The Canadian International Tax System: Review and …€¦ · THE CANADIAN INTERNATIONAL TAX SYSTEM 1793 (1995), Vol. 43, No. 5 / no 5 INTRODUCTION The international aspects of the

1792 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE

(1995), Vol. 43, No. 5 / no 5

The Canadian International TaxSystem: Review and Reform

Brian J. Arnold*

PRÉCIS

Cet article constitue un examen des aspects internationaux du régimefiscal du Canada. Ces aspects sont divisés en trois principaux domaines :l’imposition des résidents sur le revenu de sources étrangères,l’imposition canadienne des non-résidents du Canada sur le revenu desource canadienne et les conventions fiscales. L’évolution de la loicanadienne à l’égard de chacun de ces domaines y est présentée, lesprincipales lacunes dans chaque domaine y sont identifiées et dessuggestions de réforme y sont formulées. En général, les règlescanadiennes sur l’imposition des non-résidents et les diversesconventions fiscales du Canada sont bien fondées et conformes à lapratique internationale. Cependant, l’imposition du revenu de sourcesétrangères comporte de sérieuses lacunes. Le système d’exemptiondes dividendes de sociétés étrangères affiliées s’applique à tort auxdividendes de sociétés étrangères affiliées situées dans certains paradisfiscaux. De plus, le système d’exemption peut servir à éroder l’assiettefiscale du Canada.

ABSTRACTThis article reviews the international aspects of the Canadian income taxsystem, which are divided into three major areas: the taxation ofresidents on foreign source income, the Canadian taxation of non-residents on Canadian source income, and tax treaties. The article tracesthe development of Canadian law in each of these areas, identifies themajor deficiencies in each area, and makes suggestions for reform. Ingeneral, the Canadian rules for the taxation of non-residents and theCanadian tax treaty network are sound and conform with internationalpractice. The taxation of foreign source income, however, is seriouslyflawed. The exemption system for dividends from foreign affiliatesapplies inappropriately to dividends from foreign affiliates in certain taxhavens. Moreover, the exemption system can be used to erode theCanadian tax base.

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* Of the Faculty of Law, The University of Western Ontario, London, and associatedwith Goodman Phillips & Vineberg, Toronto.

THE CANADIAN INTERNATIONAL TAX SYSTEM 1793

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INTRODUCTIONThe international aspects of the Canadian income tax system fall intothree major structural areas:

1) the taxation of residents of Canada on their foreign source income;

2) the taxation of non-residents on their Canadian source income; and

3) tax treaties.

This article presents a broad picture of how these three areas developed,an assessment of how the current international tax rules perform, and anagenda for reforming these rules. In essence, the article addresses threequestions with respect to Canada’s international tax system. Where has itcome from? Where is it now? And where is it, or should it be, going?

These questions are fair and important ones. The world has changedenormously since income tax was first introduced in 1917, and our in-come tax system has changed in response. International trade andinvestment have always been important for Canada, from its origins as asource of furs and other raw materials for Great Britain. As the 21stcentury approaches, however, the global economy has become a reality.Canada, as a signatory of the Agreement Concerning the World TradeOrganization (which consolidated the General Agreement on Tariffs andTrade [GATT] and the General Agreement on Trade in Services [GATS]),has committed itself to eliminating barriers to cross-border trade andinvestment. Canada is also part of the North American Free Trade Agree-ment (NAFTA), which appears likely to encompass some South Americancountries in the near future. Financial markets and products have becomeinternational in scope and operate efficiently. Virtually all sectors of theeconomy are dominated by huge multinational enterprises. These are therealities of the mid-1990s that form the context for Canada’s internationaltax system. Setting an appropriate international tax policy in this contextis extremely difficult.

The nature of this article requires a broad-brush approach. Microscopicdescription of technical rules is both impossible and inappropriate. I haveassumed that the reader has a basic understanding of the current Canadianrules for taxing foreign source income and non-residents, and the con-tents of a typical Canadian tax treaty.

HISTORICAL DEVELOPMENT FROM 1917 TO 1971Foreign Source IncomeThe first comprehensive federal income tax was introduced in 1917 as atemporary measure to raise revenue for the war effort.1 The jurisdictionalscope of the new income tax was fundamentally the same as it is now.2

1 Income War Tax Act, 1917, SC 1917, c. 28.2 In 1919, the words “whether derived from sources within Canada or elsewhere” were

added to the reference to income in section 3(1) of the Income War Tax Act. SC 1919, c.55, section 2(1).


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Individuals resident in Canada and corporations domiciled in Canada weresubject to tax on their worldwide income at a rate of 4 percent. Non-residentswere taxable only on certain income derived from sources in Canada.

The new income tax did not include any foreign tax credit. Foreigntaxes paid by a resident of Canada on income earned outside Canada werethought to be deductible in computing the amount of income subject toCanadian tax.3 In 1919, a unilateral foreign tax credit was introduced.4

This credit extended to income taxes paid to Great Britain and otherterritories in the British Empire on income derived from those countriesand income taxes paid to other countries, provided that they allowed areciprocal credit for Canadian income taxes. In both cases, the credit waslimited to the amount of Canadian tax payable in respect of the foreignsource income.5

This system for the relief of international double taxation continueduntil 1938. In that year, Canadian public companies were granted anexemption in respect of dividends from wholly owned foreign subsidiar-ies.6 As originally introduced, this exemption applied only if 75 percentof the combined capital of the parent and its subsidiaries was used out-side Canada and only if the subsidiaries were resident in countries thatgranted a similar exemption for dividends paid by Canadian subsidiaries.

By 1938, four fundamental elements of the Canadian taxation of for-eign source income were in place:

1) the taxation of resident individuals and corporations on their globalincome;

2) the allowance of a foreign tax credit for foreign taxes paid in re-spect of foreign source income;

3) the deferral of Canadian tax on the foreign source income of foreigncorporations until the receipt of dividends by Canadian shareholders;7 and

3 Canada, House of Commons, Debates, July 25, 1917, 3764, statement of Sir ThomasWhite, the minister of finance. This presumption, however, appears to have been incorrect.Subsequent cases held clearly that municipal, provincial, and foreign taxes are not deduct-ible expenses of earning income but appropriations of income after it has been earned. SeeRoenisch v. Minister of National Revenue (1930), 1 DTC 199; [1928-34] CTC 69 (Ex. Ct.);McLeod v. Minister of National Revenue (1931), 1 DTC 227; [1928-34] CTC 88 (Ex. Ct.);and First Pioneer Petroleums v. MNR, 74 DTC 6109; [1974] CTC 108 (FCTD).

4 SC 1919, c. 55, section 3(3), adding section 4(5) to the Income War Tax Act.5 In 1927, this limitation was carved out of section 4(5) and placed in section 8(2) of

the Income War Tax Act (see RSC 1927, c. 97). In 1939, section 8(2) was amended by SC1939, c. 46, section 9, to make the calculation of the limitation more specific.

6 SC 1938, c. 48, section 4, adding section 4(r) to the Income War Tax Act.7 This deferral was subject to one exception. In order to prevent the use of corporations

to earn investment income and thereby avoid higher personal tax rates, the “personalcorporation” provisions were introduced into the tax system in 1926 (SC 1926, c. 10,section 3, adding section 3(10), which became sections 2(i) and 21 of the Income War TaxAct, RSC 1927, c. 97). A “personal corporation” was defined to be a corporation, whether

(The footnote is continued on the next page.)


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4) the complete exemption from tax for dividends received by certainCanadian companies from certain foreign corporations.

Although this system was simplistic, it was probably quite appropriate atthe time. Canadian residents had little foreign investment, and what therewas, was concentrated in high-tax countries such as the United Kingdomand the United States.

