to preserve control over taxation has increased in North America and abroad because governments lost their ability to influence domestic goals with other policy tools such as tariffs when they agreed to enter into regional trade agreements like NAFTA or larger multilateral processes such as the World Trade Organization. They are therefore understandably reluctant to forgo the use of tax to meet the perceived needs of citizens. Tax integration may involve the NAFTA countries agreeing to adopt similar tax systems in some circumstances, but such integration imposes constraints on the ability of governments to employ their tax systems as they see fit to achieve domestic policy goals. Yet, as the economies of North America proceed with further integration, there will likely be increased pressure on the NAFTA countries to integrate their tax systems as well. 3.2 Tax and Domestic Policy Goals Fiscal demands vary from country to country within North America. At first glance, this position may not be as clear with respect to Canada and the United States. Both countries have many similarities in terms of criteria such as per capita economic wealth, population growth rate, and industrial base (see chapter 7). Moreover, in many ways the tax system of each country imposes similar burdens in certain circumstances: for example, in 2002 the disposable income of an average production worker as a percentage of gross pay, after taking into consideration personal

Background Issues 19

income tax and social security contributions, was 74.3 per cent in Canada and 75.7 per cent in the United States.21 In contrast, the average Mexican production worker took home 96.4 per cent of her gross pay. Yet significant differences between Canada and the United States in terms of the needs satisfied through taxation remain. For example, Canadians tend to support a system of government that preserves a generous social safety net through measures such as universal health care and a variety of other benefits. The total tax burdens imposed in each country reflect this fact: total tax receipts in Canada in 2001 made up 35.8 per cent of GDP, whereas tax receipts in the United States made up 29.6 per cent of GDP (the corresponding figure for Mexico is 18.5 per cent).22 The gap widens in the U.S.-Canada context when total revenues (that is, taxes plus other sources such as resource royalties) are taken into account: total government revenues amounted to 44.1 per cent of GDP in Canada while the corresponding figure was 34.7 per cent for the United States (Mexican figures are unavailable).23 Nonetheless, Canada and the United States are similar in most macroeconomic aspects: both countries are mature industrial economies that provide a relatively high level of wealth to most citizens. Mexico, in contrast, is a much less wealthy country with a transitional economy. The nature of the Mexican economy also differs in that it generally produces low value-added and low skill-intensive components for export. Canadians and Americans enjoy similar standards of living while many Mexicans often have less wealth and less government institutional support for social needs. It is anticipated, however, that Mexico will resolve some of its past economic problems and, according to some estimates, its future growth rates should surpass those of Canada and the United States.24 Political differences also exist among the NAFTA countries. Canada and the United States have a strong historical commitment to a multiparty system of democratic government while Mexico has, until recent years, been ruled by one party. Further, the legal systems of Canada and the United States are based on common law principles (with the exceptions of Quebec and Louisiana), whereas Mexico has adopted the civil law system. Some commentators have suggested that NAFTA will contribute to a greater convergence of political and economic institutions among the NAFTA countries, at least in the long run.25 As perceived social and economic needs become more similar, perhaps the NAFTA countries will become less reluctant to adapt their tax systems to a NAFTA-wide common set of tax rules.

20 The Current Regime

3.3 International Tax Policy Principles and Goals Given the tension between efficiency and sovereignty concerns, how should the NAFTA countries develop an appropriate international tax policy strategy? Policy analysts at times refer to international tax policy goals when evaluating existing or proposed international tax rules. These goals are typically divided into concerns about economic efficiency and concerns that focus more explicitly on justice or fairness among nations.26 On the efficiency side of the coin, analysts often examine whether tax systems promote capital export neutrality or capital import neutrality. As discussed, a concern has arisen that national tax differences distort international capital flows by favouring or punishing different types of cross-border economic activity. Capital export neutrality is achieved if a taxpayer’s choice between investing at home or in a foreign country is not influenced by taxes. This can be accomplished by providing a foreign tax credit for taxes paid to the foreign government so that the tax burden on the investment is the same whether the investment takes place at home or abroad. Most countries, including all of the NAFTA countries, offer these credits (see chapter 3). Complete neutrality, however, can only be achieved if nations permit unlimited crediting even if the foreign jurisdiction has relatively higher taxes than the domestic jurisdiction. No countries have implemented unlimited crediting because, in effect, it would mean that the domestic treasury would subsidize the foreign country’s tax system. For example, if France taxed business activity at higher levels than Canada, the Canadian tax authorities would be required to issue tax refunds to Canadian firms with operations in France so as to ensure that these firms were taxed at levels commensurate with Canadian firms operating at home. According to the goal of capital import neutrality, companies operating abroad should be placed in the same tax position as their local competitors. This goal could be achieved if countries exempt all foreign income from taxation (the so-called territorial approach). Multinational firms often support tax rules that promote capital import neutrality on the basis that these rules encourage domestic industries to be more internationally competitive. Additional efficiency goals include the promotion of low tax administration costs for tax authorities and low compliance costs for multinational firms. Simple rules that taxpayers can follow and tax authorities can enforce act to promote international trade and investment by reducing costs associated with tax systems. From a fairness perspective, an international tax regime can be evalu-

Background Issues 21

ated by scrutinizing whether the regime supports inter-nation equity. Equity concerns often centre on whether a tax system promotes a fair sharing of the international tax base. Some commentators stress that international tax policy should help, or at least not harm, the interests of developing nations, especially since most of the international tax rules and principles have been devised and implemented by wealthier countries.27 Others suggest that heightened international cooperation is required to meet the vexing tax challenges that face the world community.28 Equity is also used to evaluate whether international tax rules and principles harm domestic policy goals and encourage or discourage a fair distribution of the tax burden among taxpayers of a particular country. For example, a so-called residence system that taxes individual taxpayers on their worldwide income can help to support efforts to tax these taxpayers on their ability to pay – individuals with more income have more resources to pay higher taxes (vertical equity). There continues to be much disagreement and debate on the appropriate policy goals for international tax developments.29 This study strives to make a modest contribution to this debate by suggesting that tax sovereignty concerns should play a more prominent and explicit role as a guiding principle in the development of international tax policy proposals (see chapter 9). 4 Conclusion This chapter has reviewed many of the potential problems created by the interaction of the NAFTA tax regimes in an increasingly integrated economic environment. Any steps towards comprehensive tax integration in North America, however, would fly in the face of government attempts to preserve sovereign control over tax policy. For the time being, the NAFTA-country governments appear to prefer to suffer possible reductions in economic welfare in order to preserve tax sovereignty. Such is the state of the world today: NAFTA generally permits its member nations to develop and pursue any tax system that they wish, and bilateral tax treaties are used to smooth over the problems created by the interaction of national tax systems.

CHAPTER 3

The Tax Systems

1 Introduction This chapter reviews the different tax systems of the NAFTA countries. I do not attempt to provide a detailed description of these systems; rather, the analysis is intended to focus attention on specific tax areas that contribute to potential tax integration problems. The chapter is divided into three parts: general federal individual and corporate income tax regimes; subnational tax systems; and the international aspects of each tax system. 2 Difference in the Tax System 2.1 Tax Reform Efforts Since the mid-1980s, all three NAFTA countries have undertaken similar tax reform strategies intended to improve the efficiency and equity of their tax systems: tax bases were broadened and taxes were reduced, while deductions and incentives were curtailed. In 1986 the United States reduced its corporate income tax rate from 46 to 34 per cent, eliminated its investment tax credit, reduced depreciation allowances, and introduced an alternative minimum tax. Canada also underwent major tax reform (beginning with reforms announced in the 1985 federal budget) that reduced tax rates; eliminated a number of tax incentives, including the general investment tax credit; and modified a number of deductions. In 1988, Canada introduced a General AntiAvoidance Rule (GAAR). Beginning in 1987, Mexico also implemented significant tax reform that broadened the tax base to curtail avoidance and reduced personal, VAT, and corporate tax rates. An objective of the

The Tax Systems 23

Mexican tax initiatives was to bring the tax regime in Mexico more in line with so-called modern tax systems like that of the United States.1 To a certain extent, many of the efficiencies gained in the 1980s were unravelled by tax reform efforts in the United States and Canada during the 1990s. In 1997, the United States adopted the Taxpayer Relief Act, which introduced complexity in calculating capital gains, among other things. The Internal Revenue Service Restructuring and Reform Act of 1998 restructured the administration of taxes by American tax authorities. In Canada, a government committee chaired by Jack Mintz reviewed business tax issues and issued a report recommending a series of reform efforts, partly in response to perceived deficiencies in the Canadian corporate income tax system vis-à-vis the system in the United States.2 The 1990s also witnessed a general trend towards lower taxes in all NAFTA countries, partly because of political pressure from taxpayers. Corporate tax revenues nevertheless remained robust throughout the decade due to strong economic growth. Mexico managed to rebound from the collapse of the peso in the mid-1990s and Canada and the United States reduced annual federal government deficits during this time. North American economic growth slowed in 2000, leading to declining tax revenues and concerns that deficit financing would return in force. In 2000, the Canadian government announced that the general corporate income tax rate would be reduced from 38 to 31 per cent by 2004. The Mexican government announced similar tax cuts for corporations beginning in 2003. In addition, the government offered tax relief for individuals in certain circumstances (for example, home mortgage interest and medical insurance premiums will be deductible). Rate reduction was motivated in part to ensure the Canadian and Mexican tax systems remained competitive with the U.S. system. Recent tax reform efforts in Canada and the United States are discussed in chapter 6. 2.2 Differences in Tax Provisions Table 3.1 summarizes some of the important differences among the tax systems of the NAFTA countries, with an emphasis on the federal income taxes.3 All three federal income tax systems have similar watereddown definitions of taxable income based on the Haig-Simons definition. Under this comprehensive definition, most increases in wealth over the course of a fiscal year are taxable.4 The NAFTA countries, however, do not generally tax increases in unrealized capital appreciation or impute income. The concept of ‘taxable income’ forms the tax base in the

Table 3.1 Differences in tax provisions (2003) Canada

United States

Mexico

Resident and deemed resident Individual income Tax credits Deductible to limit Realized at death

Citizens and resident persons Individual or family Tax exemptions Declining tax credit Stepped up at death

Resident and deemed resident Individual income No tax credit or exemption No deductions Exempt from tax

Incorporated in U.S. [also ‘check the box’ rules]

Incorporated in Mexico or principal place of management

Consolidation

Incorporated in Canada or central management and control No

Yes, with government permission

Indexation for inflation

No

Affiliated domestic corporations and foreign branches No

Taxable, except pension contribution and certain fringe benefits Taxable Taxable, except qualified state and local bonds

Taxable, except certain fringe benefits

I. The Tax Unit A. Personal Liability Rate structure Dependents Child care expenses Capital gains on bequests

B. Corporate Liability

II. The Tax Base (Income) A. Personal Non-cash employer compensation Private pension benefits Interest

Taxable, except pension contribution Taxable with credit Taxable

Yes

Taxable Taxable at reduced rate

Table 3.1 (continued) Canada

United States

Mexico

Capital gains

Taxed at 1/2 regular rate with exemption for personal residence

Taxable at reduced rate with exemption for personal residence

Gifts

Exempt

Taxable over $1 million

Taxable at reduced rate, for personal residence and sale of certain Mexican shares Exempt for certain family members

Taxable when repatriated from foreign affiliate

Taxable when repatriated from foreign affiliate

Intercorporate dividends

Exempt for active business income of certain foreign affiliates Exempt

Exempt

Capital gains

Taxed at 1/2 regular rate

Full deduction for ‘affiliated’ domestic corp. with declining deductions for less than 80% ownership Fully taxed

B. Corporate Foreign income

III. The Tax Base (Deductions and Credits) A. Personal Mortgage interest No State and local taxes No

Medical expenses

Credit in excess of 3% net income or $1,615

Charitable donations

Credit

Deduction with limit Deductions for state and local income and real property taxes Deduction in excess of 7.5% of AGI and exclusion for employer provided benefits Limited deduction

Fully taxed

Deduction No, in most cases

Fully deductible

Deduction

Table 3.1 (continued) Canada

United States

Mexico

Private pension plan

Deduction to limit (e.g., RRSP)

Exemption for certain contributions

Dividends

Credit if from domestic corporation Yes

Deduction through employerprovided plan (401k), individual retirement account, etc. if AGI is below set amount No credit or deduction

Alternative minimum tax

B. Corporate State and local taxes Depreciation

44 classes, declining balance deductions for most

Intangible assets

Amortize patents, licences generally over limited life FIFO or average cost

Income and property taxes deductible 6 classes of personal property with declining balance or straight-line; 2 classes of real property with straight line 15-year amortization for certain purchased intangibles LIFO or FIFO

Backward 3 years, forward 27 years No (AMT for Ontario only)

Backward 3 years, 15 years Yes (AMT)

Inventory cost Loss carryover Minimum tax

Property taxes deductible

Yes

Not taxed in hands of shareholders No

Deductible 14 classes with straight-line or allowable depreciation deductions

No deduction for goodwill Adjust for inflation (equals average cost) No carryback, forward 10 years Yes (1.8% asset tax)

Table 3.1 (concluded) Canada

United States

Mexico

4 brackets (ranging from 16% to 29%) None

4 brackets (ranging from 15% to 35%) Surtax for income over $250,000 0 to 10.5%

8 brackets (ranging from 3% to 34%) None

Graduated to 35%

34%

To 10%

None

Yes, 7% GST (on most goods and services) No

No

Yes (0.225% in excess of $10 million) [to be phased out by 2008]

No

Yes, 15% VAT (on most goods and services) Resident corporation must set aside % of gross profits for employee profit sharing (labour legislation) No

IV. Pertaining to Tax Rates A. Personal Graduation Surtax

Provincial/state income taxes 6.2 to 24.5%

B. Corporate Tax rate, most firms

31% (less 10% federal tax abatement) Provincial/state income taxes To 17%

V. Other Taxes National value-added tax Mandatory pension plan

Federal capital tax

No

None

Sources: Information drawn from the tax legislation of each NAFTA country. See North American OneDisc (Washington: Tax Analysts; discontinued).

28 The Current Regime

NAFTA countries upon which the federal income tax rate is applied. As demonstrated by table 3.1, however, different rules have arisen from these similar concepts due to differing domestic agenda, or possibly to the political interaction of tax reform and interest groups. 2.2.1 Taxation of Individuals The differences among the federal income tax systems of the NAFTA countries are more obvious at the individual taxation level. For example, the United States and Canada have come up with different tax rules to provide taxpayer relief in areas such as medical expenses, charitable contributions, and pension savings. At times, these tax incentives can have cross-border implications. Canada only permits tax deferral through registered retirement savings plans as long as the foreign holdings do not surpass a stipulated percentage of the portfolio (currently set at 30 per cent). The tax provisions provide an incentive to Canadians to invest in equity of domestic companies to obtain the tax relief even though these individuals might be able to enjoy higher returns on investments in another NAFTA state. Many of the different approaches among the NAFTA countries reflect different tax policy choices with respect to the most efficient and equitable way to tax individuals. These policy choices reveal underlying theoretical or practical concerns about the role that tax should play within market-oriented democracies.5 This view follows from the notion that tax laws can have real impacts on the lives of individuals, helping or hindering their activities. Kathleen Lahey has noted that tax regimes, like other social institutions, have often detrimental impacts on traditionally marginalized groups that do not receive the benefits.6 Common tax rules developed from top-down may not be as sensitive to local preferences and policy needs. In any event, tax differences at the individual level will likely persist, due to the relatively immobile nature of labour under NAFTA (with the possible exception of highly skilled workers who tend to have higher mobility).7 NAFTA takes few steps to encourage the free movement of labour among the NAFTA countries, although the agreement does provide for temporary work stays and makes migration easier for professional workers like lawyers, economists, and management consultants.8 There is little incentive to standardize taxes on individuals, as none of the NAFTA countries has to be overly concerned that its workers will become ‘tax refugees’ fleeing their own country for a more hospitable tax jurisdiction. Pressure to harmonize individual taxation measures,

The Tax Systems 29

however, will increase if restrictions to migration among the citizens of the NAFTA countries are reduced or eliminated. Individual tax burdens may motivate emigration among more highly skilled workers, resulting in a ‘brain drain’ from the countries with the heaviest tax burden. This is a constant worry for Canadian policy makers, who watch many skilled workers set sail for sunnier and more lucrative careers south of the border. According to Statistics Canada, Canadian emigration to the United States increased steadily throughout the 1990s, representing an average annual exodus of 22,000 to 35,000 individuals.9 These migrants tended to have higher levels of education than the population as a whole, along with higher incomes. Analysis of income tax data on taxpayers leaving Canada to all foreign destinations showed that individuals earning more than $150,000 a year were seven times as likely to leave Canada as the average taxpayer was.10 Those who had incomes between $100,000 and $150,000 were five times as likely to move. There are clearly a number of reasons for this migration, including the pursuit of career opportunities, a milder climate, or better pay. One report attributes the increase in Canadian migration to the United States in part to the NAFTA provisions that permit temporary emigration for certain professionals.11 While taxes probably play a smaller role in influencing cross-border moves, they may be an important factor. A certain amount of care must therefore be taken to avoid large divergences between individual tax burdens.12 There is little information available, however, concerning the characteristics of these migrants, which is necessary to measure their actual tax burdens.13 Finally, tax burdens on individuals ultimately affect the tax cost of more mobile factors such as capital, which are more sensitive to national tax differentials. Personal income taxes and other taxes placed on individuals alter the after-tax return that must be paid to the shareholder or debt-holder to induce her to put up her funds. This issue is discussed in greater detail in chapter 5. 2.2.2 Taxation of Corporations Pressure for harmonization – the unification of tax bases and tax rates – is more likely to be felt at the corporate income tax level, due to the mobility of capital and the fact that multinational firms can have operations in two or more NAFTA countries. Robin Boadway and Neil Bruce have reviewed the question of whether Canada and the United States should harmonize their corporate income tax systems,14 and their review

30 The Current Regime

suggests that the systems have converged, partly because of the need to maintain attractiveness to mobile capital.15 The authors conclude: ‘It is not obvious that there is much to be gained from further explicit agreement [to harmonize corporate income tax systems].’ Roger Gordon and Eduardo Ley have examined the differences in corporate tax policy between Mexico and the United States;16 they conclude that the corporate tax laws are now very similar and, although NAFTA will likely increase cross-border activity between Mexico and the United States, this ‘should not generate much immediate pressure to rethink domestic tax policy in either country.’ It was noted, however, that certain differences, such as the tax treatment of leases and indexation of taxable income to inflation in Mexico, would distort the location of economic activity. In 2004, Canada imposed a general corporate income tax of 31 per cent (without taking into account the 10 per cent provincial abatement) while the United States and Mexico imposed a general rate of, respectively, 35 and 34 per cent. The apparent similarity in corporate tax rates may be somewhat misleading. Statutory tax rates tell only part of the story: actual tax burdens are influenced by other tax provisions like depreciation schedules, as well as interest and inflation rates. Differences in the total tax burdens facing marginal investments among the NAFTA countries are reviewed in chapter 5. Further, significant differences remain in the structures of the tax systems of the NAFTA countries. The OECD has recognized that similar tax structures and tax bases are necessary to promote efficiency in the interaction of tax systems.17 The United States continues to employ a ‘classical’ system of taxation where corporate earnings are taxed twice, once at the corporate level and again when distributed dividends are taxed at a reduced rate in the hands of individual shareholders (see chapter 6).18 Distributions of cash or property by a corporation to its shareholders are taxable dividends to the extent of the corporation’s ‘earnings and profits.’ If the corporate distribution is not from earnings and profits, then shareholders reduce basis in stock by the amount of the dividend. If the distribution is in excess of that basis, the excess is taxed as a capital gain. Canada offers partial shareholder relief from corporate taxation in many circumstances. This is achieved through a gross-up of dividends received from Canadian corporations and a non-refundable dividend tax credit against the shareholder’s federal tax liability.19 Partial integration results from the fact that, for most firm earnings, the dividend grossup does not entirely make up for the tax paid at the corporate level.

The Tax Systems 31

Canadian Controlled Private Corporations (CCPCs), which are subject to a reduced tax (22 per cent) on the first $225,000 (this amount rises to $300,000 by 2006) of annual active business income, however, receive almost full corporate income tax integration treatment as the dividend tax credit eliminates almost all double taxation on business income up to the stipulated threshold. Mexico now taxes corporate profits only once at the corporate level: dividends are generally not taxed in the hands of shareholders.20 This is sometimes called the zero-rated or dividend exclusion method. When a distribution occurs, however, the corporation is taxed on a gross basis to the extent that the dividends were not previously taxed at the corporate level at the rate of 35 per cent.21 More technically, dividends that arise from operating profits are recorded in an account called Cuenta de Utilidad Fiscal Neta, or CUFIN, and are only taxed at the corporate level upon distribution if they have not already been taxed. Dividends paid to shareholders that do not arise from the CUFIN are grossed up by a factor of 1.515 and then taxed at the 35 per cent rate at the corporate level. Gustavo Prado has indicated that Mexico removed the double taxation of corporate profits in order to improve its tax competitiveness with other nations.22 The interaction of these different corporate/shareholder structures causes certain problems: the most obvious one is that the different structures result in the fact that a resident of one of the NAFTA countries will bear different tax burdens for dividends received from corporations resident in another NAFTA state.23 One commentator suggests that the lack of harmonized rules regarding the integration of corporate and shareholder taxation is the most significant obstacle to the free movement of capital under NAFTA.24 Although an integrated or imputed system of corporate taxation is often cited as desirable tax policy, the classical system is likely easier to adapt to the international setting. The classical system permits a distinction to be made between the tax attributable to the source of corporate profits (that is, corporate tax) and the tax attributable to the return on capital (that is, tax applied at the shareholder level). If each NAFTA country adopted a classical system, tax discrimination against foreign investment could be removed through foreign tax credits and nondiscrimination provisions in tax treaties.25 The drawbacks of such a system at the national level, however, arguably make such a system undesirable for NAFTA-wide implementation. There may be other viable approaches to eliminate tax discrimation.26 An integrated (or imputed) system can have a discriminatory effect

32 The Current Regime

on non-residents when full shareholder relief is only granted to resident shareholders of a company. Non-resident shareholders of Canadian companies are not permitted the same level of tax relief as resident shareholders in most circumstances.27 This approach, which is sometimes justified as a tax expenditure, discriminates against foreign investors. Further, corporate taxes paid outside of Canada are generally not integrated with a resident taxpayer’s individual taxes as no credit is given for dividends paid by firms that are not residents of Canada. The Canadian integration method has been attributed with creating serious tax rate disharmony with respect to portfolio investments within North America.28 Integrating foreign taxes may be undesirable from Canada’s perspective, because the tax credit would come from the Canadian treasury while the corporate taxes would go to the treasury of Mexico or the United States (unless the dividends are received out of the exempt surplus accounts of foreign affiliates and are hence generally not subject to any Canadian tax). A European committee of tax experts – the so-called Ruding Committee – recognized that the interaction of different corporate tax systems distorted the allocation of cross-border investments within the European Union (see chapter 7). The Ruding Committee was unable to agree on an ideal system, although certain members of the committee favoured a shareholder relief plan similar in nature to the Canadian system. Unlike the Canadian system, however, measures aimed at avoiding the double taxation of dividends received by individuals were to be extended to shareholders residing in other EU countries in order to remove the discrimination that favours domestic investors. In 2001, the European Commission began to concentrate its efforts on the development of a comprehensive solution whereby companies can operate one consolidated corporate tax base for their European Union–wide activities (see chapter 7). The Commission hopes that a consolidated corporate tax base will reduce compliance and administration costs associated with twenty-five different sets of national tax rules. For example, under the ‘home state taxation’ approach the EU tax base would be computed under the tax rules of the company’s home state. The common consolidated tax base could then be allocated to the relevant EU countries, perhaps by way of some formula, and each country could apply its national tax rate to its share of the profits. The approach would not seek to fully replace existing national tax regimes. The NAFTA country that agreed to alter its corporate tax structure to bring it in line with its two trade partners (by implementing a classical,

The Tax Systems 33

imputed, or zero-rated system) would have to undertake a serious reevaluation of its tax policy. Similarly, comprehensive solutions such as a NAFTA-wide consolidated corporate tax base would require a major rethinking of each NAFTA country’s traditional tax policy approach to domestic and international affairs. 2.3 Tax Incentives Table 3.1 illustrates a number of areas where individuals or business entities are given ‘tax breaks’ for engaging in certain activities. For example, the NAFTA countries grant tax breaks for individual capital gains, home ownership sales (Canada and the United States), mortgage interest (the United States), corporate capital gains (Canada), charitable contributions, and pension plan contributions. These subsidies or tax expenditures are used to encourage or promote the activities in question. The definition of what constitutes a tax incentive is controversial. An observer has suggested that: ‘In general, tax expenditures are considered to be departures from an ideal or model tax base. Since, however, there is no consensus concerning what is an ideal tax base, there is much disagreement about whether particular items, such as charitable donations, are tax expenditures.’29 A NAFTA country can either provide direct financial aid to encourage the activity in question or use the tax system to do so. Both methods tend to distort trade and capital flows. In his review of the expenditure systems, Paul McDaniel notes that North American tax systems provide cost sharing for export activities that influence whether a firm undertakes export activities; influence the location of investments by providing incentives for foreign over domestic investment, or vice versa; and provide incentives to invest in a certain industry.30 The United States and Canada both publish extensive tax expenditure accounts; Mexico apparently does not publish this type of accounting. The list of tax expenditures for the former two countries includes small businesses, agricultural industries, financial services, manufacturing, investments, oil and gas industries, research and development, and export subsidies.31 Mexico provides tax subsidies for export activities, farming and forestry, pensions, special deductions for new investments, job creation tax credits, and tax exemptions for individuals on repatriation of foreign capital.32 The extent to which tax expenditures and other tax incentives encourage ‘excessive’ or ‘harmful’ tax competition is under scrutiny by the OECD and the European Union (see chapter 10). The OECD efforts,

34 The Current Regime

directed generally at financial services, take to task the use of tax provisions concerning non-resident-owned investment companies, international banking centres, and international shipping in Canada and the use of foreign sales corporation provisions in the United States.33 These latter provisions subsidize foreign exports and have also been found to be an illegal trade subsidy by a World Trade Organization panel.34 Mexico escaped the OECD’s wrath, as it did not have any non-conforming tax provisions. Further, the tax systems of the NAFTA countries, at times, discriminate against or favour foreign investment.35 As indicated above, Canada does not extend shareholder relief to foreign investors in most circumstances, nor are resident Canadians entitled to the relief from dividends received from non-resident corporations. The Canadian tax system also discriminates against foreign activities by offering tax incentives that are restricted to activities taking place only in Canada, including research and development, mining, development of oil and gas resources, and regional investment. The United States offers more limited tax incentives for local activities, including energy conservation, alternative energy production, and scientific research. The most obvious discrimination in favour of foreign investment within the Mexican tax system involves the use of maquiladoras, foreign companies that import raw material and re-export them as final products. Maquiladoras are permitted reductions in corporate income tax as well as an exemption from the VAT for imports: this preferential treatment is scheduled to be phased out.36 The tax treatment results in significantly lower effective tax rates for maquiladoras in comparison to domestic Mexican business activities. There is a trend, however, towards treating maquiladoras the same as other Mexican corporations for tax purposes. Mexico introduced new tax rules, effective 1 January 2003, that streamlined its tax rules for taxing maquiladoras to encourage greater business certainty and promote more investment.37 3 Subnational Taxation In addition to potential problems caused by the national level tax systems of the NAFTA countries, attention must also be paid to the subnational (that is, provincial/state and local) tax systems. The importance of subnational tax systems is illustrated by the fact that up to 40–50 per cent of overall tax revenues in Canada and the United States are

The Tax Systems 35

collected through these taxes.38 Subnational taxes are less important to Mexico and bring in less than 20 per cent of overall tax revenues.39 Many of the issues involved in international tax harmonization have already been faced by Canada and the United States under their system of federal and subnational taxation: the subnational tax systems reflect a balance between the federal government’s desire for tax uniformity and the subnational government’s desire for tax sovereignty. Discussion of these subnational tax systems often involves whether they promote efficiency within the federation: a provincial/state or local tax can influence investment location or discourage trade within a country.40 Canadian subnational income tax systems are almost completely harmonized with the federal level tax: most provinces have a tax collection agreement with the federal government for corporate and personal income taxes. Only Quebec collects its own individual income tax; Quebec, Alberta, and Ontario collect their own corporate income taxes. The provinces have the constitutional right to choose their own income tax base but in most circumstances they have chosen to harmonize this base with the federal tax base, in part to facilitate compliance and administration.41 Five Canadian provinces also subject the sale of goods to a provincial sales tax. Harmonization between the federal goods and services tax and provincial retail sales taxes is less apparent, with only Quebec (the Quebec sales tax) and three provinces (New Brunswick, Nova Scotia, and Newfoundland) agreeing to harmonize their systems with the federal government (the harmonized sales tax). Concern remains that the different sales tax systems distort and impede capital and trade flows within Canada.42 In contrast to Canadian provincial income taxes, individual states in the United States pursue varied tax policies in many circumstances. There is no income tax harmonization between the states and federal government in the United States (although most states conform to the federal definition of the tax base). The states collect their income taxes separately from the federal government and no formal collection agreements exist. The number of different state income tax regimes and lack of harmonization with the federal government arguably have a harmful effect on the U.S. economy.43 The independence of state tax policies ‘arises from the federal nature of the U.S. system. States vigorously protect their sovereignty over tax policy. The inability of the U.S. congress to impose uniformity in multistate taxation, despite apparent ben-

36 The Current Regime

efits of uniformity to both taxpayers and tax administrators, reflects the strength of this sovereignty.’44 During the 1960s and 1970s, a few states (notably California) required multinational firms to submit a worldwide report of their income and pay tax on this income. This development caused some concern among foreign countries and their multinational firms and led to an unsuccessful judicial challenge on constitutional grounds that states do not have the authority to impose worldwide taxation.45 Responding to the political pressures brought by multinational firms and the federal government in the wake of the U.S. Supreme Court’s ruling sustaining the constitutionality of worldwide combined reporting, states modified their statutes to make worldwide combined reporting elective.46 No states currently require worldwide combined reporting, except for Alaska vis-àvis oil companies. In addition to state income tax measures, U.S. state and local governments impose sales and use taxes on the sales of goods. Forty-five states impose these sales taxes while, astonishingly, there are over seven thousand local sales tax jurisdictions. The vast majority of the local sales tax jurisdictions have identical tax bases to the state base and the state government collects the tax on behalf of the local governments. Partly because of pressure from remote Internet sales, state tax authorities are contemplating radical tax harmonization through the Streamlined Sales Tax Project (see chapter 8). Mexico does not have the same potential internal coordination problems, as the Mexican tax structure is essentially federal. The Mexican VAT is administrated solely at the federal level and there are no state sales taxes. Local municipal taxes include property taxes, duties to obtain licences for businesses operations, and health permits. State-level taxation involves only payroll and property taxes. For example, the Federal District imposes a 2 per cent tax on salaries paid to employees by employers. François Vaillancourt has examined the degree of subnational tax harmonization within and between Canada and the United States.47 In Canada, the main source of revenue for provinces is the personal income tax. In contrast, U.S. states collect roughly one-third of their revenues from retail sales taxes, one-third from income taxes, and onethird from miscellaneous excise taxes. Vaillancourt concludes that significant locational decisions are influenced by the interaction of the different subnational tax systems of Canada and the United States. Accordingly, even if the federal tax systems of these two countries were

The Tax Systems 37

harmonized, the differences in the subnational tax systems would continue to distort resource allocation between the two jurisdictions. International tax harmonization requires common definitions of tax bases, which would be hard to achieve if tax systems within each country are varied at the subnational level. Indeed, full harmonization within each country has been called a prerequisite for international tax harmonization.48 Efforts at the federal level to encourage subnational harmonization encounter difficulties due to the federal structure of the NAFTA countries: a province/state may be constitutionally empowered to form its own tax system without constraints from the federal government. As a result, negotiators of changes to the U.S.-Canada tax treaty reportedly took care to avoid constraints on subnational jurisdictions.49 The political difficulties encountered by the U.S. and Canadian federal governments with respect to their subnational tax systems reflect similar problems that would be encountered in any attempts to integrate the national tax systems of the NAFTA countries. 4 International Aspects Each NAFTA country – especially Canada and the United States – has developed complex rules to deal with the various avenues of international tax planning. These rules reflect the diverse ways in which companies can invest in other countries through the use of different business entities (for example, a branch or a wholly owned subsidiary), different financing alternatives (for example, debt, equity, or hybrid securities), and different ownership structures (for example, investing directly or by way of a holding company). The review below does not take into account many of these complexities.50 4.1 Double Taxation Relief Canada and Mexico tax worldwide income based on residence status as well as the source of income.51 The United States taxes on the basis of citizenship along with residency and source of income.52 As a result, foreign-source income may be taxed by both the country of source (the country where the foreign firm conducts its activities) and the country of residence (the country where a business is based or incorporated). International double taxation occurs when two countries try to impose comparable taxes on the same item of income or capital gain of the same taxpayer during the same taxation period. Each country has developed its own tax rules to give relief to this potential double taxation

38 The Current Regime

scenario. In addition to these rules, the network of bilateral tax treaties negotiated among the NAFTA countries are designed to provide relief from double taxation (see chapter 4). Generally speaking, all NAFTA countries use the foreign tax credit method to provide relief from international double taxation (Canada and the United States also permit a deduction for foreign taxes paid). Under this method, the residence country provides its taxpayers with a credit against income taxes otherwise payable to a foreign country. The foreign taxes paid by the taxpayer generally reduce taxes payable by the amount of the foreign tax. If the foreign tax rate is less than the domestic tax rate, the foreign-source income will be subject to additional tax by the residence country. As a result, the combined foreign-source tax rate and the residence-source tax rate will now approximate the domestic tax rate. This method reflects the international tax policy goal of capital export neutrality because the taxpayer will be subject to roughly the same amount of tax whether it invests at home or abroad (see chapter 2). Nevertheless, if the foreign tax rate is higher than the domestic rate, the NAFTA countries do not give out tax refunds. As such, the foreignsource income is generally taxed at the higher of the domestic and foreign tax rates. In the case of the United States, this foreign tax credit limitation is applied separately to different ‘baskets’ of foreign income, which generally fall into categories of passive income and active income. Within each basket, a worldwide limitation is applied that permits the averaging of high and low foreign taxes on income within the basket.53 Canada has enacted major exceptions to the credit method. Dividends received by a Canadian corporation from a foreign affiliate are subject to a combined exemption/credit system. A foreign affiliate is defined as a corporation in which a Canadian corporation owns at least 1 per cent of the shares of any class and the corporation and related persons own at least 10 per cent of the shares. In most cases, Canada exempts from taxation any dividends paid from foreign affiliates if the income is active business income and is generated in a tax treaty partner. The dividends are deemed to be paid first out of the exempt surplus of the foreign affiliate, then out of its taxable surplus, and finally out of its pre-acquisition surplus. This exempt surplus includes active business income from tax treaty countries, certain capital gains and related party dividends if they are received out of the exempt surplus of the payer.54 The Canadian exception to the credit method reflects the goal of capital import neutrality, where taxpayers investing in foreign countries

The Tax Systems 39

will be subject to roughly the same tax burdens as taxpayers from the source country (see chapter 2). Capital import neutrality arguably promotes tax competition, because resident taxpayers are given an incentive to transfer their investments to jurisdictions with relatively lower tax burdens. In practice, the tax regimes of the NAFTA countries reflect the goals of both capital export neutrality, and capital import neutrality, depending on specific circumstances. For example, the U.S. tax regime will not generally tax income generated in foreign countries until dividends are repatriated to the home country. A corporate affiliate located in the foreign country would thus be subject to the foreign tax rate until this repatriation occurs, if ever. This strategy reflects the capital import neutrality approach. Further, Canada does not exempt income generated in non-treaty countries, which are often low or nil taxing jurisdictions. In addition, the NAFTA countries have a series of rules, discussed below, that tax passive income in certain circumstances whether or not the income is repatriated. These rules support the goal of capital export neutrality. 4.2 Transfer Pricing Corporations with related parties in more than one country transfer goods and services or capital to these related parties. Transfer prices are the prices set by these taxpayers on the resources exchanged among the related parties. The transfer price received or charged for goods, services, or financing will be included in the income of the supplier and the corresponding cost or payment will be deducted from the profits of the related party. Each NAFTA state has developed rules to help to ensure that multinational firms cannot carry out related-party transactions at artificially high or low prices in order to transfer income and expenses from one country to another (a tax-planning strategy sometimes referred to as ‘income shifting’). The NAFTA countries’ tax rules and tax treaties generally accept the principle that a related-party transaction should be priced as if the parties were dealing with each other at arm’s length: an arm’s length price for the transfer is obtained by looking to market exchanges between unrelated parties. The OECD issued revised guidelines for transfer pricing in 1995 that confirm the use of the arm’s-length principle over profit-split formulas, although it indicates that the profit-split formulas can be used as a ‘last resort.’55 Both Canada and Mexico follow this approach. Taxpayers in

40 The Current Regime

Canada have traditionally been asked to use a flexible ‘reasonable in the circumstances’ test when considering what transfer prices should be used.56 The Canada Revenue Agency generally favours this transactional approach to transfer pricing, although it permits the use of profit-split formulas (discussed below).57 Tax reform in 1997 introduced a number of changes to the Canadian transfer pricing regime, including bolstered documentation requirements, in an attempt to ensure that multinational firms in Canada paid an appropriate amount of tax on their crossborder transfers.58 Mexico reformed its transfer price rules beginning in 1996 by introducing the potential use of profit-split formulas.59 In 1994, the United States finalized detailed rules with respect to international transfer pricing.60 These rules indicate that the taxpayer must keep documentation to support the choice of the ‘best method’ for pricing the intercompany transfers. According to Treasury regulations, taxpayers should choose ‘the best method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.’61 These methods involve choosing between separate categories for comparable pricing or using a profit formula to apportion the transfer prices. The rules do not indicate a preference as to which rule should be used; rather, the taxpayer must choose the method that will most reliably reflect the arm’s-length price under the circumstances. Under the comparable pricing category, a taxpayer has three options. The comparable uncontrolled price (CUP) method establishes an arm’s-length price by reference to sales of similar products between unrelated parties. The resale price method permits the taxpayer to subtract a mark-up from the price that would have been sold to unrelated parties. Under the cost plus method, the taxpayer adds an appropriate profit percentage to its costs of producing the product. The profit-based formulas employ two approaches. Under the profitsplit method, the taxpayer determines its total taxable income from related party transactions and then allocates the income in proportion to the contribution of each party. The comparable profit method (CPM) permits the taxpayer to establish a range of profits for the related party for the sale of goods or the licence of intangibles. (The Canada Revenue Agency, however, rejects the use of CPM in almost all circumstances.) If the related party’s profits fall within this range, its transfer prices will be accepted by the Internal Revenue Service (IRS). If the related party’s profits fall outside the range, then the tax authorities may adjust the transfer prices so that the profits fall within the range.

The Tax Systems 41

These detailed American rules have been criticized as being overly aggressive in terms of allocating income to the United States: taxpayers may be over-complying with the U.S. rules under fear of audit by the IRS.62 The OECD Guidelines with respect to transfer pricing suggest that ‘transfer pricing is not an exact science but does require the exercise of judgment on the part of both the tax administration and the taxpayer.’63 Transfer pricing remains a contentious issue among all of the NAFTA countries due to hundreds of billions of dollars in cross-border relatedparty transactions that take place each year (see chapter 9). Moreover, all the NAFTA countries have procedures that allow for advance (transfer) pricing arrangements (APAs), which permit a multinational firm and the relevant tax authority or authorities to come to an agreement on the methodology that will be used to calculate the transfers.64 Under the American process, the IRS begins the procedure with a prefiling conference to work out the details of the agreement.65 The agreement will cover a proposed methodology to be used in specific transactions between the taxpayer and related parties. The IRS will consider methodologies that are consistent with the arm’s-length standard, even if they are not set out in the tax code. The APAs employed by the NAFTA countries often rely on profit-split formulas. The number of unilateral, bilateral, and multilateral (that is, between a NAFTA country and one or more other countries) APAs negotiated by the NAFTA countries has grown in recent years. For example, Mexico had completed approximately two hundred APAs by the end of May 1996.66 Canadian officials have stressed that they will refuse to recognize a unilateral APA that is negotiated by a foreign tax authority and that bilateral and multilateral APAs are the preferred method. In recent years, the Canada Revenue Agency (CRA) has made efforts to promote its APA program and to shorten the amount of time necessary to reach agreement on the APA between the taxpayer, the CRA and other tax authorities. 4.3 Anti-Avoidance Rules The NAFTA countries (with Mexico to a lesser extent) have developed additional rules to ensure that their tax revenues are not diminished by undue international tax avoidance. These rules include anti-avoidance doctrines, special tax haven provisions, foreign investment fund rules, thin capitalization rules, and controlled foreign corporation (CFC) legislation. This section reviews the last two types of tax rules.

42 The Current Regime

4.3.1 Thin Capitalization Rules Thin capitalization generally refers to the situation where a corporation, usually a subsidiary of a foreign parent, is financed with very little equity relative to debt.67 The NAFTA countries all permit interest to be deducted, which reduces taxable income and may reduce the cost of capital for a firm’s ventures. Extensive use of debt financing is perceived to erode corporate tax revenues and thus Canada and the United States have passed legislation that attempts to constrain this type of financing, while Mexico has recently passed less extensive legislation for the first time in this area. Canada follows the so-called objective approach that prevents a resident corporation from deducting interest on a portion of its loans from non-resident shareholders that have a significant ownership interest in the resident corporation.68 The interest deduction will be denied where outstanding debts of the non-resident company exceed two times the permitted equity.69 The denied interest generally equals the interest paid on the debt that exceeds the permitted 2:1 ratio. The United States pursues the so-called subjective approach with respect to its thin capitalization rules, although it also has rules that reflect the objective approach.70 Under the subjective approach, the IRS can compare the levels of capitalization of any company on a case-bycase basis, using factors such as debt-to-equity ratios, comparable arm’slength situations, and the relationship between the parties. Under this test, the IRS can deny interest deductions when it deems it appropriate. The passage in 1989 of earning stripping provisions provided the IRS with additional authority on a more objective basis. Corporations with a debt-to-equity ratio exceeding 1.5:1 must defer their interest deductions if the interest is paid to a related person and the payor’s net interest expense exceeds 50 per cent of its ‘adjusted taxable income.’ The U.S. rules also cover back-to-back loan arrangements (in which the lender loans funds to an intermediary who then loans it to the true borrower) and loan guarantees, while the Canadian rules only cover the back-to-back loan arrangements. In the U.S. administration’s fiscal 2005 budget plan, it is proposed to eliminate the protection offered by the debt-to-equity ‘safe harbour’ and limit the carryforward for disallowed interest to ten years (from an indefinite carryforward under current rules).71 Effective 1 January 1997, Mexico also pursued the subjective approach: there are no fixed debt/equity rules. In light of certain facts, however, interest paid to related non-resident shareholders may be reclassified as

The Tax Systems 43

a dividend and hence no deduction for the interest payment will be permitted. In addition to thin capitalization rules, each NAFTA country (with Mexico and Canada to a much lesser extent) has developed rules to try to ensure that expenses such as interest payments are properly allocated to the jurisdiction where the related earnings are subject to tax. For example, the United States has developed both general rules applicable to all types of deductible expenses as well as more detailed rules for certain expenses such as interest. Under the general approach, deductions are first allocated to a class of gross income where there is a ‘factual relationship’ between the deduction and the class of income.72 Interest expenses, however, are generally required to be allocated to all classes of gross income under the view that the interest expense is attributable to all activities and property regardless of any specific purpose for incurring the debt.73 Once interest has been allocated, tax rules determine how it will be apportioned between foreign-source income and U.S.-source income to ensure that excessive interest payments will not erode the U.S. tax base. 4.3.2 Controlled Foreign Corporation (CFC) Rules All of the NAFTA countries tax their residents on a worldwide basis, but they generally defer taxation until profits are repatriated to their home countries from foreign-based corporate affiliates. Multinational firms could avoid or defer tax payments by simply keeping their profits sheltered in a corporate affiliate located in low or nil tax jurisdictions, absent CFC rules. The anti-avoidance rules developed in the NAFTA countries are designed to impute income to the home country businesses in certain circumstances, despite an absence of repatriation of the profits from abroad. The gist of the legislation is similar: resident shareholders that control, or have a substantial interest in, a foreign corporation are currently taxable on their share of the passive income or certain types of base company income of the foreign corporation, whether or not the income is actually distributed to them. Canada applies foreign accrual property income (FAPI) rules to ‘controlled foreign affiliates’: indirect and constructive ownership rules determine whether the affiliated is controlled.74 FAPI is generally limited to passive investment-type income and consists of income from property, income from investment businesses, and certain capital gains.75 Canada uses the transactional approach: the FAPI rules only apply if the income falls within the defined category, regardless of whether the foreign

44 The Current Regime

affiliate is located in a low or nil tax jurisdiction. The Canadian government introduced complex new foreign investment entity rules, effective 1 January 2003, that interact with the FAPI regime.76 The United States has implemented complex CFC rules pursuant to Subpart F of the Internal Revenue Code.77 Resident shareholders of a foreign corporation controlled by U.S. shareholders are subject to the U.S. tax. Passive foreign investment fund (PFIF) rules supplement the CFC rules and apply primarily to income and assets that are passive in nature, even if the corporations are not controlled by U.S. residents.78 Effective 1 January 1997, Mexico implemented a new CFC regime. The rules are straightforward (at least in contrast with the rules of the other NAFTA countries) and indicate that a Mexican resident taxpayer may be subject to Mexican income taxes on the profits of any controlled non-resident entity that is situated in a listed tax haven. 4.4 International Consumption Taxes The previous sections have reviewed a number of international income tax issues within North America. Canada and Mexico have additionally implemented a federal-level consumption tax called, respectively, the goods and services tax and the value-added tax.79 Both taxes are similar in broad outline. The GST is imposed at a 7 per cent rate on the purchase (‘taxable supply’ in GST jargon) of most goods and services within Canada. Similarly, the Mexican VAT is imposed at a rate of 15 per cent on the purchase of most goods and services. Certain items, such as basic foods and medicine, are exempt from taxation under both systems. Both taxes are imposed all along the value-adding economic chain, from the supply of raw materials to ultimate consumption by an end consumer. For business-to-business transactions, businesses are charged GST or VAT and can collect a credit for the amounts paid to their suppliers when accounting to the tax authorities for the GST or VAT they have charged their customers. End consumers, however, do not get the credit. With respect to international transactions, the GST and the VAT are imposed on the import of many tangible goods at the border by customs agents. Exports leave Canada and Mexico tax free: the export is ‘zerorated.’ For many business-to-business transactions, the Canadian or Mexican purchaser of a good from a foreign supplier similarly must assess the amount of GST or VAT owed and can later claim an input tax credit for this amount: the Canadian or Mexican company hence has an incentive

The Tax Systems 45

to report the transaction in order to secure the credit. Additional elements of the Canadian GST system are discussed in chapter 8. 5 Conclusion The NAFTA countries derive significant tax revenues from their federal individual and corporate income tax systems. The basic elements of these tax regimes are similar, although the detailed tax rules vary greatly in many circumstances. Many of the differences, especially the different corporate/shareholder structures, are suspected to influence the misallocation of capital among the NAFTA countries. Tax expenditure provisions and other tax incentives continue to distort resource allocation decisions within each country as well as across borders. In addition, the widespread use of provincial/state and local taxes in Canada and the United States complicates the interaction of their tax systems. The subnational tax jurisdictions in Canada and the United States may hamper future efforts to develop centralized tax integration mechanisms among the NAFTA countries because of their constitutional taxing powers. Further, each NAFTA country has adopted rules to avoid international double taxation as well as to prevent undue tax avoidance (although Mexico had not implemented detailed rules in this last regard). The next chapter reviews the international agreements among the NAFTA countries that deal with the tax treatment of crossborder economic activity.

CHAPTER 4

Tax Coordination

1 Introduction This chapter discusses the two main international agreements employed to coordinate the tax treatment of cross-border flows among the NAFTA countries. It begins by reviewing the relevant provisions within NAFTA, and then discusses the three tax treaties negotiated between each trade partner. 2 NAFTA and Taxation Article 2103 of NAFTA deals with tax measures. The provision indicates that nothing in NAFTA affects taxation measures unless it is specifically set out in the article. The main goal behind NAFTA is to gradually eliminate tariff barriers among the NAFTA countries. These taxlike barriers, which include custom duties, anti-dumping and countervailing duties, and importation fees, are not considered ‘taxation measures’ pursuant to article 2107 of NAFTA and hence do not fall under article 2103, permitting tariff reduction to go forward without interference from this provision.1 2.1 Tax Treatment of Goods Article (3)(a) of NAFTA indicates that the national treatment obligations respecting goods set out in article 301 apply to taxation measures to the same extent as article II of the General Agreement on Tariffs and Trade (GATT).2 The GATT provision states that imported goods shall not be subject, directly or indirectly, to internal taxes in excess of those applied to similar domestic products.

