Canada: Corporate Canada Beware – Our Neighbors Want To Change The Tax Rules Of The Game

This fall, the Republican Party rolled out tax reform proposals aimed at simplifying the U.S. tax code and making it more competitive to attract corporate business. Some of these draft proposals will inevitably impact Canadian commerce by swinging the tax pendulum in favor of doing business south of the border. Although the framework does not come with any dates for its implementation and is subject to further amendments, no business operating in a cross-border economy can afford not to evaluate and prepare for their enactment. Since the tax reform plan is likely to impact Canadian companies doing business in the U.S., those looking to do business there, or U.S. companies investing in Canada, we have summarized some of the  proposed measures that Canadian businesses should evaluate.

First, the framework is aiming at reducing the U.S. corporate tax rate from 35 per cent to 20 per cent. For many years, Canada has had the upper hand in exploiting corporate tax rates, but the aggressive and far-reaching corporate rate cuts will surely reflect a paradigm shift to attract business. Reducing its corporate tax rate below Canada's will likely change how businesses are structured going forward. Moreover, corporate buyouts and mergers between large U.S. and Canadian based corporations could diminish in volume. Some of these mergers, referred to as corporate inversions, are designed to reduce a company's overall global tax rate. Since the tax advantage of such deals is significantly diminished, the incentives  for large American based multinationals to consolidate their head offices in Canada may be reduced.

Another major change may allow companies making investments in certain depreciable assets (other than structures) to be directly written off (i.e., immediately expensed for tax purposes) for the next five years. Canadian companies planning on making large capital expenditures might find it more tax-efficient to do so through their U.S. based corporate subsidiaries. This would enable them to claim an up-front substantial deduction, instead of deducting the cost over several years. Similarly, American companies considering expanding their operations might eliminate Canada as a potential hub, since business expansions typically require large capital expenditures that could be accomplished in a more tax-effective manner in the U.S.

Also, the tax proposals contain a provision to limit the interest deductions of a corporation to 30 per cent of its taxable income. It is difficult to predict how significant such a proposal might become since the process for limiting interest deductibility has yet to be determined. However, on the surface, the limitation's effect might give rise to double taxation. For example, many Canadian companies have heavily leveraged themselves to expand into the U.S. and/or to acquire American subsidiaries. Historically, it made sense for the interest on such loans to be deductible in the U.S. subsidiary, since the U.S. corporate rate was higher and larger tax savings were achieved. Accordingly, the proposed interest deduction changes may require revisions to a group's Canadian and U.S. capital and funding structure.

Other International Tax Reform Repercussions

Under current law, there are no incentives for U.S. companies to repatriate after-tax retained earnings from their foreign subsidiaries, since the U.S. parent could be subject to additional taxes if the corporate tax rate of the subsidiary is less than the U.S. corporate rate. The current U.S. rules made it much more advantageous for foreign subsidiaries to keep their profits outside the U.S. and defer taxes for as long as possible, while still being able to use the funds for expansion outside the U.S. The proposed rules intend to revamp how global profits can be repatriated, tax free, to the U.S. Going forward, it may be possible to exempt dividends received by U.S. parent companies from their foreign subsidiaries, if certain conditions are met. To be exempt, the parent company must own at least 10 per cent of the foreign subsidiary for a certain period of time.

In order to make this transition, a one-time tax (payable over several years) will be imposed on the offshore accumulated earnings of the U.S. companies at time of change, presumably as of late 2017. The rate of the transition tax still needs to be finalized, but could range from 5 per cent to 14 per cent. Is it reasonable to expect these proposals to incentivize U.S. corporations to repatriate profits and cash amassed abroad, since the levy of a one-time tax on accumulated earnings would be at rates much lower than the current U.S. tax rate of 35 per cent. Whether the fact that substantial profits could be repatriated to the U.S. will mean that Canadian subsidiaries will have less cash to reinvest domestically in plants and working capital is uncertain. If this is the case, the reform may negatively impact the Canadian economy.

Other international tax reform proposals include a minimum tax ranging from 10 per cent to 12.5 per cent on deemed U.S. foreign subsidiary profits relating to intangibles (intellectual property income) and the ability to repatriate on a tax-free basis foreign based intangible assets back to the U.S. The measures are aimed at providing an incentive to secure intellectual property profits and assets within the U.S.

Canadian businesses should also be aware that under the proposed changes, the cost that U.S. buyers might incur on certain transactions with Canadian-related parties could be greater and might ultimately cut into a Canadian vendor's profit margin. More specifically, the new proposals include a 20 per cent U.S. excise tax on certain payments, or would require a Canadian company to elect to file a U.S. tax return to include such income.

The U.S. tax reform proposal aims at significantly lowering tax revenues by reducing the U.S. corporate tax rate, allowing for immediate write-offs of certain capital expenditures, and revising international tax reform rules to eliminate U.S. tax on foreign income received from certain foreign subsidiaries. It is envisioned that these tax reductions will be financed through reduced interest deductions, larger corporate and personal incomes reported domestically, the one-time transition tax on foreign earnings, and significant new anti-base erosion rules that apply to US corporations with foreign subsidiaries.

Given these measures and the possibility that NAFTA will be unraveled, businesses will need to review their tax structures and business practices in order to stay competitive and tax efficient. Should the Trump administration amend its U.S. tax code as described above, the Canadian Government must institute policies and tax measures which focus on remaining competitive with our largest trading partner.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Karyn Lipman, BComm, CPA, CA
Adam Gur
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