A review of the Canadian tax system from 1938 to 1972 reveals a clearand consistent policy of extending both the exemption for dividends fromforeign corporations and the foreign tax credit.8 In 1941, the credit wasextended to excess profits taxes.9 In 1944, the reciprocity requirement forforeign taxes paid to non-Commonwealth countries was eliminated.10 Inthe same year, an indirect foreign tax credit was introduced for dividendsfrom wholly owned foreign subsidiaries that did not qualify for exemp-tion.11 This indirect foreign tax credit permitted a deduction in computingCanadian tax for the foreign income taxes paid by a wholly owned sub-sidiary on income out of which it paid dividends to its Canadian parentcompany. In 1947, the indirect credit was extended to dividends fromforeign companies in which the Canadian company owned more than 50percent of the voting shares.12 In addition, it was extended to foreigntaxes paid by second-tier foreign corporations as long as the first-tierforeign subsidiary was wholly owned and derived more than 75 percentof its income from dividends paid by more than 50 percent owned foreigncorporations.13

In 1948, the mechanism for taxing dividends from foreign corporationswas altered. All dividends from foreign corporations were included inincome, but qualifying dividends were deductible in computing the Cana-dian corporation’s taxable income.14 In the following year, the exemptionwas liberalized significantly. The requirement that 75 percent of the capi-tal of the Canadian parent and its foreign subsidiary be used outside

domestic or foreign, controlled by a person or a person and his spouse or other member ofhis family. The income of a personal corporation was taxed to its shareholders directly,whether or not it was distributed to them. Consequently, although directed primarily atdomestic corporations, the personal corporation provisions controlled the use of foreigncorporations as “incorporated pocketbooks” to defer Canadian tax. These provisions wererepealed in 1972.

8 See, generally, R.J. Dart and R.D. Brown, “Taxing International Income—A CanadianPerspective,” International Tax Planning feature (1976), vol. 24, no. 2 Canadian Tax Jour-nal 144-52, at 145.

9 Excess Profits Tax Act, SC 1940-41, c. 15, section 11; and Income War Tax Act, SC1941, c. 18, sections 13 and 14.

10 SC 1944-45, c. 43, section 6(1).11 Section 8(2A) of the Income War Tax Act as added by SC 1944-45, c. 43, section 6(2).12 SC 1947, c. 63, section 6(1).13 Ibid.14 SC 1948, c. 52, section 28.

7 Continued . . .


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Canada, the reciprocity requirement, and the requirement that the profitsof the foreign subsidiary be subject to foreign tax were all deleted.15 Withthis expansion of the exemption, the indirect foreign tax credit for divi-dends that did not qualify for exemption was considered to be unnecessaryand was repealed.16 Therefore, after the 1949 amendments, dividends re-ceived by Canadian corporations were either completely exempt from taxor fully taxable with a credit only for any foreign withholding taxes onthe dividends. The ownership requirement for the exemption was furtherreduced to 25 percent in 1951.17

Foreign investment by Canadian residents increased significantly afterWorld War II. The need for a more sophisticated approach to the taxationof foreign source income gradually became apparent. The Royal Commis-sion on Taxation (the Carter commission), which reported in 1966,18

proposed extensive changes to the Canadian system of taxing foreignsource income. Most important, it recommended the withdrawal of theexemption for dividends from 25 percent foreign-owned corporations.However, the system recommended by the Carter commission to replacethe exemption—a 30 percent minimum tax on income earned by Cana-dian residents indirectly through foreign corporations and an arbitrary 30percent credit for foreign taxes—was crude and inconsistent with interna-tional practice.19 The Carter report did not recommend the adoption ofanti-tax-haven measures because of their complexity; also, the report tookthe position that the 30 percent minimum tax would restrict the use of taxhaven corporations.

In response to the Carter report, the government’s 1969 white paperendorsed two general objectives with respect to the taxation of foreignsource income derived by Canadian residents:

1) The tax system should not influence a taxpayer’s decision to investabroad or in Canada: “The proposals are designed neither to provide anincentive to Canadians to invest abroad, nor to place a barrier in the wayof their doing so.”20 At the same time, the tax system was designed toencourage Canadians to invest domestically.

15 SC 1949, c. 25, sections 12 and 23.16 Ibid., section 18.17 SC 1951, c. 51, section 7(1).18 Canada, Report of the Royal Commission on Taxation (the Carter report) (Ottawa:

Queen’s Printer, 1966).19 For a detailed description and assessment of the recommendations of the Carter

report concerning foreign source income, see Donald J.S. Brean, “The International Di-mension of Canadian Tax Policy: Contributions of Carter and Subsequent Developments,”in W. Neil Brooks, ed., The Quest for Tax Reform: The Royal Commission on TaxationTwenty Years Later (Toronto: Carswell, 1988), 265-76; and B.J. Arnold, “The Taxation ofForeign-Source Income: Dividends from Foreign Corporations and Anti-Tax Haven Meas-ures,” ibid., 277-98.

20 E.J. Benson, Proposals for Tax Reform (Ottawa: Queen’s Printer, 1969) (herein re-ferred to as “the white paper”), 72.


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2) The government recognized that Canadian businesses “would findit hard to compete on the international scene if they were subject to moreonerous taxes than those which apply to their competitors.”21

With respect to the taxation of dividends from foreign corporations,the government refused to choose between the exemption and credit meth-ods: “neither of these systems is either ‘right’ or ‘wrong.’ ”22 A combinedexemption and credit system was adopted that, with a few modifications,is the present Canadian system. The exemption for dividends received byCanadian corporations from foreign corporations became dependent onthe type and source of income earned by the foreign corporation (namely,active business income earned in listed or treaty countries). At the sametime, the government adopted the foreign accrual property income (FAPI)rules to prevent the use of tax haven corporations to defer Canadian taxon passive investment income.

Taxation of Non-ResidentsUnder the 1917 income tax, foreign corporations and non-resident indi-viduals were liable to tax only on their business income derived in Canada.In 1918, Canadian jurisdiction to tax non-residents was extended tonon-residents employed in Canada23 or rendering services in Canada for aresident or a non-resident carrying on business in Canada. Suchnon-residents were taxable only on their employment or services incomeearned in Canada. In 1927, the concept of carrying on business in Canadawas expanded to include non-residents who solicit orders or offer any-thing for sale in Canada and non-residents who rent anything for use inCanada or who receive royalties for anything used or sold in Canada.24

Persons paying rent or royalties to non-residents were obligated to with-hold at a rate of 12.5 percent; however, this withholding obligation didnot represent the non-resident’s final Canadian tax liability.25

In 1924, the first Canadian transfer-pricing rule was adopted.26 Thisrule allowed the minister to determine the “fair price” of any purchase orsale of a “commodity” by any corporation carrying on business in Canadafrom or to an associated corporation. In many ways, the currenttransfer-pricing rules in subsections 69(2) and (3) of the Act27 are notmuch more sophisticated than the original rule.

21 Ibid.22 Ibid., at 73.23 SC 1918, c. 25, section 3. Non-residents who were only temporarily or occasionally

employed in Canada were not subject to Canadian tax.24 RSC 1927, c. 97, section 27.25 SC 1932-33, c. 41, section 12.26 SC 1924, c. 46, section 2, adding section 3(2)(a) to the Income War Tax Act. Section

3(2) of the 1917 Income War Tax Act allowed the minister to determine the fair price ofgoods sold by a subsidiary corporation to its parent. This provision applied to domesticand foreign corporations.

27 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “theAct”). Unless otherwise stated, subsequent statutory references in this article are to the Act.


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In 1930, a provision was introduced taxing non-resident directors, of-ficers, or employees of Canadian corporations on dividends and interestreceived from those corporations.28 This provision was a punitiveanti-avoidance rule intended to prevent non-residents from avoiding Ca-nadian tax on their employment income by receiving dividends or interestinstead.

In 1933, the government introduced a 5 percent withholding tax on thegross amount of dividends, interest, and royalties received by non-residentsof Canada from Canadian payers.29 Interest paid or guaranteed by thegovernment of Canada was not subject to withholding. A withholding taxalso applied to income from Canadian estates or trusts received bynon-residents.

Therefore, by 1933, the three fundamental elements of the taxation ofnon-residents were in place:

1) non-residents employed in Canada, performing services in Canada,and carrying on business in Canada were taxable on their net Canadiansource income at the applicable rates;

2) non-residents receiving investment income from Canada were sub-ject to withholding tax at a flat rate on the gross amount; and

3) the tax authorities had the power to adjust intercompany prices.