Tax Coordination 47

Further, GATT prohibits its members from applying internal taxes to imported and domestic products in a manner that would protect domestic industry.3 GATT article III has commonly been interpreted to cover only indirect taxes such as sales taxes and not to apply to direct taxes such as corporate income taxes. The NAFTA provision will hence affect taxes that are applied to goods, such as sales taxes, excise taxes, and value-added taxes (for example, the goods and service tax in Canada and the value-added tax in Mexico). Article 301(2) extends nondiscrimination requirements to states and provincial governments. This probably does not prohibit a NAFTA country from using tax expenditures to promote trade (see chapter 3 for a discussion of the controversy surrounding the definition of ‘tax expenditures’).4 NAFTA national treatment requirements do not extend to any non-conforming tax measures that are currently in force, or to measures that continue or amend the initial measure in such a way as not to decrease the conformity.5 An additional provision prohibits the NAFTA countries from imposing export taxes on the export of goods to another NAFTA country in most circumstances.6 A NAFTA country is not permitted to impose a tax on the export of goods to another NAFTA country unless the same tax is imposed on the good when destined for domestic consumption and when exported to all NAFTA countries. Although export taxes are not prohibited outright, the requirement that a corresponding tax be imposed on goods destined for domestic consumption defeats their purpose.7 For U.S. purposes this provision may be redundant, as the United States has a constitutional bar, at both the state and federal level, against taxes on exports. An exception to the general rule regarding export taxes permits Mexico to adopt export charges for up to one year on food items in conjunction with government stabilization plans designed to keep domestic prices below world prices. The exception allows Mexico to relieve critical food shortages by ensuring that the food products stay within Mexico.8 2.2 Taxes on Services NAFTA has certain national treatment and most-favoured-nation (MFN) obligations with respect to specified services. These obligations ensure that, in many circumstances, each NAFTA country accords service providers of another NAFTA country similar treatment to that provided to domestic service providers.9 As discussed below, these obligations extend to taxation measures under certain circumstances.

48 The Current Regime

NAFTA generally provides that each NAFTA country shall give to service providers of another party no less favourable treatment than that accorded to its own service providers. This national treatment is extended to tax measures that relate to the cross-border purchase or consumption of services, including taxes on income, capital gains, or the capital of corporations.10 It should be noted that the national treatment obligations do not cover the taxation of service providers themselves, but relate to the purchase or consumption of services. For example, the NAFTA countries are prohibited from denying a tax benefit such as a deduction for medical expenses to a purchaser or a consumer of a service provided by another NAFTA country if that benefit was available with respect to the purchase or consumption of services from a domestic service provider. National treatment in taxation measures extends in a more limited manner to the actual cross-border service providers, financial service providers, financial institutions, investors, and their investments.11 In these circumstances, national treatment is extended to tax measures that do not include taxes on income, capital gains, or capital of corporations.12 The provision would therefore apply to the Canadian goods and services tax as well as the Mexican value-added tax. The protection against discriminatory tax measures relating to crossborder services is subject to two important qualifications. NAFTA exempts from this protection all existing tax provisions of the NAFTA countries at the time of signing as well as any renewals or non-aggravating amendments. Future changes to the tax law are permitted if they try to ensure the fair and efficient imposition or collection of taxes. This broad exemption is narrowed to a certain extent by prohibiting future tax laws that arbitrarily discriminate between persons, goods, or services of the NAFTA countries or which arbitrarily nullify or impair benefits. 2.3 Conditional Tax Benefits Article 2103(5) of NAFTA indicates that a NAFTA country cannot grant a tax benefit for domestic investments that are tied to specific performance requirements.13 A NAFTA country cannot therefore create conditional tax benefits where a firm must meet requirements such as purchasing locally produced goods, achieving specified levels of domestic content, or meeting certain export levels. Certain requirements are exempted from this prohibition, including requirements to locate production facilities in designated areas or the necessity to undertake research and development. Further, a NAFTA country is permitted to

Tax Coordination 49

impose requirements relating to domestic content or the purchase of domestically produced goods that involve export promotion or foreign aid programs. 2.4 NAFTA and Tax Treaties Article 2103(2) indicates that NAFTA does not affect the rights or obligations of any NAFTA country under any tax treaties. The provisions in the tax treaties will prevail to the extent of any conflict between the tax treaty and NAFTA. This allows tax treaties to take precedence over the provisions in NAFTA, including tax treaties negotiated between a NAFTA country and a non-NAFTA country. Because of this treatment, NAFTA countries can agree through their tax treaties to impose discriminatory taxes on each other, despite the fact that such behaviour is prohibited by NAFTA. This permits the NAFTA countries to use tax measures to breach the NAFTA provisions dealing with national treatment and MFN treatment granted to investors.14 3 Tax Treaties in North America Tax treaties remain the primary mechanism for the NAFTA countries to coordinate their tax treatment of cross-border economic flows. Unlike NAFTA, the tax treaties were negotiated bilaterally. As a result, the NAFTA countries have extended reciprocal tax benefits between each other without necessarily extending these benefits to the third party. After a brief review of the history of tax coordination in North America, this part sets out some of the main differences among the tax treaties of the NAFTA countries. These differences may give rise to tax distortions that are clearly undesirable in an integrated economic environment. 3.1 The Purpose of Tax Treaties Countries have traditionally sought to use bilaterally negotiated tax treaties as the primary mechanism to assist in resolving problems created by the interaction of national tax systems. Unlike the situation that would arise under tax harmonization, a country does not generally agree to change its domestic laws when it agrees to be bound by tax treaty obligations. Vern Krishna notes five general goals of modern tax treaties: (a) the elimination of double taxation (by trying to ensure the taxpayer is taxed only once on its activities); (b) the elimination of discrimination through ‘national treatment’

50 The Current Regime

(the members agree to treat each others citizens and corporations no differently than their own for tax purposes); (c) the prevention of tax evasion (by permitting the exchange of information between administrative authorities); (d) the removal of administrative obstacles between the contracting parties; and (e) the equitable allocation of tax revenues between the contracting parties.15 Although tax treaties accomplish all of these goals to a certain extent and assist in the administration and tax treatment of cross-border income, they do not resolve a number of concerns created by the interaction of the tax systems of the NAFTA countries (see below, ‘The Limitation of Tax Treaties’). 3.2 Historical Review of Tax Coordination in North America 3.2.1 Canada–United States Tax Coordination Canada and the United States concluded their first limited treaty involving income taxes imposed on non-resident individuals in 1936. They signed a more comprehensive treaty with each other in 1942.16 This agreement was amended by a number of protocols and replaced by a new treaty in 1980.17 During the period between the two treaties, the tax systems of both countries underwent significant changes. It has been said that negotiating the new treaty proved to be an ‘exceptionally difficult matter’18 for a number of reasons. The huge volume of capital and income flows between the two countries made any changes to the tax treaties a significant issue to the treasuries of both countries. Further, the amount of tax reform initiated by each party after 1942 complicated the negotiation process. Protracted negotiations led the treaty to be amended by two protocols prior to ratification in 1984.19 Three more protocols were subsequently negotiated.20 In addition to a shared history of tax coordination, progress has been made in tax treaty interpretation between these two countries. The courts of the United States and Canada have made efforts to ensure that both countries interpret treaty provisions in a similar manner. For example, in interpreting the Canada–United States tax treaty certain Canadian courts have referred to decisions by U.S. courts and to IRS rulings as persuasive authorities, although clearly not binding.21 These courts

Tax Coordination 51

have emphasized that inconsistencies with U.S. decisions regarding treaty interpretation should be avoided because they could lead to double taxation.22 A 1962 U.S. court decision interpreted the term ‘permanent establishment’ (discussed below) consistently with the interpretation of that term in Canadian case law:23 the court indicated that it would be desirable for courts in both jurisdictions to interpret terms in the same way.24 3.2.2 Tax Coordination with Mexico In contrast with the Canada–United States situation, formal tax coordination between Mexico and the other two NAFTA countries has only occurred in the last decade. Mexico was reluctant to enter into a tax treaty like the OECD Model Treaty (used by many industrialized countries as the basis for negotiating tax treaties) because this treaty was viewed as having a bias towards developed countries: the OECD Model Treaty was seen as shifting revenues to the treasuries of these developed countries, which are generally capital exporters. In 1943, a subcommittee in the League of Nations (predecessor to the United Nations) came up with the so-called Mexico Draft of a model tax convention to address perceived problems in other tax treaty models. Provisions were inserted to tax income at its source in order to give the Mexicans and similarly situated countries more authority to tax foreign business operations even if they did not maintain a traditional physical presence within their borders.25 Because the drafting of this convention took place during the Second World War, the majority of the subcommittee was comprised of Latin American representatives, which would help explain the favourable terms for nations that were capital importers. This new model tax treaty did not prove successful and Mexico refused to negotiate tax treaties with other countries that provided less favourable terms. Mexico later entered into a multilateral tax treaty, called the Andean Pact, with other Latin American countries that supported income taxation by source countries. A growing acceptance of international trade, however, eventually led Mexico to the bargaining table with the other NAFTA countries.26 Mexico initially concluded agreements for the exchange of tax information with the United States in 1989 and Canada in 1990.27 As a complement to NAFTA, Mexico concluded negotiations with Canada in 1991 for a comprehensive income tax treaty (effective 1 January 1992), notable for being the first comprehensive double tax treaty entered into by Mexico.28 The Mexico–United States Tax Treaty came into effect 1 January 1994.29

52 The Current Regime

The exchange of information agreement and tax treaty with the United States was later amended.30 The two countries signed an additional protocol, which entered into force in 2003, that modified the treaty to, among other things, eliminate withholding taxes on certain inter-company dividends.31 3.3 Comparative Review of Tax Treaties It is necessary to review and compare the three bilateral tax treaties negotiated by the NAFTA countries to see whether these conventions serve to fragment the North American market.32 It should be noted at the outset that all three tax treaties are similar in a substantive and drafting sense, because tax treaties are generally based on existing models. Although most industrialized countries follow the OECD model tax treaty when negotiating tax treaties, the United States has developed its own model, which is similar in most respects to the OECD model. Canada also uses a model tax treaty for negotiation purposes, but this model has never been formally published. Mexico often bases its negotiating position on the United Nations model tax treaty, which contains provisions to support taxation of cross-border activities by developing countries. 3.3.1 Taxes Covered All three tax treaties – the Canada-U.S. treaty, the Canada-Mexico treaty, and the U.S.-Mexico treaty – apply to all income taxes imposed by the federal governments of each NAFTA country.33 The two treaties with Mexico also cover the asset tax imposed pursuant to the Mexican Asset Tax Law (a 1.8 per cent tax imposed on assets that acts as a minimum tax, which can be credited against other taxes payable to the Mexican government). Under the first protocol to the U.S.-Mexico tax treaty, the application of the assets tax is limited in certain cases where there would be no Mexican income tax liability because of the tax treaty. Further, the non-discrimination provisions in each tax treaty apply to additional taxes (see below, ‘Anti-Discrimination Provision’). The CanadaU.S. tax treaty specifies that taxes on capital will also be included.34 None of the tax treaties covers payroll or property taxes. 3.3.2 Residence Residency determines in most circumstances whether an individual or a firm is liable to be taxed by each NAFTA country. Under the tax treaties, a person, either an individual or a business entity, is considered to be a

Tax Coordination 53

resident of a country if, under the laws of that country, the person is subject to taxation by that country because it is that person’s country of domicile, residence, place of management, place of incorporation, citizenship, or by reason of other criteria of a similar nature. The determination of residency is important because only residents of each NAFTA country can claim the benefits of the tax treaties. When it appears that an individual has dual residency, a series of ‘tie-breaker’ rules apply which deem the individual to be a resident of a particular country (for example, if the person has a permanent home in one country). Each tax treaty has a different manner for resolving dual residency of corporations. Under the Canada-U.S. tax treaty, corporations with dual residency are generally deemed resident of the country where they are first incorporated.35 Under Mexican law, a corporation is deemed a resident if it has its effective place of management in Mexico as well as if it was incorporated in Mexico. Canadian and U.S. tax laws generally indicate that a corporation is resident in their countries only if it was incorporated there (although the place of management test is also important in Canada). Accordingly, a situation could arise where a company is incorporated in either Canada or the United States and has its centre of management in Mexico, hence creating dual residency for the corporation. 3.3.3 Business Profits Pursuant to all of the tax treaties, ‘business profits’ of a business enterprise of one country are taxable in the other country only to the extent that the profits are attributable to a ‘permanent establishment’ (see below) in the other country through which the enterprise carries on, or has carried on, business. The profits are to be determined as if the permanent establishment were a separate legal entity that dealt at arm’s length with the non-resident. Under the tax treaties, deductions can be made for reasonable business expenses incurred by the permanent establishment. The U.S.-Mexico tax treaty contains a so-called restricted force of attraction provision36 that permits the state to tax activities that do not emanate from the permanent establishment in some circumstances.37 The state is permitted to tax the business profits derived from the sale of goods or merchandise of the same or similar kind as those normally sold through the permanent establishment. This clause is typically requested by developing countries to prevent avoidance of tax through the use of a home office in the foreign country to conduct business normally done at the permanent establishment.38 The clause, however, will not apply if

54 The Current Regime

the foreign enterprise demonstrates that the sales were not made from the home office to avoid the tax on profits attributable to a permanent establishment. The Canada-U.S. tax treaty alone has a provision39 that indicates that no business profits shall be attributed to a permanent establishment that provides executive, managerial, or administrative facilities or services to the foreign resident. 3.3.4 Permanent Establishment The NAFTA countries have agreed not to tax each other’s business activities unless a permanent establishment is located in their jurisdiction. Further, only profits attributable to a permanent establishment can be taxed (unless the previously discussed restricted force of attraction rule in the U.S.-Mexico tax treaty applies). The term ‘permanent establishment’ is generally defined as a fixed place of business through which a resident of one country engages in business in the other country. It includes, inter alia, a place of management; a branch; an office; a factory; a workshop; and a mine, quarry, or other place of extraction of natural resources. The two tax treaties with Mexico indicate that a permanent establishment will include a building site or construction or installation project which exists for more than six months (this provision tracks the one suggested by the United Nations model tax treaty).40 The Canada-U.S. tax treaty has a similar provision but the operations must exist for more than twelve months.41 The two treaties with Mexico also incorporate a provision dealing with foreign insurance companies operating in one of the NAFTA countries.42 The provisions indicate that a dependent agent who collects premiums or insures risk in one state on behalf of a foreign insurance company will be deemed to have a permanent establishment. The Mexican delegation requested these provisions in order to clarify the rules that will apply when Mexico permits foreign insurance companies to insure risks in Mexico.43 All three treaties have rules that specify when the use of a dependent agent (for example, an employee) will constitute a permanent establishment. A dependent agent who habitually concludes contracts on behalf of his principal will constitute a permanent establishment, entitling the source country to tax the profits associated with the agent’s activities. The U.S.-Mexico tax treaty has a provision that is not included in the other two treaties.44 Under this provision, a dependent agent who does

Tax Coordination 55

not have authority to conclude contracts in the name of the enterprise will nevertheless be deemed to have a permanent establishment of the enterprise if the agent habitually processes on behalf of the enterprise goods or merchandise owned by the enterprise using assets furnished, directly or indirectly, by the enterprise or an associated enterprise. The provision is meant to clarify that a dependent agent that processes inventory of its principal using assets of the principal, without itself having ownership of either the inventory or the assets used in the processing, represents a permanent establishment of the principal.45 3.3.5 Dividends Dividends paid by a company resident in one country to a resident of the other may be taxed in that other country. In addition, each NAFTA country may tax dividends paid by a resident company to a non-resident by a gross withholding tax. Withholding rates represent the amount of tax that the source country (where the business operations are located) can apply to payments made by residents to foreign companies or persons. The payer typically has a legal obligation to withhold the stipulated amount of tax and remit it to the relevant tax authority. Each NAFTA country has domestic tax rules that permit the levying of gross withholding taxes at high rates on cross-border transactions. The general statutory withholding tax rate is 25 per cent in Canada, 30 per cent in the United States, and 35 per cent in Mexico. As set out in table 4.1, the tax treaties negotiated between the NAFTA countries serve to reduce these withholding tax rates. The rate of withholding tax is limited if the beneficial owner of the dividend is a resident of the other country. The revised third protocol to the U.S.-Canada treaty signed on 17 March 1995 amended the withholding rates on direct dividends paid to corporate shareholders, reducing the rate to 5 per cent. Pursuant to the Canada-Mexico tax treaty, the rate is 10 per cent if the beneficial owner controls at least 25 per cent of the shares of the company paying dividends (otherwise, the rate is 15 per cent).46 Pursuant to the U.S.-Mexico tax treaty, the general withholding tax rate is 10 per cent. If the beneficial owners control at least 10 per cent of the shares of the company paying the dividends, the rate falls to 5 per cent. For dividends paid after 1 September 2003, the rate falls to zero for certain companies that own at least 80 per cent of the stock of the dividend-paying corporation. According to a U.S. Senate report, this is the first time that a U.S. tax treaty provides for the complete exemption

56 The Current Regime

from withholding taxes on dividends. The report notes that the intent of the new provision is ‘to further reduce the tax barriers to direct investment between the two countries.’47 Mexico, however, does not impose withholding taxes on dividends repatriated by foreign companies under its current tax policy. This has not always been the case. In 1999, Mexico adopted a dividend withholding tax, but this tax was repealed in 2001.48 As a result, the new zero withholding tax will only benefit Mexican direct investors in U.S. companies, because Mexico does not impose a dividend withholding tax on distributions from Mexican companies to foreign investors. Further, the Mexico-U.S. treaty has a most-favoured-nation provision that indicates that if the United States negotiates a lower dividend rate with another country, this new rate also applies to Mexico. In exchange for Mexico’s dividend exclusion for Canadian shareholders, Canada grants a 15 per cent notional credit against Canadian tax to Canadian shareholders of Mexican corporations.49 A tax of 15 per cent is deemed to be paid to Mexico by Canadian shareholders for portfolio dividends repatriated from a Mexican corporation under most circumstances. As discussed, Mexico does not impose any tax, including withholding taxes, on dividends from income where the corporate income tax has already been applied (see chapter 3). This credit reflects Canadian acceptance that it should not benefit from the way that Mexico has chosen to integrate its corporate and shareholder taxes.50 The United States has not agreed through its tax treaty to give credit to Mexican companies in similar circumstances, possibly because of its resistance to tax-sparing credits, or perhaps as a result of its stronger bargaining power.51 3.3.6 Interest Interest may be taxed in one country only if the beneficial owner of the interest is a resident of that country; the interest arose in that country; or the debt claim to which the interest relates is effectively connected with a permanent establishment or fixed base in that country. Interest may also be taxed in the country where it arises, but, if beneficially owned by a resident of that other country, the withholding tax imposed by the source country is limited to 10 per cent under the Canada-U.S. tax treaty, 10 per cent under the U.S.-Mexico tax treaty (or 15 per cent for some interest), and 15 per cent under the Canada-Mexico tax treaty.52 The protocol to the Canada-Mexico treaty has an MFN provision which indicates that if Mexico agrees to a rate of tax on interest or

Tax Coordination 57

royalties with another OECD country, then the lower rate (to a minimum of 10 per cent) will apply for purposes of the Canada-Mexico treaty. Accordingly, the effective withholding rate for Canada and Mexico is reduced to 10 per cent. Beginning in 1984, the United States does not impose withholding taxes on portfolio interest paid to non-residents.53 This development caused massive portfolio inflows from other nations to the United States, partly because of tax evasion efforts.54 Residents of countries that do not have the ability to track the worldwide income of their taxpayers knew that they could safely invest in interest-generating investments without the risk of taxation by the United States or, in many cases, the home country (see chapter 8). 3.3.7 Royalties Royalties are payments of any kind received as consideration for the use of, or the right to use, any copyright of literacy, artistic, or scientific work, patents, trademarks, designs, models, plans, secret formulae, or any tangible personal property. Generally, royalties that arise in one state and are paid to a resident of the other state may be taxed in both countries. Beginning in 2000, the OECD model tax treaty suggests that no withholding taxes should be applied to royalty payments, although Canada and Mexico have been reluctant to follow this guide in most circumstances. The withholding tax imposed in the source country may not exceed 10 per cent of the gross royalty under the Canada-U.S. tax treaty, 15 per cent under the Canada-Mexico treaty, and 10 per cent under the U.S.Mexico treaty.55 Pursuant to the MFN provision in the Canada-Mexico treaty (described above), the withholding rate for Canada-Mexico is reduced to 10 per cent. Pursuant to the third protocol to the CanadaU.S. tax treaty, the withholding tax was eliminated on royalties in a number of areas, including computer software programs and patents.56 3.3.8 Capital Gains and Corporate Reorganizations Article XIII of each tax treaty deals with the taxation of capital gains and indicates that the residence country is entitled to impose tax on the gains. The tax treaties, however, all permit the host country to tax gains derived by residents of treaty partners from the sale of ‘immovable property’ (in the case of the Canada-Mexico tax treaty and the U.S.Mexico tax treaty) or ‘real property’ (in the case of the Canada-U.S. tax treaty).

58 The Current Regime

Further, the Canada-U.S. tax treaty indicates that, for the purposes of real property situated in Canada, real property includes shares in a company or interests in a business entity, the values of which are derived principally from real property situated in Canada.57 This extended definition does not apply to real property situated in the United States. The U.S.-Mexico tax treaty also covers interests in business entities to the extent that their assets consist of immovable property as well as shares in a company, the assets of which consist of at least 50 per cent, by value, of immovable property.58 Finally, the Canada-Mexico tax treaty permits a state to tax the gains derived from the sale of shares that form part of a substantial interest in the capital stock of a company if the value of the shares is derived principally from immovable property.59 Additional provisions in the Canada-U.S. tax treaty and the CanadaMexico tax treaty attempt to deal with the problem of double taxation that may arise when one country imposes capital gains tax on a corporate reorganization but the other gives roll-over treatment to the same transaction. The source country may assert jurisdiction to tax a transfer of property on the corporate reorganization while the country of residence provides non-recognition for the transferor. In order to resolve this potential for double taxation, the country of source extends nonrecognition treatment. Article XIII.8 of the Canada–United States tax treaty permits the competent authority in the taxing country to agree to defer recognition in order to avoid double taxation. Nevertheless, Catherine Brown and Christine Manokalas indicate that there are a number of circumstances in which double taxation will occur because of various forms of cross-border reorganizations.60 The different tax treatments set out in the three tax treaties in North America likely constitute a serious impediment to cross-border acquisitions and reorganizations, and thus North American firms maintain suboptimal structures to avoid adverse tax consequences.61 3.3.9 Anti-Treaty Shopping Provisions As previously indicated, tax treaty benefits are only extended on a reciprocal basis: the benefits are not extended to all other trade partners. Multinational firms will therefore sometimes create a business entity in a country that has an advantageous tax treaty with another country. The United States has attempted to negotiate anti–treaty shopping provisions (also called limitation of benefits provisions) within its tax treaty network. Canada has resisted the provisions out of the belief that

Tax Coordination 59

treaty shopping promotes more foreign investment in the Canadian economy.62 As a result, the third protocol to the U.S.-Canada tax treaty includes a provision where the limitation on benefits operates unilaterally to protect the United States against the use of the Canada-U.S. tax treaty by treaty shoppers seeking to gain unintended U.S. treaty benefits through Canada.63 The unilateral provision will still permit investors to use the treaty to gain tax benefits when investing in Canada and is only enforceable by the United States. Both Canada and the United States, however, are permitted to deny treaty benefits if the benefits would result in ‘abuses’ of the tax treaty. The U.S.-Mexico tax treaty contains a general anti–treaty shopping clause with provisions inserted to ensure that current and new members of NAFTA are not discriminated against: benefits of the convention are extended to companies in Mexico or the United States that are partly owned by NAFTA members once the expanded agreement enters into force.64 Finally, the Canada-Mexico tax treaty has no provisions concerning a limitation of benefits to treaty shoppers.65 3.3.10 Anti-Discrimination Provision The tax treaties of the NAFTA countries contain provisions designed to protect individuals and firms of one country from discrimination by the other country. The national treatment provisions generally provide that a NAFTA country cannot impose a tax measure on a non-resident person that is not imposed on a similarly situated domestic person. Canada, however, grants national treatment solely to permanent establishments of non-residents in Canada.66 Only MFN treatment is granted to Canadian companies owned or controlled by foreigners. The three tax treaties indicate that the national treatment provision applies to different taxes. The U.S.-Mexico tax treaty indicates that all taxes by all levels of government are covered.67 The Canada-U.S. tax treaty covers only national level taxes (thus, the goods and services tax is covered).68 Finally, only taxes subject to the tax treaty (that is, federal income taxes and the Mexican asset tax) are covered by the CanadaMexico tax treaty.69 3.3.11 Mutual Agreement The tax treaties contain a provision that authorizes tax authorities to consult to attempt to alleviate individual cases of double taxation or cases of taxation that are not in accordance with the tax treaties. Article 14 of the third protocol to the Canada-U.S. tax treaty implements bind-

60 The Current Regime

ing arbitration for dispute resolution. If the governments of both countries as well as the taxpayer agree, then all parties will be bound by the decision of the arbitration board. The U.S.-Mexico tax treaty contains similar provisions concerning binding arbitration but the provisions are absent from the Canada-Mexico tax treaty. 3.3.12 Exchange of Information The Canada-U.S. tax treaty provides for the exchange of information necessary to carry out the provisions of the treaty for the prevention of fraud or for the administration of the treaty. The provision covers Canadian income tax and estates and gift taxes as well as all taxes imposed by the United States under the Internal Revenue Code.70 Prior to negotiating tax treaties with its NAFTA partners, Mexico initially negotiated Exchange of Information Agreements with the NAFTA countries. Article 27 of the Mexico-U.S. tax treaty incorporates the agreement negotiated with the United States in 1989. Additional provisions dealing with the exchange of information will only apply if the first agreement is terminated. The Canada-Mexico tax treaty does not refer to the Exchange of Information Agreement negotiated by the parties in 1990. Article XXV of the Canada-Mexico tax treaty contains further provisions that stipulate the parties agree to exchange tax information in certain circumstances. Presumably, both the provisions in the tax treaty and the more detailed provisions in the Agreement for the Exchange of Information continue to apply, as the NAFTA countries executed and ratified both agreements. 3.3.13 Enforcement of Tax Claims Article XV of the third protocol to the Canada-U.S. tax treaty created a new tax assistance collection regime between the two countries. For the first time, the parties agreed to enforce each other’s tax claims against individuals and businesses. The two other tax treaties in North America do not have similar provisions regarding the enforcement of tax claims. The Canada-U.S. provisions operate in a similar manner, as legislation regarding the reciprocal enforcement of court judgments that has been in place between the two countries for decades. Pursuant to the new provisions, each country agrees to treat the other country’s revenue claim as if it were a claim from the first country’s own tax authorities. The obligation, however, is not mandatory, since the authorities of each country ‘may’ accept a request to provide assistance.

Tax Coordination 61

Accordingly, a Canadian could no longer avoid paying her tax debt if she relocated to the United States with all of her assets. The American authorities can now enforce the Canadian tax claim by resorting to the regular remedies available to them under their tax code (for example, garnishing wages or sale and seizure of assets). It is interesting that these measures have only recently been adopted by two countries that have historically striven to ensure that their legal systems could not be thwarted by physically moving or relocating assets across the border. Perhaps a concern surrounding the confidentiality of tax information prevented the two countries from previously reaching an agreement. 3.4 The Limitation of Tax Treaties As discussed, tax treaties attempt to resolve many of the problems caused by the interaction of different national tax systems. Commentators have noted, however, that the tax treaty process is inherently limited in some circumstances.71 An initial problem with tax treaties is their bilateral nature, attempting as they do to co-exist within a multilateral trade and investment regime. The lack of uniformity among many of the provisions within the North American tax treaties may lead to distortions in the North American capital market. This problem will only be exacerbated if NAFTA expands its membership to other countries such as Chile, which have their own tax treaties with each of the NAFTA countries. For these reasons, Brian Arnold and Neil Harris recommend that the NAFTA countries trilateralize their tax treaty provisions, at least with respect to investment flows.72 Similarly, a group of European tax experts proposed that a common external tax treaty policy among EU countries was necessary to help reduce market distortions; more recently, the European Commission has proposed to develop an EU model tax treaty (see chapter 7).73 Table 4.1 notes a number of differences in the withholding tax rates in the tax treaties of the NAFTA countries. Some of these differences are mitigated by the most-favoured-nation provision of the Canada-Mexico tax treaty. The withholding tax rates on interest and royalties are reduced to the levels of the United States–Mexico Tax Treaty pursuant to this provision. Harmonization of the withholding rates may be insufficient: these taxes can inhibit or distort cross-border investments. Gross withholding taxes are applied to cross-border payments despite the fact that the multinational firm may not have enjoyed any net profits from its international transactions. Alternatively, withholding taxes can discourage cross-

62 The Current Regime Table 4.1 Withholding tax rates (2003) Treaties

Parent/subsidiary dividendsa Portfolio dividends Interestb Royaltiesc Capital gains

Canada– Mexico (%)

Canada– United States (%)

United States– Mexico (%)

10 15 15 15 0

5 15 10 10 0

0 10 4.9–10 10 0

aDividends:

Pursuant to the Canada-Mexico tax treaty, the dividend withholding rate is 15% when the recipient company holds less than 25% of the voting power of the company paying the dividends. Pursuant to the U.S.-Mexico tax treaty, the zero withholding rate is subject to a number of restrictions to prevent abusive tax transactions. Note that Mexico does not impose a withholding tax on dividends paid to non-residents under its current tax policy. bInterest: The United States does not generally impose a withholding tax on portfolio interest paid to non-residents. Pursuant to the Most Favored Nation provision in the Canada-Mexico treaty, the withholding rate is reduced to 4.9% under the same rules applicable to U.S. residents. cRoyalties: Pursuant to the Most Favored Nation provision in the Canada-Mexico treaty, the withholding rate is reduced to 10% under the same rules applicable to U.S. residents. Pursuant to the Canada-U.S. tax treaty, withholding rates are zero for cultural royalties, royalties for the use of computer software and any patent or information concerning industrial, commercial, or scientific experience.

border investments by raising the cost of doing business to the extent that the non-resident taxpayers cannot obtain tax credits for the withholding taxes paid to the foreign tax authority. The NAFTA countries permit withholding taxes to be credited against foreign tax paid in most circumstances, which therefore only results in revenue transfers among these states instead of imposing significant barriers to cross-border capital flows. Cross-border investments are likely particularly sensitive to withholding taxes applied when a parent company distributes a dividend to a related company located in another NAFTA country. A commentator has noted that the elimination of parent/subsidiary dividend withholding taxes will play a significant role in harmonizing tax burdens on crossborder investments within North America.74 Recommendations to reduce or eliminate dividend withholding taxes in Canada have been issued in order to promote investment in that country.75

Tax Coordination 63

While the United States generally favours reducing treaty withholding taxes, Canada and Mexico typically have differing views on the topic, principally because these two countries are net capital importers from the United States. At times, tax barriers to investment flows are viewed as being different in nature when compared to other potential barriers such as tariffs or government subsidies. This distinction is probably untenable in a free trade area, as taxes impose costs on businesses and impede investment flows in a similar manner as tariffs. Joel Slemrod has noted: ‘[A]lthough international trade theory has been applied principally to policy instruments such as tariffs, quotas, and dumping, tax policy can have at least as large an effect on the flow of goods across countries, the location of productive activity, and the gains from trade as these trade policy instruments.’76 In addition to differences resulting from the bilateral nature of tax treaty negotiation, other areas of concern remain unresolved, including the inability to avoid international double taxation in certain circumstances. As discussed, a primary goal of tax treaties is the removal of double taxation of earnings from business entities operating in two countries at once. Although tax treaties help to reduce double taxation among the NAFTA countries, taxpayers continue to pay double tax in certain situations. This arises because the NAFTA countries have differently defined tax bases as well as different income allocation rules: foreign tax credits are not given on the worldwide income of companies in certain circumstances. For example, the United States grants foreign tax credits to help relieve double taxation of earnings in foreign countries, but these credits are limited by the amount of tax paid on ‘foreign source income.’ Under the U.S. tax code, only certain types of income qualify for this characterization, even though the income is generated abroad. An example would be a sale of inventory by a U.S. subsidiary in Canada where title passes on the goods in the United States pursuant to the agreement of purchase and sale even though the physical sale takes place in Canada. The U.S. tax code indicates that since the agreement specified title passing in the United States it will be considered U.S.-source income.77 A U.S. taxpayer may hence be subject to double tax on its foreign earnings because it might not obtain full credit against foreign taxes paid. Moreover, transfer pricing may lead to unresolved double taxation problems among the NAFTA countries. Transfer pricing between related parties operating in different nations are supposed to be valued at arm’s length in order to impose some objectivity (see chapter 3). The

64 The Current Regime

NAFTA country tax authorities each have the right to impose transfer prices on companies if they feel that the companies have not valued the transferred goods at the appropriate amount. Although the tax treaties of the NAFTA countries have provisions that allow the tax authorities of the participating countries to negotiate a value for the transfer price, the authorities may not be willing or able to negotiate a settlement.78 Because transfer pricing determinations often have significant revenue implications, transfer pricing is becoming a more contentious issue among governments. Revenue Canada (now the Canada Revenue Agency) took the unusual step of publishing in January 1994 an announcement that transfer prices determined under U.S. rules might not be accepted by Canadian tax authorities. The following example shows how double taxation can occur when tax authorities do not agree on the same transfer price approach. Suppose a Canadian parent (‘Company A’) has a subsidiary (‘Sub A’) operating in the United States. According to the transfer prices set by Company A, Sub A will realize a profit of $100 in the United States and Company A will realize a profit of $200 in Canada. American tax authorities may assert that Company A charged Sub A too much for the goods and services that it transferred to Sub A. They may therefore decide to decrease these prices and Sub A’s profits will correspondingly increase to, say, $150. Sub A will have to pay more U.S. tax on the additional $50 profits. By the time the American tax authorities revise Sub A’s tax return, Sub A has already paid tax in Canada on the $50 which was reflected in Company A’s Canadian tax return. To make things fair, Company A’s return should be adjusted to reduce earnings by $50. Canadian tax authorities, however, may disagree with the U.S. valuation and may assert that Company A properly valued its transfer prices. Accordingly, Sub A ends up paying double tax on the same earnings. The process of using the ‘competent authority’ provisions of the NAFTA country tax treaties to resolve double taxation issues is a lengthy and costly one, and the recent arbitration procedures in the Canada-U.S. tax treaty are thus a welcome attempt at resolving these issues. Agreements at the centralized level under NAFTA that mandate timely responses could assist this process further. Tax coordination among the NAFTA countries with tax treaties may also be problematic due to the long periods of time that may elapse before new tax treaties are implemented. The negotiation of tax treaties is often a long and technical process, due to differences among tax systems. As exemplified by the Canada–United States treaty negotiation

Tax Coordination 65

process described above, years might pass after a NAFTA country initiates comprehensive tax reform before a new treaty can be finalized. Accordingly, the tax treaties may not reflect the international tax policy positions of a NAFTA country for long periods. Finally, tax treaties do not remove many of the economic distortions caused by the differences in tax systems in the NAFTA countries. As discussed in chapter 2, tax rules that promote different after-tax rates of return will influence the cross-border flow of mobile economic factors. Tax treaties do nothing to prevent resources from relocating to the jurisdiction with the lesser tax burden. The potentially inefficient allocation of resources such as capital is therefore not curtailed by treaties. 4 Conclusion This chapter has discussed the principal agreements among the NAFTA countries that govern the tax treatment of cross-border flows. NAFTA does not deal at length with tax issues and defers to bilateral tax treaties as the primary tax coordination mechanism in North America. Canada and the United States have a lengthy history of negotiating tax treaties, while Mexico has only recently entered into such agreements with its NAFTA partners. The provisions in the three tax treaties among the NAFTA countries are very similar, based as they were on similar model tax treaties (namely the OECD and United States models). However, certain differences persist in areas such as withholding tax rates. The bilateral approach towards coordinating tax systems may no longer be appropriate because it creates at least the potential to fragment a marketplace created through a multilateral trade and investment deal. Further, tax treaties do not alleviate other problems, such as lengthy transfer pricing disputes. The old model of addressing international tax policy concerns may no longer be effective as the economies of the NAFTA countries become increasingly bound together in an interdependent manner.

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PART II

The Economic Stakes

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CHAPTER 5

Taxes and Cross-Border Investments

1 Introduction Under the legal regime that coordinates the tax treatment of crossborder flows the NAFTA countries are permitted to maintain different tax burdens on different types of cross-border economic activity. As we have seen, some believe that the interaction of the tax systems will lead to the misallocation of mobile economic factors such as capital among the NAFTA countries. This chapter begins by establishing the importance to the NAFTA countries of maintaining a tax-hospitable jurisdiction to domestic and foreign investment. It then examines the extent to which taxes are suspected to influence cross-border investment flows. Finally, the chapter reviews a number of marginal effective tax rate studies that scrutinize the Canadian, American, and Mexican tax regimes for insight into the potential for taxes to distort investment decision making within North America. 2 The Importance of Foreign Investment within North America 2.1 Investment Flows and the NAFTA Countries The importance of investment to economic activity is illustrated by a study that concludes that almost half of economic growth between 1948 and 1980 in the United States is directly attributable to new investments.1 This capital can come from domestic or foreign sources. The North American economies increasingly rely on foreign capital supplies to meet domestic investment needs (see the discussion in chapter 2). Table 5.1 provides a breakdown of the total international investment positions in the NAFTA countries. The table indicates that foreign hold-

Table 5.1 Total foreign direct investment Direct investment flows

Direct investment positions

Inflows

Inward

Outward

% of GDP

Million US$

Outflows % of GDP

Million US $

Million US$

Million US$

Country

2002 1992

2002

2002

1992

2002

1992

2001

1991

2001

1991

Canada Mexico United States

2.93 0.22 0.29

21,404 4,722 13,627 4,393 30,114 19,823

3.82 0.02 1.18

0.63 – 0.77

27,938 969 123,528

3,589 – 48,266

209,120 140,376 1,514,374

117,032 30,790 533,404

244,440 – 1,598,072

94,387 – 643,364

0.83 2.23 0.31

1992

– not available Source: OECD, International Direct Investment Statistics Yearbook (Paris: OECD, 2003).

Taxes and Cross-Border Investments 71 Table 5.2 NAFTA direct investment positions Outward direct investment position (million US$) From Canada

Canada United States Mexico

1990

2000

51,466 210

110,680 2,483

From the United States

From Mexico

1990

2000

1990

2000

69,508

126,421

–11 575

93 2,471

10,313

35,414

ings of direct investment in Canada rose from approximately US$117 billion in 1991 to US$209 billion in 2001. Canadian holdings of foreign direct assets more than doubled in the same period (rising from $94 billion to $244 billion). Direct investment inflows into Canada increased from 0.83 per cent of GDP in 1992 to 2.93 per cent in 2002. A Canadian government report notes that foreign investment in Canada is now ‘essential for the competitiveness of the economy.’2 The report indicates that, in addition to spurring economic growth, FDI has a number of other important benefits, including technology transfers (the use of new technologies in Canadian industry), the creation and preservation of high value-added jobs (mainly through manufacturing investments), increased access to international markets for Canadian goods, and increased tax revenues. Tables 5.2 and 5.3 sets out the direct investment positions and flows among the NAFTA countries. Table 5.2 indicates that Americans owned roughly US$126 billion in direct investments in Canada in 2000 (up from US$69 billion in 1990). This represents approximately two-thirds of the total foreign holdings in Canada. Table 5.3 further indicates that direct investment inflows from the United States to Canada reached US$15 billion in 2000, almost three times the amount received in 1990. (It should be noted that the two years leading up to 2000 were a period of unusually high FDI among the NAFTA countries, with a significant drop-off beginning in 2001.) Table 5.1 reveals the growing importance of international investment to the United States and Mexico. FDI flows into the United States rose from US$19 billion GDP in 1992 to U.S.$30 billion in 2002, while the corresponding figures for Mexico are US$4.3 billion in 1992 and US$13.6 billion in 2002. During this period, U.S. direct investment outflows increased from 0.77 per cent of GDP to 1.18 per cent of GDP. Foreigners

72 The Economic Stakes Table 5.3 NAFTA direct investment flows Direct investment flows (million US$)

To Canada To United States To Mexico

Outflows from Canada

Outflows from the United States

Outflows from Mexico

1990

2000

1990

2000

1990

2000

5,560

15,370

3,679 10

14,018 245

–21 225

25 741

2,049

3,152

Sources: Statistics Canada, Canada’s International Investment Position, 1990, Catalogue No. 67-202-IB. (Ottawa: Minister of Industry, 2001). Statistics Canada, Canada’s International Investment Position, 2000. Catalogue No. 67-202-XIB. (Ottawa: Minister of Industry, 2001). Bureau of Economic Analysis, Foreign Direct Investment in the U.S.: Country and Industry Detail for Capital Inflows, 1990 and 2000. (Washington, DC: U.S. Department of Commerce, 2001). Bureau of Economic Analysis, U.S. Direct Investment Abroad: Country and Industry Detail for Capital Outflows, 1990 and 2000. (Washington, DC: U.S. Department of Commerce, 2001).

held approximately US$1.5 trillion in U.S. direct assets in 2001, an increase from US$533 billion in 1991. By 2001, American investors held approximately US$1.6 trillion in foreign direct assets, over double the amounts from 1991. Traditionally a provider of capital, the United States is now a major recipient of FDI. Mexico also requires much-needed foreign capital to buoy its economy and to encourage fiscal stability. Direct investment from domestic and foreign sources is thus crucial to the economies of North America. The trends also suggest that Canada is increasingly dependent on global financial markets to find required funding for domestic activities, underscoring the necessity of maintaining a climate that is attractive to international capital. According to the Canadian federal budget of 2003, ‘A competitive tax system is also critical in encouraging investment in Canada, leading to economic growth and job creation.’3 As discussed below, Canada must take particular care to ensure that it remains an attractive place to invest relative to the United States. 2.2 Competition for Investment and NAFTA Rules of Origin Investment needs and shortfalls in domestic savings have led many countries to intensify their competition for international capital.4 Each NAFTA country must seek out capital from foreign sources, even if the provision of this capital would otherwise have gone to one of its trade

Taxes and Cross-Border Investments 73

partners under NAFTA. Under NAFTA, foreign investors are encouraged to establish facilities within one of the NAFTA countries in order to produce goods of local ‘origin,’ which will enjoy preferential tariff treatment among the NAFTA countries. FDI from outside of North America may thus be directed towards one of the NAFTA countries in order to receive the preferences granted by NAFTA to goods originating inside its boundaries (unlike the situation in a customs union such as the European Union, where benefits of free circulation are granted to goods once within a common tariff wall).5 Placement choice of FDI directed at NAFTA may fall into two categories from the perspective of a foreign investor: capital intensive or labourintensive investments. An obvious choice for capital-intensive investments is either Canada or the United States, due to their skilled work force, higher productivity, and institutional support for such activities (see chapter 7). Mexico would be more likely to receive labour-intensive FDI, due to its wage and productivity gap vis-à-vis its NAFTA partners. Because foreign investors perceive Canada and the United States to have roughly similar investment climates, the potential for diverting FDI away from Canada increases if Canadian tax treatment of FDI is unfavourable relative to the United States.6 United States tax reform that creates a more hospitable investment environment may thus discourage foreign companies from placing their next capital-intensive investment in Canada; they may instead invest in the United States to gain access to the North American market (see chapter 6). 3 Does Tax Influence the Movement of Foreign Direct Investment? As discussed, portfolio investment moves across national borders with relative ease (see chapter 2). The amount or direction of these flows is influenced in part by changes in net returns on investments. Tax reform affects these flows through its impact on after-tax returns. Portfolio investment can switch from country to country with the push of a computer button as cross-country differentials in interest rates on bonds and net returns on equity securities fluctuate. FDI, however, is more resistant to movement as it may involve the placement of assets or other forms of business activity and thus substantial costs may be incurred. Unlike the arbitrage activities associated with international portfolio investments, FDI is normally undertaken as a long-term investment to exploit a business opportunity arising in another market.

74 The Economic Stakes

The more permanent nature of FDI promotes long-term economic growth, as earnings from this type of investment are often retained in the country where the investment takes place. For example, the bulk of the FDI increase during the 1980s in Canada was attributable to reinvested earnings by foreign-controlled enterprises.7 Further, as indicated above, FDI brings benefits to an economy beyond promoting growth. The extent to which tax can influence FDI movements (that is, relocating existing investments or attracting new investments) is briefly reviewed below. 3.1 FDI Is Influenced by a Number of Non-Tax Factors It is important to note at the outset that FDI movements are influenced by a number of non-tax factors and that tax consideration may not play a role in the determination to invest abroad. A report published by the World Economic Forum lists eight principal factors for assessing the investment climate of a country: overall economic strength, barriers to international trade and investment flows, government policies, quality of financial services, infrastructure, management skills, scientific and technological capacity, and human resources.8 Separating these different factors to understand how one single factor impacts investment decision making is a difficult task. Taxes might be important to certain business people but way down on the list of priorities for others. In order to address this problem, tax economists have striven to isolate the impact of tax policy on FDI movements. 3.2 Taxes and FDI Movements An extensive body of literature has examined whether tax plays a role in influencing FDI movements. Economists have examined the different ways that tax policy could potentially affect international investment flows,9 including the impact of residence-based or territorial tax systems on FDI flows10 and the impact of significant tax reform on the worldwide allocation of capital.11 The empirical analysis generally demonstrates that tax is playing an increasingly larger role in influencing FDI flows.12 The results of these studies have been bolstered by business surveys in which respondents suggest that tax is an important consideration when considering investing in foreign countries.13 Some commentators note that results may be skewed depending on the use of data and assumptions concerning actual tax burdens faced by firms investing abroad.14 Still, the studies do lead to a generalized view that tax affects FDI flows, although the extent of this influence continues to generate debate.

