Enhancing the Competitiveness of Canada’s International Tax System (Part 9)

By: Wally Conway

A New Approach to Tax Base Protection

The Canadian Income Tax Act includes certain provisions commonly referred to as the base erosion rules. These are rules are intended to prevent the shift of Canadian income to foreign jurisdictions by having a Canadian company establish a foreign affiliate. The foreign affiliate is to serve as a captive property procurement, insurance, financing or services company in a manner whereby a Canadian resident (usually the Canadian company or non-arm’s length person) incurs deductible charges from the affiliate and the resulting income is taxed in a foreign jurisdiction, often at a lower tax rate.

The Advisory Panel on Canada’s System of International Taxation in its December 2008 final report noted that Canada’s current base erosion rules are considered by many Canadian businesses as being too broad and prevent them from taking full advantage of global supply chains they have built up to support their global operations.

As Canadian companies expand globally, they acquire intellectual know-how, service and manufacturing capabilities in foreign jurisdictions, that they want use globally, in the most productive and cost-efficient manner possible. Providing their Canadian operations with access to such acquired capabilities, even in a manner that meets accepted transfer pricing guidelines, can run afoul of Canada’s base erosion rules.

Conceptually, base erosion rules should not apply to income that is derived by a foreign affiliate from active business operations carried on in a permanent establishment in a foreign country. Otherwise, the result is that such foreign active business income is inappropriately included in foreign accrual property income (FAPI) of the affiliate. This is contrary to the tax policy underlying the foreign affiliate rules. It also precludes such foreign affiliates from competing in the Canadian market place and the Canadian market place from benefiting from that competition.

The Advisory Panel recommended that the scope of Canada’s base erosion rules be reviewed to ensure they do not impede bona fide business transactions and the competitiveness of Canadian businesses.

A number of countries, including Australia and even the U.S., have or are considering the scope and necessity of their base erosion rules.  More recently, the UK has stated that its CFC rules will only include profits that have been artificially diverted from the UK.

In the March 29th federal budget, the government promised that amendments would be made to the base erosion rules to alleviate the tax cost to Canadian banks of using excess liquidity of their foreign affiliates in their Canadian operations as well as ensuring certain securities transactions undertaken in the course of a bank’s business are not inappropriately caught by these rules.

This is a very positive development for foreign operations of Canadian banks and a step in the right direction in re-evaluating Canada’s base erosion rules. But more work is needed to ensure that the global operations of Canadian companies in other industries are also not adversely affected by Canada’s base erosion rules.