During the period from 1933 to tax reform in 1972, these fundamentalfeatures of the system for taxing non-residents remained unchanged; how-ever, some minor modifications were made. In particular, the withholdingtax was extended and refined. The withholding tax was extended to royal-ties in respect of non-copyright works in 1936, but only 60 percent ofroyalties for motion picture films was taxable.30 The rate of withholdingtax was increased to 15 percent in 1942.31 The withholding tax on rentsand royalties was significantly revised in 1968 to include payments forthe use of technology and to exclude copyright royalties. In 1963, the rateof withholding tax on dividends was reduced to 10 percent for dividendspaid by resident corporations that had a degree of Canadian ownership.32

At the same time, the tax was extended to management fees. The optionto pay tax on rent and timber royalties on a net basis was added to the Actin 1940.33

28 SC 1930, c. 24, section 6.29 SC 1932-33, c. 41, section 9, adding section 9B(2) to the Income War Tax Act. As a

transitional measure, the tax did not apply to dividends paid by a wholly owned Canadiansubsidiary to its non-resident parent corporation if the parent was incorporated before1933 and less than 25 percent of the subsidiary’s income was derived from dividends andinterest.

30 SC 1936, c. 38, section 8.31 SC 1942, c. 28, sections 6, 9, and 13(3).32 SC 1963, c. 21, sections 23(3) and 28(1).33 SC 1940-41, c. 18, section 23.


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An exemption for foreign business corporations was introduced in1918.34 These corporations were incorporated and resident in Canada butcarried on business almost exclusively outside Canada. In effect, foreignbusiness corporations were used by non-residents to avoid foreign taxesand, in this regard, Canada was a tax haven until the provisions wererepealed in 1972.

In 1936, the special provisions with respect to non-resident-owned in-vestment corporations were introduced.35 In effect, these corporations weretaxed as conduits. They could elect to pay Canadian tax at the withhold-ing rate rather than at the corporate rate, and dividends paid to theirnon-resident shareholders were not subject to withholding tax. These spe-cial provisions were restricted to corporations owned almost exclusivelyby non-residents and deriving almost all of their income from passiveinvestments.

In 1960, the branch tax was introduced to eliminate the advantage fornon-resident corporations to carry on business in Canada through a branchrather than a subsidiary.36 The branch tax was imposed at a rate of 15percent (the same as the rate of withholding tax at that time) on anyCanadian source profits of the non-resident corporation that were notreinvested in Canada.

The Carter commission accepted the appropriateness of the Canadiansystem for taxing non-residents on their Canadian source income. Thecommission’s principal recommendations were to increase the rate of with-holding tax to 30 percent on payments to non-residents other than dividendsand to extend the withholding tax to payments for services. Other recom-mendations included

• the incorporation of the treaty concept of permanent establishmentinto Canadian tax legislation so that the existence of a permanent estab-lishment in Canada would be conclusive evidence that a non-resident wascarrying on business in Canada;37

• the treatment of interest paid by a Canadian corporation to itsnon-resident parent as a dividend, in order to deal with the problem ofthin capitalization;38 and

• the elimination of both foreign business corporations and non-resident-owned investment corporations because they facilitated avoidance of othercountries’ taxes.39

34 SC 1918, c. 25, section 4, adding section 4(k) to the Income War Tax Act.35 SC 1936, c. 38, section 12.36 SC 1960-61, c. 17, section 12, adding part III(A) to the Income Tax Act, RSC 1952,

c. 148, as amended.37 Supra footnote 18, vol. 4, at 545.38 Ibid., at 549. As a result, the payment would be taxable at the Canadian corporate

rate rather than the withholding rate.39 Ibid., at 558-60.


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With respect to the taxation of non-residents, the government’s 1969white paper started with the proposition that “[t]he over-all thrust ofCanada’s present provisions for taxing the Canadian income of non-residents is generally regarded as reasonable.”40 To encourage countriesto enter into treaties, the government increased the rate of withholdingtax to 25 percent but indicated that it would agree to a reduced rate of 15percent by treaty. Although the Carter commission’s recommendation toeliminate foreign business corporations was adopted, the provisions relat-ing to non-resident-owned investment corporations were retained. In thelight of the adoption of a capital gains tax in 1972, the government ap-plied the tax to non-residents disposing of “taxable Canadian property,”which includes real property in Canada, business assets in Canada, part-nership interests, and certain shares of Canadian corporations because ofthe ease of transforming gains on the sale of the other assets into gains onthe sale of shares.

Finally, the thin capitalization rules were introduced in 1972 to preventnon-resident owners of Canadian corporations from extracting the corpo-ration’s income in the form of deductible interest at a tax cost of only 15percent (the treaty withholding rate). In announcing these new rules, thegovernment stated:

Such a provision is necessarily arbitrary and it is difficult to administer. Itmay have to be altered at a later date in the light of experience.41

As discussed subsequently, experience has indicated that the thin capitali-zation rules are seriously flawed and should be revised.

Tax TreatiesAt the time of tax reform in 1972, Canada had entered into tax treatieswith only 16 countries. Most of these treaties were negotiated in the1950s. Because of changes to the treatment of dividends from foreignaffiliates, the government announced that improving Canada’s meagre taxtreaty network would be a high priority.42 Although at the time manycommentators scoffed at the government’s ability to deliver on this com-mitment,43 time bears out the success of the program to expand and updateCanadian treaties.

FOREIGN SOURCE INCOMEIntroductionThe basic structure of the system for taxing Canadian residents on theirforeign source income is sound and consistent with international norms.

40 Supra footnote 20, at 71.41 Ibid., at 78.42 Ibid., at 72.43 See, for example, James S. Peterson, “Canada’s Foreign Tax Credit,” in Report of

Proceedings of the Twenty-Third Tax Conference, 1971 Conference Report (Toronto: Cana-dian Tax Foundation, 1972), 158-67, at 159.


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Residents are taxable on their worldwide income, and a credit is availablefor any foreign income taxes payable on the income. Residents are not,however, taxable currently on income earned indirectly through foreigncorporations, even controlled foreign corporations, unless the FAPI or theoffshore investment fund rules apply. Foreign source income earnedthrough foreign corporations in which Canadian residents own shares issubject to Canadian tax only when the shareholders receive dividends ordispose of their shares. Moreover, dividends received by a Canadian cor-poration from a foreign affiliate are subject to a special combined exemp-tion and credit system. If dividends are received out of the foreignaffiliate’s exempt surplus, the most important ingredient of which is ac-tive business income earned in treaty countries, the dividends are exemptfrom Canadian tax. Dividends out of taxable surplus, which includes allof the foreign affiliate’s other income, including active business incomeearned in non-treaty countries, are subject to Canadian tax, and a credit isavailable for any foreign withholding taxes on the dividend and an indi-rect foreign tax credit for any underlying foreign taxes paid by the for-eign affiliate on the income out of which the dividends were paid. Anyother dividend from a foreign affiliate is not treated as a recovery of cost.

These rules for taxing foreign source income of residents have been ineffect since 1976, and only minor modifications have been made in theinterim. There has, accordingly, been no major overhaul of the rules sincethey were conceived as part of the 1972 tax reform. In the light of subse-quent developments in other countries and the Canadian experience withthe rules over the past 20 years, it seems appropriate for the government toundertake a fundamental review of the system for taxing foreign sourceincome of residents. In the following material, some of the major structuralelements of the system are evaluated and suggestions are made for reform.

FAPI RulesAs described earlier, the FAPI and foreign affiliate rules were introduced in1972 and became effective for the 1976 and subsequent taxation years. Theintroduction of the FAPI rules was very controversial and vigorously op-posed by Canadian multinationals and their advisers. At the time, only theUnited States and Germany had anti-avoidance measures similar to the FAPIrules. Since then, at least 10 other countries have adopted similar measures,which are often referred to as controlled foreign corporation (CFC) rules.

I have argued elsewhere that the Canadian FAPI rules are weaker thanthe comparable rules of most other countries.44 Events since 1972 havedemonstrated clearly the deficiencies in the FAPI rules. Several of thesedeficiencies were pointed out by the auditor general in his 1992 report.45

44 Brian J. Arnold, The Taxation of Controlled Foreign Corporations: An InternationalComparison, Canadian Tax Paper no. 78 (Toronto: Canadian Tax Foundation, 1986).