Taxes and Cross-Border Investments 75

4 Measuring the Influence of Taxes on Investment Decisions 4.1 Why Use Taxes on Marginal Investments? It is clear that tax regimes influence many decisions made by firms and households. Both individuals and businesses often cast a wary eye towards the tax system before they take any actions. In order to understand the relationship between a tax system and this decision-making process it is necessary to derive an appropriate measure of the actual tax burden that will be imposed on the activity in question. One concept that might presumably be used to gauge the impact of taxation on decision making is the statutory tax rate. For example, a Canadian business person could look up the corporate income tax rate in Mexico before deciding to invest. She might consider locating her next manufacturing plant in Mexico if the tax rate compares favourably with that of her home jurisdiction. While the statutory rate might provide an initial starting point when looking at the tax burden imposed on businesses, however, this rate does not present a complete picture of the tax burden on the person or entity in question. It does not take into account a variety of important tax factors such as depreciation, or when capital gains become payable. Further, the total tax burden attributable to the investment may be influenced by personal taxes imposed on the Canadian investor because she will ultimately have to pay Canadian taxes on, for example, any dividends she repatriates and includes in her gross income. In short, reliance on the corporate statutory tax rate would mislead potential investment decisions, as it does not measure the full burden imposed by taxes on the activities of firms and households. Another potential source for comparing tax systems is the average tax rate. The average tax rate is the total amount of taxes payable divided by the income earned by the taxpayer.15 In the international context, the tax competitiveness of a particular nation is sometimes measured by using the average tax concept but in this case, the percentage of collected tax against GDP is typically employed.16 Although the ratio of tax receipts to GDP is useful in reflecting the overall amount of taxation imposed on an economy, it does not assist in telling us how a nation competes for resources.17 Average tax rates do, however, provide useful tax burden comparisons for existing investments. When looking at how tax influences investment decision making, economists generally prefer marginal tax rates, which measures the tax paid on the last unit of investment activity. A marginal investment is a project that is expected to earn a rate of return that is just sufficient to persuade investors that the project is worth investing in. Under eco-

76 The Economic Stakes

nomic theory, a firm will accumulate capital until the last increment earns just enough operating income, net of taxes paid by the corporation, to render its rate of return equal to its hurdle rate. This last increment of capital is referred to as the marginal unit of capital: it just ‘breaks even’ in an economic sense.18 Marginal tax rates are important because they help to explain the influence of taxes on the decision-making process of whether to accumulate capital. The average tax rate, in contrast, measures the average tax paid on all decisions, both marginal and inframarginal. For example, because tax law changes apply to new investments, marginal and average tax rates can differ significantly.19 4.2 The Theory of Effective Tax Rates Economists developed a concept known as the marginal effective tax rate to measure the total tax burden on new investments.20 One method for deriving effective tax rates on marginal investments was developed by two British economists, Mervyn King and Don Fullerton.21 Effective tax rates take into account statutory tax rates, other aspects of the tax system such as depreciation, and non-tax factors such as interest and inflation rates. Under the theory of effective tax rates, investment decisions are influenced by taxes on investment and savings.22 A tax on capital such as a corporate income tax reduces the profitability of a firm and must be taken into account before an investment decision is made. Taxes on personal income affect savings and result in investors receiving less than they otherwise would when they invest funds. Both forms of taxes make investment less attractive by lowering potential returns to businesses and investors. By way of example, suppose that it is possible for an investor to earn a 5 per cent after-tax return by depositing money in a savings account at a bank.23 This investor will only invest her money with a company if she believes she will be provided a return of at least 5 per cent after tax. Accordingly, the company must pay dividends and/or capital gains of at least, say, 7 per cent in order to give the shareholder the 5 per cent return. The difference in these last two figures represents the amount of funds paid as personal tax by the investor. Moreover, in order to pay the gross dividends of 7 per cent, the company may have to earn a pre–corporation tax return of 11 per cent: the difference being paid in corporate tax. In this example, the tax burden creates a difference of 6 per cent between the return on capital originally invested (5 per cent) and the return earned before taxes by

Taxes and Cross-Border Investments 77

the company (11 per cent). This burden is shared by both the business and the investor and represents the combined impact of taxes on the investment being contemplated. Economists attempt to calculate how taxes reduce the return from 11 to 5 per cent in order to generate the effective tax. 4.3 Calculating the Effective Tax Rate As indicated, the difference between the pre–corporate tax rate of return on a marginal investment and the post–personal tax rate of return on the savings used to finance the investment needs to be calculated in order to come up with the total tax burden. It is fairly straight forward to calculate the post–personal tax rate of return by measuring market rates on savings and deducting from them the appropriate taxes facing households. As discussed below, measurement of this rate of return may vary depending on what assumption is used concerning the return demanded by the investor. In measuring the pre-tax corporate rate, one cannot directly observe the market for the marginal investment because of the difficulty in identifying the marginal project. As discussed, economic theory maintains that the pre-tax rate of return on the marginal project must be just enough to cover all costs of the project, including capital and tax costs. The pre-tax rate of return is derived from the measurement of these costs. The theory implies that if a firm rationally pursues maximum profits, then investments will be pursued until the point at which the marginal benefit of a dollar’s worth of capital per period equals the cost of holding the dollar of capital for the period. This cost is sometimes referred to as the ‘user cost of capital’ and consists of the cost of financing the capital plus the loss in value of the capital due to economic depreciation. Taxes are then applied to the costs in order to generate the precorporate tax marginal product of the dollar’s worth of investment. The important conceptual point here is that pursuant to economic theory the pre–corporate tax return on a marginal investment is the same thing as the cost of capital for the firm. This cost of capital measure is a useful figure to use when comparing different tax systems in an open economy context. 4.4 Problems with Marginal Effective Tax Rate Studies Prior to discussing marginal effective tax rate studies involving the NAFTA countries, some attention needs to be paid to the limitations of these

78 The Economic Stakes

studies. As recognized by the authors themselves, most of these limitations result from an attempt to simplify the complexities of the tax system in order keep the studies manageable.24 It is clearly not possible, for instance, to calculate a separate effective tax rate for every conveivable marginal investment. The methods of aggregation employed by the study will obviously influence the results obtained. The King and Fullerton approach is often used to review economies as a whole; it takes into consideration the taxation of various industries. Businesses are typically aggregated into broad categories such as manufacturing, construction, or retail trade. Most countries, however, tax a variety of industries in different manners. If a study only incorporates, say, manufacturing into the analysis the results will not accurately reflect the entire tax system. Households, for their parts, may be aggregated depending on average personal tax rates or highest marginal tax rates, and some assumption is made concerning tax-free or tax-deferred investments like registered retirement savings plans in Canada, or individual retirement accounts in the United States. But most tax systems contain numerous personal tax rates for a number of entities and therefore any results will not accurately reflect these complexities. Further, capital assets are slotted into categories to impose a limit on the amount of potential investments. For example, some studies limit their analysis to certain assets such as industrial buildings, machines, and inventories. In order to maintain the manageability of the study, a variety of other potential investments is often not considered and the results will reflect this incompleteness. The studies also do not take into account complex financial instruments used by companies to raise funds. Generally, only debt, new equity, or retained earnings are reviewed. Multinational firms also use sophisticated tax planning, which may influence the ultimate cost of capital of a marginal investment; for example, related-party loans, hybrid financial instruments, and transfer pricing can be employed to alter the ultimate tax burdens paid in different countries. Further, the methodology generally assumes that investment decisions are made on the current tax system and the current tax rate, whereas in reality, expected profitability depends on expected inflation rates and tax changes. As a result, certain studies attempt to take into account expectations surrounding inflation and interest rates. Difficulties are also created when an effective tax rate study attempts to offer comparative analysis by comparing one country’s tax regime with another. The economists who model these countries must often

Taxes and Cross-Border Investments 79

make simplifying, and frequently controversial, assumptions about the way one tax system works in order to make it comparable for analysis purposes to another system. For example, because the manner in which assets are depreciated affects the cost of capital, comparing the U.S. tax system to the Canadian system would require converting the various separate pools of personal and real property that have different depreciation approaches into Canadian capital cost allowance classes, which primarily employ a declining balance approach. The assumptions made to simplify this conversion may ultimately have a large impact on the effective tax rates. Moreover, a study may leave out certain taxes due to a lack of available data or, again, in an attempt to reduce complexities. These taxes may include wealth taxes on individuals or firms, tax incentives to particular industries, taxes on foreign exchange gains or losses, and payroll taxes. Omitting any taxes that firms must pay out from calculations will obviously alter the results obtained. The studies also do not generally take into account tax compliance levels. For example, Mexico has suffered serious compliance problems in the past, and these will ultimately affect the amount of tax paid by firms and individuals. An additional limitation in many effective tax rate studies is the assumption that investment takes place in a risk-free environment.25 Riskier investments require higher expected returns to compensate for the risk element. Firms are generally said to face two types of risk on their investments: capital risk and income risk.26 Capital risk refers to uncertainty regarding the economic rate of depreciation due to the physical rate at which an asset breaks down. Income risk contemplates uncertainty regarding future net revenues. Tax would not have any impact on this risk if losses and gains were treated in the same way by the tax system. This would only be true if the tax system permitted full loss offsetting (that is, if negative taxes could be fully refunded to the taxpayer or if unlimited carrybacks and carryforwards of the tax loss with interest costs were permitted). Tax systems, however, do not generally permit refunds and limit the availability of carrybacks and carryforwards. It has been estimated that only about 50 per cent of investment in Canada and 80 per cent of investment in the United States is conducted by firms that are fully tax paying.27 An assumption of full-loss offsetting does not therefore reflect what actually occurs in an economy. The results obtained in any given study must obviously be taken with a rather large grain of salt. As one commentator has noted, ‘One comes away from this recipe book with the distinct feeling that effective tax

80 The Economic Stakes

rates, like sausage, are best enjoyed in their final form, and that one can quickly lose one’s appetite by looking too carefully at the details of preparation.’28 Food metaphors aside, marginal effective tax rates can be viewed as a rough approximation of the potential distortions imposed by taxes on investment decision making. 5 Studies of the NAFTA Tax Systems The results obtained by the studies employing the marginal effective tax rate approach will now be reviewed and compared in order to see how they can be used to formulate tax policy decisions. The emphasis in this part will be placed on reviewing the results regarding the Canadian, United States, and, to a lesser extent, the Mexican tax system (tax rate studies involving Mexico have only recently become available). As discussed, the tax systems of the NAFTA countries may encourage an inefficient allocation of resources among the NAFTA countries by creating different after-tax rates of return on investments in different jurisdictions, assets, and industries (see chapter 2). A relatively higher cost of capital on a marginal investment in one country compared to the cost of capital in another country will tend to discourage investment by making it costlier to engage in such activities. Differences in marginal costs of capital indicate the degree to which countries’ tax rules are non-neutral with respect to investment decision making. Resources are thus misallocated to the extent that capital inputs are directed from their most productive uses (that is, where investments earn the highest rate of return before taxes) to locations where the resources are less productive (that is, they yield greater after-tax returns) due to their favourable tax treatment. Real investment may be encouraged to move to countries with lower effective tax rates, even if these same countries have lower before-tax rates of return on real investments and thus can use the capital less efficiently than other countries. The economic inefficiencies caused by non-neutral tax treatment among the NAFTA countries reduces capital productivity and lowers levels of total output (with corresponding reductions in standards of living) in NAFTA. 5.1 Marginal Effective Tax Rate Studies of Canada and the United States A Canada–United States study conducted by Kenneth McKenzie and Jack Mintz, using a modified version of the King and Fullerton approach, concludes that, although significant historical differences ex-

Taxes and Cross-Border Investments 81

isted in the past, the cross-industry effective tax rates of the two countries have moved more closely together in recent decades (the study calculated rates for 1975, 1980, 1985, and 1990).29 The overall industry aggregate effective tax rate in Canada was calculated to be 28.9 per cent in 1990, whereas the figure calculated for the United States equals 20.4 per cent. Most industry-specific results revealed even closer effective tax rates. For example, the 1990 effective tax rates for the manufacturing industry for Canada and the United states were calculated to be 31.1 per cent and 27 per cent, respectively. The above-noted results were derived from base-case assumptions: risk was ignored, firms were assumed to be fully tax paying, and multinational investment was not considered. McKenzie and Mintz performed sensitivity analysis on this base case and found that, generally speaking, when the models are altered to take into consideration the elements that were ignored in the base case conclusions were not altered. When companies experiencing tax losses are incorporated into the analysis, however, the study indicated that differences in effective tax rates between Canada and the United States were almost eliminated. The study concludes that although the corporate tax systems of the two countries have become more ‘harmonious,’ significant differences remain in effective tax rates. For example, 1990 Canadian effective tax rates exceeded American rates by 19.5 per cent in construction, 13.9 per cent in transportation and storage, and 10.1 per cent in wholesale trade.30 The study also found that effective tax rates in both countries are sensitive to interest and inflation rates. It was noted that existing effective tax rate differences might become greater in the future if the inflation and interest rates of the two countries diverge, as neither tax system indexes for inflation. An OECD study employing the King and Fullerton methodology also indicated that the 1991 cost of capital results in Canada and the United States are very similar: the overall pre–corporate tax required rate of return necessary when the real interest rate is 5 per cent is 6.2 per cent for Canada and 5.8 per cent for the United States.31 The overall average tax wedge (the difference between the pre–corporate tax rate of return and the post–personal tax rate of return) for Canada and the United States was calculated to be 3.5 per cent and 3 per cent, respectively. The OECD study further conducted sensitivity analysis by altering inflation rates, real interest rates, and economic depreciation rates; the overall impression derived from base-case results remained unchanged after the sensitivity analysis.32

82 The Economic Stakes

A more recent study using the modified King and Fullerton approach compared the impact of tax on the cost of capital for investments in Canada and the United States for the years 1971 to 1996.33 Again, the results indicated that, although the U.S. cost of capital has been significantly lower historically, the two countries have moved closer together in recent years. The higher cost of capital in Canada, however, was found to be generally attributable to higher real interest rates in Canada, although the tax systems contributed to the differences. By 1996, the cost of capital for aggregate non-manufacturing investments was almost identical. The study further indicates that changes in the relative cost of capital have had small but statistically significant impacts on the relative investment levels in the two countries for equipment investment, although not for structures investment. A more recent marginal effective tax rate study that takes into account tax reform efforts in 2003 suggests that Canadian multinational firms continue to be tax disadvantaged in comparison to U.S. investments (see chapter 6). 5.2 Marginal Effective Tax Rate Studies for All NAFTA Countries Comparative cross-industry marginal effective tax rate studies involving Mexico are less available. One study touched on the subject, although it was primarily concerned with how the tax policies of certain Latin American countries affect foreign direct investment from either the United States or Canada.34 The study indicates that 1992 effective corporate tax rates for marginal manufacturing investments among the NAFTA countries are comparable, with Canada imposing the highest tax burden and Mexico imposing the lowest. For services, Mexico had higher effective corporate tax rates than Canada or the United States.35 Mexican effective corporate tax rates drop significantly for a certain type of investment called maquiladoras (see chapter 3), companies that are operated by non-residents in Mexico and that import raw material and re-export final products outside of the Mexican domestic market. Maquiladoran enterprises have historically been exempt from certain taxes and tariffs on imports. Effective corporate tax rates on maquiladoran firms with investments in manufacturing and services are significantly lower than rates for Canada and the United States.36 A cross-country comparative marginal effective tax rate study by Duanjie Chen and Kenneth McKenzie reviewed the 1995 tax systems of the NAFTA countries as well as other countries.37 They indicate that Mexico imposed the lowest marginal effective tax rates among the NAFTA

Taxes and Cross-Border Investments 83

countries for domestic investors, at 16.5 per cent for manufacturing investments and 17.7 per cent for investments in services. The relevant figures for the United States were 21.5 per cent for manufacturing and 19.9 per cent for services, while Canada imposed rates of 25.5 per cent for manufacturing and 32.2 per cent for services. The study also reviewed the tax treatment of Canadian and American multinational corporations investing in each other’s country; it generally indicates that Canadian and American investors face lower marginal effective tax rates when they invest abroad. Marginal effective tax rates for Canadian investments in American manufacturing are 18.3 per cent while U.S. multinational firms investing in Canadian manufacturing face a rate of 21.4 per cent. These lower tax costs are attributed to lower costs of financing and the requirement of higher after-tax rates of return for foreign investments. Canada and the United States offer marginal effective tax rates that are similar to most of their competitor nations (with the exception of Hong Kong). Mexico appears to impose a tax burden on capital that is lower than the one imposed by its NAFTA partners. This is partly attributable to the fact that Mexico does not impose a subnational corporate income tax. The study suggests that the higher taxes facing Canadian investors are thought to provide relatively greater tax disincentives to invest in Canada. A more recent study of the NAFTA countries by Duanjie Chen and Jorge Martinez-Vazquez, conducted in 2001, provides marginal effective tax rates for investments in manufacturing and services.38 Under the approach developed by the authors, a model is created where one country acts as the host country for the investment while the other two countries are simulated to act as foreign investors. Table 5.4 sets out the main results from this study; it includes only Mexican rates that reflect the situation when Mexico acts as a host country for exporters, which are exempt from import duties. When Mexico acts as a host country for nonexporters, and this exemption is unavailable, marginal effective tax rates tend to increase significantly. As indicated in table 5.4, Mexico again appears to be the lowest taxed country within the NAFTA region. Canada similarly appears to be the highest taxed country for foreign investors. Further, the analysis reveals that Canadian and Mexican investors are at a tax disadvantage when they invest in each other’s country when compared to U.S. investors in these countries. According to the authors this result comes from the fact that the United States has negotiated more favourable treaty provisions with

84 The Economic Stakes Table 5.4 NAFTA marginal effective tax rates (METR) (%) Mexico, as host country, for exporters Manufacturing METR

United States 17.9

Services Canada 19.8

United States 15.6

Canada 17.0

Canada as host country Manufacturing METR

United States 25.3

Services Mexico 33.5

United States 27.1

Mexico 35.0

United States as host country Manufacturing METR

Mexico 23.4

Services Canada 21.2

Mexico 23.8

Canada 21.3

Source: See Jorge Martinez-Vazquez and Duanjie Chen, The Impact of NAFTA and Options for Tax Reform in Mexico (Atlanta: Georgia State University International Studies Program, Working Paper 01-2, 2001).

its partners in comparison to the Mexico-Canada treaty. (This study does not take into account more recent U.S.-Mexico treaty developments that reduce parent/subsidiary withholding taxes to zero in certain circumstances, which would provide even more favourable treatment for investors in these countries. See chapter 4.) The study notes that ‘welfare losses arising from these distortions [created by differential marginal effective tax rates] are not likely to be large.’39 5.3 Capital Risk Analysis Study Involving Canada and the United States In order to address some of the limitations surrounding risk assumptions noted earlier, John Shoven and Michael Topper employed a different approach. They define the cost of capital in the same way as the other models, as the expected rate of return necessary to satisfy both the company and the tax authorities.40 The measure includes an interest factor, a risk premium, and a variety of tax factors. Shoven and Topper, however, do not present the cost of capital as one figure, but rather as a schedule of figures involving different amounts of risk. They calculate the cost of capital by examining the relationship between the interest

Taxes and Cross-Border Investments 85

rate, the risk aversion shown in the capital market line, and the tax system. The measurement incorporates uncertainty about projected cash flows (income risk) and uncertainty about the depreciation of the investment (capital risk) by adding random variables to the expected return of the real interest rate which must be earned by the marginal investment. Shoven and Topper then calculate the risk premium that must be paid to an investor in order to induce him to invest. The risk premia figures are determined from the observed equity premium on the capital market line. An assumption must be made concerning the amount of the total risk premium caused by income and capital risk. Building on previous empirical research, Shoven and Topper assume that 90 per cent of the total risk is attributable to depreciation risk and the remaining 10 per cent is attributable to income risk. Tax considerations are then added in a manner similar to that employed in the King-Fullerton model. Differences in the 1988 effective tax rates between Canada and the United States as revealed by the Shoven-Topper approach are difficult to gauge, as the results are presented in chart form and the cost of capital returns vary depending on systematic risk. Measurements of the tax wedge between the cost of capital and the capital market line were not provided. A general conclusion of the study, however, is that the cost of capital results are very similar in Canada and the United States.41 The study also indicates that the two countries have adopted tax systems that accord similar treatment to risky investments. Accordingly, the authors conclude that investment location considerations will often be driven by factors other than tax or financial market considerations.42 6 Conclusion Further economic integration has increased the focus on tax as a possible influence on the allocation of capital among nations. When formulating domestic tax policy, governments now place a greater emphasis on how their tax systems interact with foreign systems. Marginal effective tax rates reveal potential distortions imposed on investment decision making and help us to understand how tax influences inward and outward investment flows. The rates also offer a useful guide for understanding how certain activities are promoted or discouraged by a tax system in the domestic context, and they can be viewed as a rough approximation of the potential influence of taxation on investment decisions. It is important to note, however, that these studies do not

86 The Economic Stakes

attempt to estimate the actual welfare losses associated with maintaining different tax regimes under NAFTA. Marginal effective tax rate studies involving the NAFTA countries indicate that overall rates are generally similar in most circumstances. But differences continue to exist in after-tax rates on return on investments in different assets, industries, and financing alternatives. These differences can create distortions where an inefficient amount of capital is employed in an economy and an inefficient allocation of capital is employed across assets and jurisdiction: ultimately, economic growth and productivity may be reduced. The most recent study involving all of the NAFTA countries indicates Mexico imposes the lowest tax burden on foreign investments while Canada imposes the highest burden. Further, significant differences exist when Canadians invest in Mexican manufacturing or service industries in comparison to the more favourable treatment offered to American investors with similar investments in Mexico. These differences are attributable in large part to the more favourable provisions within the Mexico–United States tax treaty.

CHAPTER 6

The Impact of U.S. Dividend Tax Reform

I Introduction The preceding chapter investigated the potential for the tax regimes of the NAFTA countries to influence investment decision making. The analysis revealed that each tax regime imposed differing tax treatment on assets and industries as well as on how the investment was financed. Nevertheless, overall results suggest that the NAFTA countries impose roughly similar tax burdens on investment activity. What would happen if this situation were to change? This chapter reviews the implications of U.S. tax reform in 2003, which significantly reduced tax rates on dividends received by individuals. Canadian policy makers paid close attention to these reform efforts, due to their potential impact on the Canadian economy. Their proactive decision to lower tax burdens on investments, along with the decision of the United States to extend dividend tax relief to U.S. shareholders of Canadian companies, likely reduced potential harmful effects to the Canadian economy. The analysis provided below highlights the policy of regulatory emulation whereby Canadian tax authorities take steps to ensure that their tax burdens on capital are similar to U.S. burdens. The tax authorities will need to keep a watchful eye on U.S. developments to see whether additional dividend relief is offered or, as contemplated, the U.S. income tax system is replaced with a consumption tax system. 2 Capital Market Integration between Canada and the United States The discussion begins with a brief review of the degree of capital market integration between the United States and Canada; this review sets the

88 The Economic Stakes

stage for the subsequent analysis of the possible impact of the recent U.S. tax reform efforts on the Canadian economy. United States tax reform is important to Canadian tax policy analysts primarily for one reason: Canada’s economic success often depends on developments within the U.S. economy. In particular, U.S. firms supply roughly three-quarters of the foreign direct investment within Canada (see chapter 5). Studies indicate that the capital market shared by these two countries is highly integrated, permitting investments to flow between them with relative ease. For example, a review of the cost of capital and risk/return ratios of the individual capital markets of Canada and the United States has led two economists to conclude that the two markets have a high degree of integration.1 Another study suggests that barriers remain to the free flow of investment goods, leading to a certain amount of fragmentation between the Canadian and U.S. equity and debt markets.2 U.S.-Canada capital market integration is promoted by agreements that coordinate the securities law regimes of the two countries. For example, the multijurisdictional disclosure system (MJDS) adopted by the U.S. Securities and Exchange Commission and Canadian provincial securities regulators such as the Ontario Securities Commission facilitates cross-border offerings of debt and equity instruments. MJDS permits public offerings of eligible U.S. issuers to be made in Canada based on a prospectus prepared in accordance with U.S. requirements with some additional Canadian legends and certificates. Further, most private offerings by way of offering memoranda to the United States or Canada from the other country can be done by simply adding a ‘wrapper’ (a twopage sheet that wraps around the disclosure document) that includes additional information for the foreign investors, such as exchange rates. A highly integrated capital market has resulted from the close historical legal and economic ties and lack of financial restrictions between Canada and the United States. The close relationship between these two markets makes the Canadian economy sensitive to any fiscal reform in the United States that might affect the treatment of capital flows. Further, the impact of U.S. tax reform on the Canadian economy is magnified by the fact that the American economy is over ten times the size of the Canadian economy. 3 Dividend Tax Reform in the United States 3.1 Background: U.S. Anti-Tax Sentiments and Sources of Tax Revenues Anti-tax sentiments have been brewing within the United States for at least the past two decades. In the mid-1990s, several U.S. politicians

The Impact of U.S. Dividend Tax Reform 89

proposed to scrap the income tax system and replace it with a consumption tax system.3 A consumption tax generally excludes from taxation amounts that are saved or invested (what is left has been consumed). In other words, the proposals emphasize taxing people on what they take out of society (measured in part by what they consume) and less on what they contribute to society (measured in part by their income). Consumption tax reforms have been considered for some time in Canada as well. In 1966, the Royal Commission on Taxation (known as the Carter Commission) discussed the principle of moving towards the taxation of consumption.4 Other government reports in Canada, the United States, and elsewhere have discussed whether tax burdens should be shifted from income to consumption.5 In 1996, a Republican-sponsored report (known as the Kemp Commission’s Report) recommended that the U.S. Internal Revenue Code be repealed and replaced with a single low-rate consumption-based tax such as a flat tax.6 The most prominent flat-tax proposal was developed by two Stanford University professors.7 The flat tax would be applied at both the household and firm level. Businesses would be permitted to write off any new investments immediately; they would also be permitted deductions for labour costs, cost of inputs, and pension contributions. The remainder of their income would be taxed, under one proposal, at a flat rate of 17 per cent.8 Individuals would be taxed at the same rate on their wages and pension distributions.9 While they would not be able to deduct their savings, they would not be taxed on the earnings from the savings (other proposals would permit deduction for amounts of income placed in savings). The flat tax hence taxes income from capital investments only once at the business level. There would be no tax rebate for exports, and imports would enter the country tax free. Further, the foreign-source income of U.S. corporations and individuals would not be taxed. The editorial board of the Wall Street Journal came out in support of flat taxes,10 while the editors of Canada’s national newspaper, the Globe and Mail, took a position against flat taxes.11 It is important to note that this flat tax is very different from the provincial flat tax employed by Alberta, which taxes individuals at one rate: the Albertan tax is still an income tax, while the American flat tax proposals focus on consumption as the appropriate tax base. Table 6.1 sets out the main sources for tax revenues in Canada and the United States. The table shows that the two countries raise remarkably similar revenues from their federal and subnational income tax systems. Canada and the United States both raise roughly 48 per cent of their tax

90 The Economic Stakes Table 6.1 Sources for total tax revenues (2001) Canada

United States

Mexico

Revenue type

% of total tax receipts

% of total tax receipts

% of total tax receipts

Personal income tax

36.8

42.4

27.3a

Corporate income tax

11.1

8.5

–

Social Security: employee contributions

5.7

10.2

–

Social Security: employer contributions

8.2

11.9

16.4b

Taxes on goods and services

24.4

15.7

53.1

Other revenues

13.8

11.3

3.2

aIncludes

personal and corporate income taxes: not available separately. employee and employer contributions. Source: OECD, OECD in Figures (Paris: 2003) at 38–9. bIncludes

revenues from corporate and personal income taxes. Canada already has a federal-level consumption tax, the GST, which, along with provincial sales taxes, brings in about 25 per cent of total revenues. In contrast, the United States raises fewer revenues from taxes on goods and services: subnational taxes and other taxes on goods and services raise 16 per cent of total revenues. Table 6.1 also sets out the tax revenue sources for Mexico: this country raises significantly less from its corporate and personal income taxes (30 per cent of total revenues), although taxes on goods and services, including the Mexican VAT, raise 51 per cent of total revenues. 3.2 The Jobs and Growth Reconciliation Act of 2003 When the consumption tax proposals proved unsuccessful, Republican lawmakers enacted tax legislation to reduce tax burdens on businesses and individuals. The Growth and Tax Relief Reconciliation Act of 2001 provided tax cuts for individuals for a ten-year period and scheduled the repeal of the estate tax in 2010 (although the scheduled repeal sunsets in 2011). A subsequent statute, the Job Creation and Worker Assistance Act of 2002, curtailed taxes on businesses. On 28 May 2003, President Bush signed into law the third major tax bill of his administration: the Jobs and

The Impact of U.S. Dividend Tax Reform 91

Growth Reconciliation Act of 2003 (the Act). The initial proposal was to eliminate the double taxation of corporate dividends by granting a complete exclusion of dividend income from an individual’s gross income. The administration hoped to stimulate a lagging economy by providing incentives to consumption and investments in the form of reduced dividend tax rates. The total dividend exclusion would ‘effect what is arguably the most fundamental change to the taxation of corporations and their shareholders since 1913.’12 The proposal to eliminate dividend taxation was initially discussed in a U.S. Department of Treasury report that came out in 1992; if enacted, it would have created a corporate income tax system within the United States that paralleled the system adopted by Mexico.13 The movement towards dividend exclusion was motivated in part by international concerns, as most of the major trading partners of the United States, including Canada and Mexico, offer some form of relief from double taxation of corporate income.14 While the more radical aspects of the President’s proposal were generally not adopted, the Act nonetheless introduced significant tax rate reductions in many circumstances. The Act reduces taxes that individuals pay when they receive corporate dividends from a high of 38.6 per cent to 15 per cent. Individual taxpayers subject to lower tax brackets of 10 and 15 per cent will only be taxed at a rate of 5 per cent for dividend income. Thus, dividends will be taxed at rates of 5 to 15 per cent. Longterm capital gains tax rates were also reduced from 20 to 15 per cent. Further, the highest marginal tax rate on ordinary income was lowered from 38.6 per cent to 35 per cent. The Act also increased the first-year depreciation deduction from 30 to 50 per cent for certain property. All tax cuts within the Act were retroactive to 1 January 2003. The legislation contains automatic ‘sunset’ provisions where, without an act of Congress, many of the Act’s tax cuts will eventually expire. For example, the dividend and capital gains tax reductions will expire after 2008 and the individual tax rate cuts are set to end after 2010: the rates will then return to the higher tax rates applicable before 1 July 2001. Possible radical consumption-based tax reform continues to enjoy political support in some circles. The U.S. Senate, for example, introduced an amendment to the Act to ‘undertake a comprehensive analysis of simplication or flat tax proposals, including appropriate hearings, and consider legislation providing for a flat tax.’15 John McNulty has noted that many recent tax reform efforts within the United States have reduced the tax burden on savings and investment to a significant extent and could represent a slow evolution towards a consumption tax system.16

92 The Economic Stakes

4 The Impact of U.S. Dividend Tax Reform on Canada 4.1 The Effect of Previous U.S. Tax Reform Efforts Previous economic studies examined how Canada’s economy reacted to the significant tax reform undertaken in the United States through the Tax Reform Act of 1986 (TRA86) (see chapter 3). These studies indicated that TRA86 caused share prices across industries in Canada to react in an inverse manner compared to share price behaviour in the United States,17 and that TRA86, as well as tax reform in Canada, altered the manner in which U.S. corporations operating in Canada funded their investments.18 The impact of TRA86 on Canada, however, was no doubt lessened by the fact that Canada implemented its own tax reform in 1987. This reform was similar in nature to TRA86: income tax rates were lowered, marginal rate brackets were reduced, deductions were curtailed, and the tax base was broadened.19 Following these reforms, a similar overall tax burden on capital existed in both countries. Government discussion of this type of tax reform actually took place earlier in Canada and was largely a reaction to developments in tax policy in England. TRA86 hastened the implementation of Canadian reform, as the government attempted to ensure that its tax system better reflected U.S. developments.20 It appears that TRA86 did not have a major impact on the Canadian economy. This could perhaps be attributed to the swiftness of the Canadian response to the U.S. legislation, which ensured that capital received a similar tax treatment. 4.2 Impact of Tax Reform on Canadian FDI Flows 4.2.1 Comparing the Tax Burdens after the Reform Efforts The following analysis offers a rough comparison of the tax treatment of dividends in Canada and the United States after the 2003 reform efforts in both countries. As discussed, the Canadian corporate and individual income tax systems are partially integrated: Canadian shareholders claim federal/provincial credits of roughly 20 per cent of the gross dividend (which equals 125 per cent of the dividend received due to the dividend gross-up (see chapter 3)). Individuals must pay income taxes on the gross dividend, although they can claim the credit against taxes owed. For individuals in the highest marginal income tax bracket, this results in a federal/provincial tax rate of roughly 32 per cent on dividend income (20 per cent for the federal rate and 12 per cent for the average provincial rate).21

The Impact of U.S. Dividend Tax Reform 93 Table 6.2 Canada-U.S. corporate income tax rate comparisons Canada

2003 (%)

2008 (%) (proposed changes)

Federal income tax rate Surtax Provincial weighted average income tax rate Federal-provincial income tax rate Federal-provincial corporate tax rate (including capital taxes)

23 1.12

21 1.12

12 36.1

9.8 31.9

39.4

33.8

35 39

35 44 39

40

40

United States Federal income tax rate Average state income tax rate Federal-state income tax rate Federal-state corporate tax rate (including capital taxes)

Source: Department of Finance, The Canadian Tax Advantage (Ottawa: Department of Finance, 2003), repr. in no. 1644 Tax Topics 1 (Don Mills, ON: CCH, 2003).

As set out in table 6.2, a Canadian corporation is generally taxed at a rate of 36.1 per cent (after taking into account federal and provincial income taxes) on $100 of net profits, leaving roughly $63.90 after taxes. Assuming this full amount is distributed by way of dividend, the individual will pay $20.50 in income taxes on the dividend, which leaves $43.40 after taxes. The result creates a total tax bill of $56.60 on dividend income in 2003. In the United States, the corporation is taxed at a combined federal-state rate of 39 per cent on $100 of net earnings, leaving $61 after taxes. If the total amount is distributed to an individual shareholder by way of dividend, the dividend will be taxed at a rate of roughly 20 per cent (15 per cent federal rate and 5 per cent net state rate after federal reduction)22 for a tax bill of $12.20, leaving an after-tax amount of $48.80. In other words, the dividend income is taxed at an effective rate of 51.2 per cent in 2003. These calculations show that Canadian shareholders in domestic firms will face higher tax rates on dividend income compared to the rates faced by American equity investors. But these statutory tax rates tell only part of the story; other aspects of the tax system, such as capital taxes and depreciation deductions, and non-tax factors such as interest rates must be considered to get a better estimate of the investment incentives offered by taxes (see chapter 5).

94 The Economic Stakes

Taking into account the recent Canadian and U.S. developments, one study estimates that Canada imposed a marginal effective tax rate of 31.8. per cent for large companies in thirteen industries in 2003 (declining to 27.4 per cent by 2008), while the U.S. rate for similar investments in that year was 20.11 per cent. The authors indicate: ‘Surprisingly, and depressingly, business investment will remain more highly taxed in Canada than in the United States, even after significant reductions in corporate taxes in the past several years, as well as those planned for the future.’23 The study attributes the imbalance primarily to more preferential tax treatment for depreciation expenses in the United States, as well as lower state capital taxes in comparison to the capital taxes levied by certain Canadian provinces. 4.2.2 Mitigating Factors The potential adverse impact of the Act on the Canadian economy was likely reduced by three factors: (1) the U.S. tax reform extended tax relief to dividends repatriated from Canadian corporations; (2) the Canadian government introduced its own tax reform efforts through the February 2003 budget, which reduced tax burdens on new investments; and (3) the tax relief provided through the Act is temporary in many circumstances. First, the Act extended dividend tax relief to domestic and ‘qualified foreign corporations.’ A qualified foreign corporation includes a foreign corporation whose shares trade on a U.S. stock exchange (for example, Nortel Networks), as well as a corporation residing in a country that has both a tax treaty with the United States and an exchange of information program. This development, which has been characterized as an ‘extraordinary concession,’ would extend the tax relief to dividends from Canadian corporations, as Canada has previously negotiated an exchange of information provision within its tax treaty with the United States (see chapter 4).24 Consequently, the Act may not significantly lower marginal effective tax rates for investments in Canada by U.S. individuals in comparison to the tax burdens accompanying domestic U.S. investments. It is important to note that the dividend tax reduction only applies to U.S. individual taxpayers: foreign and Canadian shareholders will not receive any tax benefits from the dividend reform provisions of the Act. Further, the Act does not change the tax treatment of cross-border intrafirm dividends: the provisions in the Act that offer dividend relief are only directed at individual recipients of corporate dividends. In addition, dividends received from Canadian corporations that are char-

The Impact of U.S. Dividend Tax Reform 95

acterized, for U.S. tax purposes, as foreign investment companies, passive foreign investment companies, or foreign personal holding companies, will not be eligible for the tax relief. Finally, both the United States and Canada will continue to impose (creditable) withholding taxes on cross-border dividends (see chapter 4). The extension of the tax relief to dividends provided by Canadian corporations exposes Canada to continued criticism for its own dividend integration method, in which dividend tax relief is only granted to shareholders of Canadian corporations (see chapter 3). As previously discussed, an important international tax policy goal is to encourage neutral tax treatment between inbound and outbound investments (see chapter 2). The Act, unlike the Canadian approach, serves to promote this goal by extending the dividend tax reductions to dividends offered by foreign companies. Second, the Canadian government introduced a number of tax measures in its February 2003 budget that serve to reduce tax burdens on new investments in Canada.25 The budget phases out the capital tax on large corporation from 2004 to 2008. Moreover, the general corporate income tax rate was reduced by two percentage points, from 23 to 21 per cent, in 2004. Finally, the budget increases the contribution limits for pension retirement savings plans such as registered retirement savings plan to $18,000 by 2006. In addition, several provinces have similarly proposed corporate income tax rate cuts. In 2003, Alberta reduced its corporate income tax rate to 11.5 per cent, with subsequent rate cuts to 8 per cent as long as certain budget requirements are met. The 2003 and proposed 2008 corporate income tax rates for federal and provincial/state governments within Canada and the United States are set out in Table 6.2. By 2008, the total Canadian federal/provincial corporate tax rate (including capital taxes) is predicted to be 6.2 per cent lower than the U.S. federal/state corporate tax rate (including capital taxes). Third, the recent tax cuts introduced by the Act are set to expire unless Congress takes legislative steps to continue or increase the cuts. It is unclear how individuals and firms will react to the sunset provisions within the Act. Taxpayers may take a ‘wait and see’ attitude before committing their resources to projects or they may feel that, given the current and expected political climate, the rate reductions will become permanently enshrined within the U.S. tax code. This uncertainty promotes greater investment risk and makes it difficult to estimate the extent of changes to taxpayer behaviour that could flow from the Act.

96 The Economic Stakes

4.2.3 The Impact on Canadian Direct Investment Flows The Act lowers the tax burdens placed on marginal investments in the United States by reducing tax burdens on dividends and capital gains as well as permitting firms to expedite their depreciation deductions. Dividend tax policy in particular can have significant effects on a firm’s investment strategy by reducing the cost of capital and changing incentives to retain earnings or distribute these earnings by way of dividend.26 Reduced costs of capital in the United States will make it easier for firms to fund capital investments. Because the marginal tax burdens in Canada would become relatively larger than the American tax burden, all else being equal, the interaction of the tax systems provide incentives for investments to take place in the United States rather than Canada. As discussed, international firms seeking access to the North American market must locate facilities in one of the NAFTA countries in order to take advantage of the origin of goods requirement necessary for tarifffree circulation (see chapter 5). An international firm seeking a skilled workforce and infrastructure to support capital-intensive projects will likely choose between Canada and the United States as potential investment locations.27 If the tax burdens are sufficiently less attractive in Canada, the firm may decide to locate the new investment in the United States since the two countries are generally similar with respect to other potential investment criteria. The American reform efforts appear to create incentives for companies to locate in the United States rather than Canada. These incentives have been modified to a certain extent by the Canadian government’s own reform efforts, the fact that U.S. dividend tax relief was extended to distributions by Canadian companies, and the fact that the reduced tax levels will expire unless Congress takes further action. Whether the dividend tax reforms will actually lead to capital outflows from Canada to the United States thus remains unclear. 4.3 Impact on Financial Strategies The U.S. dividend tax reform could influence the manner in which companies with operations in Canada and the United States conduct their financial affairs. Double taxation of dividends produces at least three kinds of tax non-neutralities: the decision to retain or distribute profits, the financing choice between debt and equity, and the decision of firms to incorporate.28 The U.S. decision to maintain its double taxation of dividends will continue to promote these sorts of tax distortions although, by lowering the tax burden on dividends, the Act arguably promotes fewer distortions.

The Impact of U.S. Dividend Tax Reform 97

4.3.1 Increasing Dividend Distributions The classical taxation system employed in the United States provides an incentive to U.S. firms to keep their foreign earnings offshore, because dividends are taxed upon repatriation. As mentioned, the Act does not change the tax treatment of cross-border intrafirm dividends: the provisions in the Act that offer dividend relief are only directed at individual recipients of corporate dividends. Cross-border intracorporate dividends would continue to enjoy tax relief as long as the U.S. parent owns, for example, 80 per cent of the shares of the Canadian subsidiary. Nevertheless, lowering the individual-level dividend tax reduces the disincentive against repatriation, at least to a certain extent. Firms might repatriate these funds from Canadian subsidiaries to bolster distributions to individual shareholders if other U.S. firms increase dividend payouts. An empirical study suggests that U.S. multinational firms repatriate relatively more profits from a foreign subsidiary when the tax cost of repatriation is temporarily lower than normal.29 Further, U.S. individual shareholders with equity investments in Canadian companies may become more likely to pull their money out of corporations by way of dividends. In addition, the decision by a U.S. multinational firm to repatriate funds from foreign subsidiaries is influenced in part by whether the U.S. parent company is in an ‘excess credit’ position with respect to its foreign tax credits. Pursuant to section 904(c) of the Internal Revenue Code, the amount of foreign income tax above the credit limitation paid in any given year can be carried back to the two previous taxable years and forward to the five subsequent taxable years (for a discussion of U.S. foreign tax credits, see chapter 3). The distribution of a dividend from a Canadian subsidiary generates more foreign source income for the U.S. parent and hence can be used to ‘soak up’ excess credit. U.S. multinational firms will tend to find themselves in an excess credit position with respect to Canadian taxes if Canadian tax rates are generally higher than U.S. rates, which is no longer the case. 4.3.2 Debt Financing of Canadian Affiliates The cost of capital of a Canadian investment by a U.S. parent is affected by the manner in which it is funded. The Canadian subsidiary can finance ventures by borrowing locally, issuing shares, or using retained earnings. The U.S. parent could fund the venture in Canada by transferring debt or equity capital to the subsidiary, which could in turn use one of the three methods to finance the project. These different avenues will result in different amounts of tax paid on the Canadian project because

98 The Economic Stakes

of the different tax treatment that each avenue receives at the company and investor level. By lowering the cost of capital for equity financing, U.S. firms are offered an incentive to raise funds by offering equity to new shareholders. These firms could use this new equity in part to loan money to their Canadian subsidiaries. This would create a deductible interest expense in Canada and a corresponding increase in the profits of the U.S. parent, leading to Canadian tax base erosion. One study suggests that U.S. firms have engaged in this sort of debt financing strategy with their Canadian affiliates because Canadian corporate income tax rates have traditionally been higher than U.S. rates.30 This type of strategy is subject to Canada’s thin capitalization rules, which attempt to prevent a Canadian subsidiary from reducing its taxable Canadian profits by maximizing its interest expense to related non-resident creditors (see chapter 3). Recent efforts to lower the Canadian corporate income tax rate reduce the tax benefit of debt financing within Canada (lower tax rates reduce the amount of interest that can be expensed), which may discourage additional debt financing by Canadian firms. The fact that, as of 2003, the U.S. corporate income tax rate is higher than the Canadian rate may work as a counteracting incentive that would inhibit debt financing within Canada (see table 6.2). 4.3.3 Manipulation of Transfer Prices Multinationals with operations in both Canada and the United States could try to lower their overall tax burdens by taking advantage of the difference in marginal effective tax rates using income shifting strategies. This would be a particularly sensitive area given the enormous amount of related-party transactions between the two countries (see chapter 3). With transfer pricing, U.S. firms might increase cross-border charges to their Canadian affiliates in order to reduce taxes in Canada (and hence reduce revenues to the Canadian fisc). Alternatively, Canadian multinationals may try to shift profits to the United States. This type of strategy is subject to the Canadian and U.S. tax rules regarding the valuation of transfers between related parties, which generally provide that the prices should conform to prices charged in comparable arm’slength transactions (see chapter 3). My observations on various financial strategies that might be used by multinational firms with operations in Canada are very general in nature and ignore more sophisticated tax planning strategies such as the use of

The Impact of U.S. Dividend Tax Reform 99

hybrid entities, double-dip financing, or hybrid financial instruments.31 It is unclear whether the U.S. reform efforts will lead to a significant erosion of the Canadian tax base due to tax arbitrage strategies. Empirical research would need to be conducted to confirm whether Canadian and American firms have actually changed the way they conduct their financial strategies as a result of the reform efforts. 5 Canadian Reaction to U.S. Dividend Tax Reform 5.1 Economic Integration and Canadian Tax Reform A ‘do nothing’ strategy is clearly not a realistic option if U.S. tax reform will have a long-term negative impact on the Canadian economy. In an environment of economic and financial market integration, the ability of Canada to go its own way is greatly diminished. No reaction from the Canadian government could encourage capital outflows to continue and tax revenues to be depleted. Rather, the government often strives to match the effect of the U.S. reform by creating similar tax burdens on cross-border capital. There is evidence that the U.S. reform efforts in 2003 influenced Canadian tax reform efforts. When the Bush administration announced plans to eliminate the income tax on dividends received by individuals, Canadian business groups warned that Canada needs to have a tax regime at least as competitive as the U.S. regime.32 These concerns were motivated in part by the fear that the U.S. tax reform would lead to a loss of Canadian employment and investment. Before the Canadian government issued its February 2003 budget, a spokesperson for the finance minister indicated that the proposed U.S. tax changes would be taken into account when the government formed its own plans.33 While elimination of the capital tax was on the political radar screen prior to the U.S. proposals, the U.S. reform efforts may have hastened the phasing out of the capital tax announced by the budget.34 Canadian concerns about tax competitiveness are also reflected in an exchange that took place between the Opposition party and the governing Liberal Party on 9 May 2003. An Opposition member of Parliament said: Mr. Speaker, the U.S. Congress is proposing changes to the Bush tax plan that could seriously hurt Canadian business. It would only restrict dividend tax reduction to domestic companies. This would leave hundreds of Canadian companies, such as Nortel, Canadian Pacific, TELUS and many others,

100 The Economic Stakes that have offices in the United States out in the cold. My question is for the Minister of Finance. Has the Minister of Finance made the appropriate calls to his counterpart in the United States to tell him this is simply wrong?

The secretary of state (international financial institutions) answered: Mr. Speaker, the honorable member can rest assured that the government is quite confident with its tax plan, which is very competitive as we operate within the North American economic space. Our corporate tax rates, by the time we implement the plan, will be 6.6% below the Americans. It is clear to me that the tax plan that the government has put in place is working well for Canadians.35

As discussed above, the U.S. dividend tax cuts were ultimately extended to certain foreign corporations, which served to reduce the potential adverse impact of the U.S. tax changes on Canada. 5.2 Matching and Undercutting U.S. Tax Changes The 2003 Canadian federal budget demonstrates how closely Canadian finance policy makers watch U.S. developments and that they measure Canadian economic and tax performance against U.S. benchmarks. The 382-page budget contains 185 references to the ‘United States’ or ‘U.S.’ In contrast, the 347-page U.S. budget for the fiscal year 2004 contains only six references to ‘Canada’: four concern border security issues and none deal with tax issues.36 The same budget contains only three references to ‘Mexico,’ all dealing with border issues. The Department of Finance noted within the budget that, ‘With the cuts implemented to date, the average (federal and provincial) corporate tax rate in Canada is now below the average U.S. rate. Moreover, with the reduction in the capital gains inclusion rate to one-half under the tax reduction plan, the average top capital gains tax rate is now lower than the typical top tax rate in the U.S.’37 In addition, the Department of Finance indicated that the elimination of the capital tax would continue to generate a tax advantage for Canada even after the U.S. tax reform proposals, including dividend tax relief, were taken into account.38 The budget also noted, ‘The proposed changes to the tax structure of the resource sector will improve the international competitiveness of Canada’s resource sector, in particular relative to the United States.’39 The statements within the Canadian budget, along with the government’s tax strategy and response to proposed U.S. tax cuts, serve as

The Impact of U.S. Dividend Tax Reform 101

evidence of the phenomenon of regulatory emulation (see chapter 10). The Canadian government at times pursues a course of unilateral harmonization by ensuring that its tax system does not offer unfavourable tax treatment to cross-border capital relative to the United States. In recent years, the Canadian government appears to be striving more explicitly to impose tax burdens on investments within Canada that are less than the burdens imposed on investment activity within the United States. A 2003 Department of Finance Tax Bulletin entitled The Canadian Tax Advantage sets out a number of comparisons between the U.S. and Canadian tax system and points out, ‘The average corporate tax rate in Canada is now below the average U.S. tax rate, and will be more than 6 percentage points lower by 2008.’40 These acts are consistent with the view that it is rational for Canada or Mexico to engage in limited tax competition by undercutting U.S. tax burdens in order to make up for the loss of sovereignty that occurs when the former two countries reform their tax systems to match U.S. developments (see chapter 10). 6 Conclusion The U.S. Jobs and Growth Reconciliation Act of 2003 is unlikely to create significant problems for the Canadian economy. The most dramatic change within the Act is a reduction of the maximum individual dividend tax rate from 38.6 to 15 per cent. This rate reduction, along with other corporate tax relief, will reduce the tax burden on marginal investments within the United States, which could lead to investment outflows from Canada, and ultimately to a reduction in Canadian economic growth and tax revenues. The risk of this outcome, however, has been reduced by, among other things, the fact that the dividend tax relief has been extended to recipients of dividends distributed by Canadian corporations. While the Act created a degree of concern and required a tweaking of the Canadian tax system, it did not necessitate significant changes. More worrisome is the fact that certain political circles within the United States continue to call for the complete elimination of dividend taxation, or for the replacement of the income tax system with a consumption tax system. These more radical reform efforts would likely force the Canadian government to take more drastic steps to ensure that Canada maintains a hospital tax climate for investments. The discussion in this chapter highlights the tax policy implications of the interdependent economic relationship that exists between Canada

102 The Economic Stakes

and the United States. Relatively small countries (in economic and not territorial terms!) like Canada and Mexico must constantly be on the alert for significant fiscal policy changes by large trade partners when these countries co-exist in a regionally integrated trade and investment area. As the North American economies become more entwined, the economic impact of fiscal reform in the United States (and possibly Canada or Mexico) on the other NAFTA partners will only increase.

