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Treasury & Taxation

A Double Canadian Tax Arrangement Coming Soon?

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July 24, 2018

With US tax reform, Canada will have to take proactive measures to protect its tax base

IRS and dollarUS tax reform’s 14% corporate-rate cut will all but certainly reduce the likelihood US companies will choose inversions to countries with lower rates, and while the change is unlikely to draw full-blown inversions to the US, companies should reconsider their cross-border configurations—especially with Canada.

US reform fits into a global trend, as countries seek to attract companies. The average 25% rate comprising federal and state taxes puts the US slightly below the average of the top 30 countries in terms of GDP and slightly above the OECD average. For other countries, especially neighboring ones like Canada, the US’s biggest trading partner, the more important change may be less its southern neighbor’s more attractive tax rate, and more its own relatively less attractive one.

That may be semantics, but Canada’s significantly lower 26% average rate, comprising national and provincial taxes, made it highly competitive jurisdiction pre-US reform to locate profitable operations.

“Now countries that can match the US on factors such as education, infrastructure and access to markets, and used to rely on their tax advantage, can no longer do that,” said Cathy Koch, Ernst & Young’s Americas tax policy leader. “[Canada is] going to have to think about that now. And the closer geographically to the US—the easier it would be for companies to relocate into the US.”

Michael Kandev, a partner at Davies Ward Phillips & Vineberg, noted countries with significantly smaller economies than the US’s have drawn corporate attention by offering low corporate tax rates; for example, 12.5% for Ireland.

“So that’s something Canada must ponder,” Mr. Kandev said, adding he believes it unlikely that the current Canadian government would take that route.

Now that Canada is somewhat tax disadvantaged, a merger between Canadian and US companies may prompt management to reconsider the historical tendency to place as few profit-generating functions as possible in the US, where they were formerly subject to a very high tax rate.

Besides the lower corporate rate, US tax reform has provisions that make setting up shop in the US even more attractive in certain situations. The new deduction for foreign-derived intangible income (FDII), for example, effectively lowers the tax rate to 13.125% for US companies generating income from products and services sold to foreign markets.

Additionally, companies with cross-border operations may want to reconsider where they take the wide variety of deductions available to them, since the US no longer has the higher corporate rate where deductions are most effective. If a company decided it is more tax effective to move intercompany items generating deductions into Canada, that typically means its assets generating that income, such a fee to use intellectual property or a management fee, would be located in the US, where taxes are lower.

“Canada is on the front line for this, since it is so dependent on bilateral trade with the US,” said Paul Seraganian, managing partner, Osler Hoskin & Harcourt.

US tax reform also upsets the transfer-pricing norms that companies in the US and Canada have gotten used to. As a high-tax jurisdiction, the US was under significant pressure, both fiscally and administratively, to protect its tax base from the myriad deductions companies devise. Now the tables have turned somewhat.

“Canada and other jurisdictions, which have been operating in more favorable tax circumstances, will have to gird themselves to more vigorously defend their own tax bases from cuts stemming from transfer pricing ingenuity,” Mr. Seraganian said. “Companies are very good with coming up with ways to shift and create deductions in the right place, and now people are going to say, ‘Maybe the right place isn’t the US, maybe it’s Canada.

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