45 Canada, Report of the Auditor General of Canada to the House of Commons 1992(Ottawa: Supply and Services, 1992), 46-51.


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In response to that report, in the February 1994 budget, the minister offinance tabled draft amendments to the FAPI and foreign affiliate rules.After going through two revisions, issued in June 1994 and February1995,46 the amendments are expected to be enacted before the end of1995. The amendments make several important changes to the FAPI andforeign affiliate rules:

• new definitions of income from property and income from an activebusiness have been introduced;

• new rules have been adopted deeming certain Canadian source in-come earned by a controlled foreign affiliate to be FAPI;

• paragraph 95(2)(a), which deems certain passive income to be activebusiness income, has been restricted in certain respects and broadened inother respects;

• the deductibility of active business losses of a foreign affiliate againstits FAPI has been eliminated;

• constructive ownership rules for purposes of the definition of a for-eign affiliate have been introduced; and

• the concept of a listed country has been replaced by the concept of adesignated treaty country, and new rules introduced with respect to thedetermination of the residence of a foreign affiliate.

Most of these changes are designed to prevent obvious abuses and arelong overdue. It would be a mistake, however, to think that the 1995amendments constitute a comprehensive reform of the FAPI and foreignaffiliate rules. The changes respond to specific points made by the auditorgeneral in his 1992 report. Although the decision to provide definitions ofincome from property and income from an active business is welcome,serious consideration should also be given to expanding the definition ofFAPI to include certain base company sales and services income.47 Even asamended, the FAPI rules still do not prevent Canadian multinationals fromestablishing sales and service subsidiaries in tax havens, engaging in trans-actions with related parties, and doing business outside the tax haven.

At a more fundamental level, consideration should be given to theadoption of a designated jurisdiction approach for the FAPI rules. Thecurrent FAPI rules operate on a transactional basis. In other words, eachitem of income earned by a controlled foreign affiliate must be character-ized as FAPI or as income other than FAPI. This approach was borrowedfrom the US subpart F rules, which were the only model available in

46 See, generally, Sandra E. Jack, “The Foreign Affiliate Rules: The 1995 Amend-ments” (1995), vol. 43, no. 2 Canadian Tax Journal 347-400; Larry F. Chapman, “ForeignAffiliate Amendments: Three Strikes and You’re Done,” International Tax Planning feature(1995), vol. 43, no. 2 Canadian Tax Journal 433-46; and Brian J. Arnold, “An Analysis ofthe 1994 Amendments to the FAPI and Foreign Affiliate Rules” (1994), vol. 42, no. 4Canadian Tax Journal 993-1036.

47 See Arnold, supra footnote 44, at 583-84.


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1972, when the Canadian FAPI rules were first devised. Since then, how-ever, several countries have adopted CFC legislation that applies only tocontrolled foreign corporations established in defined tax havens. In addi-tion, several countries have adopted an entity approach under which,generally, all of the income of a controlled foreign corporation is charac-terized by reference to factors such as the extent of the corporation’spresence in the tax haven, the nature of its income-earning activities, andthe primary source of its income. In these countries, the CFC rules aremuch more narrowly focused than the Canadian FAPI rules. The legisla-tion applies only if the controlled foreign corporation is resident in a taxhaven and earns primarily tainted income. This alternative approach isobviously not without problems. However, its great virtue is that thecompliance and administrative burdens of the rules are minimized. Inshort, the CFC rules, if adopted in Canada, would not affect any Canadiantaxpayer operating through a foreign affiliate in a country that was notdesignated as a tax haven. As a result, Revenue Canada could focus itsenforcement efforts on tax haven corporations, where the serious prob-lems of abuse occur.

Foreign Affiliate RulesLike the FAPI rules, the foreign affiliate rules were introduced in 1972and became effective for the 1976 and subsequent taxation years. In es-sence, the foreign affiliate rules provide a combined exemption and creditsystem for the taxation of dividends from foreign corporations in whichCanadian corporations own at least 10 percent of the shares of any class.Although technical amendments have been made to these rules since 1976,the government has not undertaken any fundamental review of the rules.Several difficulties with the current system are readily identifiable.

First, it must be acknowledged that, from a theoretical perspective,there is justification for an exemption system for dividends paid by aforeign affiliate of a Canadian corporation out of active business incomesubject to foreign tax that is equal to or higher than Canadian tax. Ineffect, such an exemption system is a proxy for a credit system: wherethe foreign tax on the foreign source income is equal to or higher thanCanadian tax, any Canadian tax will be totally offset by the foreign taxcredit. Therefore, the exemption for such dividends is a simpler way ofachieving the same result. The difficulty with the current foreign affiliaterules is that the exemption is not restricted to active business incomesubject to foreign income taxes that are equal to or higher than Canadiantaxes. For example, the recent amendments to the rules with respect tothe concept of a designated treaty country and the residence of a foreignaffiliate provide specific statutory authority for Canadian corporations tocontinue using international business corporations established in Barba-dos to avoid Canadian and foreign tax. Offshore companies in Cyprus andholding companies in Luxembourg receive the same protection. At thesame time, several other Caribbean tax havens that were formerly listedwill not be designated treaty countries. As I have argued previously and


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in more detail, the special treatment accorded international business cor-porations in Barbados “provides convincing evidence of the completebankruptcy of the designated treaty [country] concept.”48 For many years,many, and probably most, Canadian multinationals have been using inter-national business corporations in Barbados as international finance orroyalty companies. These corporations can be used to earn intragroupincome, which is not subject to the FAPI rules because of paragraph95(2)(a) and which can be repatriated to Canada tax-free even though it issubject to a tax of only 2.5 percent in Barbados. This situation is soclearly abusive that it is difficult to understand how the government candefend it with a straight face. International business corporations in Bar-bados and similar corporations in Cyprus and Luxembourg should notqualify for exempt surplus treatment; but if they do so qualify, then soshould any foreign affiliate in a similar tax haven.

Second, the foreign affiliate rules are incredibly complex. This com-plexity places a significant administrative burden on Revenue Canada andan even greater compliance burden on Canadian corporations. The majorsources of complexity in the foreign affiliate rules are

• the necessity of allocating income earned by a foreign affiliate eitherto exempt surplus or to taxable surplus;

• the necessity of computing surplus accounts separately for each for-eign affiliate;

• the necessity of determining a Canadian corporation’s interest in thesurplus of a foreign affiliate and adjusting the calculation to reflect cer-tain transactions involving the foreign affiliate;

• the intersection of foreign legal and tax rules with Canadian taxrules; and

• the ability of a Canadian corporation to make an election under sub-section 93(1) to treat as a dividend all or part of the proceeds from thedisposition of shares of a foreign affiliate.

Third, because dividends out of the exempt surplus of foreign affiliatesare exempt from Canadian tax, any expenses incurred by Canadian corpo-rations to earn such exempt income should not be deductible. However,as a practical matter, it appears that such expenses are deductible, and theCanadian tax base is eroded in consequence. This problem is discussed inmore detail below.

Fourth, the current tax treatment of dividends out of taxable surplus ofa foreign affiliate effectively discourages the repatriation of such incomeunless it has been subject to foreign tax equal to or greater than the Cana-dian tax. Such treatment represents questionable tax policy for a capital-importing country such as Canada. It seems unlikely that much Canadiantax is collected in respect of dividends out of the taxable surplus of for-eign affiliates. There are various ways in which Canadian multinationals

48 Arnold, supra footnote 46, at 1026.


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can avoid paying dividends out of taxable surplus, including the use of aninternational holding company to trap dividends from operating companiesand the use of upstream loans or other disguised distributions.

Fifth, dividends paid by a Canadian corporation to its individual share-holders resident in Canada qualify for a dividend tax credit. Where suchdividends are paid out of income that has not been taxed at the corporatelevel, the shareholder should not be allowed a dividend tax credit. Formany Canadian corporations, dividends out of the exempt surplus of for-eign affiliates constitute an important element of exempt income.