PART III

Sovereignty Concerns

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CHAPTER 7

Lessons from Europe

1 Introduction Europeans have been struggling with cross-border tax issues under regional economic integration at least since the Treaty of Rome was signed in 1957. As a customs union with a broad political and economic integration agenda, the member countries of the European Union have considered whether they should sacrifice tax sovereignty by agreeing to a set of common tax rules. These countries have had limited success in overcoming the sovereignty hurdle and proceeded with partial VAT harmonization as of 1 January 1993; they have had even less success in the area of corporate income tax harmonization. Accordingly, the European experience offers a number of lessons to countries considering further tax integration in a regionally integrated trade area. This chapter compares the movement towards heightened economic and tax integration within Europe with North American developments. The analysis highlights how different regional integration strategies can generate different ways of thinking about regional tax integration. In contrast to the situation in Europe, the North American governments view their free trade deal as almost exclusively focused on the promotion of economic goals without creating any significant political linkages. While the Europeans have to a certain extent overcome the fear of loss of tax sovereignty, the NAFTA countries would be extremely reluctant to cede control over their tax systems to a system of common tax rules. 2 European Economic Integration and Tax Harmonization 2.1 The Movement towards Political and Economic Integration in Europe In order to understand the progression in Europe towards tax harmonization, this development must be placed within the greater context of

106 Sovereignty Concerns

European economic integration. The European Union had to overcome significant sovereignty issues in order to develop into what stands as the most fully integrated regional economic union in the world today. This section briefly surveys the movement towards greater economic and political integration in Europe in the last forty years. The focus will be on identifying the tension between this movement and the loss of sovereign control by the countries that have participated in European regional integration. Elaborate analysis of European integration can be found elsewhere;1 this section attempts only to touch on areas that are relevant to identifying this tension. In 1957, six countries in Europe2 successfully negotiated a customs union arrangement that came to be known as the Treaty of Rome.3 A number of other European countries subsequently joined the union by signing the treaty.4 It has been said that the drive towards integration was influenced by factors beyond economic rationales that included real social and political concerns: the integration movement was viewed by its creators ‘as a meta-value in itself above any mundane cost-benefit analysis.’5 This meta-value arose from the recognition that some mechanism was required to thwart the nationalist tendencies that resulted in two devastating world wars in the prior half-century. It was hoped that the Treaty of Rome would provide such a mechanism, allowing the countries of Europe to co-exist in a relatively peaceful fashion,6 and the treaty attempted to fulfil this political goal by creating interstate political linkages such as centralized decision-making institutions. It was further hoped that economic integration would create the necessary economies of scale to accelerate the process of rebuilding Europe after the Second World War.7 From its inception, integration in Europe has gradually deepened to the point where the Treaty of Rome has been recognized in a case heard by the European Court of Justice as ‘the basic constitutional charter’ of the European Union.8 As of 1 January 1993, Europe was transformed into the European Union under the Single European Act,9 continuing the movement towards greater economic and social integration with the potential for ultimately greater political union on the horizon. This transformation, however, was not accomplished without some difficulty.10 European integration was characterized by fits and starts, with periods of stagnation. Between 1958 and 1972, the European Court of Justice took upon itself an active role in ‘constitutionalizing’ the Treaty of Rome to preserve the drive towards integration. This was partially accomplished by the court’s confirmation of the supremacy of the Treaty of Rome over

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the national EU country constitutions. In turn, the courts of the EU countries accepted that the Court of Justice had the proper authority and jurisdiction to interpret the treaty. In fact, as subsequently discussed, the European Court of Justice has also exerted a growing influence on the development of the corporate tax systems of the EU countries.11 The court’s actions led to a loss of political control, creating a greater reluctance on the part of the European countries to cede decision making to supranational bodies such as the European Commission. They also created an environment of political stagnation where European integration was concerned, which lasted from 1973 to the mid1980s. The fear of continued economic stagnation eventually led the European countries back to the bargaining table. In 1985, the European Community set out a strategy to achieve a single market by the end of 1992.12 This strategy resulted in the Single European Act, which detailed the legislative agenda for achieving the common market, defined in the Act as ‘an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured.’13 A principal objective of the single market was to allow European firms to obtain the economies of scale deemed necessary to effectively compete in the international marketplace. In fact, article 100 of the Treaty of Rome calls for the harmonization of the laws of the EU countries that ‘directly affect the establishment or functioning of the Common Market.’ Harmonization efforts were initially directed at attempting to create uniform technical regulations. These harmonization attempts, however, proved slow and ineffective right through the 1970s: the European Community was a common market in name but not in reality. Indeed, it took eleven years to agree on standards for mineral water! The deadlock was finally broken with the development of a principle called ‘subsidiarity.’ Article 3B of the Treaty of Rome reads, ‘In areas which do not fall within its exclusive competence, the Community shall take action, in accordance with the principle of subsidiarity, only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the member countries and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Community.’ This principle expresses the idea that the central European Commission authorities should not prescribe comprehensive rules but should restrict themselves to measures that are indispensable to the functioning of the internal market. Proposals were to focus on steps that could not be taken by the EU countries themselves, or that were unlikely

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to be generated by market forces.14 A result of this change was a revitalized Commission with an active political role in moving the integration agenda forward. Over a decade has passed since the development of the common market in the European Union, and integration has deepened to the point where many EU nations accept a common monetary policy and a common currency. In fact, European politicians sometimes speak of a ‘United States of Europe’ on the political horizon. 2.2 Tax Harmonization in Europe The next sections describe European efforts to harmonize direct and indirect taxes, with an emphasis on the political hurdles involved. 2.2.1 Harmonization of Direct Taxes The lack of initial success for general harmonization efforts in Europe was mirrored by early tax harmonization attempts. This lack of progress occurred despite the fact that the Treaty of Rome expressly recognized that tax differences would hinder the achievement of the common market. Articles 95 through 99 of the treaty contain provisions that explicitly deal with indirect taxation (for example, VATs) and removing obstacles to the free movement of goods. These provisions, however, do not explicitly mention direct taxation (for example, corporate or individual income tax). Only article 220 refers implicitly to direct taxation, by indicating that EU countries should enter into negotiations to abolish double taxation within the European Union.15 Despite this apparent lack of legislative will, there has been much discussion concerning the harmonization of direct taxes in Europe.16 In fact, the focus was initially placed on direct taxes rather than indirect taxes soon after the European Economic Community came into being. In 1960, the Commission appointed a fiscal and financial committee to study how direct taxation differences impede the realization of an integrated market. The committee (chaired by Dr Fritz Neumark) reported in 1962 that these differences distorted competition and recommended that taxes (with the exception of taxes on individuals) be centrally regulated. It was noted that article 3(f) of the treaty calls for ‘the establishment of a system ensuring that competition shall not be distorted in the Common Market.’ It was felt that the distortion caused by direct taxes would impede the efficient allocation of resources among the EU countries. Firms would make decisions based on the different tax regimes and not on pure economic rationales.

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In 1967, the Commission submitted to the European Council a proposal to harmonize corporate income taxation; the next year the Commission published two draft directives relating to the taxation of corporations that would address the problems of cross-border mergers.17 In 1975, the Commission proposed the harmonization of corporate tax systems,18 and in 1980, it announced that it would publish draft proposals on a common tax base for business profits.19 Discussion, however, did not give rise to action as none of the proposals were ratified or implemented. It became clear that a number of the EU states were unprepared to cede control over their domestic direct tax policy to the extent proposed in the draft directives. Harmonization efforts in fiscal matters under article 100a of the treaty require unanimous consent by the EU countries prior to the adoption of any legislation. A new mechanism was needed to overcome this obstacle. In 1990, the Commission published a document with more modest expectations, in line with the new subsidiarity principle and the view that centralized rules should only be developed for activities that are indispensable to the functioning of the common market.20 Efforts were then concentrated on the removal of double taxation of cross-border taxation flows and two Directives and a Convention were quickly adopted unanimously by the European Council in June 1990. For almost the first time in the history of the European Union, its member countries agreed on centralized measures in the field of direct taxation.21 The Directives and the Convention are designed primarily to avoid double taxation and to help ensure that businesses operating across borders are not burdened by less favourable tax conditions than those applicable to their activities in the country where they are established. The so-called Merger Directive, first proposed in 1969, introduced a common system of taxation applicable to mergers, divisions, transfers of assets, and exchanges of shares taking place among companies of different EU countries.22 The objective of this Directive is to permit these operations to be carried out in a tax-neutral manner.23 The Directive provides relief from immediate taxation by ensuring that transfers of assets from one EU country to another are accomplished on a taxdeferred basis.24 The so-called Parent-Subsidiary Directive, which was also first submitted by the Commission in draft form in 1969, created a common system of taxation that applies in cases of parent companies with subsidiaries in different EU countries.25 In order to ensure neutrality of taxation and to reduce compliance costs, the Directive attempts to abolish double taxa-

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tion and withholding taxes levied in the source country on profits distributed by a subsidiary to a parent resident in another country (where the parent holds at least 25 per cent of the shares of the subsidiary). Alex Easson has noted that this reform effort is considered the most important, since the EU countries already granted double taxation relief by exempting dividends received from tax or granting foreign tax credits.26 The so-called Arbitration Convention is a multilateral convention (based on article 220 of the Treaty of Rome) allowing for arbitration where the EU countries cannot reach agreement on the elimination of double taxation in connection with the adjustment of transfer of profits between associated enterprises.27 The Arbitration Convention has not been in force since 2000, because certain EU member states did not ratify a protocol in 1999 that would have extended its duration. Additional proposals submitted involved the abolition of withholding taxes on interest and royalty payments between subsidiaries and parent companies established in different EU countries28 and the deductibility of losses incurred by a foreign affiliate from the parent company’s profits (permitting a form of European-wide tax consolidation in balance sheets where losses can be offset against profits incurred in other EU countries).29 2.2.2 The Establishment of the Ruding Committee A committee was formed by the Commission in December 1990 to gain a better understanding of the long-term measures required in the field of corporate taxation once an internal market was established. This committee (the ‘Ruding Committee’) was chaired by Dr Onno Ruding, a former Dutch finance minister, and consisted of a number of nongovernmental tax experts from various European countries.30 The mandate of the Ruding Committee was to investigate the major distortions caused by corporate taxation in the internal market and the impact that these distortions might have on competition. The Ruding Committee was further mandated to propose measures to mitigate the impact of these distortions. At the outset, it indicated that ‘the Committee has been mindful of the extent to which tax measures should be used to implement other social and economic objectives ... Any action at the Community level will be considered by the Committee ... to the extent to which such action encroaches upon European countries’ freedom to pursue their own policy objectives through the use of tax measures.’31 According to the results obtained in the empirical survey conducted

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by the Ruding Committee, the tax differences among the EU countries have a major impact on investment location decisions of multinational companies and the distortions impair economic efficiency by leading to a misallocation of resources. The Ruding Committee made it clear that each country should be able to impose its own tax burden on domestic investments without interference by the Commission unless the tax burden causes serious distortions in the functioning of the internal market. It was noted that tax burdens on outward and inward investment were generally higher than the ones for domestic investments.32 There was evidence that the EU countries were lowering corporate income taxes in order to attract capital and other mobile economic resources. Further, the Ruding Committee indicated that tax distortions harm the Community’s overall competitiveness relative to countries such as the United States and Japan. In March 1992 the Ruding Committee made thirty-eight recommendations to eliminate the fiscal distortions and improve competitiveness, ranging from the general (the most appropriate corporate income tax integration method should be studied) to the specific (corporate statutory tax rates should be prescribed to fall between 30 and 40 per cent).33 The Ruding Committee did not propose that the EU countries adopt a specific form of taxing corporate profits, although a common system was said to be a desirable objective.34 It recommended that the EU countries should be permitted, in many ways, to maintain their current regime of taxing business income. Major proposals included removing the tax features that impede crossborder investment and shareholding, establishing common rules for a minimum tax base to eliminate excessive tax competition to attract mobile investment factors, and encouraging transparency of any tax incentive granted by EU countries. The Ruding Committee also recommended that the Commission work with the European countries to establish a common tax treaty policy among the EU members as well as with non-EU countries.35 The corporate tax rate harmonization proposals of the Ruding Committee received less than enthusiastic political support from the Commission and the governments of the EU countries. To date, the Commission has not attempted to pursue most of the Committee’s harmonization recommendations, including the proposal of implementing a minimum corporate tax rate of 30 per cent and a maximum rate of 40 per cent. The Commission indicated that a number of proposals went beyond the bounds of the principle of subsidiarity.36 Further, the recom-

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mendations received little support from the EU-country finance ministers who, after meeting to discuss the Ruding Committee report, commented that: ‘Community action on business taxation should be limited to the minimum necessary to ensure the internal market functions smoothly.’37 Harmonization of corporate tax rates and bases would require the EU countries to give up a significant part of their fiscal sovereignty. This is particularly important as many of these countries have already agreed to relinquish control over monetary and exchange rate policies under the European Monetary Union, partly through the adoption of the Euro as a common currency, and are consequently reluctant to cede control over tax, one of the remaining fiscal tools to promote domestic socioeconomic policies. 2.2.3 Recent Developments: Harmful Tax Competition, Corporate Tax Base Consolidation, and European Court of Justice Decisions The issue of corporate income tax disharmony within the European Union refuses to go away. A High-Level Group of Taxation Experts was established within the European Union to review the issue of tax harmonization; it began deliberations in March 1997.38 The experts reviewed the process of ‘fiscal degradation’ within the European Union that results from revenue losses attributable to competition for investment. Following that review, the European Union adopted a non-binding code of conduct according to which EU countries and Commission representatives try to identify ‘harmful’ tax aspects and oversee the dismantling of such measures (see chapter 10).39 The code of conduct thus places limited constraints on state-aid and tax competition. In 2001, the European Commission announced that it would begin to emphasize, as part of a longer term strategy, the ‘consolidation’ of corporate income tax bases, while permitting the member countries to impose their own tax rates.40 It hoped that this form of limited harmonization would inhibit tax distortions that lead to an inefficient allocation of resources and harm the competitiveness of European firms when compared with firms located outside of the European Union. Interestingly, the Commission rejected the Ruding Committee’s earlier proposal to harmonize tax rates, despite the fact that more recent empirical work confirmed that corporate tax rates are the main cause of locational inefficiencies, and that the adoption of a common tax base might result in an even greater dispersion of effective tax rates among different EU countries.41

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In 2003, the Commission announced that its efforts would concentrate on studying the viability of a ‘home state taxation’ system, as well as the possibility of using harmonized accounting standards as the basis for a consolidated tax base for companies with European Union-wide activities.42 Under home state taxation, profits of a multinational firm would be computed according to the rules of one tax system only: the system of the home state of the parent company or head office of the firm. Each country would continue to tax its share of the firm’s profits at its own corporate tax rate. Unlike full-blown harmonization, proposed corporate tax consolidation schemes would co-exist with existing national tax regimes, thus preserving tax sovereignty to a greater extent. For example, the Commission is studying whether European Companies (EU companies incorporated under the European Company Statute that takes effect on 1 January 2005) that have adopted common accounting standards can serve as the basis for developing a consolidated tax base. Other companies that employ country-specific accounting standards would be subject to the traditional tax rules under the different national tax systems. This approach may be problematic, as in many instances it would promote different tax treatment for economically equivalent cross-border transactions. In addition to the long-term strategy, the European Union is targeting short-term measures to address more pressing problems.43 For example, the Commission has proposed revisions to the Merger Directive and the Parent/Subsidiary Directive to, among other things, extend their scope to cover new business entities such as European Companies and European Cooperative Societies. In addition, the Commission adopted the Interest and Royalty Directive, which promotes information exchange among tax authorities (with temporary exceptions for four countries that wish to maintain their bank secrecy laws but agree to impose withholding taxes on cross-border payments).44 The Commission also continues to explore ways to achieve cross-border loss offsetting, such as the approach under the ‘Danish joint taxation system,’ where parent companies can take into account losses incurred by foreign branches and subsidiaries. Finally, the European Court of Justice continues to play an important role in EU tax developments. While EU countries retain the right to develop their direct tax systems as they wish, they must do so in a way that does not infringe on freedoms guaranteed (i.e., free movement of goods and persons and the right of establishment, services, and capital) by the

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treaty. For example, in the ‘Lankhorst-Hohorst’ decision, the European Court of Justice ruled that thin capitalization rules (see chapter 3) cannot impose unequal treatment between resident and non-resident EU companies, leading many EU countries to redesign these rules.45 Other cases raise questions concerning the viability of dividend taxation systems that interfere with the free movement of capital by discriminating in favour of domestic shareholders.46 Moreover, the European Court of Justice has held that tax rules cannot discriminate against nationals of other EU states by treating their business entities less favourably than domestic taxpayers in comparable situations.47 Malcolm Gammie notes that the European Court of Justice plays an increasingly important role in influencing the design of direct tax regimes within the European Union, as member countries are forced to comply with decisions by removing tax obstacles to cross-border economic flows.48 Nevertheless, a piecemeal approach to resolving outstanding tax issues through litigation may create even more obstacles, as the decisions are implemented on an uneven basis by the EU countries. Alternatively, the decisions may create incentives for more comprehensive solutions to outstanding cross-border tax problems, although, three years after the Commission’s 2001 proposed strategy, political resistance is building against proposals such as the European Union–wide consolidated tax base.49 2.2.4 Harmonization of Indirect Taxes 2.2.4.1 Legislative Impetus for Harmonizing Indirect Taxes As indicated, articles 95 to 99 of the Treaty of Rome govern indirect taxation and are designed primarily to supplement the rules concerning the removal of obstacles to the free movement of goods. Articles 95 to 98 prohibit discrimination in the tax treatment of similarly situated domestic and imported goods; article 99 constitutes the basis for the EU valueadded tax system. The VAT was introduced to the European Economic Community in 1967 by a Council Directive, which required the EU countries to replace their various systems of indirect taxation with a common VAT system.50 2.2.4.2 Abolition of Barriers to Trade Caused by the VAT Once the Council Directive was introduced, the various EU countries implemented their own VAT. Although all EU countries have applied the VAT since 1987, a number of differences regarding the number and level

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of VAT rates remained: for example, standard VAT rates varied from 12 per cent in Luxembourg to 25 per cent in Ireland.51 Accordingly, article 99 of the treaty was amended by the Single European Act to provide for the harmonization of legislation concerning indirect taxes by 1 January 1993. This step was necessary for the free movement of goods in the internal market scheduled to take place on 31 December 1992. As border checks in relation to the VATs would be removed by this date,52 it was feared that differences in indirect taxation would lead to the risk of fraud, distortion of competition, and income transfers. Since 1 January 1993 the EU countries have applied a standard VAT rate of at least 15 per cent without a ceiling, along with one or two optional reduced rates (to a minimum of 5 per cent) on certain defined goods (e.g., certain food necessities) and services. After the reform was initiated, large differences in rates remained: ten percentage points between Denmark (with a VAT rate of 25 per cent) and Germany, Luxembourg, and Spain (with standard rates of 15 per cent). Despite efforts to harmonize VAT bases, some commentators fear that rate differentials may encourage trade distortion as individuals cross borders to reduce their tax payments.53 Finally, the EU nations tentatively agreed to move towards an originbased approach for their VATs for trade among participating nations. Under this approach, the goods are taxed in the jurisdiction in which they are manufactured regardless of where they are consumed. The revenue from the tax on the goods goes to the exporting jurisdiction. Explicit border tax adjustments are not required as rebates are not given to the exports. The European nations traditionally employed the destination principle (as do Canada and Mexico) with respect to their VAT policy, where goods and services are taxed based on location of consumption or destination. Because the tax is only placed in the jurisdiction in which the goods are consumed, exports must leave the exporting jurisdiction free of tax. A compensatory tax is therefore required on imports, so that the goods carry the same tax burden as domestically produced goods. This is generally achieved through border tax adjustments, which were eliminated in the new, borderless European Union. At the time of writing, the European Union continues to operate a ‘transitional arrangement’ that combines origin and destination-based taxation. For individuals, origin-based taxation is employed. Consumers can purchase and pay VAT on goods in other EU countries and return to their home country without paying any more VAT (there are two major exceptions: purchases of motor vehicles and mail order sales remain

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under the destination-based system). Businesses continue to be subjected to various destination-based methods and must maintain records of purchases and sales to other EU countries. 3 The Drive towards Economic Integration under NAFTA This section sets out the reasons that drove the North American governments to deepen their trade and investment relationship; it also examines the institutional structure of NAFTA to see whether it could encourage tax harmonization efforts. Finally, the section reviews the sovereignty concerns that would likely frustrate harmonization efforts within North America. The situation within NAFTA is ultimately contrasted with EU developments. 3.1 Why Have Free Trade within North America? The decision to enter into a free trade agreement with the United States in 1989 had caused much political soul-searching in Canada. In 1988, an election was won by the Conservative Party almost solely on the question of whether or not to have free trade with the United States. When negotiating the Canada–United States Free Trade Agreement54 (the CUSTA), the federal government assured Canadians that cultural industries would be protected through a cultural exemption provision.55 The CUSTA signalled a turning point in Canada, as it can be viewed as a recognition by many Canadians of the necessity for closer trade alliances to promote domestic wealth and successful competition in the global marketplace.56 Canada’s entrance into NAFTA was much less politically divisive, although concern was expressed about competing with low wage earners in Mexico.57 Gaining access to the Mexican market was not a major issue: trade between Canada and Mexico was negligible at the time Canada entered into NAFTA negotiations in 1991. The Canadian government’s stated objectives in negotiating NAFTA were to gain access to the Mexican market on the same footing as the United States, to ensure there were no reductions in the benefits and obligations of the CUSTA, and to ensure that Canada remained an attractive location for investors wishing to serve the entire North American market.58 Further, Canada’s long-term economic interests might be promoted by gaining access to Latin American markets through participation in future hemispheric trade negotiations.59 From the American perspective, a principal incentive to negotiating a

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trade agreement with Mexico arose from the fact that the Mexican government, in the 1980s, had gradually shifted from a centrally planned economy with trade protection to a more open economic approach: the United States could expand its exports as Mexican citizens became wealthier under the new economic strategy. Further, an expanded North America-wide trade deal was portrayed by the government as a means of improving the competitive position of the United States against Japan and the European Union.60 Although the principal motives for negotiating NAFTA were economic, the United States had additional, non-economic goals. It was hoped that the agreement would help to reduce the amount of illegal immigration from Mexico into southwestern states, which created a strain on the economies of such politically important states as Texas and California. If NAFTA could assist Mexican economic growth, the incentive for illegal emigration to the United States might decline.61 Potential job loss due to low Mexican wages,62 however, created an acrimonious national debate in the United States over NAFTA.63 Side agreements were eventually negotiated in the politically sensitive areas of labour and the environment to appease certain constituencies,64 and these side agreements became the focus of the sovereignty debate. The attention focused on sovereignty is somewhat ironic, however, as the terms of side agreements do not require any changes in the labour and environmental laws of any of the NAFTA countries.65 It is important to note that economics played a significant role in the debate surrounding both of the side agreements: constituencies within the United States pushed for a more level playing field, where domestic industry would not be punished for operating in an atmosphere of costlier labour and environmental standards. Aside from some social concerns, there was no discussion of greater American political linkages with Mexico or Canada. The Mexican impetus for initiating the negotiation of NAFTA was likewise primarily economic. In the mid-1980s Mexico began to restructure its economy, adopting a more market-oriented approach. Despite historical antipathy towards investment by foreigners, the Mexican government took steps to open up Mexico to external trade possibilities. It unilaterally reduced trade barriers and embarked on a substantial privatization program. This greater emphasis on external trade was demonstrated when Mexico finally became a party to the General Agreement on Tariffs and Trade in 1986. From the Mexican perspective, NAFTA was said to be a logical exten-

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sion of the government’s economic strategy to foster exports as the most important vehicle for sustaining economic growth, attracting foreign investment, and ensuring a presence in regional trading blocs.66 There was no substantial resistance in Mexico to the agreement, despite a historical tension with the United States that dates back to military conflict.67 Although this tension was far enough in the past to permit NAFTA to go forward, the level of mistrust of the Americans would be sufficient to prevent any potential increase in political ties between the countries. Since entering into the NAFTA deal, Mexico has concentrated on acting as a ‘hub and spoke’ in the Americas by negotiating free trade agreements with the European Union, Japan, and Central America. 3.2 The Institutional Structure of NAFTA As discussed, the Treaty of Rome created significant centralized institutions with the power to adjudicate and legislate. The European Commission, the Council of the European Union, the European Court of Justice, and the European Parliament are all charged with bringing to life the legislative aspirations of the treaty. Some of these bodies assist in taking a general notion such as greater tax coordination and implementing detailed plans. The European Court of Justice’s decisions, which promulgated the idea that these centralized institutions have legal authority over national institutions, assisted in the process of ceding authority to supranational bodies with the power to make and implement laws. In short, the European Union can be described as institution intensive, with all of the necessary tools to pursue the harmonization of differing national legal systems such as tax. NAFTA, on the hand, can be characterized as institution impoverished, as demonstrated in the next section. The Treaty of Rome sets as a goal the harmonization of laws ‘directly affecting the establishment or functioning of the common market.’ This goal was the impetus for a number of substantial harmonization efforts, including tax. In contrast, NAFTA goals are more modest and focus on the progressive elimination of tariff and non-tariff barriers to trade in goods and the establishment of reciprocal national treatment obligations with respect to trade in services and investment. Although certain provisions deal with approximating regulations for health and technical standards,68 NAFTA does not create any obligation to harmonize and it does not give power to any institution to mandate harmonization. As a free trade area rather than a customs union, NAFTA requires much less institutional support. Its objectives are less ambitious; a free trade area does not attempt to create the free movements of goods,

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services, labour or capital. The major NAFTA institutions exist as a setting for consultation and cooperation among the NAFTA countries. The negotiators of NAFTA apparently took great care to avoid granting to any centralized body the power to make decisions that would directly bind NAFTA countries. Section A of NAFTA Chapter Twenty establishes the basic institutional framework by creating the Free Trade Commission and the Secretariat. The Free Trade Commission is comprised of Cabinet-level officers of the NAFTA countries, or their appointees, and is charged with supervising the implementation and overseeing the elaboration of NAFTA. This structure is supplemented by various committees and working groups created under NAFTA provisions covering specific sectors. Taxation measures are not included. The Secretariat is comprised of national Sections with permanent offices to assist the Free Trade Commission and provide administrative assistance to dispute resolution panels, committees, and working groups. The Free Trade Commission, pursuant to article 2001 of the NAFTA, shall ‘consider any other matter that may affect the operation of this Agreement’ and ‘take such other action in the exercise of its functions as the Parties may agree.’ Any ‘action’ not set out in the text of NAFTA must be agreed upon by the NAFTA countries. This acts as a limitation of the Free Trade Commission’s ability to expand its own authority.69 Section B of NAFTA Chapter Twenty sets out the dispute resolution mechanisms. Panel decisions are not binding in that they do not affect the domestic law of any NAFTA country and will not be enforced through the courts of a NAFTA country. If a party does not respond to an adverse decision by a panel, the other party has the right to suspend NAFTA benefits, but it has no other recourse.70 This is to be contrasted with the situation in the European Union, where decisions of the European Court of Justice are generally binding on the national courts of the European countries. There is a separate dispute resolution process for anti-dumping duties (dumping occurs when an exporter exports its products at a lower price than it charges in its own country, or at a price below its cost) and countervailing duties (which offer redress against government subsidies to exported products). A party is permitted to challenge whether amendments to the anti-dumping and countervailing duty laws of the NAFTA country conform to the norms established by NAFTA. Unlike dispute resolution in other areas under NAFTA, panel decisions concerning these matters are binding on the parties.71

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3.3 Comment on the Institutional Structure of NAFTA It is clear that the framers of NAFTA took care to avoid creating centralized institutions that would transfer governmental authority to supranational bodies.72 The institutions under NAFTA are consistent with the individual goals of the NAFTA countries to seek a closer economic union without surrendering sovereignty to international organizations. The NAFTA countries desired to obtain the benefits of economic integration but were understandably reluctant to allow centralized decisions to interfere with the distinct policy needs of each country. Under NAFTA, there is no legislative impetus to achieve tax harmonization, nor are there mechanisms that would assist with this harmonization. As Michael Trebilcock has recognized, institutions create path-dependent outcomes: good institutions produce good results and bad institutions produce poor results.73 The institutional setting of NAFTA is therefore not conducive to producing greater levels of tax integration. A lack of institutions does not prohibit the NAFTA countries from reaching a decision to harmonize tax systems; such a decision could be reached through multilateral negotiations. Still, the absence of institutions reduces the opportunities for the NAFTA countries to reach a consensus on harmonization objectives and issues. Further, the NAFTAcountry governments would likely have to ratify any substantive tax harmonization proposals prior to implementation. In short, tax harmonization efforts would likely be drawn out and costly affairs under NAFTA. 4 The Loss of Sovereignty under NAFTA Tax Harmonization This section examines some of the sovereignty concerns that the NAFTA countries might raise with respect to any potential business tax harmonization initiatives. 4.1 Tax as a Policy Tool to Pursue Distinct Socio-Economic Objectives Under tax harmonization, the NAFTA countries would agree to be bound by a system of common tax rules. They would likely have to reach an agreement that would ensure that a similar tax burden is placed on cross-border activities in order to remove tax distortions that may lead to a misallocation of resources. This could be achieved with respect to capital flows by harmonizing both the tax rates and tax bases associated with business activity. Such an agreement, however, would place con-

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straints on future tax policy by the governments of the NAFTA countries. The NAFTA countries currently have differing views on the role of taxation in the promotion of social and economic objectives: they use their tax regimes to promote their own particular policy agenda as well as to raise the necessary revenues (see chapter 3). Table 7.1 sets out social and economic indicators for the NAFTA countries, which offers a survey of the distinct needs that each country might have. Canada and the United States have mature, industrialized economies and their citizens enjoy a relatively high level of wealth and prosperity. Table 7.1 reveals a number of similarities in terms of population growth rate, vital statistics, GDP per capita, sectoral contributions, female participation rates in the labour markets, health and education expenditures, and illiteracy levels. The United Nations Human Development Index in 2002 ranked Canada at number three in the world and the United States at number four. This index is meant as a rough indication of standards of living. The countries had similar figures for GDP per capita in 2002: US$29,900 in Canada and US$36,100 in the United States (a worrisome trend for Canadian policy makers is the fact that the gap in GDP per capita between the two countries has grown in recent decades). Mexico, in contrast, is a much less wealthy country with higher population growth rates and higher infant mortality rates; it emphasizes agriculture and spends less on health and education. In 2002, the United Nations ranked Mexico at number fifty-four on the Human Development Index and its GDP per capita was US$9,200. All of the NAFTA countries use their tax systems to promote their particular domestic socio-economic agendas. The role of taxation as a means to a policy end may assume increasing importance as other tools traditionally used by governments to promote domestic policy, such as tariffs or subsidies, are curtailed under NAFTA. Accordingly, the NAFTA countries may be very much concerned with any proposals that would restrict their ability to meet the perceived needs of the citizenry with tax policy. 4.2 Different Revenue Objectives within North America Along with differing policy objectives, the NAFTA countries have different fiscal needs. Table 7.2 reviews a number of government revenue and expenditure figures among these countries. Revenue requirements differ, with Canada placing the most emphasis on the role of government in funding social needs: total Canadian government revenues equalled 44.1 per cent of GDP in 2001, while the corresponding figure for the

122 Sovereignty Concerns Table 7.1 NAFTA country comparisons (2001) Canada

United States

Mexico

9,976.1 31,111 1.0 3

9,372.6 285,545 0.9 30

1,972.5 100,051 1.4 50

5.3

6.9

21.4

76.7 82

74.1 79.5

72.1 77.1

940

10383

925

29,900

36,100

9,200

3.5

3.2

2.7

2.5 31.8 65.7

1.6 22.8 79.4

4.1 27.9 68.0

16,300 7.2 70.5

144,925 4.7 70.7

39,159 2.1 41.6

268.4 304.3

1,383.0 1,034.4

185.2 170.6

Expenditure on health (% of GDP)

9.7

13.9

6.6

Expenditure on public education, 1999 (% of GDP)

5.33

4.9

4.39

3

4

54

Area (sq. km (’000)) Population (millions) Growth rate, 1995/94 (%) Density (persons per sq. km) Vital statistics Infant mortality rate (per 1000 live births) Life expectancy at birth males females Gross Domestic Product, 2002 ($US billion (using PPP)) GDP per capita ($US), using Purchasing Power Parities Average annual growth, 1992–2002 (%) Sectoral contributions Agriculture & forestry (% of GDP) Industry (% of GDP) Services (% of GDP) Labour Markets Labour force (millions) Unemployment rate (%) Female labour participation rate (%) Trade (goods and services) Imports (billion US$) Exports (billion US$) Health and education

Standard of living, 2002 (rank in world)

Sources: OECD, OECD in Figures (Paris: OECD, 2003), OECD, Labour Force Statistics (Paris: OECD, 2002), OECD, National Accounts (Paris: OECD, 2003). Standard of living rank: United Nations Human Development Index (2002).

Lessons from Europe 123 Table 7.2 Fiscal figures for the NAFTA countries (2001) Category

Canada

Mexico

United States

Total tax receipts (% of GDP) Disposable income of average production worker as % of gross pay (single person), 2002 Disposable income of average production worker as % of gross pay (married with two children), 2002 Social Security transfers (% of GDP) Total general government revenue (% of GDP) Total general government expenditure (% of GDP) Net government savings (% of GDP) Government final consumption expenditure (% of GDP at current prices)

35.8

18.5

29.6

74.3

96.4

75.7

84.9 10.9 44.1 42.3 2.0

96.4 1.7 N/A N/A 0.1

88.7 11.3 34.7 34.9 0.7

18.9

11.1

15.1

Source: OECD, OECD in Figures (Paris: OECD, 2003) at 36–7.

United States was 34.7 per cent (Mexican data was unavailable). Total tax receipts as a percentage of GDP in 2001 were 35.8 per cent for Canada, 29.6 per cent for the United States, and 18.5 per cent for Mexico. Tax takes a bigger bite out of some members of the workforce in Canada and the United States in comparison to Mexico: the disposable income of average production workers in the former two countries is significantly less than that of their counterparts in Mexico. For example, the disposable income of an average production worker is roughly 74 per cent in Canada, 76 per cent in the United States, and 96 per cent for a similar worker in Mexico. The bottom line is that there would be considerable disagreement among the NAFTA countries concerning potential tax uniformity. Canadians, through their democratic institutions, have chosen a higher mix of taxes and expenditures than the United States. The Canadian government may find any proposal to lower tax rates or reduce tax burdens unacceptable, as it has prioritized a reduction of the federal fiscal deficit along with a desire to maintain sacred public services such as universal health care. Mexico, as a transitional economy, places the least emphasis on collecting taxes from its individuals and business entities. Any common tax measures that potentially reduce tax revenues, social services, investment levels, or employment levels would be difficult to accept by the NAFTA country that would be adversely affected.

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4.3 The Need to Reform Non-Tax Laws Tax harmonization may only be effective in reducing distortions if significant uniformity is reached with respect to the NAFTA countries’ tax systems and other economic factors. Even adopting the same tax rate and tax base may not produce similar tax burdens, since a number of non-tax factors influence the amount of tax that firms pay. For example, general compliance with tax laws influences overall tax burdens on firm activity. Tax compliance levels vary among the NAFTA countries, with Mexico having experienced serious tax law enforcement problems in the past. Inflation rates also influence how much tax firms end up paying. Although Canadian and American inflation rates have been similar in the past, Mexico has seen relatively high inflation rates. This explains why the Mexican tax system, unlike the regimes of the other two NAFTA countries, is indexed for inflation. The differences in inflation distort tax burdens among the NAFTA countries and create incentives to finance activities in different matters. For example, Canadian and American firms investing in Mexico would be better off financing their Mexican ventures through debt issues in order to take advantage of the lack of indexation for inflation in their own tax systems. Debt issues permit deductions for nominal interest payments (which take into account inflation and the real rate of interest). Another harmonization issue involves the fact that the NAFTA countries have developed different business entities with differing attributes. For example, a Nova Scotia Unlimited Liability Company is taxed as a corporation in Canada and as a flow-through business entity in the United States, creating a so-called hybrid entity that can be used as a taxplanning device. Tax measures affect net earnings in different ways if the businesses have different cash flow methods. Some business law reform may therefore be required to achieve desired uniformity in tax burdens. Real tax harmonization may necessitate non-tax legal reform. 4.4 Tax Harmonization with a Big Player It is difficult to imagine a scenario that would bring the United States to the bargaining table to agree on a set of common tax rules for North America. There are signs that the U.S. political mindset is not overly supportive of NAFTA or international trade. From the mid-1990s, U.S. administrations have sought to expand NAFTA as well as other trade deals, but these efforts have been derailed time and time again by protectionist legislators: for example, both the Democrat and Republi-

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can administrations have been unable to secure ‘fast-track’ approval74 for the trade negotiation process as a result of insufficient Congressional support.75 Any agreement to constrain U.S. tax policy through an international agreement is likely infeasible (see chapter 10). While there has been a gradual recognition in Canada and Mexico that external trade relationships benefit their citizens, this belief is less apparent in the United States, where polls indicate that a majority of citizens do not support more extensive free trade agreements.76 Within the United States, there is currently a certain ‘go it alone’ sentiment that is less apparent in the other two NAFTA countries, which are more likely to believe that their standards of living are tied to export strategies. These positions make some sense: U.S. exports and imports represent only about 18 per cent of U.S. GDP, whereas the figures are approximately 48 per cent for Canada and 37 per cent for Mexico (see table 7.1). Relations with the United States often dominate Canadian and Mexican public policy. Both countries are very sensitive to any measures that would be viewed as impinging on their cultural identity and, until recently, both would have considered the cultural costs of greater economic ties with the United States as prohibitively high. However, recognizing that external trade ties are crucial to their economic success, Canadians and Mexicans sought them out: Canada and Mexico rely largely on exports to and foreign direct investment from the United States (see chapter 2).77 In contrast, although Canadians and Mexicans are, respectively, the first and second most important trade partners of the United States, their needs are generally subordinate to the domestic or international agenda of the United States. Canadian support for tax harmonization proposals may be grounded in the view that the Canadian tax system constrains the ability of domestic firms to compete with American businesses. The conventional wisdom in Canada is that a greater tax burden on businesses and capital causes outflows in investment activity to the United States.78 A NAFTAwide uniform corporate income tax system may therefore be attractive to Canadians, as it might hinder capital outflows. Further, uniform rules may constrain future American efforts to initiate tax reform that may have an adverse impact on the Canadian economy (see chapter 6). Still, the political obstacle concerning any loss of sovereignty would be difficult or impossible to overcome. Canadians continue to be very sensitive about their relationship with the United States: tax system uniformity will be viewed by some as a further way to erode Canadian distinctiveness and cultural identity.79 Finally, it may be in Canada’s interest to maintain

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the current regime as this permits Canada to engage in limited tax competition, which may ultimately prove to be beneficial to the Canadian economy (see chapter 10). With respect to a potential Mexican position, tax uniformity with the other NAFTA members might contribute to the confidence-building process: any strengthening of fiscal ties under NAFTA could be seen as a vote of confidence in Mexico.80 A number of factors, however, might erode support for the measure. A loss of domestic tax control under tax harmonization might be perceived by Mexicans as a transfer of authority to two developed countries that may have interests that are adverse to Mexico in some circumstances. A fear may develop that these two countries would gang up on Mexico to create tax uniformity that would damage Mexican interests. Further, traditional Mexican hostility to potential loss of control over tax policy has, until the last few years, prevented Mexico from pursuing formal tax coordination with other countries (see chapter 4). It is thus difficult to picture the Mexican government embracing tax harmonization efforts. The sense of community in North America required to assuage these sovereignty concerns does not appear to exist. A treatise investigates whether the NAFTA countries, with their unique histories and contemporary conditions, can find common ground to create this sense of community. The authors assert that, despite past differences, common ground can be found in a shared liberal tradition as well as a ‘history of incorporating many voices.’ This commonality, it is said, ought to permit the NAFTA countries to participate in a functional, if not formal community: ‘the model of a federated, European-style community with a capital “C” is unlikely to apply to North America. Yet as we sort out the distorting perspectives of history and unexamined stereotypes, it is plausible to envision a loosely structured and largely informal community with a small “c”.’81 Perhaps a perceived convergence of interests in the future will help to reduce the tension inherent in tax harmonization. For the time being, however, the NAFTA countries view the sovereignty costs associated with tax harmonization as very high indeed. 5 Conclusion The European experience suggests that time might act as balm to smooth away the tension surrounding any potential harmonization efforts. The EU countries gradually learned to trust one another and became aware of the benefits of a deepening relationship. They developed a mutual

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loyalty and accepted the centralized institutions that represented their collective interest. Yet even the passage of time and the development of a better working relationship may ultimately be insufficient to allow tax harmonization, as evidenced by European reluctance to harmonize corporate income taxes. Some of the factors that encourage tax harmonization initiatives in Europe are summarized below: (a) the Treaty of Rome called for the harmonization of all legal regimes that impede the free flow of goods, services, capital, and labour; (b) the EU countries created a deal with political linkages and centralized institutions which encouraged discussion and consensus to develop on tax harmonization issues; (c) the passage of several decades permitted the EU countries to learn to trust each other and accept further integration; (d) the citizens of the EU countries arguably felt that tangible benefits resulted from the economic union and thus were prepared to accept further integration; (e) a new approach towards harmonization promoted the idea that the Commission would only impose centralized harmonization in areas that are indispensable to the functioning of the internal market; and (f) European Court of Justice decisions require changes to many direct and indirect tax laws that interfere with the free flow of goods, services, persons, or capital. The situation in North America is completely different. In contrast to the Europeans, North Americans have had little time to digest their deal. American public opinion is not convinced of the benefits of NAFTA. Further, Mexican and Canadian wariness of potential U.S. interference in their public policy makes these two countries reluctant to transfer any power to any centralized system of tax rules. Given the current political climate in North America, the NAFTA countries would probably be extremely reluctant to relinquish autonomy, despite the benefits of a more uniform tax system.

CHAPTER 8

E-Commerce Tax Policy

1 Introduction Nowhere is the clash between sovereignty and international tax policy more pronounced than in the new environment of electronic commerce (e-commerce) the world’s first truly borderless form of commerce. E-commerce enables companies to post a website and sell digital goods and services into foreign markets without having to set up branch operations: these goods and services pass through national borders without detection. The advent of the Internet and the proliferation of digital goods and services thus pose a number of challenges to traditional international tax rules and principles. This chapter discusses the initial efforts by Canada and the United States to formulate an e-commerce tax policy (Mexico has yet to make any efforts in this area) and shows how these initial steps fail to address the challenges of e-commerce in many circumstances. The focus of the chapter is placed on challenges to North American international tax rules that emphasize control over physical space: the NAFTA countries are reluctant to modify these rules partly because doing so would require surrendering tax sovereignty in some circumstances. The first section reviews efforts by Canada, the United States, and the OECD to form new tax rules for the taxation of cross-border profits through permanent establishment/computer servers. The next section shows how the Internet frustrates the ability of Canada and Mexico to enforce their GST and VAT rules on consumer sales from U.S. e-commerce businesses. The third section discusses how the NAFTA countries could use Internet technologies to improve the sharing of taxpayer information and assist with tax collection, especially in the area of cross-border portfolio investments.

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2 Taxing Cross-Border E-Commerce Profits 2.1 Technology as a Catalyst for Economic Integration Advances in technology are often accompanied by heightened economic integration at the international and subnational level. Improvements in transportation and communication technologies enable businesses to reach foreign markets at lower costs, increasing the returns on such activities. Technological innovation increases the ability of individuals and firms to produce goods and services from available resources: improvements in roads, steamships, railways, and other modes of transportation enabled individuals to sell goods to foreign markets.1 Similarly, the developments of the post, telegraph, telephone, and more recent communication technologies improved the ability of business people to gather or relay information across borders and around the world. In recent years, the advent of the Internet, reduced telecommunication costs, an expanding global computer network, and the proliferation of digital goods and services have significantly enhanced global trade and investment.2 Capital and economic markets at the international and federal level become increasingly integrated as cross-border trade and investment is promoted through technology change. According to one commentator, ‘[T]he single most influential factor in international law, and in particular in the regulation of economic activities since World War II, ... would be the progress of science and technology.’3 As discussed below e-commerce developments accelerate this economic integration process, but NAFTA possesses little in the way of ‘sticks’ or ‘carrots’ that would encourage the North American governments to engage in cooperative behaviour to address the challenges presented by this new form of commerce. 2.2 Background Reform Efforts The tax treaties negotiated among the NAFTA countries contain the same general rule for taxing cross-border business profits: source countries are only entitled to tax these profits if the non-resident business maintains a ‘permanent establishment’ and profits can be attributed to this permanent establishment.4 The U.S.-Mexico tax treaty varies this rule to a certain extent through the adoption of a restricted force of attraction principle (see chapter 4). The permanent establishment concept represents a critical feature in each treaty, because it determines which country can assert its tax jurisdiction over cross-border profits and corresponding tax revenues.

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In recent years, the permanent establishment principle has attracted renewed attention because of the advent of the Internet and e-commerce.5 The Internet, essentially a network of networks linked by a common communications protocol, enables and facilitates remote economic activity. At times, the Internet removes the necessity for traditional intermediaries (for example, foreign branches) that were used to enable cross-border transactions. Computer servers (that is, computers that are networked to the Internet) can perform similar functions to traditional permanent establishments (stores, depots), as the software within the server can display a web page on the Internet, take a customer’s order, accept payment, and transmit digital goods and services. Other information technology developments encourage source-state tax erosion under traditional principles by, among other things, promoting (a) the consolidation of foreign operations; (b) the replacement of physical establishments with websites to transfer transactions costs to customers; (c) a reduction of source-country offices for customer support and after-sales services; (d) the replacement of agents with remote contracting; and (e) the enhanced provision of remote services.6 Governments and commentators are concerned that these new commercial developments may dilute source-country tax jurisdiction and revenues,7 accelerating an already worrisome trend.8 In November 1996, the United States Treasury Department became the first national tax authority to issue a report on the international tax policy implications of e-commerce.9 This discussion draft was meant to frame the policy challenges presented by e-commerce. Nevertheless, the report’s view that the nature of the Internet and an increase in remote economic activity likely meant that residence-based taxation would take on greater importance caused concern.10 This was a worrisome suggestion to many non-American tax authorities as, at the time and to this day, the United States produced and exported the lion’s share of international e-commerce.11 Further, the report suggested that servers would not likely constitute permanent establishments under U.S. tax policy.12 In contrast, most other national tax authorities took a more cautious approach to the server/permanent establishment issue. For example, in 1998 Revenue Canada (as it then was) refused to take a position when a U.S. company asked about the tax implications of storing proprietary information on a Canadian-based server.13 Further, two Canadian government reports published in 1998 suggested that a server might in fact constitute a permanent establishment under certain circumstances.14

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Other tax authorities, including the Australian Tax Office, similarly suggested that a server might constitute a permanent establishment.15 Against this background, the OECD began to play an active role in trying to help its member states reach consensus on many international e-commerce issues, including cross-border income and consumption tax issues. In October 1998, the (then) twenty-nine OECD member states reached consensus at the Ministerial Meeting on Global E-commerce in Ottawa on the principles that should guide the development of international tax rules for e-commerce. The OECD member states unanimously adopted the so-called Ottawa Taxation Framework Conditions, which asserted, among other things, that traditional tax rules and principles should generally be applied to e-commerce; neutral tax treatment should be maintained between e-commerce and traditional commerce; and reform proposals should encourage a ‘fair’ sharing of the tax base.16 Importantly, businesses and governments also signed on to nearly identical guiding principles in the ‘Joint Declaration of Business and Government Representatives.’17 It was clear that governments and businesses would not tolerate radical changes to the international income tax regime or new rules for e-commerce alone. 2.3 Computer Servers as Permanent Establishments The OECD then appointed a Working Group to study the issue of permanent establishments; after a two-year period of issuing drafts and soliciting feedback, this group presented its recommendations in December 2000. These recommendations were subsequently adopted by the OECD into the Commentary to the OECD model tax treaty.18 Courts in Canada and the United States often look to the Commentaries to determine the appropriate interpretation of provisions within the Canada–United States tax treaty. The Commentary essentially creates a new permanent establishment category for computer servers. At the same time, the view that websites should constitute permanent establishment was rejected. Servers now constitute a permanent establishment under the OECD model tax treaty if: (a) the server performs integral aspects of a cross-border function; and (b) the non-resident firm owns or leases the server within the source country.

