Section 899 imposes countermeasures to DST and undertaxed profits rule
Executive summary
A proposed U.S. tax measure, section 899, could significantly impact Canadian businesses and investors with U.S. ties. Introduced in response to what the U.S. deems "unfair foreign taxes", the legislation outlines potential tax hikes, including increases of withholding tax. As the proposal advances through the U.S. legislative process, taxpayers may need to reassess their cross-border structures and tax planning strategies.
Contained in the One Big Beautiful Bill, the U.S. budget bill, is a proposal for a new section of the tax code with potentially costly implications for Canadian businesses earning income from U.S. business activity and Canadian investors earning income from U.S. investments.
The proposed section 899 would levy retaliatory action when a foreign country imposes "unfair foreign taxes", defined as digital services taxes (DSTs), the Pillar II undertaxed profits rule (UTPR) and any other discriminatory or extraterritorial tax determined to disproportionately impact U.S. companies and individuals and other entities.
Canada has imposed a DST and has proposed to impose the UTPR, which could become effective for financial years starting on or after Dec. 31, 2024. Therefore, Canadian companies who receive income from the U.S. may see an increase in U.S. taxes from section 899 if Canada does not take action to exclude U.S. companies and individuals from the scope of the DST and UTPR.
Planning for section 899
- Companies should consider revisiting how their U.S. activities and investments have been structured and consider modifying intercompany payments to provide lower tax options.
- Where section 899 results in higher taxes, foreign tax credits may be used to offset the cost. Intended to prevent double taxation, foreign tax credits decrease the Canadian tax payable on income that was taxed first in a foreign country. The credit is generally equal to the amount of foreign income or profits tax actually paid meaning documentation of paying foreign taxes is important to retain. Though these credits can be carried over between years, they are non-refundable and cannot reduce Canadian tax payable for a year to less than zero. Planning opportunities may exist to maximize utility of these credits.
- Ensure cross-border agreements address the person liable to pay withholding tax, with the possibility of increased withholding taxes.
Proposed changes
Section 899, titled Enforcement of Remedies Against Unfair Foreign Taxes, proposes to increase:
- The withholding tax on interest, dividends, rents, and royalties by 5 per cent every year the Canadian "discriminatory" tax is in effect, with a maximum rate of 50 per cent (20 per cent above the statutory rate).
- The tax rate applicable to income that is effectively connected with a trade or business in the U.S. (ECI), and income from the disposition of U.S. real property which is treated as ECI.
- The branch profits tax rate imposed on deemed remittances to Canadian companies from U.S. branches.
It would also expand the scope of the base erosion and anti-abuse tax (BEAT) by removing the gross receipts and base erosion thresholds, making the tax applicable to mid-sized Canadian companies with U.S. affiliates and U.S. corporations used in investment structures to block attribution of ECI.
The legislation would be applicable to any individual or foreign corporation (other than a controlled foreign corporation (CFC) or other United-States owned foreign corporation) that is tax resident in a country which has a DST, UTPR, or other "discriminatory" tax in force which is applicable to U.S. persons and CFCs. It would also apply to foreign corporations organized in a country which does not have a DST, UTPR, or other "discriminatory" tax (and U.S. corporations with respect to the BEAT) if they are 50% owned (directly or indirectly) by persons that are resident in a jurisdiction which has in force a DST, UTPR, or other "discriminatory" tax. Proposed section 899 would also apply to non-corporate entities, including foreign partnerships and certain trusts.
Undertaxed profits rule and Canada
In 2024, Canada enacted the Global Minimum Tax Act (GMTA) based on recommendations from the Organisation for Economic Co-operation and Development to ensure large multinational enterprises (MNEs) pay at least a 15 per cent effective tax rate on income earned in every country they do business. The GMTA was enacted without the UTPR, but the Canadian government has proposed to amend the act to include this rule.
The UTPR would apply a top-up tax where entities within an MNE group are still undertaxed relative to the minimum tax rate, acting as a backstop to other rules in the GMTA. The concern with the UTPR is its extraterritoriality. It is effectively applicable where the home country of the MNE does not apply Pillar II, as is the case in the U.S., and considers the entire MNE group even if only a subsidiary is located in a low-tax jurisdiction.
Digital services tax and Canada
Canada's Digital Services Tax Act (DSTA) became effective June 28, 2024 and applies retroactively to revenues from Jan. 1, 2022. It has been introduced as an interim measure to protect Canada's tax base as countries await an OECD agreement on tax challenges arising from a digital economy.
The DSTA imposes a 3 per cent tax on digital services revenue earned by corporations who meet certain revenue thresholds. It has been argued these high minimum revenue thresholds of the DSTA would capture many US digital service providers while excluding most Canadian competitors. In a February executive order, President Trump asked the U.S. Trade Representative to determine how to pursue the next step in its current dispute with Canada regarding the DSTA under the Canada-United States-Mexico trade agreement.
Section 899—impact on Canada
Unless Canada chooses to repeal the DSTA, Canadians are likely to see higher taxes with respect to their U.S. operations and income received from U.S. entities. Where U.S. taxes do increase, companies may be able to leverage foreign tax credits to proportionally decrease their Canadian taxes.
The interaction of this legislation with the Canada-U.S. tax treaty will be determinative of the legislation's impact on withholding taxes and taxes imposed on ECI. Canada's tax treaty with the U.S. lowers the withholding tax rates otherwise imposed on dividends, interest, and royalties to rates between 0 per cent to 15 per cent, depending on the type of income and ownership. The treaty also decreases the branch profits tax rate and provides certain benefits that may reduce the amount of ECI subject to the branch profits tax.
Though an explicit override of the treaty has been removed from the version of the proposed legislation that passed the House and is now under consideration in the Senate, the legislation still contains a provision that would likely allow section 899 to increase the reduced rates in the treaty. However, it is unclear how section 899 will interact with the treaty provisions which provide exemptions based on the status of the Canadian resident (e.g., the exemption for ECI which is not attributable to a U.S. permanent establishment and exemptions on dividends and interest received by exempt organizations and certain registered plans).
As Canadian companies receiving income from the U.S. plan for a potential increase to their taxes payable, they will need to consider these uncertain times when evaluating the benefits and costs of long-term changes.
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