These deficiencies in the foreign affiliate rules are serious and shouldbe addressed by the government immediately. Moreover, there are clearlyseveral options for improving the rules. These improvements include sim-plifying the rules for most Canadian corporations to which they apply andrestricting or eliminating those aspects of the rules that can be used toavoid Canadian tax inappropriately.49

Passive Foreign Investment FundsThe FAPI rules apply only to foreign corporations that are controlleddirectly or indirectly by a group of five or fewer Canadian residents;moreover, even if the foreign corporation is a controlled foreign affiliate,its FAPI is attributed only to the Canadian shareholders that own 10 per-cent or more of the shares of any class. Consequently, in the absence ofother rules, the FAPI rules can be easily avoided by having the shares ofa foreign corporation widely owned by residents of Canada. In responseto the elimination of many domestic deferral opportunities in the late1970s and early 1980s, it became common to use widely owned offshoremutual funds and unit trusts to defer or avoid Canadian tax. These fundsallowed Canadian residents not only to defer Canadian tax, but also toconvert ordinary income, usually interest on Canadian government secu-rities, into capital gains on the disposition of their shares in the foreigncompany or their units in the unit trust. In 1982 and 1983, securitiesdealers started to market these offshore funds aggressively, and the gov-ernment was forced to take action against them.50

Under section 94.1 of the Act, which was introduced effective after1984, Canadian residents with an interest in an “offshore investment fundproperty” must include in income a notional amount equal to the pre-scribed rate of interest applied to the designated cost of the interest.51

Section 94.1 applies only where the offshore investment fund property

49 See Arnold, supra footnote 44, at 525-70.50 See Robert B. Goodwin, “Canadian Real Estate Funds and Offshore Mutual Funds,”

in Report of Proceedings of the Thirty-Fifth Tax Conference, 1983 Conference Report(Toronto: Canadian Tax Foundation, 1984), 231-53.

51 For a detailed description of section 94.1, see Brian J. Arnold, “The Taxation ofInvestments in Passive Foreign Investment Funds in Australia, Canada, New Zealand, andthe United States,” in Essays on International Taxation in Honor of Sidney I. Roberts(Deventer, the Netherlands: Kluwer, 1993), 5-59, at 30-36.


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derives its value, directly or indirectly, primarily from portfolio invest-ments in certain types of property. Moreover, the rules do not apply ifnone of the main reasons for the taxpayer’s acquiring the interest is toavoid Canadian tax, taking into account all the circumstances includingthe nature of the offshore fund, the terms and conditions of the taxpayer’sinterest in the fund, the foreign tax paid by the fund, and the extent towhich the fund distributes its income.

Section 94.1 is clearly an anti-avoidance rule that is intended to pre-vent Canadian taxpayers from investing in passive foreign entities thatare not subject to the FAPI rules. It is not intended just to eliminate thebenefits of investing in foreign investment funds as opposed to Canadianfunds. The imputed income approach used in section 94.1 will often pe-nalize taxpayers for investing in passive foreign investment funds. Section94.1 stands out as an arbitrary, crude, prophylactic measure; however, itappears that, to date, it has been reasonably effective in curtailing the useof foreign mutual funds and unit trusts to avoid the FAPI rules. The interrorem effect of the provision may be short-lived. Revenue Canada hasenormous difficulty in applying purpose tests such as the one in section94.1. It is probably just a question of time before taxpayers test the scopeof section 94.1, if they are not already doing so.

Since Canada enacted section 94.1, a number of other countries haveadopted measures to deal with passive foreign investment funds.52 Noneof these countries uses the Canadian imputed income approach except asa measure of last resort. Some countries use a mark-to-market approach;others tax the shareholders on their pro rata share of the income of theforeign entity; still others tax distributions when received and gains whenrealized, but impose an interest charge to eliminate the benefit of defer-ral. The government should study the taxation of interests in passiveforeign investment funds and replace section 94.1 with measures that arefairer to taxpayers, that can be administered effectively by RevenueCanada, and that will be effective in preventing such investments frombeing used to defer or avoid Canadian tax.

TAXATION OF NON-RESIDENTSIntroductionAs the Carter report concluded in 1966, the Canadian rules for the taxa-tion of non-residents are generally sound and in accordance with interna-tional practice. Canada should exact an appropriate tax from non-residentsderiving income from Canada if the tax will not have the effect of dis-couraging foreign investment.

The Canadian taxation of non-residents involves two categories of in-come and tax consequences:

1) Non-residents employed in Canada, carrying on business in Canada,or disposing of taxable Canadian property are subject to Canadian tax on

52 Ibid.


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their net income from such activities in Canada at the applicable rates. Inthe case of non-resident individuals, the applicable rates are the ordinaryprogressive rates of tax that apply to individuals resident in Canada. Inthe case of non-resident corporations, the applicable rate is the ordinarycorporate rate of tax applied to Canadian corporations, although non-resident corporations carrying on business in Canada are also subject tothe branch tax.

2) Non-residents receiving payments of investment income from Ca-nadian sources are subject to Canadian withholding tax on the gross amountof such payments. The statutory rate of tax is 25 percent, although it maybe reduced pursuant to an applicable tax treaty.

Canadian source income derived by a non-resident that does not fall withinone of these two categories is not subject to Canadian tax. Examples ofsuch exempt income are capital gains realized by non-residents on thedisposition of property in Canada other than taxable Canadian property,and business income derived from Canadian sources by non-residentswho are not carrying on business in Canada.

Canadian taxation of non-residents is in broad accordance with inter-national practice with respect to items of income subject to tax and taxrates.53 Canada has a strong commitment to source taxation because of itshistory as a capital importer. Over the years, the tax policy of the govern-ment has been focused more on the taxation of non-residents than on thetaxation of foreign source income. In contrast, until quite recently theUnited States emphasized the residence principle in its tax policy andpaid little attention to the taxation of non-residents.54 Canada has appro-priately been at the forefront of tax policy with respect to the taxation ofnon-residents, both substantively and in the development of enforcementmechanisms. We were among the first countries to adopt the branch tax,thin capitalization rules, and the deemed realization of income when tax-payers cease to be resident in Canada. The withholding system operatesas an effective method of enforcement for both investment income andincome from services. Similarly, the section 116 certificate proceduresare quite effective in collecting tax with respect to dispositions of taxableCanadian property by non-residents.55

Source RulesNon-residents carrying on business in Canada or disposing of taxableCanadian property are subject to tax on their taxable income earned inCanada. For this purpose, it is necessary to determine the geographical

53 David B. Horsley, “Canada,” in International Fiscal Association, Cahiers de droitfiscal international, vol. 70a, The Assessment and Collection of Tax from Non-Residents(Deventer, the Netherlands: Kluwer, 1985), 315-31.

54 Michael J. McIntyre, “A Critique of the Source Principle” (September 1989), 1 TaxNotes International 261-62, and “The Demise of U.S.-Source Jurisdiction” (October 1989),1 Tax Notes International 371-73.

55 Horsley, supra footnote 53, at 327-30.


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source of both gross income and expenses. In the case of a non-resident’sliability for withholding tax, the specification of the payments subject towithholding tax takes the place of source-of-income rules.

The Act does not contain any detailed source rules, and the case law isvery limited.56 As a result, the geographical source of income must bedetermined as a question of fact in each situation.57 Although RevenueCanada has adopted administrative positions with respect to the geo-graphical source of income and expenses,58 these positions are broad andgeneral and leave many issues unresolved. Source rules are equallynecessary for the determination of the Canadian source income ofnon-residents and the foreign source income of Canadian residents. Theneed for appropriate source rules for revenue and expenses is discussed inmore detail below.

Scope of TaxationThe history of the Canadian taxation of non-residents has been a continu-ous process of extension and refinement. Canadian withholding tax appliesto a broad range of payments to non-residents. The geographical sourceof the payment is irrelevant.59 Further, the list of payments is extendedconsiderably by deeming rules. These rules deem certain amounts (forexample, shareholder benefits) to be payments to non-residents that aresubject to withholding tax and deem certain persons to be either residentsor non-residents for purposes of withholding tax.60

It is becoming increasingly questionable whether withholding taxes onincome from portfolio investments by non-residents are in a country’snational interest.61 As a result, some countries have eliminated withhold-ing taxes on portfolio interest. The government should maintain a watchingbrief on this issue and adjust Canadian policy when necessary. One knowl-edgeable commentator has suggested the adoption of a low-rate withholding

56 Section 4 of the Act provides that income from a particular source must be deter-mined as if it were the taxpayer’s only source of income. Although the word “source” insection 4 clearly refers to the type of income (that is, employment, business, property, orsomething else) rather than its geographical source, it has been held that the calculation ofincome from sources in a particular place and of deductions relating to such sources (thatis, the geographical determination of income) also is required by section 4: InterprovincialPipe Line Co. v. MNR, 68 DTC 5093; [1968] CTC 156 (SCC).