132 Sovereignty Concerns

Further, no human intermediary is required to program or service the foreign-based server. The Commentary offers an example of a retail server/permanent establishment that displays a web page, takes a customer’s order, processes payment, and transmits a digital good or service to the end consumer. Under these circumstances the server will now constitute a permanent establishment, entitling the source country to tax profits attributable to the server. Profit attribution is likely to prove a source of controversy in this area, and the OECD has issued yet another draft report on the topic of server profit attribution as part of its broader efforts to reach consensus on the application of profit attribution in the context of transfer prices.19 2.4 Evaluating the New Rule There are persuasive arguments that servers should never constitute permanent establishments, mainly because of the fact that the location of a server need not have any geographic connection to activities that add value and create income.20 Servers and the software functions within them form part of the hardware and software infrastructure of the Internet and can be shifted outside of the country where an e-commerce firm is based or software products are developed, as well as outside of the source country in which e-commerce goods and services are purchased. Two main deficiencies of the new rule have been identified. First, server/permanent establishments will not effectively allocate taxing jurisdiction and revenues to source countries. A multinational firm can ensure that its foreign-based servers are not taxed by, for example, hosting a commercial website on a foreign-owned server or ensuring that any server it owns or leases abroad does not conduct significant aspects of a cross-border transaction. Second, server/permanent establishments offer tax-planning opportunities for multinational firms to shift income outside of residence countries. Consider the following example. USco is a U.S.-resident ecommerce company that sells digital goods and services. A significant amount of USco’s goods and services is purchased by consumers based in Canada. USco can lease servers in a low corporate income tax treaty partner jurisdiction such as Ireland. Software within the Irish servers can be designed to data mine consumers (through the use of cookies, for instance) in order to create marketing profiles of the individuals who surf its website. This compiled information creates a marketing intangible that is ‘owned’ by the Irish server/permanent establishment and which can subsequently be ‘sold’ under traditional transfer pricing prin-

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ciples to USco, creating a deductible expense in the United States and generating revenues and potential profits for the Irish server/permanent establishment. Further, none of the profits generated by crossborder sales to Canadian consumers will be taxed by Canada, because USco does not maintain a traditional permanent establishment within Canada. By attempting to develop cyberspace analogues to the traditional permanent establishment concept, OECD member states have failed to address the challenges of global e-commerce. It remains unclear whether this new rule will be successfully implemented by the OECD member states. England, Germany, and Switzerland have suggested that they will not follow the new rule. In their view, servers should not be used to create nexus. On the other hand, Spain and Portugal dissented from the OECD view because they believe websites should be treated as permanent establishments, presumably in the hope that more revenues would be allocated to these net e-commerce-importing nations through a broader view of nexus for e-commerce purposes. The United States, which in the Treasury report initially came out against server/permanent establishments, ultimately signed on to the new server/permanent establishment rule. According to a former senior Treasury official: ‘The 2003 OECD rules present a reasonable compromise, but also confirm both the prescience of the 1996 Treasury Report, a generation ago in the IT [information technology] age, and the inexorable move, there predicted, toward the demise of source based taxation in this area.’21 The Department of Treasury may have felt that the new rule would not expand source-based taxation hence effectively promoting residence-based taxation of e-commerce and placing the United States back in the position it advocated in the Treasury report. 2.5 Towards an Economic Presence Test for Income Tax Purposes For the reasons outlined above, the new server/permanent establishment rule will not share tax revenues from cross-border e-commerce profits among the NAFTA countries: the losers under this rule are Canada and Mexico, as net e-commerce importing nations. While revenue losses currently appear to be low, the Canada Revenue Agency has indicated, in an unpublished internal report obtained by the author through Access to Information Laws, that it is ‘increasingly difficult’ to collect taxes on e-commerce transactions and that ‘[i]t does appear, on the surface at least, that e-commerce will cause the world of taxation to spin out of control.’22

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This problem could be fixed by developing rules that would permit source countries to tax cross-border profits from e-commerce transactions despite the fact that the non-resident does not maintain a physical presence within the source country. Briefly, the solution could involve: (a) the use of a low rate gross withholding tax in the source country as a proxy for the income tax erosion; (b) formulary taxation with sales in the source country as one factor (see chapter 9); (c) the use of a permanent establishment fiction that would permit a source country to tax significant sales by way of a qualitative test (that is, a facts and circumstances test) or a quantitative test (that is, a stipulated threshold such as gross sales in excess of $1 million).23 The sovereignty costs of each of these options would vary, but the main problem is that an economic presence test would permit a NAFTA country to audit non-resident firms that do not maintain a physical presence within their borders. Moreover, heightened information exchange concerning taxpayer activities would likely be required. The main downside of these approaches is that they may increase compliance costs for multinational firms operating within North America, who may be forced to file returns in countries where they do not maintain a physical presence. 3 Enforcing GST and VAT Rules on E-Commerce Sales This section focuses on enforcement problems for Canada’s goods and service tax (GST) with respect to online sales to consumers. Similar issues arise for the Mexican value-added tax (VAT), although the problems may not be as pressing because far fewer Mexicans participate in ecommerce in comparison to the residents of the other NAFTA countries. The United States does not have a national VAT. 3.1 The GST and Collection Obligations The GST is imposed at a 7 per cent rate on the purchase (‘taxable supply,’ in GST jargon) of most goods and services within Canada. The tax is imposed all along the value-adding economic chain, from the supply of raw materials to the ultimate consumption by an end consumer. In business-to-business transactions, businesses are charged GST and can collect a credit (referred to as an input tax credit) for the amounts paid to their suppliers when accounting to the CRA for the GST they have charged their customers. End consumers, however, do not get the credit and must generally pay the GST at a rate of 7 per cent

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on the purchase price. For domestic purchases, a retailer (other than a small supplier) is legally obligated to register with the CRA and to charge and collect the GST on behalf of the consumer. Hence, the business intermediary plays a critical function in the collection process for domestic purchases. With respect to international transactions, the GST is imposed on the import of most tangible goods at the border by Customs agents. Exports leave Canada tax-free: the export is ‘zero-rated.’ For many business-tobusiness transactions, the Canadian-based purchaser of a good from a foreign supplier similarly must assess the amount of GST owed and can later claim an input tax credit for this amount: the Canadian company hence has an incentive to report the transaction. Things get much more complicated for international consumer transactions. A foreign e-commerce company can post a website and directly transmit a digital product or service to a Canadian consumer without resort to any domestic Canadian business intermediary or physical passage through a Canadian border. Nevertheless, in many circumstances Canadian consumers have a legal obligation to self-assess the correct amount of GST owed on the transaction and remit this amount to the Canadian government. The problem: individual consumers rarely comply with this collection obligation, raising the spectre of diminished tax revenues to the Canadian government. Under the Excise Tax Act, a non-resident (other than a small supplier) that is ‘carrying on business in Canada’ and which makes taxable supplies in Canada is required to register for GST purposes and must charge, collect, and remit GST payments to the Canadian government. A facts and circumstances test is used to determine whether a business is being carried on in Canada. Moreover, a non-resident company that maintains a ‘permanent establishment’ in Canada is treated as a Canadian resident and is subject to the same GST collection obligations as a domestic company. The term permanent establishment is defined to include a ‘fixed place of business’ such as a branch, office, or place of management through which taxable supplies are made.24 The permanent establishment definition is analogous to the previously discussed permanent establishment principle with respect to income tax issues. 3.2 Revenue Losses and Lack of a Competitive Playing Field The following two examples illustrate the problems inherent in the use of physical tests for cross-border transactions. First, consider a hypothetical retailer based in Ottawa called CANCO that sells $100 million in

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software products to Canadian consumers. As a domestic company, CANCO must register for GST purposes and charge the GST on the sales of all of its software products (whether they are shrink-wrap software sold in a store or digital software products sold online). Canadian consumers are charged an additional 7 per cent for the products and the federal government collects $7 million. In the second example, a hypothetical e-tailer (USCO) based and located in the United States sells digital software products to Canadian consumers exclusively through USCO’s website. USCO does not maintain any physical facilities in Canada, nor does it have any agents or employees in Canada. USCO enters into hosting agreements with Canadian Internet service providers (ISPs), whereby USCO leases server space in order to display its web page and facilitate the downloading process to its Canadian consumers. USCO advertises its software products through web-based marketing campaigns which are sometimes directed to the Canadian market. During the fiscal year, USCO sells $100 million worth of software products to Canadian consumers who download these products directly from USCO’s website to the harddrives of their personal computers. Under existing GST rules, can the CRA force USCO to charge, collect, and remit the GST on these consumer transactions? In applying the traditional ‘carrying on business in Canada’ test the CRA looks at a number of factors, such as the place of contracting and the place where the operations from which profits arise take place.25 USCO can make sure that the contract is made in, say, the State of California through a choice-of-forum clause in the clickwrap agreement (an online contract where the website visitor ‘clicks’ her assent to be bound by the provision in the agreement), which has been held to create a binding contractual provision by a Canadian court. Where do profits arise? Pursuant to the Canada-U.S. tax treaty, Canada has agreed to tax cross-border profits only if they are attributable to a “‘permanent establishment’ in Canada. USCO does not maintain a traditional permanent establishment in Canada and, under the recent OECD changes, the servers will not constitute permanent establishments because they are not owned or leased by USCO (hence USCO cannot be said to control these physical assets within Canada). Accordingly, USCO will not have to charge the GST on its Canadian sales and the CRA loses out on a potential $7 million in revenues. The two examples reveal the main policy deficiencies of the current GST regime. This regime leads to non-neutral tax treatment between

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domestic and foreign companies. First, tax treatment between e-commerce and traditional commerce varies because sales by foreign e-commerce companies will not be subject to the GST whereas traditional goods that cross the border will be taxed. The latter situation does not depend on consumer self-assessment. Second, the policy discriminates against Canadian companies that must charge GST on the sale of tangible or intangible goods and services. As a result: 1. Canadian businesses will be at a competitive disadvantage in comparison to foreign e-commerce companies who can charge lower prices; 2. Canada will eventually suffer revenue losses due to its inability to effectively collect tax on international digital e-commerce consumer transactions; and 3. market distortions will result (for example, a U.S. web business will not acquire a Canadian affiliate because of potential GST liability), inhibiting overall economic growth in Canada and harming Canadian economic welfare. 3.3 Developing Economic Presence Tests for the GST The solution to these problems could involve forcing foreign e-commerce companies to register for GST purposes when they have significant sales into Canada, despite an absence of any physical presence. This approach is being proposed by the European Union as well as U.S. state governments. The European Union has developed a directive to force non–EU companies to charge and collect EU VATs (for a discussion of European Union VAT issues, see chapter 7). As of July 2003, non-EU companies with sales to consumers within the European Union will need to register for VAT purposes.26 The registrant would then be subject to the same VAT collection obligations as EU domestic suppliers. Certain large Internet companies such as Ebay and Amazon.com have voluntarily agreed to comply with the new EU rules. The United States has informally opposed the European Union’s proposals, mainly because of concerns that U.S. businesses will incur significant compliance costs.27 At the sub-federal level, however, it is moving towards economic presence tests. While the United States does not have a federal VAT, states and local governments often impose sales and use taxes (see chapter 3). For constitutional reasons, states are not

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allowed to impose collection obligations on retailers unless the retailers maintain a physical presence within them.28 State governments are thus losing billions of dollars a year due to remote Internet and mail-order sales.29 In order to limit these revenue losses, the state governments have formed the Streamlined Sales Tax Project (SSTP) which, as of September 2003, is supported by forty-two of the forty-five states that impose sales taxes. Under the SSTP, states are working to simplify their taxing regimes to encourage out-of-state retailers to enter into a voluntary agreement to collect taxes on sales to local consumers. The incentive for retailers is protection from tax liability under uncertain nexus principles, as well as assistance with or monetary compensation for collecting such taxes.30 Further, an SSTP pilot project is underway with four states (Kansas, Michigan, North Carolina, and Wisconsin), in which the use of automated Internet technologies to charge, collect, and remit sales tax payments has been explored. The Canadian government could consider adopting rules similar in nature to the ones employed by the European Union or under contemplation by U.S. state governments. Under a potential economic presence test, foreign companies that have sales into Canada beyond a stipulated threshold (for example, $100,000) would have to register for the GST and charge, collect, and remit GST payment to the CRA. Only large ecommerce companies, which presumably have the resources to comply with foreign tax rules, would be subject to this system. Smaller start-up operations would be exempt as long as they have below-threshold sales and would not have to expend resources to ensure they do not fall within the facts and circumstances test under the ‘carrying on business in Canada’ or the ‘permanent establishment’ provisions. In other words, the approach should be designed to catch the big fish while letting the small fish off the GST hook. The legislation that governs the GST already makes a similar distinction between large and small fish by permitting all domestic or foreign ‘small suppliers’ to be exempt from GST registration requirements. Small suppliers are defined to include businesses that generate annual gross worldwide revenues of $30,000 or less.31 In addition, traditional GST rules already sometimes try to tax non-residents without a physical presence in Canada. For example, non-residents who solicit orders in Canada to supply property such as books, magazines, or newspapers to be sent by mail to Canadian consumers are considered to be ‘carrying on business in Canada’ and must register for GST purposes.32

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The suggested approach is admittedly not without problems. Nonneutral tax treatment would exist in certain circumstances because traditional goods imported into Canada would still be subject to the GST even when foreign retailers have below-threshold sales into Canada. There would be problems identifying sales into Canada as well as when the sales threshold has been surpassed. An automated tax collection system in which an online intermediary would identify sales into Canada and charge, collect, and remit the GST payment to a CCRA database would assist with many of these problems (see below). Any attempt by Mexico or Canada to extend their VAT or GST laws over businesses without a physical presence within their countries runs up against serious sovereignty concerns. Canada or Mexico could unilaterally impose such laws, but it is unclear how they could enforce them without U.S. cooperation. The United States would likely view the development of economic presence tests as an extraterritorial tax grab and refuse to negotiate an agreement to assist with the enforcement of laws that impose collection obligations on U.S. businesses. The NAFTA tax treaties generally only cover income taxes and do not apply to consumption taxes like the GST or the VAT (see chapter 4). Nevertheless, the development of economic presence tests for GSTs or VATs may be necessary to inhibit competitive disadvantages and, at least in the long run, significant revenue losses. 3.4 Tax Cooperation in a Free Trade Area Richard Bird has pointed out, ‘Coping with long-standing problems in taxing cross-border income flows that are exacerbated by the new technology may, for example, require new forms of international fiscal cooperation and an inevitable reduction in national fiscal sovereignty.’33 Highly integrated customs unions like the European Union, with its centralized political institutions, have already made progress in this area. Similarly, subnational governments within a federation have political institutions to accommodate diverse interests and reach practical compromises, as evidenced by the Streamlined State Sales Tax Project within the United States. NAFTA, however, has few political institutions or sanctions to encourage this sort of cooperative behaviour. It appears that closely integrated polities are better able to address tax problems promoted by technological change. The broader lesson may be that heightened political and economic integration may be a more suitable way in which to constrain adverse spill-over effects created by the increased market integration that results from technology developments.

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4 Using Internet Technologies for Tax Purposes As touched on, U.S. state tax authorities are attempting to promote the use of Internet and software technologies to assist with the tax collection process. This approach is a good example of Lawrence Lessig’s dicta that ‘code is law.’34 Code is the hardware and software technologies that make up the Internet. Governments can use these technologies to promote important policy goals like taxation which, at first glance, appear to be frustrated by these same technologies. Internet technologies could be used to facilitate the sharing of taxpayer information among the NAFTA countries. The tax authorities of these countries could be linked through an extranet (a network within the Internet that cuts off from public access) where they could monitor each other’s information concerning taxpayer behaviour. Mexico in particular might benefit from this development because, at times, Mexicans with a high net wealth evade Mexican income tax laws by purchasing portfolio investments within the United States. The United States does not impose gross withholding taxes on interest associated with a non-resident’s portfolio investment (see chapter 4). As a result, the Mexican’s interest-bearing investment in the United States will escape U.S. taxation. The interest income is subject to Mexican income tax laws, but Mexican tax authorities often have a difficult time in tracking the worldwide income of their residents. The bottom line is that these types of investments are not taxed at all, resulting in a serious capital flight problem for Mexico as well as a loss of revenues.35 Rules could be developed to share information on these sorts of investments: the U.S. tax authorities could alert their Mexican counterparts to all portfolio investments by Mexican residents. The investments are sometimes conducted using tax haven intermediaries that would frustrate identifying the beneficial holder of the investment: tax havens typically pass bank secrecy laws that make it a crime to share confidential taxpayer information. Moreover, Internet technologies could be deployed to assist in determining the geographic location of consumers – this development could assist with the previously mentioned economic presence tests for cross-border income and consumption tax purposes. Alternatively, automated software technologies could facilitate the tax collection process and lower the compliance costs for multinational firms within North America. All of these potential technological developments, while they would assist in collecting information about taxpayer identity and behaviour,

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run up against a serious problem. The Internet can be considered a ‘digital biosphere’ because it is a forum undergoing rapid technological change, in which commercial (e-commerce) and non-commercial (email, chat rooms, newsgroups, etc.) activities converge within the same network.36 Efforts by tax authorities to monitor, track, share, or locate private taxpayer information through the Internet raise major privacy issues. 5 Conclusion This chapter reviewed a few of the emerging challenges to North American tax policy created by the advent of the Internet and e-commerce. In many ways, the NAFTA countries have failed to properly address these challenges by continuing to emphasize the use of traditional tax rules and principles: these principles, including physical presence tests, are often ill-suited to e-commerce as the Internet ignores national borders. E-commerce transactions take place in the more nebulous world of cyberspace. It seems likely that the NAFTA countries will one day be forced to acknowledge the need for new rules. The mechanisms needed, including the replacement of physical presence tests with economic presence tests, will require a greater degree of cooperation among the NAFTA tax authorities, including the negotiation of bilateral or multilateral agreements to ensure that tax laws can be effectively enforced. At present, NAFTA has few tools to encourage such cooperation. It may be unrealistic, however, to expect the NAFTA countries to cede sovereignty in this area until empirical research shows that the application of traditional tax rules to e-commerce is creating significant economic harm or revenue losses.

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PART IV

Developing an International Tax Policy for NAFTA

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CHAPTER 9

Balancing Economic and Sovereignty Interests

1 Introduction The drive towards regional economic integration invariably leads to tension between two often-conflicting values: the desire to obtain greater economic efficiencies and the desire for sovereign control over government policy making. As indicated in the introduction, Karl Polanyi has called this tension the ‘double movement’ that propels modern society.1 Endemic to international trade discussions, it is perhaps no more pronounced than with respect to potential tax integration initiatives among nations. Governments considering such initiatives find the prospect of ceding the power to shape tax policies – policies traditionally used to pursue domestic political, social, and economic goals – unnerving. However, they are forced to balance the political costs of ceding control over national tax policy making with their desire to secure heightened economic efficiency. Exploring the NAFTA countries’ engagement in this balancing act, the first section of the chapter identifies the main economic concerns arising from the interaction of the tax regimes in question. The next section discusses the sovereignty concerns that NAFTA countries may have with respect to potential tax integration initiatives. 2 Economic Interests The initial focus in this section will be on the possible economic damage caused by the interaction of the different tax regimes under NAFTA. I first review whether the interaction of the tax systems of the NAFTA countries is distorting economic activity in such a way as to lead to an inefficient allocation of resources, and then consider the potential for

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special tax incentives to create harmful effects. Problems created by tax competition among the NAFTA countries are dealt with more explicitly in chapter 10. 2.1 Distortion of Direct Investment Flows Different tax regimes distort investment patterns in such a way as to reduce capital productivity within North America (see chapter 5). The tax systems of the NAFTA countries were established in part to influence investment in certain types of activities deemed worthy by their legislatures (for example, promoting research and development) by increasing after-tax returns on these activities (see chapter 3). It is thought that this approach may create an overstatement of rates of return for unproductive projects that might not have been undertaken in the absence of tax incentives. The tax distortion caused by different national tax regimes might harm the economies of a particular NAFTA country by diverting resources to another NAFTA country or a country outside NAFTA or by reducing the overall capital productivity of the entire North American trade bloc (which, in turn, lowers the overall economic welfare or living standards of citizens of the NAFTA countries). Further, economists assert that reduced capital productivity may harm the ability of countries participating in regional economic integration to compete with other countries or regional trade blocs (see chapter 2). For example, the different corporate shareholder tax structures of the NAFTA countries (the classical system in the United States, the integration system in Canada, and the dividend exemption system in Mexico) promote different tax burdens on cross-border investments, resulting in tax distortions. No economic study appears to have been made of the costs associated with this loss of capital productivity. In any event, conducting such a study would be problematic because cross-border capital (especially FDI) movements are influenced by a number of non-tax factors such as general business climate and a country’s political situation (see chapter 5). In Europe, the Ruding Committee encountered difficulties in measuring the costs attributable to the interaction of the tax regimes of the different EU countries (see chapter 7). ‘[T]he Committee has found no satisfactory way of quantifying the size of the distortions that may exist ... Nevertheless, the fact that empirical evidence gathered on behalf of the Committee indicates that taxation does have a strong influence on the location of investment and on financing decisions is prima facie evidence

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that the distortions to competition and resulting efficiency losses caused by taxation could be large.’2 The empirical evidence relied upon by the Ruding Committee consisted of marginal effective tax rate studies conducted by economists that measure the extent to which tax systems may encourage or discourage taxpayer investment behaviour. As discussed in chapter 5, marginal effective tax rate studies comparing Canada and the United States or all three NAFTA countries generally indicate that the overall tax burdens imposed on most new capital investments in North America are comparable, although the research also suggests that Canada continues to impose the heaviest tax burden on cross-border capital while Mexico tends to impose the least heavy burden. Despite recent reform efforts in Canada, the marginal effective tax rate on capital remains substantially above that in the United States (see chapter 6). Moreover, notable tax burden differences exist among the NAFTA countries for investments in different assets, industries, or financing alternatives. The studies generally suggest that tax continues to act as an incentive to locate investments in relatively lower taxed NAFTA countries (possibly at the expense of Canada, which maintains the highest burdens). Tax differences among the NAFTA countries similarly influence financing decisions and provide arbitrage opportunities for firms to shift income to the most leniently taxed jurisdiction. In the absence of studies measuring the actual welfare losses associated with maintaining different national tax systems in North America, policy proposals that seek to control the potential misallocation of capital by creating uniform NAFTAwide tax burdens on capital income may be premature. In any event, as argued earlier, even harmonized tax bases and/or tax rates would not ensure that the marginal effective tax rates would be the same among the NAFTA countries, as these rates are influenced by non-tax factors such as interest rates. 2.2 The Use of Tax Incentives As we have seen, the European Union and the OECD are currently struggling to determine which types of tax competition can be considered ‘harmful’ and thus should be subject to possible restrictions (see chapters 2 and 10). In certain circumstances, North American tax regimes offer tax incentives to favour and attract certain types of business activities (see chapter 3). Should the NAFTA countries agree to constrain the use of these incentives? Determining what type of tax subsidy warrants action at a multilateral

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level would be no easy matter. Each NAFTA country would invariably argue that its provisions are designed to promote genuine economic or social objectives and therefore should remain untouched. The matter is rendered even more complex by the difficulty of quantifying the costs associated with these tax breaks.3 The non-binding European business tax code of conduct indicates: When assessing whether such [tax] measures are harmful, account should be taken, inter alia: 1. whether advantages are accorded only non-residents or in respect of transactions carried out with non-residents, or 2. whether advantages are ring-fenced from the domestic market, so they do not affect the national tax base, or 3. whether advantages are granted even without any real economic activity and substantial economic presence within the European countries offering such tax advantages, or 4. whether the rules for profit determination in respect of activities within a multinational group of companies departs from internationally accepted principles, notably the rules agreed upon within the OECD, or 5. whether the tax measures lack transparency, including where legal provisions are relevant at administrative level in a non-transparent way.4

Recent OECD reports contain similar criteria for mobile financial services to determine whether a tax incentive should be constrained through multilateral efforts.5 The question that remains is whether the NAFTA countries should adopt measures to constrain tax subsidies, assuming that a consensus can develop with respect to which incentives are considered harmful to investment flows (for proposals in this direction see chapter 11). 2.3 Transfer Pricing Issues Differences in tax systems among the NAFTA countries also encourage tax arbitrage, whereby taxpayers attempt to gain tax benefits offered by one country without altering their economic activity in any ‘real’ sense. For example, a company in one NAFTA state may try to increase the price of intercompany transfers on goods being shipped to a subsidiary in another NAFTA country with a heavier tax burden in order to lessen the impact of taxes in that jurisdiction. Profits are allocated for tax reasons through this income shifting and do not reflect true economic profitability (see chapters 2 and 3).

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Corporate tax rates are currently similar among the NAFTA countries, although in some areas the different tax rules appear to permit shifting profits (see chapter 3).6 Given the significant amount of intercompany transfers within North America, the issue will likely remain a sensitive one.7 Each NAFTA country, with its own tax base and rules for imposing tax liability, may claim a right to tax the same earnings, giving rise to double taxation. Currently, these issues are dealt with through the ‘competent authorities’ provisions of the three bilateral tax treaties, which permit the tax authorities to negotiate a resolution to disagreements. Nevertheless, in some circumstances, the treaty mechanism is somewhat limited, especially in dealing with disputes that involve taxpayers with activities in all three NAFTA countries (see chapter 4, 3.4.). Binding arbitration and centralized advance pricing agreements would assist in reducing problems associated with transfer pricing issues (see chapter 11). Related parties also sometimes take advantage of national tax differences to conduct arbitrage activities to lower their global tax bill through cross-border transfers of capital. Transfer pricing rules and other tax rules (such as thin capitalization rules) target potentially abusive financing techniques employed by related firms within North America. Many of these arbitrage activities, however, can be inhibited by unilateral changes to the domestic tax legislation of one NAFTA country (see chapter 10). 2.4 Trade Flows The focus of this study has been on the impact of national tax differences on cross-border capital flows. Nevertheless, we have touched, from time to time, on the cross-border tax treatment of goods and services. The tax regimes of the NAFTA countries distort trade flows through the use of tax subsidies granted to a variety of business efforts, including subsidies to companies that export goods and certain domestic industries.8 However, the magnitude of this distortion in North America has not been calculated. Apart from this type of trade distortion, the cross-border tax treatment of goods and services is currently not a major area of concern. Economists generally assert that exchange rates offset the impact of taxes on goods and services, such as Canada’s GST and Mexico’s VAT, which are imposed on a destination basis (see chapter 2). Anti-discrimination provisions under NAFTA and tax treaties, along with NAFTA rules of origin that encourage goods to be stopped at the border where they can be subjected to border tax adjustments, also help to inhibit significant distortions.9

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Nevertheless, it is clear that, at least in the short term, indirect consumption taxes can have a dramatic impact, as evidenced by the millions of Canadians who flooded across the U.S. border to purchase goods after the imposition of the GST in 1991. Further, Canadian efforts to impose higher taxes on cigarettes have failed to a certain extent because they encouraged illegal smuggling of cigarettes from the United States. Finally, it is important to note that an area of greater concern is the misallocation of goods and services encouraged by the different provincial sales tax and GST regimes in Canada and the state and local sales tax regimes in the United States (see chapter 3). 2.5 Comment on the Economic Interest The interaction of the different tax systems of the NAFTA countries promotes a number of problems for cross-border investment flows. Ultimately, these differences harm the economic interests of the citizens of the NAFTA countries because the welfare of the trade bloc is not maximized. The extent of the harm caused to these citizens in, for instance, per capita GDP terms, however, has yet to be measured (assuming such a measurement is possible), and without this information it might seem premature to suggest measures that would comprehensively link the tax systems of the NAFTA countries. Still, it seems likely that the problems will become more serious as the economies of North America become increasingly integrated and taxation measures act as one of the remaining barriers to cross-border investment flows. The NAFTA countries, however, are understandably reluctant to address these problems through far-reaching tax integration initiatives because of a less tangible, less quantifiable interest, namely, the need to preserve sovereign control over their tax systems. 3 The Sovereignty Interest 3.1 Sovereignty as a Driver of International Tax Developments Why has North American international tax policy not kept up with the trend towards trade and investment liberalization?10 The answer lies in the unique place that tax measures occupy in a government’s fiscal policy: tax is viewed as an important policy tool, crucial to serving the distinct needs of the citizens of each NAFTA country (for example, through wealth redistribution). Indeed, it is ‘illusory and disastrous for tax policy makers and tax theorists to believe that tax jurisdiction can be based on other than tax territory principles.’11 The issue, then, largely boils down to one of state sovereignty.12

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This is not the typical view of analysts who scrutinize these matters.13 Contemporary international tax policy analysis often employs guiding principles to evaluate how countries treat cross-border flows. On the equity side, various entitlement theories, such as the benefit principle, economic allegiance, or internation equity, are used to justify a particular tax policy choice (see chapter 2). On the efficiency side, commentators trot out goals such as promoting capital export neutrality, capital import neutrality, the need for low compliance and tax administration costs, and so on. In truth, there is very little agreement on the appropriate set of guiding principles for international tax policy and current justifications may suffer from a certain degree of arbitrariness. The arbitrariness can be partly explained by the absence of any world tax authority to unify the disparate theories. Tax systems at the national level can, at least theoretically, be brought into concordance with accepted guiding principles through political measures, as electorates can toss out legislators who impose politically unacceptable taxes. In the absence of any world tax organization, developments in international tax policy result less from the application of accepted guiding principles than from a combination of the exercise of economic power and the pragmatic need to promote cross-border economic activity to enhance domestic welfare through international trade and investment. In other words, countries strive to collect as much tax revenue as possible from international trade and investment without upsetting the apple cart by provoking retaliations from major trade partners. Richard Bird and Jack Mintz point out, ‘Over time, less through the systemic or normative application of international tax principles than by the incremental evolution of rules deemed to be both roughly fair and roughly feasible, a regime that acknowledges and accommodates competing claims developed, for the most part with substantial international agreement as to both the underlying objectives and the means to achieve them.’14 A more pragmatic and incremental approach to the development of international tax policy rules and principles, one that respects the desire of governments to preserve tax sovereignty to the greatest extent possible, is therefore required.15 3.2 Lessons from Europe Revisited Chapter 7 reviewed some important achievements in Europe with respect to tax initiatives in the context of general European economic integration. VATs were partly harmonized in 1993, while two Directives and a Convention dealing with cross-border corporate income tax issues were issued in 1990. The Europeans continue to resist harmonizing

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business taxes, despite recommendations by tax experts and, at times, the European Commission. More recent efforts have been directed at corporate tax base consolidation, whereby pan-European firms might be subjected to the same Europe-wide tax rules while other companies would continue to be subjected to national tax laws. It is clear that the EU countries have evolved away from traditional views of sovereignty. These developments are intriguing because the modern Westphalian nation state arose in Europe in the sixteenth century. At that time it was felt that a state should not be restrained in the exercise of its freedom of action except under very unusual circumstances.16 The more recent view reflects the economic, social, and political reality of Europe today, marked by more than forty years of experience with regional integration. The evolution towards this new reality has permitted the EU countries to make progress on European tax initiatives. As we saw in chapter 7, the specific factors that contributed to this progress include a legislative impetus to harmonize certain taxes, the creation of political links through centralized institutions, the passage of time, the development of the principle of subsidiarity, and decisions by the European Court of Justice that require the removal of tax obstacles to cross-border trade and investment. As noted in that chapter, none of these conditions prevail in North America, highlighting the crucial difference between the European Union (a supranational polity) and NAFTA (a mechanism to promote economic efficiencies). This does not mean that tax integration initiatives under NAFTA are doomed to fail. It does, however, illustrate the difficulties that the NAFTA countries would encounter if they attempted to overcome the sovereignty hurdles associated with regional tax integration. The fact that, despite four decades of regional integration, tension between the desire to reap further economic efficiencies and the desire to maintain tax sovereignty persists in Europe bodes ill for any North American efforts. 3.3 Sovereignty Concerns in North America As discussed above, the movement towards greater tax uniformity in Europe has been a difficult one as the states of the European Union continue to value the preservation of tax autonomy in many circumstances. Law and society scholars teach us that legal rules both reflect and reinforce existing norms.17 Any proposals for NAFTA-wide tax harmonization must therefore convince the citizens of the NAFTA countries that more is to gained than lost through their implementation.

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Sovereignty is a somewhat nebulous concept and escapes precise definition. On an individual level, it can be something as intangible as a ‘gut feeling,’ or some notion of nationalism held dear to the heart.18 Nevertheless, analysis of the political situation in North America (see chapter 7) demonstrates that, as a broad generalization, the citizens within the NAFTA countries continue to place a high priority on preserving notions of sovereignty.19 Should the NAFTA countries be concerned about losing a degree of control over their tax systems under possible North American tax integration initiatives? The answer is ‘yes,’ as long as tax is considered a fiscal tool necessary to meet the particular needs of each country’s citizens. As argued above, tax measures within each NAFTA country currently pursue differing socio-economic agendas and raise different amounts of revenues. Tax integration efforts that affect items such as revenues, investment levels, or employment levels would be very difficult to accept in the NAFTA country that would be adversely affected. Finally, it is important to note that the NAFTA agreement itself only grudgingly gives up limited state powers. This reluctance to limit state power reflects the strong commitment to the preservation of sovereignty within the NAFTA countries. This commitment flies in the face of economic notions such as aggregate wealth maximization and the efficient allocation of resources. Unfortunately, there is often little common ground between economic theory and the values associated with nationalism (for attempts to meld these two notions together, see chapter 10). The framers of NAFTA, through their democratic institutions, continue to place an emphasis on pursuing distinct tax policies, which affects the types and amounts of public goods and services provided by the government as well as the degree and pattern of income redistribution. 3.4 Tax Reform Initiatives under NAFTA There are three general international tax policy approaches available to the NAFTA countries. First, they can decide to maintain the status quo, coordinating the taxation of cross-border activities through their bilateral tax treaties. Second, the NAFTA countries can initiate a policy of comprehensive tax reform, by either harmonizing their tax systems or adopting another far-reaching mechanism, such as a NAFTA-wide formulary approach to taxing the profits of related business entities that operate in more than one NAFTA country. Finally, the NAFTA countries can pursue a policy of gradualism involving heightened tax coordination. In the current environment, gradualism is the most appropriate

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approach, the one most likely to succeed in resolving the tension between each state’s desire to obtain greater economic efficiencies and their determination to retain sovereign control over tax rules. 3.4.1. Do Nothing Under the first possible approach, the NAFTA countries can choose to maintain their current mechanisms for dealing with cross-border flows, despite the liberalized trade and investment environment promoted by NAFTA. Maintaining the status quo will obviously preserve the most amount of tax autonomy, as the NAFTA countries’ tax systems will undergo no changes. A ‘do nothing’ strategy, however, does not ensure that tax sovereignty will continue unmolested. As discussed, relatively small players in the global capital markets, such as Canada and Mexico, must pay close attention to the tax policies of major trade and investment partners in order to avoid capital outflows. In particular, these two countries must ensure that overall tax burdens on capital income do not stray too far from U.S. levels. The United States, in turn, must ensure that its tax system does not make the country inhospitable to investment in comparison to the tax regimes of other competitor nations. In other words, external economic concerns already affect development of national tax policies and, to a certain extent, they reduce sovereign control over domestic tax measures. Under the current regime, tax treaties are the primary mechanism available to resolve problems created by the interaction of the different NAFTA country tax systems (see chapter 4). Tax treaties do not eliminate most of the economic distortions caused by differing tax burdens: tax rules that encourage different after-tax rates of return continue to influence the cross-border flow of mobile economic factors. For example, the tax treaties do nothing to prevent resources from relocating to the jurisdiction with the more favourable tax treatment of capital income relative to another NAFTA country. Treaties therefore do not curtail the potential inefficient allocation of resources such as capital. Further, bilateral tax treaties permit a NAFTA country to extend benefits to another NAFTA country without a corresponding obligation extend those benefits to all parties with which the country has outstanding trade agreements. This type of arrangement can be contrasted with trade deals such as NAFTA or GATT, which require the granting of general most-favoured-nation treatment to all contracting parties. The bilateral nature of the tax treaties thus attempts to co-exist within a multilateral trade regime. The lack of uniformity among many of the

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provisions may lead to further distortions or fragmentation of the North American capital market (see chapter 4, 3.4.). 3.4.2 Comprehensive Tax Reform Efforts At the opposite end of the spectrum are comprehensive tax reform options which would remove or greatly reduce many of the economic efficiencies caused by NAFTA-country tax differentials. Comprehensive reform initiatives would, however, be viewed as imposing an unacceptable constraint on tax policy, and thus would be unacceptable to the citizens and governments of the NAFTA countries. 3.4.2.1 Harmonization of Business Taxes The harmonization of business taxes would involve an agreement by the NAFTA countries to adopt common rules such as similar business income tax bases or tax rates. Pressures for harmonization are more likely to be felt at the corporate income tax level, due to the mobility of capital and the fact that NAFTA-country companies often have operations simultaneously in several jurisdictions. It appears that, even without formal initiatives, the corporate tax systems of the NAFTA countries have converged somewhat during the past two decades (see chapter 3). Despite the apparent conceptual similarity of the NAFTA countries with respect to their corporate income tax systems, many important differences remain. For example, each NAFTA country taxes dividend income differently (see chapter 6). These differences are perhaps due to the differing political, social, and economic agendas, and the sovereignty costs associated with business tax harmonization would thus be very high. Further, corporate income tax harmonization would place constraints on future tax policy decision making by the governments of the NAFTA countries. These constraints might seriously impair the ability of each NAFTA country to address the perceived economic or social needs of its citizens. For example, the NAFTA countries could decide to impose the same tax burden on capital income by harmonizing corporate income tax bases and rates. Under the current political environment, it would be difficult for any NAFTA country to accept harmonization measures that would adversely affect its revenue, investment, or employment levels (see chapter 7,3.). Further, the importance of provincial/state and local taxes to the NAFTA countries presents significant hurdles to any potential harmonization attempts (see chapter 3, 3.). Each NAFTA country puts emphasis on different subnational taxes as main revenue sources: personal in-

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come tax is the focus in Canada, retail sales tax and property taxes in the United States; state-level taxation in Mexico involves only payroll and property taxes. International tax harmonization requires common definitions of tax bases, which would be hard to achieve if tax systems within Canada and the United States are varied or become more varied at the subnational level. Indeed, harmonization within each of these countries can be considered a prerequisite to NAFTA tax harmonization. Moreover, efforts to encourage subnational corporate income tax harmonization are hampered by the federal structures of Canada and the United States. In certain instances, a province/state may be constitutionally empowered to develop its own tax regimes. Income tax harmonization efforts that attempted to alter subnational tax policy would be viewed as unacceptable by the subnational governments in both countries. 3.4.2.2 Formulary Taxation Paul McDaniel has discussed allocating income realized by related companies within North America by way of formulary taxation.20 This proposal would replace the current method of allocating income by the transactional arm’s-length method to calculate cross-border transfers. Instead, the income of a business that has cross-border operations in more than one NAFTA country would be divided among the countries by way of a formula. In many ways, the process resembles the system already used to divide income realized in different Canadian provinces and territories as well as different states in the Unites States, where factors such as the ratio of property, payroll, and sales in the taxing jurisdiction are to be weighed against similar factors in another jurisdiction. To implement formulary apportionment, affiliated corporations within NAFTA would be treated as a singe taxable entity by each NAFTA country.21 The tax base would be divided up among the NAFTA countries according to common apportionment rules negotiated by these states through a trilateral tax treaty. And there is the rub: the NAFTA countries would have to agree on a set of supranational tax rules to determine how much revenue each country would collect from the operations of the unitary enterprise. They would have to cede a portion of their fiscal sovereignty with respect to the taxation of multinational corporate profits. Naturally, each NAFTA country is likely to have a different perspective on what rules ought to govern formulary apportionment. Mexico and Canada, net capital importers

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from the United States, would argue for rules that strengthened source apportionment, while the United States would argue for rules for apportionment based primarily on residence.22 Deciding which factors should be included in the apportionment formula would also be problematic.23 Each NAFTA country would seek to establish a formula serving its own interest, and there could be constant argument concerning the interpretation of the factors even if agreement is reached. This disagreement may lead to an increase in double taxation of NAFTA-wide operations.24 Furthermore, even if current NAFTA-country revenue streams can be approximated through formulary taxation, new entrants to NAFTA may have different views on the elements of the formula. Would the entire formulary apportionment agreement have to be renegotiated with the addition of a new country to the trade deal? In addition, the degree of conformity among the tax systems, or perhaps non-tax systems, of the NAFTA countries may need to be increased.25 The NAFTA countries may have to reach agreement on the implementation of similar tax bases or tax rates.26 Richard Bird notes that NAFTA was not intended to be a federal state and thus mechanisms such as global formulary apportionment, which require inappropriately centralized levels of agreement, may not be called for at this time: in his view, an incremental approach is needed to resolve outstanding problems.27 Also noteworthy is the fact that the U.S. Treasury Department and the Canada Revenue Agency have rejected global formulary taxation reform efforts in the past.28 Despite these problems, the NAFTA countries may be willing in the longer term to adopt some form of profit allocation scheme for highly integrated North American firms as the transactional arm’s-length approach to transfer pricing becomes increasingly unsuitable. European reform efforts that scrutinize consolidated corporate tax bases and allocate profits on the basis of some formula (e.g., home state taxation or common consolidated corporate tax base) may offer this longer term solution. 4 Towards Heightened Multilateral Coordination The following previously discussed factors support the notion that an incremental approach towards heightened multilateral tax coordination is appropriate:

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(a) the current similarity in tax burdens on capital income suggests that direct investment flows are not being unduly distorted; (b) there is no evidence that fiscal degradation is resulting from North American tax competition; (c) no studies have attempted to quantify the actual costs of maintaining the current regime; (d) the NAFTA countries, unlike EU countries, have little experience with respect to regional integration efforts; (e) citizens and governments of the NAFTA countries want to preserve control over those aspects of their fiscal systems that are perceived to play an important role in promoting domestic social/economic goals; and (f) state/provincial governments in the United States and Canada are constitutionally empowered to pursue distinct tax policy. An agreement for freer trade and investment among the NAFTA countries calls for a corresponding movement to reduce barriers to efficiency promoted by tax differences among them. Under an environment of increased economic integration, the NAFTA countries should take steps to address these barriers as long as minimal constraints are placed on each country’s tax policy. The NAFTA countries need to get to the bargaining table and reach consensus on the mechanisms that should be adopted to limit some of the more obvious problems created by the interaction of their tax regimes. An incremental approach to gaining a better understanding and resolving these problems is preferable under the current environment. 5 Conclusion The political, economic, and social tensions that inevitably accompany proposals for international economic integration are particularly acute in the context of tax policy. Countries considering international tax integration initiatives must weigh the economic benefits of greater tax uniformity with the political costs that such initiatives would impose by constraining domestic tax policy decisions. Sovereignty concerns are entirely justified, because modern tax regimes are important mechanisms for ensuring the satisfaction of citizens’ social, economic, and institutional needs. Any reduction in the ability to use tax measures to meet these needs is unpalatable to North American governments, which view NAFTA as a means to achieve further trade and investment efficien-

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cies, not to create sovereignty-comprising political linkages. Proposals that impose significant constraints on the tax autonomy of the NAFTA countries are thus inappropriate at this time. Still, the need for greater coordination is increasing as trade and capital markets become more integrated under NAFTA. The inevitable corollary is that real governmental sovereignty over certain aspects of taxation will erode, especially for Canada and Mexico. Consequently, a strategy of heightened multilateral coordination has been recommended to deal with some of the existing problems. This strategy can be broken down into two tracks: a short-term strategy that targets the removal of certain tax barriers harming the interests of highly integrated North American firms, and a longer term strategy that studies how more fundamental reforms can resolve the ways in which national tax differences are subverting the broader economic interests of the NAFTA countries. This strategy represents a compromise between sovereignty concerns and the desire to reap greater efficiencies: it permits the NAFTA countries to adapt their tax policies to the distinct needs of their citizens while ensuring that some economic costs are controlled at a centralized level. In sum, the strategy accommodates the so-called ‘double movement’ of modern society, responding to market pressures for greater economic efficiency while minimizing the socially disruptive effects of international economic integration.

CHAPTER 10

Modelling NAFTA Tax Competition

1 Introduction The last chapter suggested that a policy of heightened multilateral coordination is the appropriate tax policy response for the NAFTA region. Such a policy avoids any movement towards the harmonization of the tax bases or rates and departs from the approach that is often advocated for the European Union. This chapter addresses more explicitly the reasons why tax harmonization is not warranted within North America. It begins by discussing theoretical concerns about international tax competition and notes that the recent OECD and EU reform efforts focus on inhibiting ‘harmful’ tax competition while permitting more benevolent types of competition to go forward. The chapter then expands on the phenomenon of regulatory emulation within North America, where Canada and Mexico seek, at times, to ensure their tax systems impose roughly similar tax burdens on capital by following the lead of the Americans. A simple game theory model is subsequently employed to demonstrate that Canada and Mexico should consider engaging in limited tax competition by maintaining lower tax burdens on mobile factors in comparison to U.S. burdens: limited competition compensates for the loss of utility associated with the sacrifice of tax sovereignty that accompanies regulatory emulation. The chapter concludes by reviewing the risks inherent in this strategy of pursuing regulatory emulation and limited tax competition. 2 Tax Competition: Theory versus Reality 2.1 Tax Competition among Subnational Governments Tax competition occurs, for example, when a government takes deliberate steps to attract mobile economic factors such as capital away from

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another country by offerimg more favourable tax treatment (see chapter 2). As we saw in chapter 3, extensive debate over whether tax competition promotes or inhibits welfare has taken place within the context of the state and local tax systems in the United States and provincial and local tax systems in Canada. Early work in this field was conducted by Charles Tiebout, who created a model for the market for local public goods.1 The Tiebout model suggested that regulatory bodies would be disciplined by the public, who would ‘vote with their feet’ if they did not approve of government policies, moving to a jurisdiction with a more favourable regulatory approach. In other words, there would be competition for voters (and taxpayers) between jurisdictions, each of which would try to achieve the optimally efficient level and composition of public spending. The jurisdiction that best reflected public preference (that is, which offered the correct mix of tax and the provision of public goods) would attract voters and hence more tax revenues. Public choice theory suggests that optimal levels of tax will be imposed on households and firms when tax payments match the benefits that users receives from the community. The tax competition literature subsequently explored whether or not competition between tax regimes results in the suboptimal provision of public goods. Some commentators suggest that competition among subnational tax jurisdictions leads to optimal results2 while others indicate that the tax differences create more harm than good.3 Beyond these theoretical concerns, it is noteworthy that the potential radical harmonization of U.S. state and local sales and use tax regimes springs from more mundane tax compliance concerns about the need to enforce tax laws on remote consumer sales (see chapter 8). In addition, Canadian provinces impose greater levels of income taxes on individuals and business entities in comparison to U.S. states, where more tax competition exists: as described in chapter 3, the provinces have generally adopted the federal government’s definition of the income tax base and most provinces have collection agreements that permit the federal government to collect their taxes. In any event, the extension of state/federal public choice theory to the international sphere has been criticized because international tax policy less frequently follows the benefit taxation approach inherent in the Tiebout model that is arguably employed by state and local government.4 Vito Tanzi additionally notes that subnational tax competition differs from global tax competition because the former typically involves totally free trade without obstacles; comprehensive access to information; a federal tax system that establishes guidelines for individual and

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corporate income tax and imposes the lion’s share of income taxes; and low-rate retail sales taxes in contrast to high-rate VATs.5 An additional difference may be that federal governments provide sticks (e.g., the threat of federal pre-emption of state taxing powers in the United States) and carrots (e.g., redistribution of income tax revenues among provinces in Canada) that can encourage cooperation to reach at least potentially efficient outcomes while the international scenario has far fewer mechanisms to promote these ends (see chapter 8). 2.2 Theories on International Tax Competition Tax scholars have advanced arguments in favour of international tax harmonization to avoid race-to-the-bottom scenarios in which countries compete for mobile resources by lowering tax burdens. Economists sometimes model international tax competition among countries in order to gauge the likely results of this process.6 In an environment where capital outflows are not restricted, Joel Slemrod notes that many models suggest that the international competition for capital will lead to a capital income tax of zero in the long run.7 Many have expressed concern that this will limit the ability to implement the activities of a welfare state. For example, Hans-Werner Sinn suggests: ‘The basic lesson from the theory of optimal taxation is that a country cannot, and should not, impose high taxes on activities whose supply and demand are price elastic. Elastic activities can escape taxation and thus imply a high excess burden relative to the tax collected. This is Europe’s new problem. The fall of the barriers will increase the possibility of tax avoidance and provide more elasticity to a number of economic activities.’8 Without harmonization, Sinn points out, the losers will include workers who depend on government benefits, because these workers will ultimately bear higher taxes in comparison to mobile businesses. Impelled by similar concerns, the Ruding Committee proposed the harmonization of corporate income tax rates for EU countries, in part to avoid the perceived detrimental effects of tax competition. When it became clear that these recommendations would not soon be implemented, the European Commission began to stress the need to harmonize corporate income tax bases to inhibit tax-induced distortions (see chapter 7). Julie Roin, however, points out, ‘Though economists have emphasized the need for international tax base harmonization – either in conjunction with or instead of tax rate harmonization – for over 30 years, there has been little discussion, let alone movement in that direction in the

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income tax context.’9 She attributes the lack of progress in part to the fear of national legislators that they would lose control over national tax policy, and to taxpayer opposition to reform efforts that could foreclose favourable arbitrage strategies. A number of economists have questioned whether harmonization will lead to any efficiency gains.10 Opponents of harmonization argue that (1) competition tames the so-called Leviathan tendencies of government to fund inefficient public services; (2) maintaining different tax regimes promotes policy experimentation and innovation that could lead to future efficiency gains; and (3) different tax regimes can better address the distinct needs of different economies (some, for instance, may prefer to subsidize certain business activities crucial for national economic success). After reviewing the literature in this area, two commentators conclude that ‘More work is needed to incorporate reasonable political processes into tax competition models, leading to sharper distinctions between good and bad tax competition.’11 2.3 Harmful versus Fair International Tax Competition This study does not attempt to resolve the theoretical debate over the value of international tax competition. It is probably safe to say that tax competition provides some useful benefits, but it also has the potential to be harmful in some circumstances. In fact, the current EU and OECD efforts directed at tax competition seem to consist of disentangling ‘fair’ or ‘good’ tax competition from ‘unfair’ or ‘harmful’ competition.12 The member states of the European Union have agreed, through a non-binding political commitment, to eliminate tax measures that promote harmful tax competition (see chapter 7 and 9). OECD member states have similarly agreed to reduce harmful preferential tax regimes in the context of mobile financial and other services.13 In addition, OECD members have agreed that they may retaliate against uncooperative tax havens who have not agreed to eliminate their harmful tax practices by 31 December 2005.14 The OECD study aims to identify the effects of tax competition; examine criteria for distinguishing between fair and harmful competition; and recommend ways in which governments acting individually or collectively could ameliorate negative tax competition effects.15 As discussed in chapter 3, the OECD found that certain aspects of the Canadian and U.S. tax regimes constituted harmful tax practices. This theme of assessing whether tax competition is ‘fair’ or ‘harmful’ will be revisited in the following discussion, which attempts to gauge the impact of tax competition among the NAFTA countries.

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3 Regulatory Emulation 3.1 Tax Competition with One Big Player The problem with analysing tax competition in the North American context is that the competition is necessarily one-sided. The economic size of the United States relative to Canada and Mexico dictates that the U.S. tax regime will have a greater impact on capital movements in North America (see chapter 6). Moreover, because the United States constitutes roughly one-third of the total world capital market, its own economic interests are not affected to any significant degree by the tax policies of its NAFTA partners. United States commentators are concerned that, for instance, corporate income tax revenues have been steadily declining over time, but they attribute this decline to changes in domestic tax law and not to international tax competition.16 From an American perspective, the United States does not necessarily use its tax system to compete with Canada and Mexico. 3.2 The Canadian and Mexican Approach The norm in North America is regulatory emulation, defined as ‘the process whereby regulators change their policies as a result of observing the regulatory policies pursued by other countries.’17 In certain circumstances, Canadian and Mexican governments change their tax policies to ensure that they impose tax burdens on mobile factors that are similar to those found in the United States. This behaviour results from the asymmetrical bargaining power and economic dominancy of the United States relative to its NAFTA partners. As explained in chpater 2, the United States provides the majority of the annual capital inflows as well as the majority of the total FDI stock to its NAFTA partners. There is evidence that both Canada and Mexico have felt pressure to alter parts of their tax systems to conform to the U.S. system. Canadian effective tax rates on capital income were gradually reduced over the last twenty years until the Canadian system imposed a tax burden on capital activity similar to the one imposed by the U.S. tax system, although commentators are uncertain whether this convergence was deliberate.18 Moreover, Canadian tax reform in 1987 and the 1990s was influenced in part by the tax reform initiated in the United States. As previously discussed, the Canadian and U.S. corporate tax systems have converged over time to the point where it is not obvious that significant efficiency gains could be reaped through harmonization of tax rates (see chapters 3 and 5).19

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Canadian policy analysts often pay close attention to U.S. developments prior to developing their own tax strategies. For example, the 299page Report of the Technical Committee on Business Taxation, released in 1998, contains 263 references to the ‘United States’ or the ‘U.S.’ Further, as we saw in chapter 6, the Canadian reform efforts in 2003 were conducted in part as a reaction to proposals by the U.S. administration. As discussed in this chapter, in 2003, the 382-page Canadian federal budget contained 185 references to either ‘United States’ or ‘U.S.’ Many of these references explicitly drew comparisons between the Canadian and American tax regimes. The political scientist Geoffrey Hale has undertaken a comprehensive review of how the Canadian Department of Finance reacts to tax developments by its southern neighbour. He notes that, in an environment of increased economic integration, Canadian changes in business taxation ‘are far more likely to reflect competitive pressures from Canada’s major trading partners – especially the United States – than domestic political forces.’20 Critics have noted that the main deficiency of this approach is that it leads to a ‘democratic deficit’: tax reform efforts are dictated by market forces and the globalization process without any political accountability to Canadian voters.21 Mexican tax reform in the 1980s was mainly initiated to mirror the government’s economic strategy at the time: to encourage stability and predictability in the Mexican economy. One way of accomplishing this goal with respect to tax policy would be to implement a tax regime that is similar in many respects to that of its major trading partner, the United States (see chapter 3). Further, certain Mexican reform efforts, such as the recent changes to maquiladora taxation, specifically address American concerns. Jorge Martinez-Vazquez and Duanjie Chen have indicated: ‘The obvious significant implication of NAFTA for Mexico is that a traditional constraint for tax policy reform has become more binding. No reform proposals should now be considered without an explicit analysis of how they may affect Mexico’s standing in NAFTA, in particular how new measures may affect cross-border trade and investment flows into Mexico from the U.S. and Canada.’22 3.3 The United States and Its ‘Go It Alone’ Approach There is no real evidence that U.S. policy makers have enacted significant tax reform measures to counter developments that take place in Canada or Mexico. Indeed, one commentator has noted that, with respect to the Tax Reform Act of 1986, which some believe to have led to

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massive capital inflows from foreign countries to the United States, ‘there is virtually nothing in the legislative history ... that indicates that concerns about international trade and investment had anything to do with the legislation.’23 A review of the two most recent U.S. Treasury Department tax policy papers that deal extensively with international tax issues also demonstrates that U.S. officials are far less likely to pay attention to Canadian or Mexican tax developments. A 1999 report on corporate tax shelters contains nineteen references to ‘Canada’ and zero references to ‘Mexico’ in 188 pages.24 The Canadian references all concern the introduction of the General Anti-Avoidance Rule by the Canadian government in 1988; the Americans were attempting to determine whether similar reform efforts should be used to combat the growth of abusive international tax shelters. A 2000 report by the Office of Tax Policy that focuses on the deferral of income earned through U.S.-controlled foreign corporations (CFCs) contains thirteen references to ‘Canada’ and one reference to ‘Mexico’ in 266 pages.25 Most of the references to Canadian taxes are to academic studies that involved cross-country comparative analysis of CFC regimes that included Canada, among them studies based on the research of two Canadian tax law scholars.26 Finally, as noted in chapter 6, the 347-page U.S. budget for the fiscal year 2004 contains only six references to ‘Canada,’ none of which deal with tax issues. The same budget contains only three references to ‘Mexico,’ all dealing with border issues. Tellingly, the dividend exclusion proposal by the Treasury Department never mentioned that the proposed system was virtually identical to the system of dividend taxation already in place within Mexico. Despite its traditional ‘go it alone’ approach, U.S. tax policy is probably becoming more constrained by global concerns.27 Policy commentators and government officials within the United States increasingly focus on the competitiveness of the U.S. tax regime vis-à-vis its main trade partners. For example, the view that the United States is one of the few industrialized countries with a classical system of corporate taxation influenced to a certain extent reform efforts in 2003 to reduce dividend taxation for individual shareholders. 4 A Game Theory Perspective on NAFTA Tax Competition 4.1 General Observations The following analysis employs game theory to assist in understanding the behaviour and strategies of the NAFTA partners with respect to their

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actual and potential international tax policies. Game theory has been defined as ‘the study of mathematical models of conflict and cooperation between intelligent rational decision-makers ... As such, game theory offers insights of fundamental importance for scholars in all branches of the social sciences, as well as for practical decision-makers.’28 There is an extensive literature on the use of game theory to model international tax competition, mainly developed by tax economists.29 In addition, game theory is sometimes employed by political scientists to model different political situations.30 The model developed below departs to a certain extent from traditional analysis by attempting to integrate the economic perspective with international relations theory, as it focuses in part on the political costs associated with tax competition and tax harmonization. 4.2 Modelling NAFTA Tax Competition A game model requires players, rules, strategies, pay-offs, and a solution. A simple model is developed in normal form to provide insights into different tax policy options available to the NAFTA countries. There are two players. Larger Economy has the relatively larger economy and is meant to represent the United States. Smaller Economy has the smaller economy and represents either Canada or Mexico. Larger Economy receives a small portion of foreign direct investment from Smaller Economy, while the second country receives the bulk of its foreign direct investment from Larger Economy. Each player has two possible strategies: the player can choose to harmonize its corporate tax base and tax rates with the other player (in a unilateral or bilateral manner) or decide not to do so. Each player is given five points as a pay-off for preserving tax sovereignty by refusing to harmonize and avoiding ‘democratic deficits.’ There is hence an assumption that both players value the preservation of this sovereignty to the same extent. Each player also get utility points for pursuing harmonization: this strategy would arguably promote national welfare by reducing the tax distortions to cross-border capital flow that promote a reduction in capital productivity and result in the long run in reduced economic wealth (as discussed above, certain theoretical perspectives dispute this point). Larger Economy receives only 1 point in utility by pursuing harmonization strategies with Smaller Economy, since the reduction in distortions resulting from harmonization will add a relatively small amount of wealth to Larger Economy’s total wealth production. In contrast, Smaller Economy gets ten points in utility by pursuing harmonization

168 Developing an International Tax Policy Figure 10.1 Smaller Economy

Larger Economy

Harmonize

Not Harmonize

Harmonize

1,10

1,5

Not Harmonize

6,10

5,5

because, as the smaller economic unit, this country depends to a greater extent on its economic ties to the larger country. The ability of Smaller Economy to access and continue to attract capital from its larger partner is critical to Smaller Economy’s long-term economic success. As a result, it places a much higher value on possible unilateral or bilateral harmonization. In addition, Smaller Economy may prefer tax harmonization with Larger Economy to prevent potential race-to-the-bottom scenarios, discussed above, so that Smaller Economy can continue to collect revenues through the taxation of corporate profits. The granting of utility points for the preservation of tax sovereignty arguably reflects a realistic perspective on the development of international tax policy, as governments are required to weigh anticipated economic benefits against the loss of sovereignty that results when countries agree to bind their tax systems at the supranational level.31 As discussed in chapter 9, this desire to protect tax sovereignty reflects the broader tension inherent in globalization, where market forces increasingly constrain governmental policy making and citizens react by demanding protectionist measures to reduce the socially disruptive effects of these forces. Figure 10.1 is a pay-off matrix where the numbers in the cells are the pay-offs received by Larger Economy and Smaller Economy. Larger Economy’s pay-offs are written first while Smaller Economy’s pay-offs are written second. The game is played on a sequential basis where Larger Economy moves first and, after closely monitoring Larger Economy’s decision, Smaller Economy moves. Larger Economy has a dominant strategy to ‘not harmonize’ no matter what choice is made by Smaller Economy. A signal by the dominant player that it will not harmonize under any circumstances clearly changes the options available to Smaller Economy. Smaller Economy knows that it cannot end up in the top left-hand corner, as Larger Economy will never make the choice to harmonize its tax regime with Smaller Economy. As a result,

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Smaller Economy has to decide between the lower right-hand corner box, refusing to harmonize, or the lower left-hand box, choosing to harmonize. The choice to ‘not harmonize’ can be quite costly because Smaller Economy, as the relatively smaller economy, depends on investments from firms and individuals within Larger Economy to ensure its economic success. Smaller Economy similarly has a dominant strategy and thus chooses to ‘harmonize’ to maximize its utility by receiving ten points. As the game does not offer the opportunity for cooperative behaviour (that is, the United States signals that it will not participate in any binding commitments), the game will not lead to a Nash equilibrium (defined as an outcome where neither player can improve by making a unilateral move). By virtue of its ‘go it alone’ approach, the United States holds the position of ‘first mover,’ makes the decision that achieves maximum utility, and forces Smaller Economy to respond. As a result, the game leads to a subgame perfect equilibrium at the lower left-hand box, where both players maximize utility by obtaining their highest ranked outcome.32 This equilibrium of course does not suggest that the parties have taken the most efficient route to achieving their outcomes, but it does suggest that this course of action is the most rational strategy, given the parameters and assumptions of the game. 4.3 Lessons from the Model A number of implications can be drawn from the model developed above. First, Smaller Economy may be presented with the opportunity to engage in limited tax competition without the threat of retaliation from Larger Economy. A game theory model of EU tax competition predicts that if two countries signal they will engage in tax competition and have the fiscal capacity to enter into this competition, then no competition will take place.33 However, if one country signals that it will not compete, tax competition might take place. In the model set out above, Larger Economy signals that it will not harmonize, but this does not necessarily imply that Larger Economy is actually willing to engage in tax competition. For Larger Economy, the utility gained from sovereignty preservation is so much greater than the utility gained through harmonization that it will not engage in tax competition with Smaller Economy. To do otherwise, Larger Economy would have to forego at least some tax sovereignty by reforming its tax system to compete with that of a foreign government.

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In fact, Smaller Economy is presented with the opportunity to engage in limited tax competition without the threat of retaliation from Larger Economy, which is either oblivious or indifferent to Smaller Economy’s tax reform efforts. Smaller Economy should not only match changes by Larger Economy, it could also undercut these reform efforts by always ensuring that Smaller Economy’s tax regime is more attractive to crossborder factors in comparison to that of Larger Economy. By engaging in limited competition, Smaller Economy could potentially increase the utility points awarded for promoting national economic welfare to make up for the loss of utility that resulted from the decision to pursue unilateral harmonization and sacrifice tax sovereignty. This sort of strategy will arguably reduce the total welfare of the trade block because tax competition would encourage more distortions of cross-border direct investment flows. However, these distortions could favour Smaller Economy by diverting flows to this country, at the expense of Larger Economy. The model, which concentrates on efficiency gains through reduced distortions, would have to be modified to take into account the fact that Smaller Economy could gain more utility by diverting these flows. Moreover, in order to attract direct investments through lower corporate taxes, an assumption needs to be made that cross-border profits are taxed on a source basis and not on a worldwide income basis. This assumption is likely valid in the North American context due to the Canadian exempt surplus rules, the Mexican dividend exemption system, and the fact that the United States offers foreign tax credits and does not tax business profits until they are repatriated (see chapter 3). Since 2000, Canada appears to have been engaging in this sort of competition by touting its ‘Canadian tax advantage’ relative to the United States, although commentators suspect that marginal effective tax rates on certain forms of mobile capital continue to be higher in Canada than in the United States (see chapter 6). These actions are consistent with the model because the Canadian government clearly perceives it will gain more utility by unilateral harmonization and by undercutting U.S. reform efforts than it would through the preservation of tax sovereignty (otherwise it would not choose to give up sovereignty by following the leader). Because the Canadian corporate tax rates started out higher than U.S. rates, the recent Canadian reform efforts might be seen as a first step towards making the non-harmonized competitive move of undercutting U.S. rates. The Canadian reform efforts can also be viewed as a way to inhibit arbitrage activities that erode the Canadian tax base,

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such as the use of excessive debt in Canadian subsidiaries of U.S. parent companies (see chapter 6). Second, perhaps the broader lesson here is that the concerns about race-to-the-bottom scenarios that motivate many of the European tax harmonization proposals seem misplaced in the NAFTA context. The race to the bottom (a so-called war of attrition) will not take place: Larger Economy will not sacrifice sovereignty by reacting to Smaller Economy tax reform efforts because, again, Larger Economy gains very little utility from trying to attract more capital flows from Smaller Economy. The key insight of the model is that tax sovereignty concerns act as a constraint on possible tax competition. Further, unilateral harmonization probably does not carry the same sovereignty costs as fullblown bilateral or trilateral harmonization, as the country continues to preserve some flexibility with respect to its business tax policy.34 The model could be modified to reflect the fact that unilateral tax harmonization would provide at least some value to Smaller Economy. Third, this type of regulatory emulation strategy may be more rational and cost-effective in a three-party game with asymmetrical bargaining power. Thomas Heller, for example, suggests that this emulation behaviour and the corresponding lower costs of governance makes sense in the North American context, in contrast to the European Union situation involving fifteen players (now twenty-five) and far more symmetry in terms of economic power.35 Fourth, it is not clear that Canada or Mexico would benefit from fullblown harmonization. One view suggests that, where regions differ only in population size, local tax competition confers an advantage on the region with the relatively smaller population.36 The tax competition literature indicates that a small country has a more elastic tax basis and will be less reluctant to reduce its tax rate (that is, more reluctant to raise it) relative to the larger country. Harmonization would not necessarily make the smaller region better off ‘because it removes the ability of small regions to exploit large regions by undercutting their taxes.’37 For example, Mexico, with its traditionally lower tax burdens on investment activity, would arguably suffer from harmonization because its current tax regime may be diverting investment flows to Mexico for tax reasons. Moreover, game theory predicts that a disproportionate share of any improvement in pay-offs derived through cooperative tax behaviour will go to the bigger player: the country with the greater power – the United States – gets to keep a greater share of the gains obtained from cooperation.38 These views support the notion that Canada and Mexico should

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emulate U.S. reform efforts not only to match U.S. changes, but to undercut these changes to ensure that the two smaller economies always maintain a lower tax burden on direct investment when compared to the U.S. burden. Fifth, without resort to base harmonization, the proposed international tax policy strategy of heightened multilateral coordination among the NAFTA countries could constrain welfare-reducing tax arbitrage strategies used by firms to take advantage of national tax differentials.39 At other times, unilateral action by one NAFTA country may inhibit arbitrage strategies. Consider the use of so-called hybrid entities to obtain better tax results by taking advantage of different national legal regimes. A Canadian parent company could previously fund its U.S.based affiliate through the use of a U.S. limited liability company (LLC). The LLC is treated as a separate taxable person for Canadian purposes and a flow-through entity for U.S. purposes. The U.S. LLC was set up to loan funds to the U.S. affiliate. Interest payments under the loan are deductible by the U.S. affiliate for U.S. tax purposes. The transfer of funds from the Canadian parent to the U.S. LLC will not trigger any Canadian tax. Moreover, a dividend distribution from the U.S. LLC to the Canadian parent may be exempt from tax (as the distribution comes from the LLC’s ‘exempt surplus’). Finally, the Canada–United States tax treaty reduced the withholding tax rates on the interest payments from the United States to the Canadian parent. Taxpayers achieved a more effective tax result while still being in full compliance with all relevant tax laws. The United States reacted by unilaterally passing laws to deny treaty benefits for this transaction and to characterize payments that would otherwise be interest payments into dividend payments, hence rendering them non-deductible.40 Coordination or, if possible, unilateral action is the preferred strategy as it preserves tax sovereignty to a greater extent than formal harmonization.41 Unlike the situation in the model, which only contemplates base or rate harmonization, the NAFTA countries have a history of cooperating together with respect to cross-border tax coordination. They should therefore cooperate in the area where there is a proven record of accomplishment of reaching goals that inhibit problems created by the interaction of different national tax systems. Finally, the analysis suggests that harmonization (whether unilateral or bilateral) becomes a more attractive option to the extent that capital flows from a trade partner or partners represent a significant portion of

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the total inward stock. At some point, the economic concerns trump the sovereignty concerns. If one were to extend the model to incorporate more players, Larger Economy might choose to harmonize because the economic benefits derived through this process would outweigh the sovereignty concerns. For example, if NAFTA were broadened into a Free Trade Agreement of the Americas, the United States might contemplate harmonization to the extent that it would gain greater utility from the efficiencies derived through the unification of the tax bases and rates of its partners. It might be possible to calculate the ratio between the utility gained by protecting tax sovereignty and the utility gains associated with encouraging more efficient capital flows. Further research in this area may prove to bear fruit. 4.4 Limitation with the Analysis There are several potential shortcomings with the analysis provided above. The model clearly represents a highly simplified version of the way in which nations approach their international tax policy positions. The pay-offs set out in the model may not accurately reflect the actual utility gains from preserving sovereignty or encouraging efficiencies: different pay-offs might generate different outcomes. For example, the model assumes that harmonization produces efficiency gains while, in fact, it could lead to an efficiency loss for a particular country that might otherwise benefit by attracting capital to an inefficient use. The pay-offs relating to the preservation of tax sovereignty could also vary to take into account the fact that harmonization may please some constituencies (e.g., the business community) to the point where there is a gain in utility (as other constituents may be more or less indifferent). Moreover, the model does not tell us anything about ways to encourage more cooperative behaviour. A lack of formal harmonization may lead to reduced capital productivity for the entire trade bloc as resources continue to be allocated for tax reasons instead of economic rationales: the model does not help us to understand how both players could enjoy higher pay-offs by cooperating. The model is meant to act as a starting point to promote an understanding of the relationship between the often-conflicting goals of wishing to preserve tax sovereignty and trying to improve economic efficiency by making national tax systems more similar. More research is required to clarify and elaborate on the potential for this sort of modelling to assist in our understanding of the conflict.

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5 Conclusion Regulatory emulation may be the most rational strategy in the NAFTA tax context, as it creates the most value for the trade partners. Canada and Mexico should pursue unilateral harmonization to ensure that efficiency losses are constrained. Furthermore, both countries should arguably ensure that their tax systems, in comparison to those of the United States, are more attractive to internationally mobile factors like foreign direct investment in order to gain additional economic wealth to make up for the loss of tax sovereignty. Canada, as a mature industrialized nation with significant expenditure commitments, may have less flexibility in this regard; Mexico should have greater latitude to undercut the U.S. tax regime. It should also be noted that the decision to engage in limited tax competition is not without risk, for at least four reasons. First, the country that lowers its tax burden on mobile capital may sustain revenue losses that exceed revenue gains generated by any increase in economic activity. Second, the United States may eventually retaliate if it feels that its trade partners are unfairly attempting to siphon off its domestic capital. Third, limited tax competition could inhibit future cooperative behaviour, including cooperation on the proposed multilateral tax coordination strategy. Finally, increased tax competition would arguably promote more distortions (perhaps in favour of the two smaller countries) and could lower the overall welfare of the trade bloc.

CHAPTER 11

Recommendations

1 Introduction Heightened multilateral tax coordination is appropriate for the NAFTA countries in the current environment of increased economic integration. This chapter sets out possible elements of the coordination approach, including efforts to curtail transfer price abuses through an arbitration procedure, trilateralize tax treaty negotiations and harmonize treaty policy, reduce barriers to cross-border capital flows by abolishing withholding taxes on parent/subsidiary dividends, move towards multilateral agreements to enforce collection obligations on e-commerce sales, and to improve administrative cooperation among national tax authorities. Building on analysis in previous chapters, the recommendations emphasize removing tax barriers for highly integrated North American firms and represent a modest step towards resolving some of the outstanding tax issues that confront the NAFTA countries without placing any real restrictions on their various tax policies. 2 Policy Recommendations 2.1 NAFTA Tax Working The European example shows that resolving the tension inherent in tax integration efforts is a slow and tedious process fraught with many political and economic difficulties. It makes sense then for the NAFTA countries to acquire a greater understanding of the interaction of their tax systems and to direct efforts towards improving the coordination of these systems. The learning process can begin by creating a permanent tax group comprised of tax experts from each NAFTA country (the tax

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authorities currently hold informal trilateral meetings on North American tax compliance issues). The group could be created under the auspices of the NAFTA Trade Commission with the consent of the NAFTA countries. This ‘Tax Working Group’ could resemble the current NAFTA Working Group on Trade and Competition, which was charged with reporting on the relationship between the NAFTA countries’ competition laws and trade within North America. The group could be comprised of officials from the NAFTA-country governmental departments that traditionally negotiate tax treaties: the Mexican Treasury Department (the Hacienda), the United States Treasury Department and the Department of Finance in Canada. Representatives from the tax authorities of each NAFTA country should also participate to resolve more complex and technical tax issues. Initial efforts should focus on reviewing the coordination of the tax systems of the NAFTA countries, especially with respect to multinational firms with operations in more than one of them. Resources ought to be directed towards determining the economic costs of maintaining the current system of tax treaty coordination. An additional role of the group will be to investigate areas of common tax ground, as well as problem areas, which will serve to highlight political obstacles that will be difficult to overcome. The working group should try to reach a consensus about which tax policies distort conditions of competition within the trade bloc, and which are essential to the pursuit of goals based on the preferences of the citizenry: the former category would then be targeted for reform (see below at 2.6). Another area of sensitivity that needs to be explored in greater detail is profit allocation and cross-border loss relief to permit resident taxpayers of one NAFTA country to offset losses incurred by branches or subsidiaries in another NAFTA country. There are currently significant limits on cross-border loss relief, which may lead to economic double taxation. As discussed in chapter 7, the European Union has proposed to deal with this issue through a common consolidated tax base and, as of 2004, is studying a variety of approaches (e.g., home state taxation, the Danish joint taxation system, and the European tax allocation system). The NAFTA countries should similarly explore different solutions to the problems of profit allocation and cross-border loss offsetting, perhaps initially through a pilot project involving select North American firms. The working group would have another important role: multilateral negotiations will permit the tax systems of new entrants to NAFTA to be

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integrated more smoothly into an expanded deal. The tax working group could thus present a forum for a fuller exploration of the impact of tax on trade and capital flows among the NAFTA countries. 2.2 Harmonize Treaty Policy The lack of uniformity among the tax treaties of the NAFTA countries can lead to distortions in the North American capital market. The Ruding Committee suggested that significant tax distortions hindered the competitiveness of the European Union despite a nearly complete network of bilateral tax treaties. The Committee proposed that, at a minimum, a common treaty policy among the European Union was necessary to help reduce these distortions. Similarly, in 2001 the European Commission proposed to develop an EU version of the OECD model tax treaty and commentary as a first step towards an EU model treaty. Tax scholars have also called for the multilateral negotiation of tax treaties to better reflect enhanced regional and global economic integration (see chapter 4).1 The NAFTA countries should consider implementing multilateral tax treaty negotiations: traditional bilateral treaty negotiation is not etched in stone.2 Further, as discussed in previous chapters, the tax policies of the NAFTA countries appear to have converged somewhat (at least with respect to business income taxes), which may make the negotiations more feasible. There has been an additional movement among the NAFTA partners to reduce withholding rates in their tax treaty negotiations in recent years, which removes an obvious barrier to this type of reform. Reluctance to enter into multilateral negotiations stems, in part, from the desire to extend tax benefits on a reciprocal basis without granting these benefits to all trade partners. In addition, for example, Canada’s interests vis-à-vis the United States are very different from Canada’s interests vis-à-vis Mexico. It may be more feasible to trilateralize treaty provisions that deal with highly mobile factors such as investment flows; other provisions that are tailored to the bilateral interests of the NAFTA partners (for example, pension income) could remain unchanged. In any event, it makes more sense to offer the same tax benefits to all trade partners in a multilateral free trade and investment area in order to reduce capital market fragmentation. The broader use of most-favourednation provisions in North American treaties (e.g., where one country agrees to lower its withholding tax rates to the rates negotiated by its other two NAFTA partners) would also go a long way towards harmonizing treaty provisions in areas that target cross-border capital flows.

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2.3 Arbitration Procedure for Transfer Pricing Disputes Increased economic integration will be followed by increased integration of business activities among the NAFTA countries. It seems likely that transfer pricing disputes will assume even greater importance in the future. The adoption of a centralized dispute resolution procedure will assist in resolving this concern. Although chapter 9 rejected formulary taxation for North America for the short and medium term, it is recognized that traditional transfer pricing rules at the international level has received much criticism. The main criticism levelled at the arm’s-length method is that it does not reflect economic reality, since the related party transfers are not the same as those among non-affiliated groups.3 Nevertheless, the treatment of transfers at arm’s length is at least a straightforward and unifying principle in theory (if not in practice!), and has been employed by the tax authorities of the NAFTA countries as well as practitioners for some time now (see chapter 3). In the longer term, the ongoing efforts by the European Union to develop a consolidated tax base for EU firms, eliminate separate accounting, and apportion the tax base through a formula (or some other mechanism) may bear fruit and these developments should be closely watched by the NAFTA countries. The adoption of the same transfer pricing rules among the NAFTA countries would no doubt assist in coordinating cross-border activities. Canada and Mexico generally follow the OECD guidelines in this area, while the United States has implemented detailed rules that permit the taxpayer to choose among several pricing methods (which are similar in approach to the OECD guidelines). There might be considerable resistance in Canada and Mexico to moving towards U.S.-type rules, due to the complexity and compliance costs associated with them. It also seems unlikely that the United States would adopt the rules of its NAFTA partners (for example, by downplaying the use of profit split formulae). It may make more sense to coordinate areas such as documentation requirements to lower compliance costs for highly integrated North American firms. For example, Canada bolstered its documentation requirements in 1997 to force firms to maintain extensive contemporaneous documentation on transfer pricing, partly in reaction to developments in the United States. By coming to agreement on documentation requirements for NAFTA-wide business activities, firms could reduce costs associated with complying with three different legal regimes in North America. This development would be consistent with the efforts of the Pacific Association of Tax Administrators (which comprises four mem-

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ber nations, Australia, Japan, Canada, and the United States) to adopt uniform documentation requirements. Binding arbitration procedures for transfer pricing disputes under some type of ‘NAFTA Tax Commission’ would resolve outstanding differences – these arbitration procedures already exist in certain circumstances in the Canada-U.S. tax treaty and the U.S.-Mexico tax treaty. The arbitration procedure could be set up in a manner similar to that employed by the Arbitration Convention adopted by the countries of the European Union on 1 January 1995 (although, as of January 2004, the Convention was not in force as several EU countries had not yet ratified legislation to prolong its existence).4 Binding arbitration might encourage business certainty and promote cross-border investments among the NAFTA countries. The multilateral dispute resolution process in North America could also be extended to cover the ground normally taken care of through the ‘competent authorities’ provisions of each tax treaty, including double taxation relief and treaty interpretation issues. This would also permit a NAFTA country whose interests are not necessarily involved in the dispute in question to have input on a decision that might affect its interests in the future. For example, if a Canadian taxpayer was arguing that her portfolio investments in the United States were being doubly taxed, a Mexican official could also sit on the panel. Currently, all of the NAFTA countries have procedures that allow for advance (transfer) pricing arrangements (APAs) to permit a multinational and the relevant tax authority to come to an agreement on the methodology which will to be used to calculate the transfers. Further, each country permits the negotiation of bilateral or multilateral APAs. It may make sense to administer the advance pricing rules for transfer pricing at a centralized level if the NAFTA countries adopt similar rules or binding arbitration. This centralized APA mechanism could also be extended to grant approval for other North American economic activity, such as corporate reorganizations or mergers (see 2.5. below) to ensure that taxpayers are not subject to a tax penalty that would arise out of the interaction of the different tax rules of each NAFTA country. 2.4 Abolish Withholding Taxes on Parent/Subsidiary Dividends Withholding taxes on dividends from a subsidiary to a parent company located in another NAFTA country creates significant tax distortions for investments from one NAFTA country to another. These distortions ultimately harm the economic welfare of the NAFTA partners. The

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member countries of the European Union have already implemented reform in this area by way of the Parent-Subsidiary Directive. The Directive covers parent/subsidiary dividends as long as the participation threshold exceeds 25 per cent of the ownership of the subsidiary.5 The NAFTA countries should consider a similar, or possibly lower, threshold.6 Mexico and the United States have recently agreed to eliminate withholding tax on parent/subsidiary dividends. Canada may be the only NAFTA country that might object to this proposal, because it would suffer revenue losses as a net capital importer from the United States: the current system diverts revenues from the U.S. fisc to the Canadian fisc. Although Mexico is also a net capital importer of the United States, it currently does not impose withholding taxes on dividends paid to foreign investors. Perhaps the Canadians should be offered a fiscal concession in some other area to compensate for the revenue losses. The elimination of withholding taxes on parent/subsidiary dividends, however, will not resolve the disharmony in tax burdens in inter-NAFTA country investments resulting from the different corporate/shareholder structures of each NAFTA country. The differing structures (the classical system in the United States, the imputation system in Canada, and the dividend exemption system in Mexico) create the most serious problems in terms of generating differing tax burdens for investors in one NAFTA country investing in another (see chapters 3 and 5). Proposals to harmonize these structures will not be suggested as such harmonization would result in undue restrictions on each NAFTA country’s tax autonomy. Nevertheless, this matter should be investigated.7 A corresponding step would be to eliminate withholding taxes levied by source countries on interest and royalty payments between related companies in different NAFTA countries.8 Canadian and U.S. treaty negotiators are currently contemplating reducing or eliminating withholding taxes on interest under the Canada-U.S. tax treaty. One observer estimates that Canadian revenue losses associated with eliminating withholding taxes would be more than offset by increased income attributable to new investments and employment promoted by the removal of these taxes.9 At the very least, royalty and interest withholding tax rates should be harmonized. 2.5 Corporate Mergers and Reorganizations Commentators have identified a number of problem areas with respect to mergers and reorganizations arising from the different tax rules of the NAFTA countries.10 These different rules, at times, can impose

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income taxes on accrued gains on different types of cross-border corporate formations, reorganizations, and liquidations: within each NAFTA country, the same activities are normally conducted on a tax-free or taxdeferred basis. The existing tax treaties provide only limited relief in this area, as capital gains taxes on cross-border restructuring operations often remain prohibitively high, forcing NAFTA firms to maintain their existing inefficient structures (see chapter 4). Further economic integration would likely be accompanied by additional consolidation of corporate activity in North America and the NAFTA countries should take steps to address this issue. Initial efforts should be directed at harmonizing the relief provisions within the network of bilateral tax treaties. Although it may be too soon to propose a EU-style Merger Directive (mainly as a result of concerns about tax avoidance by shifting assets outside of North America), a good solution would be the case-by-case approval of such activities under the proposed NAFTA Tax Commission or the APA process (which could be extended to non–transfer pricing issues).11 The Commission would grant tax-free or tax-deferred approval if it felt that the merger would not result in tax avoidance. 2.6 Reduction of ‘Harmful’ Tax Competition Chapter 9 suggested that it is too early to propose the adoption of similar tax rules for areas that are sensitive to cross-border migration. Further, previous analysis has indicated that tax competition within North America is not currently distorting direct investment flows to a significant extent, nor is it leading to reductions in corporate income tax revenues (see chapter 5). Nevertheless, the NAFTA countries should begin to examine tax rules that serve to undermine cross-border investment flows through ‘harmful’ tax competition (see chapter 3). The non-binding code of conduct from the European Commission as well as the recent OECD efforts in this area may provide guidance as to what should be considered an unfair or harmful tax incentive. At this point, suggestions to curtail specific tax incentive provisions, tax expenditure provisions, or even parts of a NAFTA country’s general tax regime would merely serve to open Pandora’s Box, with each country complaining that its tax provisions are a necessary part of its fiscal strategy designed to meet the needs of its citizens. It may be more useful to simply grandfather current discriminatory tax measures and restrict the development of future non-conforming ones by the NAFTA countries. After all, the real concern in the North American context is the

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future development of tax provisions that will significantly distort crossborder investment patterns (see chapter 6). 2.7 Multilateral Agreement on the GST and VAT Because of e-commerce, companies can generate significant crossborder sales of digital goods and services without having to set up shop in foreign countries (see chapter 8). The most pressing issue concerns the enforcement of Canadian GST and Mexican VAT rules on remote Internet consumer sales: Canada and Mexico (to a much less extent) will eventually lose significant tax revenues if they cannot enforce these laws. For example, U.S. businesses can generally sell GST-free digital goods and services into Canada as long as they do not maintain a physical presence within the country. The NAFTA countries should explore a possible multilateral agreement that would permit Canada and Mexico to enforce their taxes on remote consumer sales. This would likely involve the development of an economic presence test that would permit, for example, Canada to impose GST collection obligations on a U.S. company if the company enjoyed gross sales in excess of $100,000 to Canadian consumers. The United States would probably oppose this type of development, as it would permit Canadian and Mexican tax authorities to audit American companies in certain circumstances even if they only maintain operations within the United States. The United States may also be concerned that this type of agreement will impose unacceptable compliance costs on U.S.-based e-commerce companies. Moreover, state governments within the United States may insist that their retail sales taxes should similarly apply to cross-border transactions, so that Canadian and Mexican companies with sales to U.S. consumers would have to assess and remit these taxes. It may be premature to move forward with a multilateral agreement until Canada and Mexico can empirically demonstrate significant revenue losses arising out of the current regime. 2.8 Improving Administrative Cooperation Additional proposals could focus on improving the relationship among the NAFTA-country tax authorities and making it easier for companies to comply with cross-border tax requirements. The NAFTA countries should extend the tax enforcement of each of their tax claims (currently contemplated in the Canada-U.S. tax treaty only) as well as permit other NAFTA-country tax officials to maintain a presence in their countries. The NAFTA countries should increase cooperation and improve the formal channels for the exchange of information, perhaps, as discussed

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in chapter 8, with a secure extranet accessible only by tax authorities (the information collected might also assist taxpayers and tax authorities to discern appropriate transfer prices). Recent developments in this area are encouraging. In 2004, Canada signed the Convention on Mutual Administrative Assistance in Tax Matters (the United States signed in 1991). This multilateral agreement, sponsored by the Council of Europe and the OECD, provides for the exchange of tax information and assistance in collection. Also in 2004, the United States, Canada, the United Kingdom, and Australia announced that they were setting up a new international taskforce to identify and combat tax avoidance schemes. The NAFTA countries can also expand joint and multilateral audit procedures. In this regard, the NAFTA countries should consider expanding the use of Simultaneous Examination Procedures (SEPs), whereby two or more countries conduct a simultaneous audit of a multinational firm and exchange the audit findings. Further, the NAFTA countries should try to devise measures to reduce administrative and compliance costs for cross-border investments from one NAFTA country to another. They should probably exempt each other’s taxpayers from compliance with some of the more onerous international tax rules (especially the CFC rules) designed to counter tax avoidance and tax evasion. Similarly, the NAFTA countries should consider implementing so-called safe harbours, which would permit multinational firms to be exempt from ordinary transfer pricing methods or documentation requirements under certain circumstances. 3 Conclusion The proposals made in this chapter will assist in reducing barriers to the flow of cross-border capital among the NAFTA countries without sacrificing unacceptable amounts of sovereignty. But they can also be viewed as half-measures. Deepening integration will mean that the markets of the NAFTA countries will become more closely entwined, and capital flows will thus become even more sensitive to tax differences. Real governmental control over certain aspects of taxation will continue to erode (especially for Canada and Mexico). The adoption of more comprehensive measures, including a degree of tax uniformity among the NAFTA countries, is thus likely to become a more attractive alternative in the long run. The real hurdles imposed by the conflicting values of sovereignty on the movement towards greater tax efficiencies remain to be overcome.

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CHAPTER 12

Conclusion

NAFTA reflects the desire of the North American governments and their citizens to benefit from greater economic efficiencies by reducing barriers to the cross-border flow of trade and investment. Concerns have been expressed that national tax differences distort investment activity away from productive uses, reduce corporate income tax revenues through the process of tax competition, and facilitate tax arbitrage schemes employed by multinational firms to improve their economic welfare. As economies become more closely entwined, the cost of maintaining the current regime appears to be escalating. A way to resolve these problems could involve a NAFTA-wide agreement on common tax rules. However, the NAFTA governments will likely refuse to surrender their sovereign right to determine their own tax destinies. The challenge for the NAFTA countries is to resolve the clash between economic and tax sovereignty concerns by striking a policy balance between these two often-competing interests. A review of the NAFTA-country tax regimes revealed that they have converged to a certain degree in the past two decades. This convergence – more obvious at the business taxation level – has resulted partly from the process of regulatory emulation, whereby Canada and Mexico must ensure that their tax burdens on investments and other mobile factors do not stray too far from the burdens imposed by the U.S. system. Nevertheless, many tax differences remain among the NAFTA countries. Take one major example. Each NAFTA country taxes corporations and shareholders in a different way. Canada offers shareholder relief through an imputation system, the United States has adopted a classical system of taxing both corporate and shareholder earnings, and Mexico uses an exemption system that does not tax dividends at all in most

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circumstances. These different structures alter tax burdens and thus the returns earned on investments from one NAFTA country to another. Moreover, Canada and the United States support significant provincial/ state tax systems under their federal structures. The taxing powers of these subnational units, granted on a constitutional basis, may complicate any efforts at the national level to create more uniform tax rules among the NAFTA countries. Canada and the United States have a long history of tax cooperation through tax treaties, dating back to 1936, while Mexico has only begun negotiating tax treaties in recent years. The three treaties negotiated on a separate basis between each trade partner are similar in a substantive sense, having been based on the OECD and the U.S. model tax treaties. Notably, the treaties impose different withholding taxes in several circumstances. These differences create tax distortions and serve to fragment a market tied together through a multilateral trade and investment deal. Tax distortions are magnified in an increasingly integrated regional market, where tax differences play a larger role in influencing foreign direct investment flows. What is the potential for tax differences to influence investment decision making within North America? Marginal effective tax rate studies suggest that tax burdens on investments are generally similar among the NAFTA countries, although Canada continues to impose the highest burden and Mexico the lowest burden. In addition, differences persist among different industries, assets, and financing methods. While tax may not currently be a major factor in influencing direct investment flows among the NAFTA countries, this situation could change if new tax incentives or comprehensive tax reform are initiated, causing marginal effective tax rates to diverge. This last scenario was discussed in the context of dividend tax reform in the United States and its possible impact on the Canadian economy. This reform, among other things, reduced the maximum tax rate for individual dividend income to 15 per cent. The United States extended the tax relief to dividends repatriated from many foreign corporations, including Canadian corporations. Moreover, the Canadian government took steps to lower capital tax burdens, partly in reaction to the U.S. developments. As a result, it is unlikely that U.S. reforms will adversely affect the Canadian economy. In addition, the reform will probably not encourage multinational firm arbitrage activities that could erode the Canadian corporate income tax base. Nevertheless, Canada and Mexico must constantly be on the lookout for U.S. fiscal developments that could undermine their economic interests. The main problem with this

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follow-the-leader approach is that it leads to a democratic deficit, with Canada or Mexico initiating tax reform based on external developments rather than the wishes of their electorates. The Europeans have been struggling with these sovereignty and economic issues for decades, and their progress has been uneven. The European Union has implemented value-added tax harmonization, but many EU countries have thus far refused to adopt similar rules with respect to business taxes, despite calls from tax experts and the European Commission to do so. Progress has, however, been made with respect to multilateral efforts to enhance tax coordination through the Parent/Subsidiary Directive, the Merger Directive, and the Arbitration Convention, which serve to reduce the barriers to the free flow of capital within the European Union. In contrast to the European Union, NAFTA, as a free trade area, was formed almost exclusively to promote trade and investment. The NAFTA deal does not envision any sovereignty comprising political linkages, nor does NAFTA call for the free flow of capital or speak to harmonizing tax measures. Most importantly, the NAFTA countries are newcomers to the whole idea of regional integration. Moreover, each NAFTA country continues to place a high priority on maintaining control over its tax system, for a variety of historical and cultural reasons. The political environment in North America thus does not bode well for comprehensive tax integration solutions that would place restrictions on tax policy. The fact that NAFTA contains few sticks and carrots to encourage cooperative tax behaviour also makes it harder to effectively confront the tax challenges presented by the new economic environment of ecommerce. Tax rules in North America emphasize the need for a business to maintain a physical presence within one of the NAFTA countries before a country can exert its tax jurisdiction over a firm’s activities. However, the Internet facilitates cross-border sales without the need to set up shop in foreign markets. The most pressing issue is the ability of American firms to sell GST-free digital goods and services into Canada, leading to revenue losses for the Canadian government and an uneven competitive playing field for U.S. and Canadian firms. No solution to this problem is visible on the horizon. The challenges presented by e-commerce highlight the need for the NAFTA countries to engage in more cooperative behaviour to limit the damage caused by national tax differences. Canada and the United States have a lengthy history of cooperation in the area of tax coordination via tax treaties, and in the last decade, Mexico has agreed to

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coordinate its tax regime with its NAFTA partners. It thus makes sense to develop an international tax policy strategy that encourages an incremental and pragmatic approach to achieve more cooperation through enhanced tax coordination. A number of factors support the view that ‘heightened multilateral tax coordination’ is the appropriate policy for the NAFTA countries. These factors, as we have seen, include the current lack of consensus on international tax policy principles and the theoretical uncertainty concerning what constitutes ‘harmful’ international tax competition as opposed to ‘good’ forms of such competition; the current similarity in tax burdens on cross-border investment flows, which suggests that these flows are not being unduly distorted; the absence of evidence that NAFTA tax competition results in fiscal degradation; the absence of empirical studies that measure the welfare losses associated with maintaining national tax differences; the inexperience of the NAFTA countries with respect to regional integration; the very real desire to maintain tax autonomy; and the fact that comprehensive tax integration among the NAFTA countries would be impeded by the different tax systems employed by the states and provinces in the United States and Canada. Moreover, it is not clear that tax harmonization would provide the greatest utility to the NAFTA countries. These countries derive ‘value’ from preserving the ability to determine their own tax destinies. In a three-player game with one large player, it may be most cost effective and rational for the two smaller players to follow the U.S. lead, as unilateral tax harmonization does not carry the same perceived sovereignty costs. This environment also permits the smaller players to engage in limited tax competition by undercutting U.S. changes to make up for their loss of tax autonomy. They can engage in this competition without triggering a race to the bottom because the United States will get far less utility by attracting capital from the smaller partners (in comparison to the loss of utility associated with foregoing tax sovereignty) and hence will not engage in a war of attrition. On this view, the NAFTA countries should only cooperate in areas where cooperation has proven to generate success in the past, such as through tax coordination via the tax treaty process. The proposed heightened multilateral tax coordination strategy accommodates Karl Polanyi’s so-called double movement of modern society by incorporating the pressure from market forces while ensuring that the socially disruptive elements of these forces are largely constrained. The main recommendations of this book involve forming a NAFTA Tax

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Working Group; harmonizing tax treaty policy under a multilateral tax treaty; binding arbitration for transfer pricing disputes along with advanced pricing agreements administrated at a centralized level; abolishing withholding taxes on parent/subsidiary dividends; developing rules to ensure that cross-border mergers and reorganizations are approved for tax purposes on a case-by-case method; reviewing the ability of different tax incentives to unduly distort the flow of investments within North America; and enhancing administrative cooperation among tax authorities. This strategy does not address many of the tax concerns that are assuming greater importance in North America. Deepening economic integration will mean that capital flows become more sensitive to tax differences, and real governmental control over certain aspects of taxation will continue to erode (especially for Canada and Mexico). The adoption of more comprehensive measures, including some tax uniformity, among the NAFTA countries will thus eventually become a more attractive alternative. But for the time being, the policy of heightened multilateral tax coordination will address many of the areas of sensitivity without intruding on the tax sovereignty of the NAFTA countries. Increased cooperation in the tax treatment of cross-border flows is an initial step towards aligning political mechanisms with the actual realm of markets that, more and more, refuse to recognize national borders or political sovereignty.

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Notes

Chapter 1 Introduction 1 Adam Smith, The Wealth of Nations (1776; repr. London: J.M. Dent & Sons Ltd., 1962) at 2:331. 2 OECD, Taxing Profits in a Global Economy: Domestic and International Issues (Paris: OECD, 1991) at 12. 3 North American Free Trade Agreement, 8–17 Dec. 1992, 32 I.L.M. 289; 32 I.L.M. 605. 4 For a general introduction to the main purposes of tax laws, see Arthur J. Cockfield, ‘Tax Law,’ in Law, ed. A. Schwabach and A. Cockfield, in Encyclopedia of Life Support Systems (EOLSS), Developed under the Auspices of the UNESCO, Eolss Publishers, Oxford, UK, 2003 [http://www.eolss.net]. 5 Karl Polanyi, The Great Transformation: The Political and Economic Origins of Our Time (Boston: Beacon Press, 1957) at 138. 6 OECD, Main Economic Indicators (Paris: OECD, 2003) at 243 (using 1995 exchange rates). Chapter 2 Background Issues 1 See generally Jon R. Johnson, The North American Free Trade Agreement: A Comprehensive Guide (Aurora, ON: Canada Law Book, 1994) at 26. 2 For a description of these provisions see Gary C. Hufbauer and Jeffrey J. Schott, NAFTA: An Assessment (Washington, DC: Institute for International Economics, 1993) at 80; Seymour J. Rubin and Dean C. Alexander, eds., NAFTA and Investment (The Hague: Kluwer Law International, 1995). For an excellent review of cross-border investment issues, see Alan M. Rugman, Multinationals and Canada–United States Free Trade (Columbia: University of South Carolina Press, 1990).

192 Notes to pages 12–14 3 Chapter 17 of NAFTA sets out temporary entry visa rights for designated business people, investors, and white-collar professionals. No common market for the free movement of workers is undertaken. 4 See Joel Slemrod, ‘Free Trade Taxation and Protectionist Taxation’ (1995) 2:3 International Tax and Public Finance 471 (noting that tax policy can influence the flow of goods across countries as well as the location of productive activity); Paul R. McDaniel, ‘Formulary Taxation in the North American Free Trade Zone’ (1994) 49 Tax Law Review 691 at 715–19 (discussing tax subsidies under NAFTA). 5 See Jane G. Gravelle, ‘International Tax Competition: Does It Make a Difference for Tax Policy?’ (1986) 39 National Tax Journal 375 (explaining how exchange rates adjust to offset price effects of rebated indirect taxes and corporate income taxes); Joel Slemrod, ‘Tax Cacophony and the Benefits of Free Trade,’ in Fair Trade and Harmonization: Prerequisites for Free Trade?, ed. Jagdish Bhagwati and Robert E. Hudec (Cambridge, MA: MIT Press, 1996) at 283 (noting that indirect taxes with non-uniform rates can distort the pattern of production and trade). 6 See U.S. Embassy in Mexico, North American Free Trade Agreement: Tenth Anniversary (2003), available at http://www.usembassy-mexico.gov/ eNAFTA_figures.htm. 7 These trade numbers are based on the first place of destination and so may overstate the amount of trade as some goods go onto other countries after first landing in Canada or the United States. See U.S. Department of Commerce, U.S. Total Imports and Exports from Individual Countries, 1996–2002 (Washington, DC: U.S. Department of Commerce, 2003). 8 See Jack M. Mintz, Most Favored Nation: Building a Framework for Smart Economic Policy (Toronto: C.D. Howe Institute, 2001) at 37. 9 See U.S. Department of Commerce, U.S. Total Imports and Exports. 10 See Canada, Department of Foreign Affairs and International Trade, Canada-Mexico Trade and Investment Relations (Ottawa: Dept. of Foreign Affairs and International Trade, 2002). 11 The breakdown is: US$30 billion to the United States; US$21 billion to Canada; and US$14 billion to Mexico. See OECD, International Direct Investment Yearbook (Paris: OECD, 2002). See table 5.1. 12 Ibid. 13 For discussion on investment trends, see Arturo Guillen, Foreign Direct Investment in North America under NAFTA, Cahier de recherche 02-08 (Montreal: Université du Québec à Montréal, 2002). 14 See U.S., Bureau of Economic Analysis, U.S. Direct Investment Abroad: Country and Industry Detail for Capital Outflows, 1992 to 2002 (Washington, DC: U.S. Department of Commerce, 2003).

Notes to pages 14–21 193 15 See Statistics Canada, CANSIM Table 376-0051 (26 Mar. 2003). 16 Ibid. 17 See U.S., Bureau of Economic Analysis, U.S. Direct Investment Abroad: Capital Outflows, 2002 (Washington, DC: U.S. Department of Commerce, 2003). For a discussion of investment trends into Mexico, see Jorge Martinez-Vazquez and Duanjie Chen, The Impact of NAFTA and Options for Tax Reform in Mexico (Atlanta: Georgia State University International Studies Program, Working Paper 01-2 (2001) at 4–5. 18 For discussion, see Robert E. Hall, The International Consequences of the Leading Consumption Tax Proposals, CEPR Pub. No. 447 (Stanford: Stanford University Press, 1995) at 18. 19 See Robert Turner, Study on Transfer Pricing (Ottawa: Technical Committee on Business Taxation, Working Paper 96-10, 1996). 20 Free Trade Agreement, 22, 23 Dec. 1987 and 2 Jan. 1988, U.S.-Can., vol. 27 I.L.M. at 281. 21 See OECD, The Tax/Benefit Position of Production Workers (Paris: OECD, 2003). 22 OECD, OECD in Figures (Paris: OECD, 2003) at 36–7. See table 7.2. 23 Ibid. 24 Studies estimate that the long-term GDP gains arising out of NAFTA are less than 0.5 per cent for Canada and the United States, while estimates of the impact on Mexico range from 0.1 to 11.4 per cent. See Ralph H. Folsom and Michael W. Gordon, International Business Transactions 411 (St Paul, MN: West Pub. Co., 1995). 25 See, e.g., Robert L. Earle and John D. Wirth, eds., Identities in North America: The Search for Community (Stanford: Stanford University Press, 1995) at 196. 26 For a more in-depth review of international tax policy goals and principles, see Jinyan Li, International Taxation in the Age of Electronic Commerce: A Comparative Study (Toronto: Canadian Tax Foundation, 2003) at 57–62; Brian J. Arnold and Michael J. McIntyre, International Tax Primer, 2nd ed. (The Hague: Kluwer Law International, 2002) at 4–7; Nancy H. Kaufman, ‘Fairness and the Taxation of International Income’ (1998) 29 Law and Policy of International Business 145; Peggy Musgrave, ‘Interjurisdictional Equity in Company Taxation: Principles and Applications to the European Union,’ in Taxing Capital Income in the European Union: Issues and Options for Reform, ed. Sijben Cnossen (Oxford: Oxford University Press, 2000). 27 See generally Reuven Avi-Yonah, ‘Globalization, Tax Competition and the Fiscal Crisis of the Welfare State’ (2000) 113 Harv. L. Rev. 1573. 28 See, e.g., Vito Tanzi, Taxation in an Integrating World (Washington, DC: Brookings Institution, 1995) (suggesting that a World Tax Organization may be necessary to deal with problems caused by the interaction of different national tax systems).