57 See Bruce M. McLean, “Sourcing of Business Income,” in Current Developments inMeasuring Business Income for Tax Purposes, 1987 Corporate Management Tax Confer-ence (Toronto: Canadian Tax Foundation, 1987), 9:1-37.

58 See, generally, Interpretation Bulletin IT-270R2, February 11, 1991, paragraphs 26to 32.

59 However, some exemptions are designed to eliminate withholding tax on paymentsout of foreign source income.

60 Subsections 214(3), 212(13.1), and 212(13.2).61 See, generally, Donald J.S. Brean, Richard M. Bird, and Melvyn Krauss, Taxation of

International Portfolio Investment (Halifax: Centre for Trade Policy and Law and theInstitute for Research on Public Policy, 1991).


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tax on all international financial transactions administered through domesticfinancial institutions.62 Canada should also work with other countriesthrough the OECD and other international organizations and through itstax treaties to ensure that income from portfolio investments does notescape tax completely.

The taxation of non-residents on their net income from employment inCanada, carrying on business in Canada, and disposing of taxable Cana-dian property demonstrates Canada’s commitment to source-based taxation.These non-residents are subject to Canadian tax not only on their netincome from employment and business in Canada and on net gains fromdispositions of taxable Canadian property, but also on certain other mis-cellaneous income from Canadian sources, such as recapture of capitalcost allowance and income from the disposition of Canadian resourceproperties.63 Further, in certain circumstances, non-residents who werepreviously resident in Canada and are employed by a resident of Canadaare deemed to be employed in Canada,64 to be carrying on business inCanada,65 or to have disposed of taxable Canadian property.66 Moreover,in draft legislation issued in April 1995, the government proposed toextend the definition of taxable Canadian property to shares of corpora-tions listed on foreign as well as on Canadian stock exchanges and, moreimportant, to shares of a foreign corporation or interests in a trust if morethan 50 percent of the value of the assets of the corporation or trustconsists of taxable Canadian property.67 As a result of these amendments,it will no longer be possible for non-residents to avoid Canadian tax byholding the shares of a Canadian private corporation or Canadian realestate in a foreign corporation or trust.

Non-DiscriminationCanada should resist the temptation to overtax non-residents as comparedwith residents. The discriminatory taxation of non-residents distorts theefficient allocation of resources on an international basis and invites re-taliation from other countries. Therefore, the government should reviewthe features of the Canadian tax system that discriminate against

62 Donald J.S. Brean, “Here or There? The Source and Residence Principles of Interna-tional Taxation,” in Richard M. Bird and Jack M. Mintz, eds., Taxation to 2000 andBeyond, Canadian Tax Paper no. 93 (Toronto: Canadian Tax Foundation, 1992), 303-33,at 332.

63 Subsection 115(1).64 Subsection 115(2).65 Section 253.66 Subsection 115(2).67 Proposed amendments to subparagraphs 115(1)(b)(iii), (iv), and (v) in Canada,

Department of Finance, Draft Amendments to the Income Tax Act, the Income Tax Appli-cation Rules, the Canada Pension Plan, the Children’s Special Allowances Act, the CustomsAct, the Old Age Security Act, the Unemployment Insurance Act and a Related Act, April26, 1995.


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non-residents, with a view to eliminating any discrimination that cannotbe clearly justified.68

Transfer PricingWith respect to transfer pricing, the government’s recent response to thenew US transfer-pricing rules indicates its awareness of the need to pro-tect Canada’s fair share of the revenue from cross-border transactions.69

Obviously, it is critical in this area for Revenue Canada to have sufficientresources to ensure that the Canadian tax base is not eroded by transfer-pricing abuses. It is not necessary, in my view, for our simple legislativeprovisions dealing with transfer pricing to be revised significantly. Trans-fer pricing is essentially a factual matter. The only legislation that isrequired is authority for the tax authorities to adjust transfer prices inappropriate cases and the general basis for such adjustments (that is, thearm’s-length standard). Although transfer pricing has probably becomethe hottest tax issue of this decade, it is easy to exaggerate its importance.

Revenue Canada’s recent introduction of an advance pricing agreementprocedure represents a sensible approach to avoid costly and protracteddisputes about transfer prices, especially where the procedure operates ona bilateral or multilateral basis.70 Transfer pricing is an international prob-lem, which no country can deal with properly by itself. Canada has workedwithin the OECD to develop a harmonized approach to the application ofthe arm’s-length standard. Although the recently released OECD report ontransfer pricing is not entirely satisfactory,71 it represents the result ofinternational cooperation and compromise and is deserving of support forthis reason alone.

Thin CapitalizationAs indicated earlier, the thin capitalization rules were adopted as part ofthe 1972 tax reform. Although there have been some minor technicalamendments, the rules have not been significantly changed since theirintroduction. The deficiencies of the rules have been well documented.72

The more serious flaws include the following:

68 See Brian J. Arnold, Tax Discrimination Against Aliens, Non-Residents, and ForeignActivities: Canada, Australia, New Zealand, the United Kingdom, and the United States,Canadian Tax Paper no. 90 (Toronto: Canadian Tax Foundation, 1991), 253-66.

69 See Canada, Department of Finance, Release, no. 94-003, January 7, 1994, in whichthe departments of Finance and National Revenue warned multinational corporations thatthe comparable profit method adopted by the United States was not in accordance with thearm’s-length principle and that Revenue Canada would not automatically make a corre-sponding adjustment where the United States applies the comparable profit method.

70 Information Circular 94-4, December 30, 1994.71 Organisation for Economic Co-operation and Development, Transfer Pricing Guide-

lines for Multinational Enterprises and Tax Administrations: Part II: Applications (Paris:OECD, 1995).

72 Tim Edgar, “The Thin Capitalization Rules: Role and Reform” (1992), vol. 40, no. 1Canadian Tax Journal 1-54.


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• In the definition of a specified non-resident, the minimum shareownership threshold of 25 percent should probably be lowered, and thesupporting indirect and constructive ownership rules should be broadened.

• The computation of the elements of the debt-equity ratio should berevised in several respects.

• The calculation of non-deductible interest expense should be madeon a weighted basis rather than on the current basis, which takes intoaccount the greatest amount of debt outstanding to specified non-residents.

• The rules do not apply to partnerships, trusts, and branches.

The thin capitalization rules should be carefully reviewed and appro-priate amendments enacted to make them more effective. Alternatively,consideration might be given to replacing the rules with earnings-strippingprovisions modelled on the US rules.

Allocation of Income and ExpensesThe allocation of income and expenses between domestic and foreignsources or between various foreign sources has not received much atten-tion outside the United States. These source rules are of fundamentalimportance to the proper determination of a taxpayer’s tax liability and toan equitable sharing of tax revenues among nations. The problem of allo-cating income and expenses among different jurisdictions has manydimensions, falling into two broad areas. First, there is a jurisdictionalaspect to the problem—that is, dividing jurisdiction to tax between thesource country and the residence country. This division of taxing jurisdic-tion requires rules with respect to the determination of the source of grossincome and a method to resolve conflicts concerning these source rules.Similarly, rules are necessary to allocate expenses to various sources ofgross income. Second, it is necessary to have rules with respect to theallocation of income and expenses between related taxpayers in differentjurisdictions. This aspect of the allocation problem is usually referred toas transfer pricing. Canada has consistently ignored the first aspect of theallocation problem, and in particular the allocation of expenses.

It must be recognized at the outset that the rules for the allocation ofincome and expenses play a number of different roles in a country’s taxsystem:

1) Allocation rules are used to determine the amount of a non-resident’sCanadian source income subject to tax.

2) Allocation rules are used to determine the amount of foreign sourceincome earned by residents that is subject to current domestic tax (that is,income from foreign branch operations or income from the application ofthe FAPI rules).

3) Allocation rules are used to determine the limitation on the foreigntax credit. Since the credit is limited to the amount of Canadian tax onthe foreign source income from a particular country, it is necessary tohave rules to determine this amount.


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In general, it appears that, whatever the Canadian allocation rules are,they are the same for all three purposes. However, it is not clear that thisis appropriate, and the issue deserves careful study.

The Canadian rules with respect to the geographical source of incomeare undeveloped and unsophisticated. There are very few statutory sourcerules. Although there are some cases dealing with the source of income,the case law is not well developed. Even where reasonably clear sourcerules do exist, they are often derived from early English cases that areclearly inappropriate in modern times. For example, the rule that thesource of income from the sale of personal property is the jurisdiction inwhich the contract of sale is made has only the virtue of being simple andeasy to apply.73 Such a test allows taxpayers to manipulate the source ofincome in order to reduce tax. Like most countries, Canada needs tore-examine its source rules to ensure that they are consistent with itsinternational tax policy. I am not suggesting, however, that Canada shouldadopt comprehensive statutory source rules like the US rules. Such rulesare, in my opinion, unnecessary.

The allocation of expenses has received even less attention than theallocation of revenue. In many cases, taxpayers appear to be free to allo-cate expenses as they see fit, subject only to some vague standard ofreasonableness. Yet expense allocation rules are as crucial as source ofgross income rules to the determination of the proper amount of net in-come subject to tax in a particular country and to the determination of acountry’s appropriate share of tax revenues. Probably the most pressingaspect of the expense allocation issue is the appropriate allocation ofinterest expense. Although this problem exists in many countries,74 it isespecially serious in Canada because of the exemption for dividends paidout of exempt surplus of foreign affiliates.

Under the Act, interest on money borrowed to acquire shares of an-other corporation is deductible, even though any dividends received onthe shares are not subject to tax. This treatment makes sense in a purelydomestic context, since the corporation whose shares are acquired willearn income subject to tax. However, the rule also applies where moneyis borrowed to acquire shares of a foreign corporation. The interest iscurrently deductible against Canadian tax payable, although the incomeearned by the foreign corporation is not subject to current Canadian tax,and dividends paid by the foreign corporation on the shares will not besubject to Canadian tax to the extent that they are paid out of exemptsurplus. This situation is clearly inappropriate from a tax policy perspec-tive. Because the dividends are exempt from Canadian tax, the costs of

73 Grainger & Son v. Gough, [1896] AC 325 (HL).74 With respect to Australia, see Taxation of Foreign Source Income: A Consultative

Document (forming part of the May 1988 economic statement) (Canberra: Australian Gov-ernment Printing Service, 1988), 34. With respect to New Zealand, see International TaxReform—Part 1: Report of the Consultative Committee (Wellington, NZ: GovernmentPrinter, 1988), 59-60.


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earning the income, including any interest expense, should not be deduct-ible.75 In effect, the domestic Canadian tax base is used to subsidizeinvestments in foreign affiliates based in treaty countries.

A similar effect occurs with respect to the indirect foreign tax creditrelating to dividends paid out of taxable surplus.76 If the interest expenseincurred by the Canadian corporation is not allocated to the foreign sourceincome out of which the taxable surplus dividend is paid, the indirectcredit will be overstated. Moreover, interest is deductible in the yearincurred, whereas dividends are included in income only when received.These mismatching problems with respect to dividends out of taxablesurplus are not important for practical purposes, however, because for-eign affiliates do not often pay dividends out of taxable surplus.

The problem of interest deductibility and foreign source income isexacerbated in the Canadian context because so much of the Canadianeconomy is foreign-owned or -controlled and because Canadian corporatetax rates are relatively high as compared with the rates of other countries.Multinational enterprises will locate their borrowings in the jurisdictionwhere the cost is minimized. Accordingly, if a multinational enterprisehas a Canadian subsidiary that is profitable, the subsidiary can borrowfunds for use outside Canada and the interest will be deductible againstits Canadian profits.

The legislation required to deal with the problem of interest expenseincurred to earn foreign source income would be extremely complex.Different rules would be necessary for

• foreign source income earned directly through a foreign branch,

• FAPI, and

• foreign source income earned indirectly through a foreign affiliate.

The tracing rules that are currently used to determine the deductibilityof interest are inappropriate in the international arena because multina-tional corporations can plan their affairs so that all of their interest expenseis deductible.77 Any serious response to the problem requires interest ap-portionment rules under which interest expense would be allocated toforeign source income on the basis of the proportion of either foreignassets to total assets or foreign source income to total income. As USexperience indicates,78 expense apportionment rules are extremely complex

75 See Brian J. Arnold, “General Report,” in International Fiscal Association, Cahiersde droit fiscal international, vol. 79a, Deductibility of Interest and Other Financing Chargesin Computing Income (Deventer, the Netherlands: Kluwer, 1994), 491-541.

76 Paragraph 113(1)(b).77 For a discussion of tracing, see Brian J. Arnold and Tim Edgar, “The Draft Legisla-

tion on Interest Deductibility: A Technical and Policy Analysis” (1992), vol. 40, no. 2Canadian Tax Journal 267-303.

78 See, for example, Michael J. McIntyre, The International Tax Rules of the UnitedStates (Salem, NH: Butterworths) (looseleaf ), vol. 1, 3-49a to 3-62.


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and impose significant compliance costs. Nevertheless, in my view, thereis no alternative. The deduction of interest and other expenses to earnexempt foreign source income constitutes a serious erosion of the Cana-dian tax base, is indefensible on any tax policy grounds, and should bestopped.

The Relationship Between the Taxation of Foreign SourceIncome and Non-ResidentsAlthough tax analysts often divide international tax into residence- andsource-based taxation for purposes of analysis, it is important to recog-nize that the two aspects complement each other. For example, the FAPIrules, which form part of the system for taxing foreign source income, aredesigned to prevent the erosion of the domestic tax base. This aspect ofthe FAPI rules can be seen most clearly in the recent amendments thatrequire the inclusion in FAPI of several types of Canadian source businessincome.79 Canada has important interests as a source country and as a resi-dence country, and our international tax policy should reflect careful con-sideration of both interests. Policy changes that promote source interestsgenerally have a negative impact on residence interests. For example, with-holding taxes may deter Canadian corporations controlled by non-residentsfrom repatriating Canadian profits; conversely, foreign withholding taxesmay deter Canadian-controlled foreign companies from repatriating theirprofits. Moreover, a policy change by one nation must be evaluated in thelight of the possible reactions of other countries.80 For example, the elimi-nation of deferral by a country may promote its residence interests; butthe elimination of deferral by all of its major trading partners may makethe country less attractive for investment by non-residents.

Some recent theoretical research indicates a “see-saw” relationship be-tween source and residence taxation.81 According to this relationship,domestic taxes levied on non-residents raise the pre-tax rates of return ondomestic capital; in effect, the non-residents pass the tax on the use oftheir capital on to the domestic economy. Further, if residents are taxedpreferentially on foreign source income as compared with domestic sourceincome, this preference can be reduced or eliminated by increasing domes-tic rates of return through the taxation of non-residents. Although thissee-saw principle simplifies international tax policy unduly, it does empha-size that the taxation of non-residents on domestic source income and ofresidents on foreign source income should not be considered in isolation.The New Zealand Treasury has recently issued a discussion document oninternational tax that suggests that the see-saw principle is the appropriate

79 Paragraphs 95(2)(a.1), (a.2), and (a.3).80 See Julie A. Roin, “The Grand Illusion: A Neutral System for the Taxation of Inter-

national Transactions” (August 1989), 75 Virginia Law Review 919-69.81 See Joel Slemrod, Carl Hansen, and Roger Proctor, The See-Saw Principle in Inter-

national Tax Policy, National Bureau of Economic Research Working Paper no. 4867(Cambridge, Mass.: NBER, 1994).


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theoretical framework in which to establish the tax rates on inward- andoutward-bound investment.82 Therefore, in any major overhaul of eitherthe taxation of foreign source income, which has been suggested in thisarticle, or the taxation of non-residents, the government should examinecarefully the implications of the reforms for the other aspects of the inter-national tax system.