194 Notes to pages 21–8 29 See, e.g., Michael J. Graetz, ‘Taxing International Income: Inadequate Principles, Outdated Concepts and Unsatisfactory Policies’ (2001) 26 Brooklyn Journal of International Law 1357. Chapter 3 The Tax Systems 1 For a comparative description of tax reform in the mid-1980s among the member states, see Mahmood Iqbal, A Tax Comparison of Large Manufacturing Industries in Canada, the United States and Mexico (Ottawa: Conference Board of Canada, 1994) at 4–6; John Whalley, ‘Foreign Response to U.S. Tax Reform’ in Do Taxes Matter?, ed. Joel Slemrod (Cambridge: MA: MIT Press, 1990) at 286; Richard M. Bird, David B. Perry, and Thomas A. Wilson, Tax Reform in Canada: A Decade of Change and Future Prospects (Toronto: International Centre for Tax Studies, discussion paper no. 1, 1994). 2 See Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, 1997). 3 For a description of some of the differences and similarities among the NAFTA tax systems, see Brian J. Arnold and Neil H. Harris, ‘NAFTA and the Taxation of Corporate Investment: A View from within NAFTA’ (1994) 49 Tax Law Review 529 at 532–8. For a discussion of the income tax systems of the United States and Canada, see Hugh J. Ault, Comparative Income Taxation, A Structural Analysis (The Hague: Kluwer Law International, 1997). For a review of the Mexican tax system, see International Bureau of Fiscal Documentation, Taxation in Latin America: Mexico (Amsterdam: IBFD Publlications 1987– )[hereinafter IBFD, Mexican Taxes]. 4 See Henry C. Simons, Personal Income Taxation (Chicago: Univesity of Chigaco Press, 1938) at 50. 5 See Neil Brooks, ‘Flattening the Claims of Flat Taxes’ (1998) 51 Dalhousie Law Journal 287; Arthur J. Cockfield, ‘Income Taxes and Individual Liberty: A Lockean Perspective on Radical Consumption Tax Reform’ (2001) 46 South Dakota Law Review 8. 6 See Kathleen A. Lahey, The Impact of Relationship Recognition on Lesbian Women in Canada: Still Separate and Only Somewhat ‘Equivalent’ (Ottawa: Government of Canada, 2001) at 50–74 (arguing that Canadian taxes have a disproportionately adverse impact on lesbian and gay couples). See also David G. Duff, ‘Disability and the Income Tax’ (2000) 45 McGill Law Journal 797–9. 7 See Robin Boadway and Neil Bruce, ‘Pressures for the Harmonization of Income Taxation between Canada and the United States,’ in Canada-U.S. Tax Comparisons, ed. John B. Shoven and John Whalley, (Chicago: University of Chicago Press, 1992) at 69.

Notes to pages 21–31 195 8 For discussion of the NAFTA provisions relating to temporary entry for business persons, see Ralph Folsom and W. Davis Folsom, Understanding NAFTA and Its International Business Implications (New York: Matthew Bender, 1997) at 108 (characterizing the immigration provisions as ‘elitist’). 9 See Canada, Statistics Canada, The Daily. Brain Drain and Brain Gain: The Migration of Knowledge Workers Into and Out of Canada (Ottawa: Statistics Canada, 2000). 10 Ibid. 11 See Canadian Council of Chief Executives, Winning the Human Race: Developing and Retaining World Class Talent (Ottawa: Canadian Council of Chief Executives, Working Paper, 2000) at 13 (citing Statistics Canada data that indicates that over half of Canadian university graduates who moved to the United States in 1995 initially used a NAFTA visa). 12 Tourism, business trips, and changes in employment location already create some pressure for personal tax coordination measures. See, e.g., Roger H. Gordon, ‘Canada-U.S. Free Trade and Pressures for Tax Coordination,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 91. 13 See, e.g., Jack M. Mintz, ‘Competitiveness and Tax Policy: How Does Canada Play the Game?’ (1992) 43 Conference Report 5:1 at 5:11. 14 See ‘Pressures for the Harmonization of Income Taxation between Canada and the United States’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 69. 15 See also Nathan Boidman, ‘Interrelated Effects of Canadian and US Tax Systems Over the Past Twenty-Five Years,’ in Essays on International Taxation, ed. Herbert H. Alpert and Keesvan Raad, Series on International Taxation, vol. 15 (The Hague: Kluwer Law and Taxation, 1993) at 83, 87–96 (discussing some of the ‘evolving similarities’ between the Canadian and American tax systems). 16 See Roger H. Gordon and Eduardo Ley, ‘Implications of Existing Tax Policy for Cross-Border Activity between the United States and Mexico after NAFTA’ (1994) 47 National Tax Journal 435. 17 See OECD, Taxing Profits in a Global Economy: Domestic and International Issues (Paris: OECD, 1991) at 195 (noting that the decisions concerning integrating corporate income tax systems must increasingly take into account the international implications of increased capital flows). 18 See Internal Revenue Code ss. 316 and 311. 19 See s. 121 of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) [hereinafter the Canadian Tax Act]. 20 See art. 10A of Income Tax Law (Mexico) [hereinafter the Mexican Tax Act]. 21 See Luis Manuel Perez de Acha, ‘An Examination of the Tax Treatment of

196 Notes to pages 31–4

22 23

24 25 26

27

28 29

30 31 32 33

34 35

36

37

Dividends in Mexico’ (1994) 9 Tax Notes International 82 (discussing the taxation of repatriated dividends under Mexico’s bilateral tax treaties with Canada and the United States). ‘The Mexican Tax System’ (1992) 43 Conference Report 48:1 at 48:4. For a review of the international implications of differing tax structures, see Douglas R. Fletcher, ‘The International Argument for Corporate Tax Integration’ (1994) 11 American Journal of Tax Policy 155 at 195. John P. Steines, Jr, ‘Commentary, Income Tax Implications of Free Trade’ (1994) 49 Tax Law Review 675 at 689. See Fletcher, ‘The International Argument for Corporate Tax Integration’ at 197. For discussion see Richard J. Vann, ‘General Report: Trends in Company/ Shareholder Taxation: Single or Double Taxation?’ 88a (2003) Cahiers de droit fiscal international 21. See s. 112.1 of the Canadian Tax Act. Note that the dividend tax credit is provided regardless of whether or not the corporation distributing the dividend has actually paid the corporate level tax. See Steines, Jr, ‘Commentary, Income Tax Implications of Free Trade’ at 682. See Brian J. Arnold, Tax Discrimination Against Aliens, Non-Residents and Foreign Activities: Canada, Australia, New Zealand, the United Kingdom, and the United States, Canadian Tax Paper No. 90 (Toronto: Canadian Tax Foundation, 1991). See Paul R. McDaniel, ‘Formulary Taxation in the North American Free Trade Zone’ (1994) 49 Tax Law Review 691 at 715. Ibid. at 742–4 (describing the tax expenditures). IBFD, Mexican Taxes, 78–82 (2000). See OECD, Towards Global Tax Co-operation: Progress in Identifying and Eliminating Harmful Tax Practices (Paris: OECD, 2000) at 13–14. See also OECD, Harmful Tax Competition; An Emerging Global Issue (Paris: OECD, 1998). See WTO, United States – Tax Treatment for Foreign Sales Corporations, WT/DS108/AB/R February 2000. For a description of the discriminatory provisions in the Canadian and American tax systems, see Arnold, Tax Discrimination against Aliens, at 68–111, 235–52. See John A. McLees, Jamie Gonzalez, and Carlos Angulo, ‘Legislative Proposals Would Streamline Mexico’s Maquiladora Tax Regime’ (2002) 96:13 Tax Notes 1759. See John McLees, ‘Mexico Enacts Major Improvements to its Maquiladora Tax Regime’ (2003) 29:4 Tax Notes International 421.

Notes to pages 35–7 197 38 See Francois Vaillancourt, ‘Subnational Tax Harmonization, Canada and the United States: Intent, Results, and Consequences,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, 323, 334. 39 See Iqbal, A Tax Comparison of Large Multinational Industries, at 12. 40 See, e.g., Daniel Shaviro, ‘An Economic and Political Look at Federalism in Taxation’ (1992) 90 Michigan Law Review 895. 41 See M. Daly, ‘Tax Coordination and Competition in Canada: Some Lessons for the European Community, in Commission of the European Communities, Report of the Committee of Independent Experts on Company Taxation’ (1992) 92 Tax Notes International 36-15, at Annex 9A. 42 See Duanjie Chen and Kenneth J. McKenzie, The Impact of Taxation on Capital Markets: An International Comparison of Effective Tax Rates on Capital (Ottawa: Industry Canada, 1997). 43 See, e.g., Stephen Utz, ‘Tax Harmonization and Coordination in Europe and America’ (1994) 9 Connecticut Journal of International Law 767 at 768. 44 See Joann E. Weiner, ‘Tax Coordination and Competition in the United States of America, in Commission of the European Communities, Report of the Committee of Independent Experts on Company Taxation’ (1992) 92 Tax Notes International 36-15, at Annex 9C. 45 See Barclays Bank v. Franchise Tax Bd., 114 S. Ct. 2268 (1994) (holding that the Constitution does not impede the application of California’s worldwide combined reporting method to determine the corporate franchise tax owed by affiliated multinationals, both foreign and domestic, doing business in California). 46 For discussion, see Jerome R. Hellerstein and Walter Hellerstein, State Taxation, 3rd ed., (New York: Thomson Publishers, 1998) at ¶ 8.17. 47 See ‘Subnational Tax Harmonization, Canada and the United States: Intent, Results, and Consequences’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 323. 48 See Boadway and Bruce, ‘Pressures for the Harmonization of Income Taxation,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 69, 70. 49 See H. David Rosenbloom, ‘Sovereignty and the Regulation of International Business in the Tax Area’ (1994) 20 Canada–United States Law Journal 267 at 269. 50 For a detailed description of the international aspects of the Canadian tax system, see Vern Krishna, Canadian International Taxation (Scarborough, ON: Carswell, 1995–). For U.S. descriptions, see Michael J. McIntyre, The International Income Tax Rules of the United States (New York: Lexis-Nexis/ Matthew Bender, 1992–); Paul R. McDaniel and Hugh J. Ault, Introduction to

198 Notes to pages 37–41

51 52 53 54 55 56 57 58

59 60 61 62 63

64

65 66

United States International Taxation, 4th rev. ed. (The Hague; London; Boston: Kluwer Law and Taxation Publishers, 1998). For a comparison of certain international tax provisions of the United States and Canada, see Brian J. Arnold, Jinyan Li, and Daniel Sandler, Comparison and Assessment of the Tax Treatment of Foreign-Source Income in Canada, Australia, France, Germany and the United States (Ottawa: Technical Committee on Business Taxation, Working Paper 96-1, 1996). For a description of the international aspects of the Mexican tax system, see Nicasio del Castillo et al., ‘Business Operations in Mexico’ in Tax Management Foreign Income Portofolios (Washington, DC: Tax Management Inc, 2001). See s. 126 of the Canadian Tax Act and s. 6 of the Mexican Tax Act. See s. 1 and 901-6 of the Internal Revenue Code. See s. 904(a) and 904(d) of the Internal Revenue Code. See Reg. 5907(1)(d) of the Canadian Tax Act. See OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators (Paris: OECD, 1995). See s. 69 of the Canadian Tax Act. See Revenue Canada, Information Circular 87-2R2, International Transfer Pricing (1999). See François Vincent and Ian M. Freedman, ‘Transfer Pricing in Canada: The Arm’s Length Principle and the New Rules’ (1997) 45 Canadian Tax Journal 1213. See art. 64-A and 65-A of the Mexican Tax Act. See s. 482 of the Internal Revenue Code. See regulation section 148-1(c) of the Internal Revenue Code. See, e.g., Robert Brown and Michael Alexander, ‘Sovereignty in the Modern Age’ (1994) 20 Canada–United States Law Journal 273 at 286. For discussion, see Robert Turner, Study on Transfer Pricing (Ottawa: Technical Committee on Business Taxation, Working Paper 96-10, 1996) at 17 (reviewing aspects of the OECD transfer pricing guidelines). For American issues, see Thomas C. Louthan, ‘Building a Better Resolution: Adapting IRS Procedures to Fit the Dispute’ (1996) 13:18 Tax Notes International 1473. For Canadian issues, see Scott Shaughnessy, ‘Spotlight on APAs in Canada’ (1995) 95 Tax Notes International 1473. For Mexican issues, see Albertina M. Fernandez, ‘Mexico Issues First Maquiladora APA’ (1995) 11:20 Tax Notes International 218-3. The U.S. procedure is set out in Revenue Procedure 91-22, 199-1 C.B. 534. See Steven Audereth, ‘APA News: First U.S.-Japan Hybrid Method APA; New APAs in Mexico and Canada,’ in U.S. Taxation of International Operations (New York: Thomson Publishers, 1996) 4–8 (discussing APA developments among the NAFTA countries).

Notes to pages 42–6 199 67 For a more elaborate discussion of these rules, see W.G. Williamson and R.A. Garland, Taxation of Inbound Investment (Ottawa: Technical Committee on Business Taxation, Working Paper 96-12, 1996). 68 Ibid. at 16. 69 See s. 18(4) of the Canadian Tax Act. 70 See s. 163(i) of the Internal Revenue Code. 71 Joint Committee on Taxation, ‘Revenue Provisions in 2005 Budget’ (2004) Tax Notes Today 41–2. 72 See Treasury Regulation § 1.861-8. 73 See Treasury Regulation § 1.861-9T. 74 A foreign affiliate that is controlled by Canadian residents is a ‘controlled foreign affiliate’; see s. 95(1) of the Canadian Tax Act. 75 See s. 95(1) of the Canadian Tax Act under ‘foreign accrual property income.’ 76 For discussion, see Eric Lockwood and Nick Pantaleo, ‘Foreign Affiliates and the New Foreign Investment Entity Rules’ (2003) 51:1 Canadian Tax Journal 539. 77 See s. 951–62 of the Internal Revenue Code. 78 For a description of the PFIF legislation in Canada and the United States, see Brian J. Arnold, ‘The Taxation of Investments in Passive Foreign Investment Funds in Australia, Canada, New Zealand and the United States,’ in Essays on International Taxation, ed. Herbert H. Alpert Kees Van Raad, Series on International Taxation, vol. 15 (The Hague: Kluwer Law and Taxation Publishers, 1993) at 5. 79 The GST is governed by the Excise Tax Act, R.S.C. 1985, c. E-15. For comprehensive discussion of the GST and its international dimension, see Jinyan Li, ‘Consumption Taxation of Electronic Commerce: Problems, Policy Implications and Proposals for Reform’ (2003) 38 Canadian Business Law Journal 425. See also Arthur J. Cockfield, ‘Canada’s GST E-Commerce Policy (or How to Catch the Big Fish’ (March 2002) 3:1 Internet and E-commerce Law in Canada 1–8. An English translation of the Mexican legislation that governs the VAT is available at Foreign Tax Publishers, Mexico’s Value Added Tax Law, 97 TNI 12–18 (1997). Chapter 4 Tax Coordination 1 For a general description of these issues, see Jon R. Johnson, The North American Free Trade Agreement: A Comprehensive Guide (Aurora, ON: Canada Law Book, 1994). 2 General Agreement on Tariffs and Trade, 10 Apr. 1947, vol. 55 United Nations Tax Service at 188 [hereinafter GATT].

200 Notes to pages 47–51 3 See Baker & McKenzie, NAFTA Handbook: A Practical Guide for Doing Business under NAFTA (Chicago: CCH, 1994) at 225. 4 For a discussion on this point, see Paul R. McDaniel, ‘Formulary Taxation in the North American Free Trade Zone’ (1994) 49 Tax Law Review 691 at 715 (discussing the use of tax expenditures in Canada and the United States). Certain tax provisions of the NAFTA countries have been challenged under GATT from time to time; see Asif H. Qureshi, ‘Trade Related Aspects of International Taxation: A New WTO Code of Conduct?’ (1996) 161 Journal of World Trade 30 (describing GATT panel decisions concerning trade promoting Canadian and American tax provisions). 5 NAFTA art. 2103(4)(d). 6 NAFTA art. 2103(3)(b). 7 NAFTA art. 214. 8 NAFTA Annex 314. 9 NAFTA art. 1201. 10 NAFTA art. 2103(4)(a). 11 NAFTA art. 2103(4)(b). 12 NAFTA annex 2103.4 describes the application of the Mexican asset tax. 13 NAFTA art. 2103(5) extends the prohibition in art. 1106(3) that deals with performance requirements as a condition of receiving advantages to tax measures. 14 NAFTA arts. 1102 to 1104. 15 See Vern Krishna, Canadian International Taxation, vol. 10 (Scarborough, ON: Carswell, 1995–) at 10-6. 16 Ibid. at 10-4. 17 See Income Tax Convention, 26 Sept. 1980, Canada-United States (Chicago: CCH) [hereinafter Canada-U.S. tax treaty] at para. 1903.03. 18 See Krishna, Canadian International Taxation at 10-16. 19 The First Protocol was signed on 14 June 1983; the Second Protocol was signed on 28 March 1984. 20 An extensive revised third protocol was signed on 17 March 1995. The third protocol was initially signed on 31 August 1994 but was not ratified until it was revised to take into account a limited number of technical changes made to clarify the application of rules dealing with taxes arising on death. Finally, a fourth protocol was signed on 29 July 1997. 21 Number 630 v. M.N.R. 13 D. Tax 300 at 303 (1959). 22 Canadian Pacific Ltd. v. The Queen (1976), 76 D. Tax 6120 at 6135. 23 Donroy, Ltd. v. United States, 301 F. 2d 200, 208 (9th Cir. 1962). 24 For a discussion of these cases see Klaus Vogel, Harry A. Shannon, III Richard L. Doernberg, and Kees Van Raad, United States Income Tax Treaties (The Hague: Kluwer Law and Taxation Publisher, 1989) at 29.

Notes to pages 51–2 201 25 See Arvid Skaar, Permanent Establishments: Erosion of a Tax Treaty Principle (The Hague: Kluwer, Law and Taxation Publisher, 1991); Arthur J. Cockfield, ‘Balancing National Interests in the Taxation of Electronic Commerce Business Profits’ (1999) 74 Tulane Law Review 133 at 144–8. 26 See, e.g., Luis Manuel Perez de Acha, ‘Mexico Builds Treaty Network to Attract Foreign Investment’ (1993) 93 TNI 119-4 (‘Mexico’s recent interest in attracting foreign investment and goal to actively participate in international commerce spurred the Mexican government to form a committee to negotiate first-time bilateral income tax treaties’). 27 See ‘Convention for the Exchange of Information with Respect to Taxes,’ 9 Nov. 1989, United States-Mexico, available at http://www.natlaw.com/ treaties/taxtreat/mexusa6.htm; ‘Convention for the Exchange of Information,’ 16 Mar. 1990, Canada-Mexico. 28 See Income Tax Convention, 8 Apr. 1991, Canada-Mexico (amended by a Protocol on same date) [hereinafter Canada-Mexico tax treaty] (Chicago: CCH, 1995) at para. 34, 687. 29 See Income Tax Convention, 18 Sept. 1992, United States–Mexico [hereinafter U.S.-Mexico tax treaty] (Chicago: CCH, 1995) at para. 5, 903. 30 See Protocol Amending the Exchange of Information Agreement of November 9, 1989 between the United States and Mexico, signed on 8 September 1994 (expands the scope of information that may be provided to include matters arising from state and local taxes). Ibid. 31 See Second Additional Protocol that modifies the Convention between the Government of the United States of America and the Government of the United Mexican States for the Advoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, 26 Nov. 2002, 2002 Worldwide Tax Daily 229–21. The United States Treasury Department has provided a technical explanation of this protocol. See Department of Treasury, ‘Technical Explanation of the Protocol signed at Mexico City on November 26, 2002,’ 2003 Worldwide Tax Daily 45-29. 32 For analysis of the different tax treaties, see United States Treasury Department Revised Technical Explanation of the Convention (26 April 1984), available at http://www.irs.gov/pub/irs-trty/canatech.pdf; United States Treasury Department Technical Explanation of the Convention and Protocol (1992) [hereinafter Treasury Department (Mexico Convention)], available at, http://www.irs.gov/pub/irs-utl/mexicotrweb.pdf; Brian J. Arnold and Neil H. Harris, ‘NAFTA and the Taxation of Corporate Investment: A View from within NAFTA’ (1994) 49 Tax Law Review 529. 33 Art. II of all three tax treaties. 34 Art. II.3(b) of the Canada-U.S. tax treaty.

202 Notes to pages 53–8 35 Art. IV.3 of the Canada-U.S. tax treaty. The third protocol has additional rules, which apply when a corporation is ‘continued’ under the laws of another country. 36 Art. VII.1 of the U.S.-Mexico tax treaty. 37 For discussion of the restricted force of attraction principle, see Cockfield, ‘Balancing National Interest in the Taxation of E-commerce Profits’ at 205–12. 38 See Treasury Department (Mexico Convention) at 260. 39 Art. VII.4 of the Canada-U.S. tax treaty. 40 Art. V.3 of the Canada-Mexico tax treaty and art. V.3 of the U.S-Mexico tax treaty. 41 Art. V.3 of the Canada-U.S. tax treaty. 42 Art. V.6 of the Canada-Mexico tax treaty and art. V.6 of the U.S.-Mexico tax treaty. 43 Treasury Department (Mexico Convention) at 261. 44 Art. V.5(b) of the U.S.-Mexico tax treaty. 45 Treasury Department (Mexico Convention) at 261. 46 Art. X of the U.S.-Mexico tax treaty. 47 For a reprint of this report prepared by the U.S. Senate Foreign Relations Committee, see ‘U.S. Senate Panel Releases Report on Proposed MexicoU.S. Protocol’ 2003 Worldwide Tax Daily 55-20 at para. 12. 48 Ibid. at para. 18 (discussing Mexican international tax policy approaches). 49 Art. XXII of the Canada-Mexico tax treaty. 50 See Arnold and Harris, ‘NAFTA and the Taxation of Corporate Investment’ at 584–5. 51 Ibid. at 586. 52 Art. XI of each tax treaty. 53 See ss. 871(h) and 881(h) of the Internal Revenue Code. 54 See Arthur J. Cockfield, ‘Transforming the Internet into a Taxable Forum: A Case Study in E-Commerce Taxation’ (2001) 85 Minnesota Law Review 1171 at 1224–30. 55 Art. XII of each tax treaty. 56 Art. VII of the third protocol. 57 Art. VI.1 of the first protocol to the Canada-U.S. tax treaty. 58 Art. XIII.2 of the U.S.-Mexico tax treaty. 59 Art. XIII.4 of the Canada-Mexico tax treaty; see Ingrid Sapona, ‘Canada’s Tax Treaties: A Comparison of the Treatment of Capital Gains’ (1992) 40 Canadian Tax Journal 720 at 731. 60 See ‘Organizations, Reorganizations, Amalgamations, Divisions and Dissolutions: Cross-Border Assets, Double Taxation and Potential Relief under the

Notes to pages 58–64 203

61 62 63 64 65

66 67 68 69 70 71

72

73

74 75

76 77 78

U.S.-Canada Tax Treaty’ (1997) 26 Georgia Journal of International & Comparative Law 311 at 366–72. See Arnold and Harris, ‘NAFTA and the Taxation of Corporate Investment’ at 547. Conversation between the author and the late Jean-Marc Dery, former chief, Tax Treaty Section of the Department of Finance. Art. XVIII of the third protocol. Art. XVII.1 of the U.S.-Mexico treaty. Art. XXIII of the Canada-Mexico tax treaty, however, indicates that the treaty does not apply to a company resident in a country, but owned or controlled by non-residents of that country, where the tax imposed by that country is less than it would be if the corporation were owned and controlled by individuals resident in that country. Art. XXIII.2 of the Canada-Mexico tax treaty. Art. XXV.6 of the U.S.-Mexico tax treaty. Art. XIII of the third protocol. Art. XXIII.5 of the Canada-Mexico tax treaty. Art. XXVII of the Canada-U.S. tax treaty. See, e.g., Robert A. Green, ‘The Troubled Rule of Nondiscrimination in Taxing Foreign Direct Investment’ (1994) 26 Law & Policy in International Business 113 at 149–50. See Arnold and Harris, ‘NAFTA and the Taxation of Corporate Investment’ at 577–8. See also McDaniel, ‘Formulary Taxation in the North American Free Trade Zone’ at 739. See Commission of the European Communities, ‘Report of the Committee of Independent Tax Experts on Company Taxation’ (1992) 92 Tax Notes International 36-15, at chapter 10. See also see Jonathan S. Schwarz, ‘Ruding Committee Sets EC Tax Agenda for ’90s’ (1992) 3 Journal of International Taxation 117 at 119. See John P. Steines, Jr, ‘Commentary, Income Tax Implications of Free Trade’ (1994) 49 Tax Law Review 675 at 683. See W.G. Williamson and R.A. Garland, Taxation of Inbound Investment (Ottawa: Technical Committee on Business Taxation, Working Paper 96-12, 1996). See ‘Free Trade Taxation and Protectionist Taxation’ (1995) 2 International Tax and Public Finance 471 at 472. See Internal Revenue Code regulation section 1.861-7(c). See, e.g., Andrea Lahodny-Karner, Transfer Pricing, Mutual Agreement Procedure and EU Arbitration Procedure,’ in Tax Treaties and EC Law, ed. W. Gassner, Michael Lang, and E. Lechner, Series on International Taxa-

204 Notes to pages 69–74 tion, vol. 16 (The Hague: Kluwer Law International, 1997) at 187 (indicating that traditional mutual agreement procedure proved to be unsatisfactory and did not provide sufficient protection from double taxation). Chapter 5 Taxes and Cross-Border Investments 1 See the National Commission on Economic Growth and Tax Reform, ‘Unleashing America’s Potential: A Pro-Growth, Pro-Family Tax System for the 21st Century’ (1996) 70 Tax Notes 413 at 434 [hereinafter Kemp Commission] (the study that was cited [Dale Jorgenson, Productivity, Vol. 1: Postwar U.S. Economic Growth (Cambridge, MA: MIT Press, 1995)] was used as support for the commission’s position that the tax system should encourage capital accumulation). 2 Investment Canada Research and Policy Staff, International Investment and Competitiveness (Ottawa: Investment Canada, Working Paper No. 9, 1992) at 2 [hereinafter Investment Canada]. 3 Canada, Department of Finance, The Budget Plan 2003 (Ottawa: Department of Finance, 2003) at 134. 4 See Investment Canada Working Paper Series, ‘The Business Implications of Globalization’ (Ottawa: Investment Canada, working Paper No. 1990-V, 1990) at 20. 5 See, e.g., Frederick M. Abbott, ‘Integration Without Institutions: The NAFTA Mutation of the EC Model and the Future of the GATT Regime’ (1992) 40 American Journal of Comparative Law 917 at 920 (discussing how the structure of NAFTA may create a more trade-diverting regime than the European Union as a result of the origin of goods rule). 6 See generally Jack M. Mintz, Most Favored Nation: Building a Framework for Smart Economic Policy (Toronto: C.D. Howe Institute, 2001) at 22–5. 7 See Investment Canada Research and Policy Staff, International Investment and Competitiveness (Ottawa: Investment Canada, Working Paper No. 9, 1992) at 11 (80 per cent of the increase in FDI was due to reinvested earnings by foreign-controlled enterprises). 8 Ibid. at 49 (discussing the report by the World Economic Forum). 9 See Joosung Jun, ‘U.S. Tax Policy and Direct Investment Abroad,’ in Taxation in the Global Economy, ed. Assaf Razin and Joel Slemrod (Chicago: University of Chicago Press, 1990) at 55, 56 (concluding that U.S. tax policy on domestic investment can have a significant effect on U.S. direct investment abroad, by influencing the relative after-tax rate of return on investments in the United States and abroad). 10 See Joel Slemrod, ‘Tax Effects on Foreign Direct Investment in the United

Notes to pages 74–5 205

11

12

13

14

15

16

17

States: Evidence from a Cross-Country Comparison,’ in Taxation in the Global Economy, ed. Razin and Slemrod, at 79, 93. Alan J. Auerbach and Kevin Hassett, ‘Taxation and Foreign Direct Investment in the United States: A Reconsideration of the Evidence,’ in Studies in International Taxation, ed. Alberto Giovannini, R. Glenn Hubbard, and Joel Slemrod (Chicago: University of Chicago Press, 1993) at 119 (indicating that attributing most of the increase in FDI in the United States after the mid-1980s to TRA86 is not likely correct); Joel Slemrod, ‘The Impact of the Tax Reform Act of 1986 on Foreign Direct Investment to and from the United States,’ in Do Taxes Matter? ed. Joel Slemrod (Cambridge, MA: MIT Press, 1990) at 169, 192 (concluding that FDI flows were significantly affected by TRA86 tax incentives). For a recent literature review, see Office of Tax Policy, Department of the Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study (Washington, DC: Department of the Treasury, 2000) at 177-99 (concluding that empirical microeconomic studies suggest that capital is fairly mobile internationally while macroeconomic studies suggest that capital may be relatively immobile internationally, at least in the aggregate). See Commission of the European Communities, ‘Report of the Committee of Independent Experts on Company Taxation’ (Luxembourg: Office for Official Publications at the European Communities) reprinted in (1992) 92 Tax Notes International at 36-15, at chapter 5 (discussing how 48 per cent of respondents claimed that taxation is always or usually a major factor in the decision as to where to locate a production plant). See Kenneth J. McKenzie and Aileen J. Thompson, Taxes, the Cost of Capital, and Investment: A Comparison of Canada and the United States (Ottawa: Technical Committee on Business Taxation, Working Paper 97-3, 1997) (discussing several recent studies using more disaggregate data as well as expected cost of capital data). See Jack M. Mintz and Douglas D. Purvis, eds., The Impact of Taxation on Business Activity (Kingston, ON: John Deutsch Institute for the study of Economic Policy, Queen’s University, 1987) at 40. See, e.g., David B. Perry, ‘International Tax Comparisons, 1993’ (1994) 42 Canadian Tax Journal 1675 (where OECD member countries are ranked according to the ratio of tax collections to GDP). See Jack M. Mintz, ‘Competitiveness and Tax Policy: How Does Canada Play the Game?’ (1992) 43 Conference Report at 5:1 at 5:5. See Robin W. Boadway, Neil Bruce, and Jack M. Mintz, Taxes on Capital Income in Canada: Analysis and Policy (Toronto: Canadian Tax Foundation, 1987) at 3. But see David G. Hartman, ‘Comment,’ in Taxation in a Global Economy, ed. Razin

206 Notes to pages 76–9

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and Slemrod, at 118 (indicating average tax rates are more relevant when a direct investment is made by buying an existing company or plant); Laurence J. Kotlikoff, ‘Comment,’ in The Impact of Taxation on Business Activity, Mintz and Purvis, at 102 (indicating that taxpayers may figure out ahead of time taxes payable through their own observable circumstances and the general tax climate, thus average tax rates and not marginal ones are the appropriate measure). See Richard G. Lipsey, Douglas D. Purvis, and Peter O. Steiner, Economics, 7th ed. (New York: Harper Collins Publishers, 1991) at 368 (noting that it is always worthwhile for a firm to buy another unit of capital whenever the present value of the stream of marginal revenue products that the capital provides exceeds its purchase price). For a discussion of the contrasting results between average and marginal tax rates, see Julie H. Collins and Douglas A. Shackelford, ‘Using Financial Statement Information to Compare the Corporate Income Tax Systems of Canada, Japan, the United Kingdom and the United States’ (1994) 94 TNI 63-22. For a discussion on the historical development of effective tax rate studies, see Dale W. Jorgenson, ‘Tax Reform and the Cost of Capital: An International Comparison’ (1993) 93 Tax Notes International 74-18. See Mervyn A. King and Don Fullerton, The Taxation of Income from Capital: A Comparative Study of the United States, the United Kingdom, Sweden and West Germany (Chicago: University of Chicago Press, 1984). See, e.g., Robin Boadway, ‘The Theory and Measurement of Effective Tax Rates,’ in The Impact of Taxation on Business Activity, ed. Mintz and Purvis, at 60 (providing a more technical description of the theory and measurement of effective tax rates). The discussion in this part draws to a certain extent from this excellent source. See OECD, Taxing Profits in a Global Economy: Domestic and International Issues (Paris: OECD, 1991) at 87. Conversations between the author and Duanjie Chen, Jack Mintz, and Thomas Tsiopoulos. For a comprehensive review of the methodologies employed in marginal effective tax rate studies, see Kenneth J. McKenzie, Mario Mansour, and Adriane Brule, The Calculation of Marginal Effective Tax Rates (Ottawa: Technical Committee on Business Taxation, Working Paper 97-15, 1998). See generally Boadway, Bruce and Mintz, eds., Taxes on Capital Income in Canada, at 3. See generally Kenneth J. McKenzie, ‘The Implications of Risk and Irreversibility for the Measurement of Marginal Effective Tax Rate on Capital’ (1994) 27 Canadian Journal of Economics 604.

Notes to pages 79–88 207 27 See Kenneth J. McKenzie and Jack M. Mintz, ‘Tax Effects on the Cost of Capital,’ in Canada-U.S. Tax Comparisons, ed. John B. Shoven and John Whalley (Chicago: University of Chicago Press, 1992) at 199. 28 Laurence J. Kotlikoff, ‘Comment,’ in The Impact of Taxation on Business Activity, ed. Mintz and Purvis, at 102. 29 See McKenzie and Mintz, ‘Tax Effects on the Cost of Capital,’ at 185. 30 Ibid. at 207. 31 OECD, Taxing Profits in a Global Economy (Paris: OECD, 1991) at 99. 32 Ibid. at 115. 33 See Kenneth J. McKenzie and Aileen J. Thompson, Taxes, the Cost of Capital, and Investment: A Comparison of Canada and the United States (Ottawa: Technical Committee on Business Taxation, Working Paper 97-3, 1997). 34 See Jack M. Mintz and Thomas Tsiopoulos, Latin American Taxation of Foreign Direct Investment in a Global Economy (Toronto: International Centre for Tax Studies, Discussion Paper No. 5, 1996). 35 Ibid. at 11. The study, however, incorporates an 11 per cent Mexican tariff on capital imports, which is no longer applicable. The study does indicate that effective corporate tax rates for manufacturing activities in Mexico without the capital tariff are reduced from 33.3 to 17.9 per cent. 36 Ibid. at 15. 37 See Duanjie Chen and Kenneth McKenzie, The Impact of Taxation on Capital Markets: An International Comparison of Effective Tax Rates on Capital (Ottawa: Industry Canada, 1997) at 15. 38 See Jorge Martinez-Vazquez and Duanjie Chen, The Impact of NAFTA and Options for Tax Reform in Mexico (Atlanta: Georgia State University International Studies Program, Working Paper 01-2, 2001). 39 Ibid. at 12. 40 John Shoven and Michael Topper, ‘The Cost of Capital in Canada, the United States, and Japan,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 217. 41 Ibid. at 232. 42 Ibid. at 234. Chapter 6 The Impact of U.S. Dividend Tax Reform on Canada 1 See John Shoven and Michael Topper, ‘The Cost of Capital in Canada, the United States and Japan,’ in Canada-U.S. Tax Comparisons, ed. John Shoven and John Whalley (Chicago: University of Chicago, 1992) at 217, 229. 2 See Usha Mittoo, ‘Seasoned Equity Offerings and the Cost of Equity in the Canadian Market,’ in Financing Growth in Canada, ed. Paul J. Halpern (Calgary: University of Calgary Press, 1997).

208 Notes to page 89 3 An analysis of the merits of consumption-based tax reform is beyond the scope of this study. These merits have been given considerable attention in the United States in recent years; See, e.g., Michael Boskin, An Economist’s Evaluation of the Political Discourse on Fundamental Tax Reform Proposals (Stanford, CA: Center for Economic Policy Research, Publication no. 446, 1996). Consumption tax proponents argue that this form of taxation is superior to others since it encourages savings and investment, is less distortionary, and assists in export strategy. Critics suggest that the tax is regressive, will reduce tax revenues, and would not reduce tax complexity. See, e.g., Alvin Warren, ‘Would a Consumption Tax be Fairer than an Income Tax?’ (1980) 89 Yale Law Journal 1081; John S. Nolan, ‘The Merits of an Income Tax Versus a Consumption Tax’ (1995) 12 American Journal Tax Policy 207; John K. McNulty, ‘Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform’ (2000) 88 California Law Review 2095; Neil Brooks, ‘Flattening the Claims of Flat Taxes’ (1998) 51 Dalhousie Law Journal 287; Arthur J. Cockfield, ‘Income Taxes and Individual Liberty: A Lockean Perspective on Radical Consumption Tax Reform’ (2001) 46 South Dakota Law Review 8. For perspectives on the impact of full-blown U.S. consumption tax reform, see Arthur J. Cockfield, ‘The Impact of U.S. Consumption Tax Reform on Canada’ (1998) 4 NAFTA: Law and Business Review of the Americas 74. For another discussion of these issues, see Andrew B. Lyon, International Implications of U.S. Business Tax Reform (Ottawa: Technical Committee on Business Taxation, Working Paper 96-6, 1996) at 19. 4 See Canada, Royal Commission on Taxation, Report (Ottawa: Royal Commission on Taxation, 1966) [the Carter Commission report]. 5 See Robert Brown, ‘The Competitive Edge: The Impact of Taxes on a North American Free Trade Area’ (1987) 12 Canada–United States Law Journal 299 at 301 (noting that the Meade Commission report in the United Kingdom in 1978, the U.S. Treasury Department’s ‘Blueprint for Tax Reform’ in 1977, and the Macdonald Commission report in Canada in 1985 all advocated, in various ways, that tax burdens should be shifted from income to consumption). 6 See the National Commission on Economic Growth and Tax Reform, ‘Unleashing America’s Potential: A Pro-Growth, Pro-Family Tax System for the 21st Century’ (1996) 70 Tax Notes 413 at 416. 7 See Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, CA: Hoover Institution Press, 1995). 8 See Richard K. Armey, The Flat Tax: A Citizen’s Guide (New York: Ballantine, 1996). Steve Forbes was identified with the most popular version of a flat tax

Notes to pages 89–92 209

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proposal during his run for Republican presidential nominee in the late 1990s. Although the flat tax is referred to as a single-rate tax, this is technically inaccurate as all flat tax proposals would exempt from tax household incomes up to a certain level (for example, the Armey-Shelby proposal would exempt from tax the first $33,000 in income for a family of four). Accordingly, there are two rates: 0 per cent for household incomes up to a certain level and another rate imposed beyond this point. The use of exemptions adds a certain amount of progressivity to the flat tax system as the average taxes paid by a household will increase as their income levels go up. See Editorial, ‘The Flat Tax: Why Not?’ Wall Street Journal, 30 Jan. 1996 at A14 (a flat tax would encourage savings and investment and could encourage progressivity through exemptions at the household level). See Editorial, ‘Flat Tax, Flat Earth (I),’ Globe and Mail, 2 Feb. 1996 at A12 and Editorial, ‘Flat Tax, Flat Earth (II),’ Globe and Mail, 3 Feb. 1996 at D6 (the flat tax would be revenue losing, close incentives that serve a useful social purpose, and would not be progressive). See Herbert N. Beller, ‘ABA Tax Section Comments on Dividend Exclusion Proposal,’ Tax Notes Today, 22 April 2003. See Michael J. Graetz and Alvin C. Warren, Jr, Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (Arlington, VA: Tax Analysts, 1998). See Council of Economic Advisers, ‘Eliminating the Double Tax on Corporate Income’ (7 Jan. 2003), reprinted in Tax Notes Today, 7 Jan. 2003, 5-27 (noting that all G-7 countries other than the United States provide dividend tax relief through an imputation credit system or dividend exclusions). House of Representatives, Jobs and Growth Tax Relief Reconciliation Act of 2003 Conference Report (Washington, DC: Government Printing Office, 2003) at 204. See John K. McNulty, ‘Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform’ (2000) 88 California Law Review 2095. See Joel Slemrod, ‘The Impact of U.S. Tax Reform on Canadian Stock Prices,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 237, 238. Roy D. Hogg and Jack M. Mintz, ‘Impacts of Canadian and U.S. Tax Reform on the Financing of Canadian Subsidiaries of U.S. Parents’ in Studies in International Taxation ed. Alberto Giovannini, R. Glenn Hubbard, and Joel Slemrod (Chicago: University of Chicago Press, 1993) at 47, 49 (noting

210 Notes to pages 92–7

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27

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TRA86 altered the tax treatment of U.S. multinationals operating in Canada, which may have caused (along with non-tax factors) the Canadian companies to increase dividend payouts to their U.S. parents, since the tax incentive to reinvest earnings in Canada was reduced as well as favouring the use of more local debt financing). See, e.g., John Bossons, ‘The Impact of the 1986 Tax Reform Act on Tax Reform in Canada’ (1987) 40 National Tax Journal 331 at 333 (indicating TRA86 put pressure on Canadian policy makers to reduce nominal corporate tax rates mainly as a result of changes to U.S. foreign credit rules). See John Whalley, ‘Foreign Responses to U.S. Tax Reform,’ in Do Taxes Matter? ed. Joel Slemord (Cambrdge, MA: MIT Press, 1990) at 287, 307. See PricewaterhouseCoopers, Tax Facts and Figures (2003), available at http: //www.pwc.corn.ca. Ibid. at 48. See Duanjie Chen and Jack M. Mintz, Taxing Investments: On the Right Track, but at a Snail’s Pace (Toronto: C.D. Howe Institute, Backgrounder No. 72, 2003) at 4. See Chuck Gnaedinger, ‘Panelists Examine Canadian, U.S. Dividend Integration Laws’ (2003) 30 Tax Notes International 1098. See Canada, Department of Finance, The Budget Plan 2003 (Ottawa: Department of Finance, 2003). See J.M. Poterba and L. Summers, ‘The Economic Effects of Dividend Taxation,’ in Recent Advances in Corporate Finance, ed. E. Altman and M. Subrahmanyam (Homewood, IL: R.D. Irwin, 1985) at 227; Alan J. Auerbach and Kevin A. Hassett, ‘On the Marginal Source of Investment Funds’ (2003) 87 Journal of Public Economics 205 (arguing that dividend tax policy may have smaller impact on investment levels than previously suggested in the literature). See Jason G. Cummins, The Effects of Taxation on U.S. Multinationals and Their Canadian Affiliates (Ottawa: Technical Committee on Business Taxation, Working Paper 96-4, 1996) at 26 (‘I find that U.S. [multinational firms] are able to substitute factor inputs between their domestic and Canadian affiliates rather easily, except domestic and foreign labour which are complements’). The Department of Treasury favoured a dividend exclusion system similar to the one now in place in Mexico. See U.S., Department of the Treasury, Integrating of the Individual and Corporate Tax System: Taxing Income Once (Washington, DC: U.S. Department of Treasury, 1992). See Rosanne Altshuler, T. Scott Newlon, and William C. Randolph, Do Repatriation Taxes Matter? Evidence form the Tax Returns of U.S. Multinationals,

Notes to pages 98–106 211

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31 32 33 34

35

36 37 38 39 40

Office of Tax Policy Paper no. 70 (Washington, DC: U.S. Department of the Treasury, 1994), available online at: www.ustreas.gov/offices/tax-policy/ library/ota70.pdf. See Vijay Jog and Jianmin Tang, Tax Reforms, Debt Shifting and Corporate Tax Revenues: Multinational Corporations in Canada (Ottawa: Technical Committee on Business Taxation, Working Paper 97–14, 1998). For discussion, see Jack Bernstein, ‘Canada-U.S. Tax Arbitrage: A Canadian Perspective’ (2003) 30 Tax Notes International 683. See Ron MacLeod, ‘Canadian Government Urged to Keep Pace with U.S. Tax Cuts’ (2003) 29 Tax Notes International 137. Ibid. The Technical Committee on Business Taxation noted that most justifications for a corporate capital tax are not persuasive, but recommended that the capital tax be maintained at reduced rates. See Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, 1997) at 4.19–4.20. See Canada, House of Commons Debates (9 May 2003), vol. 38, no. 99, 2nd session, 37th Parliament (setting out an exchange between Charlie Penson, Canadian Alliance MP from Peace River, and the Hon. Maurizio Bevilacqua, Secretary of State (International Financial Institutions), Lib.). See Budget of the United States Government: Fiscal Year 2004 (Washington, DC: U.S. Government Printing Office, 2003). See Department of Finance, The Budget Plan 2003 (Ottawa: Department of Finance, 2003) at 141. Ibid. at 145. Ibid. at 146. See Department of Finance Tax Bulletin, The Canadian Tax Advantage (26 Aug. 2003), reprinted in Tax Topics no. 1644 (Don Mills, ON: CCH, 11 Sept. 2003) at 1.

Chapter 7 Lessons from Europe 1 See, e.g., Mauro Capplelleti, Monica Seccombe, and Joseph Weiler, eds., Integration through Law (New York: W. de Gruyter, 1986). 2 The six member countries who signed the Treaty of Rome establishing the European Economic Community were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. 3 See Treaty Establishing the European Economic Community, 25 March 1957 [hereinafter Treaty of Rome], 298 U.N.T.S. 11. 4 Denmark, Ireland, and the United Kingdom joined the European Commu-

212 Notes to pages 106–8

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7 8 9 10 11

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13 14

15

nity in 1973; Greece joined in 1980; Portugal and Spain in 1986; Sweden, Finland, and Austria have joined in more recent years. Ten more European countries joined the EU in 2004. Frederick M. Abbott, ‘Integration without Institutions: The NAFTA Mutation of the EC Model and the Future of the GATT Regime’ (1992) 40 American Journal of Comparative Law 917 at 917. Frederick M. Abbott, Law and Policy of Regional Integration: The NAFTA and Western Hemispheric Integration in the World Trade Organization System (Dordrecht: M. Nijholf Publishers, 1995) at 14. Ibid. Case 294/83, Parti ecologiste ‘Les Verts’ v. European Parliament, 1986 E.C.R. 1339 at 1365. Single European Act, 28 Feb. 1986, OJ 1987 L 169, 29 June 1987. See J.H.H. Weiler, ‘The Transformation of Europe’ (1991) 100 Yale Law Journal 2403. This section draws from this work. See Malcolm Gammie, ‘The Taxation of Inward Direct Investment in North America Following the Free Trade Agreement’ (1994) 49 Tax Law Review 615 at 639–40 (‘In a series of decisions, based mainly on the right of establishment and the principle of freedom of movement of workers, the Court has moved to strike down various domestic tax provisions’). Commission of the European Communities, White Paper on Completion of the Internal Market (Milan, 28–9 June 1985), Com (85) p. 310 [hereinafter ‘White Paper’]. This White Paper was authored by Lord Arthur Cockfield, then Commissioner of Industry (United Kingdom) and cousin of the author of this book. Single European Act, 1986 Luxembourg, OJL 169, 29.6. 1987. art. 8(a). The effect of the principle of subsidiarity on direct taxation, however, continues to be debated. See, e.g., Sijbren Cnossen, Reform and Harmonization of the Company Tax Systems in the European Union (Rotterdam: Erasmus University Research Centre for Economic Policy, Research Memorandum 9606, 1996) at 24 (arguing that subsidiarity suggests ‘that tax sovereignty has to be ceded in establishing the tax entitlement rules so that tax independency can be exercised more fully in administering these rules’). But see Moris Lehner, ‘EC Law and the Competence to Abolish Double Taxation,’ in Tax Treaties and EC Law, ed. W. Bassner, Michael Lang, and E. Lechner, Series on International Taxation, vol. 16 (The Hague: Kluwer Law International, 1997) at 1, 13 (concluding that subsidiarity and its impact on art. 220 of the Treaty of Rome requires the EU countries themselves to take action to abolish double taxation via their tax treaties). See Jan E. Brinkmann and Andreas O. Riecker, ‘European Company Taxa-

Notes to pages 108–10 213

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tion: The Ruding Committee Report Gives Harmonization Efforts a New Impetus’ (1993) 27 International Lawyer 1061 at 1063. This discussion draws from Alex Easson, ‘Harmonization of Direct Taxation in the European Community: From Neumark to Ruding’ (1992) 40 Canadian Tax Journal 600 at 608–9. For discussion see Maarten J. Ellis, ‘Direct Taxation in the European Community: An Irresistible Force Meets an Immovable Object?’ (1993) 28 Wake Forest Law Review 51 at 53. ‘Proposal for a Directive on the Harmonization of Systems of Company Taxation and of Withholding Taxes on Dividends,’ 1 Aug. 1975, OJ 1975 C 253/2. ‘Report from the Commission to the Council, Scope for Convergence of Tax Systems in the Community,’ 27 March 1980, Doc. COM (80) 139 final. See ‘Guidelines on Company Taxation, Commission Communication to the Parliament and the Council,’ 20 April 1990, Doc. COM (90) 601 final. In 1977, a Directive was adopted concerning mutual assistance by competent authorities of the EU countries in the field of direct taxation. See Council Directive 77/799/EEC OJ L 336/15 (1977). Merger Directive, Number 90/434/EEC on the Common System of Taxation Applicable to Mergers, Divisions, Transfers of Assets and Exchanges of Shares Concerning Companies of Different Member Countries (1990) 90 Tax Notes International 46-5. See Gammie, ‘The Taxation of Inward Direct Investment in North America’ at 641. Art. 4 of the Merger Directive. Directive Number 90/435/EEC on the Common System of Taxation Applicable in the Case of Parent Companies and Subsidiaries of Different Member Countries (1990) 90 Tax Notes International 46-4. See ‘Harmonization of Direct Taxation in the European Community’ at 615. ‘Convention Number 90/436/EEC on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises’ (1995) 95 Tax Notes International 78-16. Proposal for a Council Directive on a Common System of Taxation Applicable to Interest and Royalty Payments Made Between Parent Companies and Subsidiaries in Different States, 28 Nov. 1990, Doc. COM (90) 571 final, OJ 1991 C 53/91. Proposal for a Council Directive Concerning Arrangements for the Taking into Account by Enterprises of the Losses of their Permanent Establishments and Subsidiaries Situated in other European Countries, 28 Feb. 1991, Doc. COM (90) 595 final, OJ C 53/30.