TAX TREATIESThe third major element of Canada’s international tax system is the taxtreaty network. As of January 1, 1995, bilateral tax treaties with 55 coun-tries were in effect. We have treaties with all of our major trading partnersand with most of our minor trading partners as well.

The tax treaty network is important for both the taxation of Canadianresidents on their foreign source income and the taxation of non-residentson their Canadian source income. For example, under the foreign affiliaterules, the exemption for dividends from foreign affiliates applies gener-ally to active business income earned in treaty countries by foreignaffiliates resident in treaty countries. Consequently, Canadian multina-tionals with active business operations in a country have a significantinterest in the Canadian government’s entering into a tax treaty with thecountry. With respect to the taxation of non-residents on their Canadiansource income, the implications of tax treaties are even clearer. Canadaoften gives up its right to tax or agrees to reduce the rate of tax pursuantto a tax treaty.

The extensive Canadian tax treaty network is a product of the 1972 taxreform. As mentioned earlier, the introduction of the foreign affiliate rulesmade it important for Canada to enter into tax treaties with all of itsimportant trading partners. Consequently, it is not surprising that onlyfour of Canada’s treaties predate the 1972 tax reform.83

For the most part, Canadian treaty policy adheres to the provisions ofthe OECD model treaty, with a few notable exceptions that reflect Cana-da’s status as a net capital importer. Probably the two most significantdepartures from the OECD model treaty are Canada’s insistence on rela-tively high rates of withholding on dividends, interest, and royalties andCanada’s refusal to provide national treatment for non-residents in thenon-discrimination article. Subject to these exceptions, Canada has con-sistently supported the OECD model treaty and in recent years has playedan increasingly influential role in the development of OECD treaty policy.84

82 New Zealand, International Tax: A Discussion Document (Wellington, NZ: Govern-ment Printer, February 1995), 20. For further discussion of the document, see MichaelRigby’s review in the Current Tax Reading feature (1995), vol. 43, no. 3 Canadian TaxJournal 804-19, at 804-13.

83 The treaties with Denmark, Ireland, Norway, and Trinidad and Tobago.84 This influence has been exercised largely through the work of officials of the De-

partment of Finance such as R. Alan Short, Jean-Marc Déry, David Holland, and JacquesSasseville.


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With a few exceptions, including the treaty with the United States, thecontent of Canada’s tax treaties is remarkably consistent. This consist-ency is one reason why Canada has never been particularly concernedabout treaty shopping. The treaty with the United States is the only treatywith a limitation-on-benefits article.85 That article was introduced as partof the third protocol to the treaty signed in 1995. Canada’s lack of con-cern about the problem of treaty shopping is well illustrated by the factthat the limitation-on-benefits provision in the treaty with the UnitedStates applies only to the application of the treaty by the United States.

The most significant recent development in Canadian treaty policy isthe decision to reduce withholding rates on dividends, interest, and royal-ties. In the 1992 federal budget, the government indicated its intention toreduce the rate of withholding on dividends paid to foreign corporationsthat own a significant interest in a Canadian company from 10 percent to5 percent over five years. In the 1995 protocol to the Canada-US treaty,the rate of withholding on interest is reduced to 10 percent from 15percent. This reflects government policy to accept a lower rate of with-holding on interest. It should also be remembered that many types ofinterest payments to non-residents are exempt from withholding tax pur-suant to unilateral exemptions in the Income Tax Act. Finally, in the 1993budget, the government indicated its intention to agree, in negotiatingfuture treaties, to eliminate the withholding tax on royalties with respectto the transfer of technology, including computer software, patents, andindustrial, commercial, and scientific information.

These reductions in the rates of withholding applied to dividends, in-terest, and royalties are extremely important, because withholding taxesconstitute a significant barrier to cross-border trade and investment. Inthe last decade, the non-tax barriers to transnational investment have beensignificantly reduced pursuant to GATT, GATS, and NAFTA. Canada’s will-ingness to agree to reduced rates of withholding in its tax treaties willfurther facilitate cross-border trade and investment. For example, the 5percent rate of withholding on direct dividends (which becomes effectivein 1997) will reduce the benefits previously available to Canadian multi-national corporations that structured foreign investments through a Dutchholding company.86 This is a welcome development that will simplify andfacilitate offshore investment by Canadian corporations. Moreover, in therecent protocol to the Canada-US treaty, the parties have agreed to consult

85 Article XXIX A of the Convention Between Canada and the United States of Americawith Respect to Taxes on Income and on Capital, signed at Washington, DC on September26, 1980, as amended by the protocols signed on June 14, 1984, March 28, 1984, andMarch 17, 1995 (herein referred to as “the Canada-US treaty”).

86 See, generally, Tax Planning for Canada-US and International Transactions, 1993Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1994); andWilliam D. Anderson and James J. Tobin, “Ownership and Financing of Overseas Opera-tions of Canadian Companies: Conventional Wisdom of the 1980s Versus Realities of the1990s,” in Report of Proceedings of the Forty-Fifth Tax Conference, 1993 ConferenceReport (Toronto: Canadian Tax Foundation, 1994), 44:1-75.


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in the next three years with respect to further reductions in withholdingtaxes.87 The complete elimination of withholding taxes between Canadaand the United States and between Canada and Mexico would be consist-ent with NAFTA and should be encouraged.

The only other significant aspect of Canadian treaty policy that islikely to be the focus of attention in the foreseeable future is thenon-discrimination article.88 As mentioned earlier, Canada provides onlymost-favoured-nation treatment for non-resident investors. In contrast,the OECD model treaty and most other countries provide national treat-ment. Moreover, the Canadian tax system contains more discriminationagainst non-residents than the tax systems of other countries.89 The Cana-dian position is likely to come under increasing pressure in future treatynegotiations. Canadian policy with respect to the non-discrimination arti-cle should be reviewed with a view to minimizing the discriminatoryaspects of the Canadian income tax system and broadening the protectionin Canada’s tax treaties to national treatment, perhaps with some specificexceptions.

Overall, the Canadian tax treaty network is in good shape. Obviously,the four pre-1972 treaties should be renegotiated and the governmentshould continue to expand the tax treaty network to include countries inwhich Canadian multinationals conduct business operations. With respectto the content of our tax treaties, I have only a few suggestions:

• Within NAFTA, Canada should seek to harmonize the provisions ofthe tax treaties between the member countries.90 Currently, the treatiesvary widely with respect to several matters, including withholding rates,the definition of a permanent establishment, the treatment of portfolioinvestment, and the method for resolving disputes. These inconsistenciestend to distort trade and investment within North America, contrary to thefundamental goal of NAFTA. Further, Canada should seek to eliminate alltax barriers to trade and investment within NAFTA. For example, all with-holding taxes on payments of dividends, interest, and royalties withinNAFTA should be eliminated.

• As discussed earlier, the non-discrimination article in Canadian taxtreaties is inconsistent with international practice and should be reviewed.

• The domestic tax benefit provision of our treaties should be exam-ined carefully with a view to either omitting such a provision from future

87 Article 20(1) of the protocol signed on March 17, 1995, supra footnote 85.88 See, generally, Arnold, supra footnote 68; and Richard Lewin and J. Scott Wilkie,

“Canada,” in International Fiscal Association, Cahiers de droit fiscal international, vol.78b, Non-Discrimination Rules in International Taxation (Deventer, the Netherlands:Kluwer, 1993), 357-87.

89 Arnold, supra footnote 68, at 68-111.90 Brian J. Arnold and Neil H. Harris, “NAFTA and the Taxation of Corporate Invest-

ment: A View from Within NAFTA,” Tax Law Review (forthcoming).


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91 Brian J. Arnold, “The Relationship Between Tax Treaties and the Income Tax Act:Cherry Picking” (1995), vol. 43, no. 4 Canadian Tax Journal 869-905.

treaties or clarifying its meaning.91 The domestic tax benefit provision,which is included in most Canadian tax treaties, provides that nothing inthe treaty is intended to deprive a taxpayer of a benefit otherwise avail-able under Canadian tax law; as a result, it has given rise to the problemof cherry picking between the provisions of the Income Tax Act and theprovisions of an applicable tax treaty.

Documents

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