214 Notes to pages 110–13 30 For discussion, see Stephen G. Utz, ‘Tax Harmonization and Coordination in Europe and America’ (1994) 9 Connecticut Journal of International Law 767 at 793 (although these experts were independent they were nonetheless strongly identified with their country’s tax policy positions). 31 Ruding Committee, at chapter 1. 32 Ibid. at chapter 10. It was noted that the corporate tax component of the cost of capital relating to a typical investment undertaken by an EU country company in another EU country through a wholly owned subsidiary is 2.1 per cent. This compares with a figure of 0.7 per cent if the company undertook the same investment at home. 33 Ibid. at chapter 10. 34 Ibid. (although a majority of the Ruding Committee supported a proposal to create common system of imputation for corporate earnings where shareholder relief is granted, one member dissented indicating that the goal of harmonizing tax systems was not an appropriate goal for the committee to consider at the time). 35 Ibid. at chapter 10. See, e.g., Leif Muten, ‘International Experience of How Taxes Influence the Movement of Private Capital’ (1994) 94 Tax Notes International 49-17. 36 See John Goldsworth, ‘European Community: EC Commission Reviews Ruding Committee Report, Suggests NAFTA Country Consultation’ (1992) 5 Tax Notes International at 177 at 178. See also ‘EC Economic and Social Committee Publishes Opinions on Ruding Committee Proposals and EC Commission Guidelines on Company Taxation’ (1993) 6 Tax Notes International 512 at 513 (the Economic and Social Committee agreed with the Commission that harmonization proposals would clash with the principle of subsidiarity). 37 See, e.g., Nigel Tutt, ‘EC Finance Ministers Agree Corporate Tax Harmonization Should Be Limited’ (1992) 5 Tax Notes International 1320 at 1321. 38 For discussion on the developments that led to the creation of the High Level Group, see Alex Easson, ‘Tax Competition and Investment Incentives’ (1997) 2 EC Tax Journal 63 at 63. 39 The Conclusions of the ECOFIN Council Meeting on 1 Dec. 1997 concerning taxation policy (98/c/2/01) are reprinted in vol. 38 European Taxation EC-5 (1998). 40 See European Commission, ‘Towards an Internal Market without Tax Obstacles’ COM (2001) 582. 41 Ibid. at 35–6. 42 See European Commission, ‘An Internal Market without Company Tax

Notes to pages 113–16 215

43 44 45 46 47

48 49 50

51

52 53

54 55

56

57

Obstacles: Achievements, Ongoing Initiatives and Remaining Challenges,’ COM (2003) 726, at pp. 8–24. Ibid. at 8–11. See Council Directive 49/2003/EC of June 2003. See European Commission, ‘An Internal Market without Company Tax Obstacles’ at 6–8. Ibid. at 8. See Malcolm Gammie, ‘The Role of the European Court of Justice in the Development of Direct Taxation in the European Union’ (2003) 57 Bulletin for International Fiscal Documentation 86. Ibid. See European Commission, ‘An Internal Market without Company Tax Obstacles’ at 5–6. Implemented by Council Directives 67/227/EEC and 68/228/EEC of 11 April 1967, OJ 1967 Special Edition, 14–16. For discussion, see Craig A. Hart, ‘The European Community’s Value-Added Tax System: Analysis of the New Transitional Regime and Prospects for Further Harmonization’ (1994) 12 International Tax & Business Lawyer 1 at 5. See Jan E. Brinkmann and Andreas Riecker, ‘European Company Taxation: The Ruding Committee Report Gives Harmonization Efforts a New Impetus’ (1993) 27 International Lawyer 1061. Council Directive 91/680/EEC of 16 Dec. 1991. See Vito Tanzi, Taxation in an Integrating World (Washington, DC: Brookings Institution, 1995) at 54–6 (discussing the rate differentials and their possible adverse impact on resource allocation). Free Trade Agreement, Dec. 22, 23, 1987 and 2 Jan. 1988, U.S.-Can., vol. 27 I.L.M. 281 (effective as of 1 Jan. 1989). NAFTA adopts the same cultural industries exemption provision under Annex 2106. See, e.g., Donald S. Macdonald, ‘The Canadian Cultural Industries Exemption Under Canada-U.S. Trade Law’ (1994) 20 Canada– United States Law Journal 253 at 260. See, e.g., Alan Rugman, ‘Canada: Globalization and Competitiveness in a Regional Market’ (unpublished draft) at 5 (discussing movement by Canadian businesses away from government protection in favour of globalization). See, e.g., Micro-Economic Policy Staff, Economic Integration in North America: Trends in Foreign Direct Investment and the Top 1,000 Firms (Ottawa: Industry Canada, Working Paper No. 1, 1994) at 37 (noting that Mexican manufacturing wages are only 20 to 25 per cent of Canadian wages, although the impact of this wage differential on Canadian industry may be limited be-

216 Notes to pages 116–18

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60 61

62 63

64

65

66 67

cause labour costs as a percentage of total costs in manufacturing has been declining). See Ronald J. Wonnacott, ‘Canada’s Role in NAFTA: To What Degree Has It Been Defensive?’ in Mexico and the North American Free Trade Agreement: Who Will Benefit?, ed. Victor Bulmer-Thomas, Nikki Craske, and Monica Serrano (New York: St Martin’s Press, 1994) at 165. See Frederick M. Abbott, Law and Policy of Regional Integration: The NAFTA and Western Hemispheric Integration in the World Trade Organization System (Dordrecht: M. Nijholf Publishers, 1995) at 20. Ibid. at 9. See, e.g., Jorge A. Bustamanante, ‘NAFTA and Labour Migration to the United States,’ in Mexico and the North American Free Trade Agreement, ed. Bulmer-Thomas, Craske, and Serrano, at 79, 82 (discussion of the potential impact of NAFTA on illegal migration from Mexico to the United States). The fear of job loss was symbolized at the time by Ross Perot’s ‘giant sucking sound’ of employment shifting to Mexico. The House of Representatives and the Senate approved the implementation legislation for NAFTA in November, 1993 with the majority of Democrats in the House of Representatives voting against it. See, e.g., William C. Gruben and John Welch, ‘Is NAFTA More Than a Free Trade Agreement? A View from the United States,’ in Mexico and The North American Free Trade Agreement, ed. Bulmer-Thomas, Craske, and Serrano, at 177, 182 (disparities between U.S. and Mexican labour and environmental laws were criticized for creating an environment of ‘social dumping’ where the U.S. market would bear the costs of the lack of regulation in Mexico). See Bulmer-Thomas, Craske, and Serrano, eds., Mexico and the North American Free Trade Agreement at 203, 205 (discussing how the political leaders in the United States recognized that restrictive side agreements ‘could lead to an unwelcome diminution of national sovereignty for all three countries’). See, e.g., Jesus S. Herzog, ‘Introduction,’ in Mexico and the North American Free Trade Agreement, ed. Bulmer-Thomas, Craske, and Serrano, at 1, 3. See, e.g., Adolfo Aguilar Zinser, ‘Is There an Alternative? The Political Constraints on NAFTA,’ in Mexico and the North American Free Trade Agreement, ed. Bulmer-Thomas, Craske, and Serrano, at 119, 123 (‘Driven by hope or persuaded by government propaganda, many Mexicans, particularly those in the urban middle classes, see NAFTA as a right of passage to unseen prosperity. Criticism of NAFTA has been mute, timid or deliberately silenced by the government. There are nevertheless a number of areas where concerns have been repeatedly expressed. The most important is the issue of sovereignty’).

Notes to pages 118–26 217 68 This part draws from Jon R. Johnson, The North American Free Trade Agreement: A Comprehensive Guide (Aurora, ON: Canada Law Book, 1994) at 237 (describing sanitary and phytosanitary measures under NAFTA, which are defined under article 724 of NAFTA as measures to protect human, animal, or plant). 69 See Abbott, Law and Policy of Regional Integration, at 28. 70 See Johnson, The North American Free Trade Agreement, at 237. 71 Ibid. at 524. 72 But see Leo Panitch, Rethinking the Role of the State in Globalization: Critical Reflections, ed. James H. Mittelman (Boulder, CO: Lynne Renner, 1996) at 96 (arguing that NAFTA will function as an economic constitution, setting the types of economic policies that all governments must follow). 73 Michael Trebilcock, ‘What Makes Poor Countries Poor? The Role of Institutional Capital in Economic Development,’ in Law and Economics of Development (New York: Macmillan Press, 1997). 74 Fast-track authority expedites Congressional approval of Executive-branch negotiated trade agreements. Congress retains the right to final approval and implements the necessary legislation to accommodate the agreement. 75 For a discussion of the issues surrounding congressional reluctance to approve fast-track authority, see Pascual C. Meyer, ‘Whether for Chilean NAFTA (or NAFTA ‘Light’) Accession: The Necessity of Fast Track Authority’ (1998) 4 NAFTA Business and Law Review 137 at 138–46. 76 See George J. Church, ‘Where He Rings True: Free Trade Isn’t Always Fair,’ Time, 4 March 1996 at 28 (citing a Time/CNN poll which indicates that 51 per cent of respondents thought the effects of free trade were ‘mostly bad’); Jackie Calmes, ‘Satisfaction with Today Hides a Fear of Tomorrow,’ Wall Street Journal, 8 Mar. 1996 at R2 (citing a Wall Street Journal/NBC News Poll where 59 per cent of respondents indicated that free trade agreements cost jobs in the United States and 25 per cent of respondents indicated that free trade creates jobs). 77 See, e.g., Editorial, ‘Mexico and Canada: An Evolving Partnership,’ Globe and Mail, 10 June 1996 at A12. 78 See, e.g., Peter Cook, ‘Yes, But Can We Compete on Taxes,’ Globe and Mail, 30 Dec. 1994 at B2. 79 For a discussion of Canadian concerns relating to the ability of trade agreements to affect Canadian social policy see Michael Hart, ‘Coercion or Cooperation: Social Policy and Future Trade Negotiation’ (1994) 20 Canada–United States Law Journal 351. 80 See Rogelio Ramirez De La O, Mexico: NAFTA and Prospects for North American Integration, C.D. Howe Commentary No. 172 (Toronto: C.D. Howe Institute, 2002).

218 Notes to pages 126–30 81 Robert L. Earle and John D. Wirth, eds., Identities in North America: The Search for Community (Stanford: Stanford University Press, 1995) at 197; Dorinda G. Dallmeyer, ed., Joining Together, Standing Apart: National Identities after NAFTA (The Hague; Boston: Kluwer Law International, 1997) (examining how the negotiation of a deal to resolve economic issues may potentially encourage policy convergency among the NAFTA countries). Chapter 8 E-Commerce Tax Policy 1 For discussion, see Jack M. Mintz, Most Favored Nation: Building a Framework for Smart Economic Policy (Toronto: C.D. Howe Institute, 2001) 7–17. 2 For discussion on the historical evolution of these communication technologies, see Charles E. McLure, Jr, ‘Taxation of Electronic Commerce: Economic Objectives, Technological Constraints, and Tax Laws’ (1997) 52 Tax Law Review 269. 3 Thomas Cottier, ‘The New Global Technology Regime: The Impact of New Technologies on Multilateral Trade Regulation and Governance’ (1996) 72 Chi.-Kent Law Review 415 at 415. 4 This chapter draws to a certain extent from Arthur J. Cockfield, ‘Reforming the Permanent Establishment Principle through a Quantitative Economic Presence Test’ (2003) 38 Canadian Business Law Journal 400. 5 For greater elaboration on the issues discussed within this part, see Arthur J. Cockfield, ‘Balancing National Interests in the Taxation of Electronic Commerce’ (1999) 74 Tulane Law Review 133. 6 Ibid. at 157–9. 7 For an early discussion of this view, see David R. Tillinghast, ‘The Impact of the Internet on the Taxation of International Transactions’ (1996) 50 Bulletin for International Fiscal Documentation 524 (indicating that Internet commercial developments ‘threaten fundamentally to alter [the] division of revenue by shifting the balance of taxing jurisdiction, and revenue, decisively in favour of the country of residence’). 8 For discussion on the erosion of source-state tax jurisdiction, see Richard M. Bird, ‘Shaping a New International Tax Order’ (1988) 42 (7) Bulletin for International Fiscal Documentation (292). 9 See Office of Tax Policy, U.S. Department of the Treasury, Selected Tax Policy Implications of Global Electronic Commerce (Washington, DC: Department of the Treasury, 1996). 10 Ibid. at 18–19 (indicating ‘source based taxation could lose its rationale and be rendered obsolete by electronic commerce’). 11 According to one estimate, the United States accounted for roughly 80 per

Notes to pages 130–6 219

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cent of the global total of e-commerce in 1998. See OECD, The Economic and Social Impacts of Electronic Commerce: Preliminary Findings and Research Agenda (Paris: OECD, 1999) at 29. See Office of Tax Policy, U.S. Department of Treasury, ‘Selected Tax Policy Implications of Global Electronic Commerce.’ See Revenue Canada, Internal Memorandum 981646 (31 Aug. 1998). See Electronic Commerce and Canada’s Tax: A Report to the Minister of National Revenue Administration from the Minister’s Advisory Committee on Electronic Commerce (Ottawa: Revenue Canada, April 1998); Electronic Commerce and Canada’s Tax Administration: A Response to the Advisory Committee’s Report on Electronic Commerce by the Minister of National Revenue (Ottawa: Revenue Canada, Sept. 1998) at 21. See Australian Tax Office, Tax and the Internet: Discussion Report of the Australian Tax Office Electronic Commerce Project, para. 7.2.15. (Canberra: Australian Government Publication Service, 1997). See OECD Committee on Fiscal Affairs, Electronic Commerce: Taxation Framework Conditions (Paris: OECD, 1998). ‘Joint Declaration of Business and Government Representatives: Government/Business Dialogue on Taxation and Electronic Commerce’ (Paris: OECD, 1998). OECD model tax treaty, Commentary on Article 5. For discussion, see Arthur J. Cockfield, ‘Through the Looking Glass: Computer Servers and E-Commerce Profit Attribution’ (2002) 25 Tax Notes International 269. See Arthur J. Cockfield, ‘Transforming the Internet into a Taxable Forum: A Case Study in E-Commerce Taxation’ (2001) 85 Minnesota Law Review 1171; Arthur J. Cockfield, ‘Should We Really Tax Profits From Computer Servers?’ (2000) 21 Tax Notes International 2407. E-mail discussion between the author and Joseph Guttentag, former deputy assistant secretary for international tax affairs, U.S. Department of the Treasury. Reprinted with the permission of Mr Guttentag. Canada Customs and Revenue Agency, ‘Impact of E-commerce on the Canadian Tax Base’ (2002: unpublished draft discussion paper obtained through the Access to Information Act). See Arthur J. Cockfield, ‘Reforming the Permanent Establishment Principle through a Quantitative Economic Presence Test’ (2003) 38 Canadian Business Law Journal 400. S. 123 of the Excise Tax Act. See CCRA, Technical Information Bulletin B-090 ‘GST/HST and Electronic Commerce’ (2002) (indicating that non-resident taxpayers that sell digital

220 Notes to pages 137–40

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goods and services to Canadian consumers would not likely be considered to be carrying on business in Canada and thus not subject to GST registration rules). This regime became effective on 1 July 2003. See European Council, Council Regulation 792/2002 amending temporarily Regulation (EEC) 218/92 on administrative cooperation in the field of indirect taxation (VAT) as regards additional measures regarding electronic commerce (7 May 2002); European Council, Directive amending Directive 77/388/EEC as regards the value-added tax arrangements applicable to certain electronically supplied services and radio and television broadcasting services (12 Feb. 2002). The most recent Directive modified an earlier Directive that indicated registration would only apply if the non-EU supplier had sales to EU consumers in excess of 100,000 Euros. For commentary, see Gary Burnes, ‘Businesses and Governments Express Concern About European Commission’s Proposed E-Commerce VAT Directive’ (2000) 20 Tax Notes International 2750. See Quill v. North Dakota, 504 U.S. 298 at 315 (1992). See General Accounting Office, Sales Taxes: Electronic Commerce Growth Presents Challenges; Revenue Losses are Uncertain, GAO Report GAO/66D/OCE-OO165 (Washington, DC: General Accounting Office, June 2000) at 20–1. See also Donald Bruce and William F. Fox, State and Local Sales Tax Revenue Losses from E-Commerce: Updated Estimates (Knoxville, TE: Center for Business and Economic Research, University of Tennessee, Sept. 2001) (estimating total state and local revenue losses as a result of e-commerce to be $13.3 billion for 2001). For an excellent discussion on U.S. state and international income and consumption tax nexus issues within the new economy, see Walter Hellerstein ‘Jurisdiction to Tax Income and Consumption in the New Economy: A Theoretical and Comparative Perspective’ (2003) 38 Georgia Law Review 1. S. 148(1) of the Excise Tax Act. S. 240(4) of the Excise Tax Act. See Richard Bird, Taxing Electronic Commerce: A Revolution in the Making (Toronto: C.D. Howe Institute, Commentary No. 187, 2003) at 2. Lawrence Lessig, Code and Other Laws of Cyberspace (New York: Basic Books, 1999). For a discussion of capital flight and U.S. portfolio investment rules, see Arthur J. Cockfield, ‘Transforming the Internet into a Taxable Forum: A Case Study in E-Commerce Taxation (2001) 85 Minnesota Law Review 1171 at 1223–30.

Notes to pages 141–9 221 36 Arthur J. Cockfield, ‘Designing Tax Policy for the Digital Biosphere: How the Internet is Changing Tax Laws’ (2002) 34 Connecticut Law Review 333. Chapter 9 Balancing Economic and Sovereignty Interests 1 The Great Transformation: The Political and Economic Origins of Our Time (Boston: Beacon Press, 1957) at 138. This chapter draws to a certain extent from a previously published work by the author. See Arthur J. Cockfield, ‘International Tax Policy under NAFTA’ (1998) 34 Stanford Journal of International Law 39. This tension was also discussed in the context of European regional integration and tax harmonization initiatives in chapter 7. 2 The Ruding Committee indicated that a general convergence of corporate income tax rates among the EU countries to a lower rate was consistent with (although not necessarily proof of) tax competition among these states; see Ruding Committee, at chapter 10. 3 See Paul R. McDaniel, ‘Formulary Taxation in the North American Free Trade Zone’ (1994) 49 Tax Law Review 691 at 715–19 (discussing the comprehensive tax expenditure accounts published in the United States and Canada and advising that the magnitude of the distortions should be quantified). But see Richard M. Bird, ‘Commentary, A View from the North’ (1994) 49 Tax Law Review 745 at 755 (indicating that it is not very useful or relevant to use tax expenditures to evaluate international tax policy). 4 Conclusions of the ECOFIN Council on 1 December 1997 concerning taxation policy, reprinted in EC Update, 38 European Taxation EC-5 (1998) (the non-binding agreement indicates that a special group is to be formed to identify the harmful tax measures and oversee dismantling of the measures by 1 January 2003). 5 See OECD, Progress in Eliminating Harmful Tax Practices (Paris: OBCD, 2000). 6 See Malcolm Gammie, ‘The Taxation of Inward Direct Investment in North America Following the Free Trade Agreement’ (1994) 49 Tax Law Review 615 at 650. 7 For example, over 70 per cent of trade between Canada and the United States consists of non-arm’s-length intrafirm trade; see Alan M. Rugman, Multinationals and Canada–United States Free Trade (Columbia: University of South Carolina Press, 1990). The amount of U.S.-Canada related-party transactions reached $166 billion in 1993; see Robert Turner, Study on Transfer Pricing (Ottawa: Technical Committee on Business Taxation, Working Paper 96-10, 1996). 8 NAFTA does not prohibit this type of tax subsidization: see chapter 4.2. ‘NAFTA and Taxes.’

222 Notes to pages 149–53 9 Nevertheless, discriminatory treatment against goods and services from other NAFTA parties continues to a certain extent under NAFTA. For a review of GATT panels dealing with this alleged discriminatory treatment by Canada and the United States, see Asif H. Qureshi, ‘Trade Related Aspects of International Taxation: A New WTO Code of Conduct?’ (1996) 30 Journal of World Trade 161 at 188–93. 10 For a general review of sovereignty issues under globalization, see Saskia Sassen, Losing Control? Sovereignty in an Age of Globalization (New York: Columbia University Press, 1996). 11 Luc Hinnekens, ‘Territoriality-Based Taxation in an Increasingly Common Market and Globalization Economy: Nightmare and Challenge of International Taxation in the New Age’ (1992) 1 EC Tax Review 70 at 71. 12 Sovereignty has been called ‘the basic internal legal status of a state that is not subject, within its territorial jurisdiction, to the governmental, executive, legislative or territorial jurisdiction of a foreign state or to foreign law other than public international law’; see Helmut Steinberger, ‘Sovereignty’ (1981) 10 Encyclopedia of Public International Law 408. 13 For an elaboration on these views, see Arthur J. Cockfield, ‘Transforming the Internet into a Taxable Forum: A Case Study in E-Commerce Taxation’ (2001) 85 Minnesota Law Review 1171 at 1221–35; Arthur J. Cockfield, ‘Reforming the Permanent Establishment Principle Through a Quantitative Economic Presence Test’ (2003) 38 Canadian Business Law Journal (400). 14 ‘Sharing the International Tax Base in a Changing World,’ in Public Finance and Public Policy in the New Century, ed. Sijbren Cnossen and Hans-Werner Sinn (Cambridge, MA: MIT Press, 2003) 405 at 406. 15 See, e.g., Lawrence H. Summers, ‘Taxation in a Small World,’ in Tax Policy in the Twenty-First Century, ed. Herbert Stein (New York: J. Wiley, 1988) at 64, 75. 16 See Aaron Schwabach and Arthur J. Cockfield, ‘The Role of International Law and Institutions,’ in Knowledge Base for Sustainable Development: An Insight into the Encyclopedia of Life Support Systems, vol. 3, 611–25, UNESCO Publishing-Eolss Publishers, Oxford, UK. 17 See A. Javier Trevino, The Sociology of Law: Classical and Contemporary Perspectives (New York: St Martin’s Press, 1996) at 439 (discussion concerning the manner in which legal modifications follow social modifications and/or the ways that legal changes can instigate social changes). 18 For a discussion of the historical development of the modern conception of sovereignty, see Marc Williams, ‘Rethinking Sovereignty,’ in Globalization: Theory and Practice, ed. E. Kofman and G. Youngs (New York: Pinter, 1996) at 109 (noting that although an emphasis is placed on the political aspects of

Notes to pages 153–7 223

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sovereignty, it must also be viewed as both a norm and a practice or institution). See Joyce Hoebing, Sidney Weintraub, and M. Delal, NAFTA and Sovereignty: Trade-Offs for Canada, Mexico and the United States (Washington, DC: Center for Strategic and International Studies, 1996) (describing the sovereignty concerns expressed by each NAFTA country prior to implementing NAFTA). The following commentary draws from this source. See McDaniel, ‘Formulary Taxation,’ see also Robert S. McIntyre and Michael J. McIntyre, ‘Using NAFTA to Introduce Formulary Apportionment’ (1993) 6 Tax Notes International 851. The unitary enterprise files a tax return with each NAFTA country using the income determination rules of each country. The determined income (or loss) would then be apportioned to each country pursuant to the agreedupon formula. Each country’s tax rate would then be applied to the taxable income apportioned to that country. See Alvin C. Warren, ‘Commentary, Alternatives for International Corporate Tax Reform’ (1994) 49 Tax Law Review 599 at 611. Critics suggest that formulary methods are arbitrary in part because they allocate profits without any sound relationship to market conditions or the facts surrounding the transaction. For discussions, see Reuven S. Avi-Yonah, ‘The Rise and Fall of Arm’s Length: A Study in the Evolution of U.S. International Taxation’ (1995) 15 Virginia Tax Review 89 at 147–9; John Turro, ‘The Battle Over Arm’s Length and Formulary Apportionment’ (1994) 65 Tax Notes 1259; Sylvain Plasschaert, ‘An EU Tax on the Consolidated Profits of Multinational Enterprises’ (1997) 37 European Taxation 2 at 3–8. Possible NAFTA-wide formulary apportionment has been criticized for increasing compliance and enforcement burdens; creating problems with defining a unitary enterprise; the difficulty with approximating existing revenues; and impracticality of using standard formulas when industry practice varies. See John S. Brown, ‘Commentary, Formulary Taxation and NAFTA’ (1994) 49 Tax Law Review 759 at 761–7. The Ruding Committee rejected formulary taxation for a number of reasons including: ‘Firstly, and foremost, allocation is suitable only if States have reached an advanced degree of integration, such as common currency, common company law, common accounting standards and common expertise in the tax administrations.’ See Ruding Committee, at chapter 5. See, e.g., McDaniel, ‘Formulary Taxation’ at 714. See Richard M. Bird, ‘Commentary, A View from the North’ (1994) 49 Tax Law Review 745 at 750 (‘To twist and paraphrase a famous sentence of

224 Notes to pages 157–62 Gertrude Stein [‘A rose is a rose is a rose’], however, a free trade area is not an economic union is not a federation is not a unitary state’). 28 See, for example, Electronic Commerce and Canada’s Tax Administration: A Response to the Advisory Committee’s Report on Electronic Commerce by the Minister of National Revenue (Ottawa: Revenue Canada, 1998). Chapter 10 Modelling NAFTA Tax Competition 1 See Charles Tiebout, ‘A Pure Theory of Local Expenditures’ (1956) 64 Journal of Political Economy 416. 2 For a review of the debate surrounding creating centralized mechanisms to deal with state and local taxes in the United States, see Daniel Shaviro, ‘An Economic and Political Look at Federalism in Taxation’ (1992) 90 Michigan Law Review 895 (arguing for more uniform state tax bases). 3 See, e.g., Michael J. McIntyre, ‘Commentary, The Design of Tax Rules for the North American Free Trade Alliance’ (1994) 49 Tax Law Review 769 at 773–4 (discussing how tax competition has led to the adoption of steeply regressive tax system); Duanjie Chen and Kenneth J. McKenzie, The Impact of Taxation on Capital Markets: An International Comparison of Effective Tax Rates on Capital (Ottawa: Industry Canada, 1997) at 25 (noting how taxes across provinces and sectors within Canada encourage an inefficient allocation of capital across the provinces). 4 Peggy B. Musgrave and Richard A. Musgrave, ‘Fiscal Coordination and Competition in an International Setting,’ in Influence of Tax Differentials on International Competitiveness (Proceedings of the VIIIth Munich Symposium on International Taxation, ed. Klaus Vogel (Deventer, the Netherlands: Kluwer, 1990) at 61, 63–70 (arguing that the forces of competition cannot secure an efficient or equitable allocation of finances in the international arena). 5 See Vito Tanzi, Taxation in an Integrating World (Washington, DC: Brookings Institution, 1995) at 17–31 (discussing lessons from the American experience for global tax integration). Tim Edgar, Lesson from Federalism for Tax Competition (2003) 51:3 Canadian Tax Journal 1079. 6 Since labour is generally immobile in the international context, the models hold labour immobile and focus on the competition for mobile factors such as investment goods. See John H. Beck, ‘Tax Competition: Uniform Assessment and the Benefit Principle’ (1983) 13 J. Urban Econ. 127 (describing how local government competition for investments leads governments in some circumstances to impose taxes on business property that are less than the cost of providing goods to the businesses). 7 See, e.g., Joel Slemrod, ‘Tax Cacophony and the Benefits of Free Trade,’ in

Notes to pages 162–4 225

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Fair Trade and Harmonization: Prerequisites for Free Trade?, ed. Jandish Bhagwhati and Robert E. Hudec (Boston: MIT Press, 1996). Hans-Werner Sinn, ‘Tax Harmonization and Tax Competition in Europe’ (1990) 34 European Economic Review 489, as excerpted in Michael J. Graetz, Foundations of International Income Taxation (New York: Foundation Press, 2003) at 533. ‘Taxation Without Coordination’ (2002) 31 Journal of Legal Studies 61 at 78. See, e.g., Assaf Razin and Efraim Sadka, International Tax Competition and Gains from Harmonization, NBER Working Paper 3152 (Cambridge, MA: National Bureau of Economic Research, 1989); Enrique G. Mendoza, The International Macroeconomics of Taxation and the Case Against European Tax Harmonization, NBER Working Paper 8217 (Cambridge, MA: National Bureau of Economic Research, 2001). See John D. Wilson and David Ed. Wildasin, ‘Capital Tax Competition: Bane or Boon’ (2003) 88:6 Journal of Public Economics 1063. For another recent review, see Hans-Werner Sinn, The New Systems Competition (Oxford: Blackwell Publishing, 2003). For criticism of the OECD approaches, see Alex Easson, ‘Harmful Tax Competition: An Evaluation of the OECD Initiative,’ (2004) 34 Tax Notes International 1037. See OECD, Towards Global Tax Co-operation: Progress in Identifying and Eliminating Harmful Tax Practices (Paris: OECD, 2000) at 15. With respect to taxpayers who benefited from harmful regimes that were in place on 31 December 2000, the benefits that are derived are to be phased out by 31 December 2005. Ibid. If harmful measures are not eliminated by the deadline, then OECD countries are permitted to take defensive measures to counteract the effects of the harmful measures. Ibid. at 16. Ibid. at 19 See OECD, Progress in Eliminating Harmful Tax Practices (Paris: OECD, 2000); OECD, Harmful Tax Competition: An Emerging Global Issue (Paris: OECD, 1998). See Alan J. Auerbach and James Poterba, ‘Why Have Corporate Tax Revenues Declined?,’ in Tax Policy and the Economy, vol. 1 (Cambridge, MA: MIT Press, 1987) at 1, 20 (concluding that domestic legislative changes as well as, more importantly, a decline in corporate profits have contributed to lower corporate revenues). See also Roger H. Gordon and Joel Slemrod, ‘Do We Collect Any Revenue from Taxing Capital Income?,’ in Tax Policy and the Economy, vol. 2, ed. Lawrence H. Summers (Cambridge MA: MIT Press, 1988) at 89, 120 (arguing that the different methods of taxing capital income lead to arbitrage opportunities that reduce revenues).

226 Notes to pages 164–6 17 See Stephen Woolcock, The Single European Market: Centralization or Competition among National Rules (London: European Programme at the Royal Institute of International Affairs 1994) at 8. 18 See Kenneth McKenzie and Aileen J. Thompson, Taxes, the Cost of Capital, and Investment: A Comparison of Canada and the United States (Ottawa: Technical Committee on Business Taxation, Working Paper 97-3, 1997) at 14 (concluding that convergence is mainly attributable to a convergence in real interest rates). See also Kenneth J. McKenzie and Jack Mintz, ‘Tax Effects on the Cost of Capital,’ in Canada-U.S. Tax Comparisons, ed. John B. Shoven and John Whalley (Chicago: University of Chicago Press, 1992) at 207 (noting that the convergence may not have been deliberate). 19 See Robin W. Boadway and Neil Bruce, ‘Pressures for the Harmonization of Income Taxation between Canada and the United States,’ in Canada-U.S. Tax Comparisons, ed. Shoven and Whalley, at 69. 20 Geoffrey Hale, The Politics of Taxation in Canada (Peterborough, ON: Broadview Press, 2002) at 295. 21 See, e.g., Linda McQuaig, ‘History of Tax Reform Purged of Class Warfare and Drama’ (2002) 50:6 Canadian Tax Journal 2045; Colin Campbell, ‘Budget Surplus, Democratic Deficit’ (2002) 50:6 Canadian Tax Journal 2029. 22 The Impact of NAFTA and Options for Tax Reform in Mexico (Atlanta: Georgia State University International Studies Program, Working Paper 01-2, 2001) at 13. 23 Robert J. Patrick, ‘Comments on U.S. Tax Structures and Competitiveness’ (1998) 41 National Tax Journal 343 at 343; Charles McLure, Jr, ‘International Considerations in United States Tax Reform,’ in Influence of Tax Differentials, ed. Vogel, at 2 (discussing the pressures that influenced U.S. policy changes). 24 See Department of the Treasury, The Problem of Corporate Tax Shelters, Discussion, Analysis and Legislative Proposals (Washington, DC: Department of the Treasury, 1999). 25 See Office of Tax Policy, Department of the Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study (Washington, DC: Department of the Treasury, 2000). 26 The two works referred to are Brian Arnold, Taxation of Controlled Foreign Corporations: An International Comparison, Canadian Tax Paper No. 78 (Toronto: Canadian Tax Foundation 1986) and Daniel Sandler, Tax Treaties and Controlled Foreign Company Legislation: Pushing the Boundaries, 2nd ed. (The Hague: Kluner Law International, 1998). 27 See James A. Baker, ‘The Momentum of Tax Reform,’ in Tax Policy in the Twenty-First Century, ed. Herbert Stein (New York: Wiley, 1988) at 1, 6.

Notes to pages 167–71 227 28 Roger B. Myerson, Game Theory: Analysis of Conflict (Cambridge: Harvard University Press, 1991) at 1. 29 For a literature review, see Richard M. Bird and Jack M. Mintz, ‘Sharing the International Tax Base in a Changing World,’ in Public Finance and Public Policy in the New Century, ed. S. Cnossen and H. Sinn (Cambridge: MIT Press, 2003) at 405, 407 (noting that game theory does not fully explain international tax policy developments to date, nor does it offer a clear guide for future developments). 30 See Thomas Flanagan, Game Theory and Canadian Politics (Toronto: University of Toronto Press, 1998). 31 These views draw from an earlier work by the author. See Arthur J. Cockfield, ‘Tax Integration under NAFTA: Resolving the Conflict between Economic and Sovereignty Interests,’ (1998) 34 Stanford Journal of International Law 39 (drawing lessons from the literature on international relations theory for international tax policy). See also Charles E. McLure, Jr, ‘Globalization, Tax Rule, and National Sovereignty,’ (2001) 55 Bulletin for International Fiscal Documentation 586 (distinguishing among types of restraints on sovereignty); Walter Hellerstein, ‘Jurisdiction to Tax Income and Consumption in the New Economy: A Theoretical and Comparative Perspective,’ (2003) 38 Georgia Law Review 1 (examining the political aspects of different tax reform efforts). 32 For discussion of subgame perfect equilibria in the context of pricing strategies, see Debabrata Datta and Jaideep Roy, Undercut-Proof Subgame Perfect Equilibrium of a Pricing Game (Copenhagen: University of Copenhagen, Institute of Economics, Discussion Paper no. 01-04, 2001). 33 See Andre Fourcans and Thierry Warin, Tax Harmonization versus Tax Competition in Europe: A Game Theoretical Approach. Montreal: Centre for Research on Economic Fluctuations and Employment, Working Paper No. 132, 2001. 34 For discussion, see Daniel Shaviro, ‘Some Observations Concerning Multijurisdictional Tax Competition,’ in Daniel Esty and Damien Geradin, eds., Regulatory Competition and Economic Integration: Comparative Perspectives (Oxford: Oxford University Press, 2001) at 49. 35 See Thomas C. Heller, Regionalism in Europe, North America and East Asia (Berlin: German-Japanese Centre 1996) at 60, 63, 66. 36 See John D. Wilson, Tax Competition with Interregional Differences in Factor Endowments. Discussion Paper No. 4. Kingston, ON: John Deutsch Institute, 1990. 37 See Wilson and Wildasin, ‘Capital Tax Competition: Bane or Boon,’ at 1078. 38 See Bird and Mintz, ‘Sharing the International Tax Base in a Changing World,’ at 417.

228 Notes to pages 172–80 39 For discussion, see Tim Edgar, ‘Corporate Income Tax Coordination as a Response to International Tax Competition and International Tax Arbitrage’ (2003) 51 Canadian Tax Journal 1097. 40 S. 894(c) of the Internal Revenue Code denies treaty benefits in the context of the use of U.S. LLCs interposed between foreign parents and U.S. subsidiaries. Treasury Regulation s. 1.894–1(d)(2)(ii) was passed to counter the use of so-called domestic reverse hybrids and recharacterizes interest and royalty payments as dividend distributions. 41 For discussion, see Mitchell A. Kane, ‘Strategy and Cooperation in National Responses to International Tax Arbitrage’ (2004) 53 Emory Law Journal 89. Chapter 11 Recommendations 1 See Victor Thuronyi, ‘International Tax Cooperation and a Multilateral Treaty’ (2001) 26 Brooklyn Journal of International Law 1641 (discussing how a gradual movement towards multilateral tax treaties could be accomplished, including through the development of multilateral regional tax treaties); Diane M. Ring, ‘Commentary: Prospects for a Multilateral Tax Treaty’ (2001) 26 Brooklyn Journal of International Law 1699 (discussing different processes to promote multilateral treaty negotiations). 2 But see H. David Rosenbloom, ‘Sovereignty and the Regulation of International Business in the Tax Area’ (1994) 20 Canada–United States Law Journal 267 at 270 (‘Although there is near unanimous at the level of principle [concerning the negotiation of multilateral tax treaties], in practice and administration it is virtually impossible to pass beyond the bilateral level’). There has been discussion on efforts to multilateralize the OECD model tax treaty; see Michael Lang et al., Multilateral Tax Treaties: New Developments in International Law (The Hague: Kluwer International, 1997) (reviewing the advantages and disadvantages of multilateral tax treaties). 3 See, e.g., Sylvain Plasschaert, ‘An EU Tax on the Consolidated Profits of Multinational Enterprises’ (1997) 37 European Taxation 2 at 7; Arthur Cockfield, ‘Formulary Taxation versus the Arm’s Length Principle: The Battle among Doubting Thomases, Purists and Pragmatists’ (2004) 52 Canadian Tax Journal 114. 4 Convention 90/436/EEC on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises (1995) 95 Tax Notes International 78-16. 5 Article 5 of the Parent-Subsidiary Directive indicates that payments of dividends are not subject to withholding taxes in the host country. In order to further alleviate double taxation, article 4 indicates that each European

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country must either exempt dividends received from tax or grant foreign tax credits. The NAFTA countries already offer this second type of tax relief through their domestic tax systems and through the three bilateral tax treaties. It may make more sense to use a threshold as low as 10 per cent. This is the ownership threshold required for ‘foreign affiliates’ under the Canadian Income Tax Act in order for companies of tax treaty partners to enjoy relief from taxation of dividends of profits realized from active business income. The most serious disharmony results from Canada’s refusal to extend its dividend tax credit to non-residents. Canadians may wish to consider extending the credit to their NAFTA partners through the multilateral tax treaty (in a similar manner to the United Kingdom, which offers shareholder relief to certain treaty partners). The Canadian government may be reluctant to take this step. Withholding taxes on deductible payments such as interest, rents, and royalties raised almost Can$1.7 billion in 1995. The United States collects less significant amounts from Canada and Mexico. In 1990, the United States collected approximately US$2.2 billion in withholding taxes from investment income. Only US$111 million, however, came from Canadian investors. See SOI Bulletin, vol. 12 (Spring 1993), 124. See Jack M. Mintz, ‘Withholding Taxes on Income Paid to Nonresidents: Removing a Canadian-US Border Irritant,’ C.D. Howe Institute Backgrounder (5 March 2001) (estimating that the Canadian annual revenue loss of almost $2 billion attributable to eliminating withholding taxes would be offset by an increase of $28 billion in capital and an income gain of over $7.5 billion to Canadians); ‘PriceWaterhouseCoopers Says Reduce Withholding on Cross-border Interest,’ 2001 TNT 159-21 (concluding that a zero-rate interest withholding tax in the Canada-U.S. tax treaty would benefit the U.S. economy). See, e.g., Catherine Brown and Christine Manolakas, ‘Organizations, Reorganizations, Amalgamations, Divisions and Dissolutions: Cross-Border Assets, Double Taxation and Potential Relief under the U.S.-Canada Tax Treaty’ (1997) 26 Georgia Journal of International and Comparative Law 311 (discussing some of the areas where double taxation relief is unavailable through the Canada-U.S. tax treaty). See Michael McIntyre, ‘Commentary, The Design of Tax Rules for the North American Free Trade Alliance’ (1994) 49 Tax Law Review 769 at 786-9 (discussing the merits of moving towards a case-by-case approval process).

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Index

Accounting, 113 Advanced pricing agreements, 41, 179 Affiliate, foreign, 38 Alaska, 36 Alberta: collection, 35; flat tax, 89; tax reform, 95 Arbitration: transfer pricing, 60, 110, 149, 179 Arnold, Brian, 61 Assets tax (Mex.), 52, 59 Australian Tax Office, 131 Bird, Richard, 151, 157 Boadway, Robin, 29 Brain Drain, 29 Brown, Catherine, 58 Bruce, Neil, 29 California, 36 Canada: compared to NAFTA partners, 121–3; cultural identity, 125; relations with U.S., 125; tax policy with U.S., 164, 170–1; trade and investment with NAFTA partners, 13–14, 69–72 Canada Revenue Agency, 40, 41, 64, 130, 133, 138

Canada-U.S. Free Trade Agreement, 18, 116 Canadian Controlled Private Corporations, 31 Capital export neutrality, 20, 38–9 Capital gains, 23, 181 Capital import neutrality, 20, 38–9 Capital market: impact of technology, 129; U.S.-Canada integration, 85, 87–8 Capital taxes, 93 Chen, Duanjie, 82, 83, 165 Civil law, 19 Classical system, 30–1 Common law, 18 Consolidated tax base, 32, 112–13, 152, 157, 176, 178 Controlled Foreign Corporations, 43–4, 166 Customs Union, 12, 73, 105–8, 118 Democratic deficit, 165, 167, 187 Directive: interest and royalty, 110, 113; merger, 109, 113, 181; parent-subsidiary, 109–110, 113, 180 Dividend: parent/subsidiary, 62,

246 Index 179–80; repatriation, 97; tax distortions, 96; U.S. tax reform, 91–9 Double taxation: defined, 17; 37; relief from, 37–9, 176, 178–9; treaty limitations, 63–4 Easson, Alex, 110 E-commerce: tax challenges, 129–39, 182, 187 Equity: inter-nation, 21; vertical, 21 Euro, 112 Europe: compared to NAFTA, 127, 151–2; economic integration, 105– 8; European Companies, 113; tax harmonization; 108–10, 114–16; tax reform, 108–16 European Court of Justice, 106–7, 113–14, 118–19, 127, 152 European Monetary Union, 112 Excess credit, 97 Exports, 13–14 Extranet, 183 Fast track approval, 125 Fiscal needs, differences among NAFTA countries, 18–19, 120–2 Flat tax, 91; Alberta, 89; as consumption tax, 89 Free trade area, 12, 73, 116–18, 139, 187 Free Trade Commission, 119 Foreign Direct Investment, 14, 56, 69–74, 80, 88; importance of, 69– 70; influence of taxes on, 73–4; total to NAFTA countries, 70–2 Foreign tax credit, 20, 38–9, 63, 97 Formulary taxation, 156–57, 178 Game theory, 5, 188; definition, 167;

models, 167; observations on NAFTA tax competition, 167–74 General Agreement on Tariffs and Trade (GATT), 46, 47, 154 Globe and Mail, 89 Goods and Services Tax, 12, 35, 44, 48, 90, 134–9, 149–50, 182, 187 Gordon, Robert, 30 Haig-Simons: definition of income, 23 Harris, Neil, 61 Heller, Thomas, 171 Immigration, Canada to U.S., 29; Mexico to U.S., 117; NAFTA rules, 28–9 Income taxes: Canada, 30–1, 92–3; corporate, 23, 29–33, 111, 146, 180, 185–6; individual, 18–19, 23– 8, 117; Mexico, 31, 91, 166; rates, 93, 101, 111; revenues from, 90; United States, 30, 93 Information exchange, 60, 94, 134, 140, 182–3 Internal Revenue Service, 40, 41 Kemp Commission, 89 Krishna, Vern, 49 Lahey, Kathleen, 28 Law and society, 152 Lessig, Lawrence, 140 Ley, Eduardo, 30 Maquiladoras, 34, 82, 165 Marginal effective tax rates: limitations with studies, 77–9; studies of Canada and U.S., 80–2, 94; studies of all NAFTA countries,

Index 247 82–4; theory of, 76–7; versus average taxes, 75–6 Martinez-Vazquez, Jorge, 83, 165 McDaniel, Paul, 33, 156 McKenzie, Kenneth, 80–1, 82 McNulty, John, 91 Mexico: compared to NAFTA partners, 121–3; reasons to enter NAFTA, 117–18; relations with U.S., 126; tax policy constraints, 165; tax reform, 22–3; trade and investment with NAFTA partners, 13–14, 69–72 Mintz, Jack, 23, 80–1, 151 Multijurisdictional disclosure system, 88 Neumark, Fritz, 108 North American Free Trade Agreement (NAFTA): antidumping rules, 119; comparisons of countries, 121–4; countervailing duties, 119; dispute resolution, 119; institutions, 118–20, 139; investment rules, 11–12; immigration laws, 12, 29; motives to negotiate, 116–18; rules of origin, 73; sense of community, 19, 126; side agreements, 117; tax rules, 46– 9; Tax Working Group, 176; trade within, 13–14 OECD: e-commerce tax reform, 131; harmful tax competition project, 34, 148, 163, 181; model tax treaty, 51, 131; transfer pricing guidelines, 39, 41 Ontario, 35 Partial integration system, 30–1, 32

Polanyi, Karl, 4, 145, 188 Portfolio Investments, 14, 32, 56, 140 Prado, Gustavo, 31 Principles, international tax, 20–1, 150–1 Privacy, 141 Public choice theory, 161 Quebec, 19, 35 Reform: Canada, 92, 95, 99–101; NAFTA countries tax, 22–3; Europe, 105–16; United States, 90–1, 92, 124–5, 165–6 Registered retirement savings plans, 28 Regulatory emulation, 5–6, 87, 100–1, 164–6, 185 Reorganizations, corporate, 57–8, 179, 180–1 Roin, Julie, 162 Royal Commission on Taxation, 89 Ruding, Onno, 110 Ruding Committee, 16, 32, 110–12, 146–7, 162, 177 Securities laws, 88 Server, 130–3 Services, tax on, 47–8, 82–3 Shoven, John, 84–5 Sinn, Hans-Werner, 162 Slemrod, Joel, 63 Sovereignty: Canada, 116, 125–6, 164; costs under different tax policy approaches, 154–7, 165, 170, 171–3; driver of international tax policy, 150–1, 185, 187; ecommerce tax concerns, 134, tax, 18–19, 152–3; Mexico, 117–18, 125–6, 164; European, 111–12;

248 Index provincial/state tax, 37, 158; need to reform non-tax laws, 124, 157; tax, 18, 99, 120–6; United States, 117, 124–5, 164 Streamlined Sales Tax Project, 36, 137–8, 139 Subnational tax, 155–6; Canada, 35, 95, 150; competition, 35–6, 161; constitutional constraints, 156, 158; Mexico, 36; United States, 35– 6, 137–8, 150, 182 Subsidiarity, 107, 111 Tanzi, Vito, 161 Tax arbitrage, 16–17, 99, 124, 148–9, 170, 172, 186 Tax avoidance, 41–4, 58–9, 60, 166, 183 Tax burdens: average, 75–6; Canada, 125; marginal, 75–6, 94 Tax competition, 16, 39, 99–100, 111–12, 126, 170–1, 187; game theory, 167–73; harmful, 16, 33–4, 112, 147–8, 160–3, 181; subnational, 160–2; theories on, 161–3 Tax compliance, 20, 79, 138, 140, 178, 182–3 Tax coordination, 21; in free trade area, 139; multilateral, 157–8, 172, 175–7, 182–3, 188; via tax treaties, 49–52, 172, 177 Tax discrimination, 16, 31–2, 34, 52, 59, 95, 149 Tax distortions, 15, 32, 49, 65, 80, 108, 110–16, 120, 146–7, 154, 176–7 Tax expenditures, 33–4, 147–8, 181 Tax harmonization, 4, 29, 31, 35–7, 49, 120–6, 127, 155–6, 162, 180, 188; European, 108–10, 114–16

Tax haven, 44, 140 Tax planning, 37, 39, 78, 92, 97–9, 124, 132–3; debt financing, 97, 171 Tax rates: calculating, 77; corporate, 30; marginal effective, 76–7, 94; withholding, 95 Tax revenues: NAFTA countries, 121, 123 Tax treaties: business profits, 54–5, 129; capital gains provisions, 57; dividend provisions, 55, 179–80; double taxation, 17–18; enforcing tax claims, 60; exchange of information provisions, 60; history, 50–2; interest provisions, 56, 180; limitations with, 61–5, 149, 154–5, 177; mutual agreement provisions, 59–60; North American, 49–65; purpose of, 49–51; reorganization provisions, 57–8, 181; relationship to NAFTA, 49; residence, 52–3; royalties, 57, 180; trilateral negotiations, 61, 156, 177 Thin capitalization, 42–3, 98, 114 Tiebout, Charles, 161 Trade: within NAFTA, 13–14; taxes on, 12, 33, 34, 35, 46–7, 63, 73, 149–50 Transfer pricing, 39–41, 63–4, 98–9, 148–9, 178–9, 183 Treaty of Rome, 106–8, 113–14 Trebilcock, Michael, 120 United Nations: human development index, 121 United States: compared to NAFTA partners, 121–3; disproportionate tax impact, 14, 71, 88, 99, 101–2, 125, 164; investment with NAFTA partners, 14, 88; tax competition

Index 249 concerns, 164, 166; trade and investment with NAFTA partners, 13–14, 69–72; trade negotiation, 125; views of e-commerce tax, 130 Vaillancourt, François, 36–7 Value-added tax (VAT): Mexican, 12, 36, 44, 48, 90, 134, 137, 149, 182;

European Union, 108, 114–16, 137 Wall Street Journal, 89 Westphalian nation, 152 Withholding taxes: explained, 55, 95; Mexican reform, 55–6; proposals to reduce rates, 179– 80; rates, 55–7; 62, 95, 172, 186 World Trade Organization, 34