On December 22, 2017, President Donald Trump signed into law the largest overhaul of the US federal tax code since 1986: the Tax and Jobs Act of 2017 (“2017 Reform”). As the US is the world’s largest economy by GDP,1 the 2017 Reform is a tax tsunami that has the potential to dramatically alter many countries’ relative tax competitiveness. In Canada’s case, the impact of the 2017 Reform will be especially disruptive because the US is our neighbour and largest trading partner.
In the past, Canada enjoyed an advantage over the US in terms of attracting investment, partly because of our competitive tax system. As will be discussed below, the 2017 Reform turns Canada’s relative tax advantage on its head and may fundamentally change the approach to Canada-US cross-border tax planning.
Key aspects to consider
40% reduction of US corporate tax rate
Pre-2017 Reform, a US corporation’s federal income tax liability was calculated under a graduated rate system with a top marginal tax rate of 35%. For tax years beginning after December 31, 2017, however, a US corporation will be taxed at a flat rate of 21%. This will benefit US corporate taxpayers going forward as it means their combined federal and state income tax rate decreases from 38.9% 2 (the highest tax rate among OECD3 countries) to 25.74% 4 (only slightly higher than the average tax rate among OECD countries).
Given that Canada’s combined federal and provincial tax rate for general corporations is 27%, the crux of Canada-US tax planning until now has been to push deductions to the US while having income in Canada, which resulted in rate arbitrage, as a dollar of deduction in the US was worth more than a dollar of deduction in Canada. However, as the US rate will now be slightly lower than the Canadian one, we may see a reverse in the flow of planning, which would eliminate a key aspect of Canada’s relative tax advantage.
Worldwide system to territorial system
US corporate shareholders were previously taxed under a worldwide system in which they were subject to US tax on dividends received from foreign corporations (minus certain foreign tax credits). Consequently, US corporations had an incentive to leave foreign profits overseas: deferring US taxation. In fact, US companies reportedly held approximately US$2.6 trillion in overseas earnings as of 2016. 5 The 2017 Reform moves the US outbound tax regime from a worldwide system to a hybrid territorial system (subject to a transitional toll charge) by generally allowing US corporate shareholders to receive dividends from 10%-owned foreign subsidiaries free from US tax.
Shifting to a territorial system removes the deferral benefit and will change how companies execute their cash deployment and repatriation strategies. In January 2018, Apple announced that it would bring back most of the US$252 billion in cash it held abroad and reinvest it into the US. 6
Canadian corporate shareholders enjoy a similar territorial system on certain dividends received from 10%-owned foreign subsidiaries. Specifically, dividends paid from these subsidiaries’ exempt surplus balance are not, in theory, subject to Canadian tax. The definition of “exempt surplus” is complex, but essentially boils down to the tax-retained earnings of a 10%-owned foreign subsidiary that is: a) resident in a country that maintains a tax treaty or tax information exchange agreement with Canada and b) carries on an active business in the country.
Since 1976, this exemption system has played an important role in distinguishing Canada as a jurisdiction in which to centralize and hold foreign investments. Thus, the US’s move to a territorial system will erode one of Canada’s relative advantages as a holding company jurisdiction. And in certain cases, the US outbound tax regime may be less restrictive, as the foreign subsidiary need not be a resident of a country in which the US maintains a bilateral tax agreement.
Special preferential tax rate for export goods and services
Countries often implement preferential tax regimes to encourage the performance of certain activities (e.g., research and development, export goods and services). The patent box is one of these regimes, taxing income associated with the development, commercialization, and exploitation of intellectual property (IP) at a lower rate.
The US enacted the foreign-derived intangible income (FDII) rules as part of the 2017 Reform to encourage not only the selling and licensing of IP from US corporations to foreign third parties, but also the export of certain properties and services. The effective tax rate on FDII is 13.125%, and it increases to 16.406% for tax years beginning on or after January 1, 2026. These rules are broader in scope than a traditional patent box, and their goal is to incentivize companies to bring jobs and intangible property back to the US.
Currently, only the Quebec and Saskatchewan provincial governments have patent box regimes that provide for a reduction of provincial taxes for certain innovative activities. British Columbia previously offered a similar program, but it was eliminated on September 12, 2017.7
Before Trump’s 2017 Reform, Canada was the preferred jurisdiction in which to hold intangible property within North America. Combined with the lower corporate income tax rate, this motivated some companies to move their tax residency from the US to Canada through inversion transactions (e.g., Burger King’s merger with Tim Hortons in 2014). Given the introduction of the FDII rules and the territorial system, however, US companies may no longer have an incentive to change their tax residency; in fact, even non-US companies may be motivated to relocate to the US, and technology companies—especially those with US investors—may be motivated to move IP back to the US.
Full expensing of new and “used” property
For US tax purposes, taxpayers are generally required to capitalize fixed assets and depreciate them at specified rates over time. The bonus depreciation system allows a taxpayer to immediately expense 50% of the cost of qualified property purchased and placed in service during certain periods. The 2017 Reform furthers this ability by allowing taxpayers to immediately expense 100% of the cost of certain new and used qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The bonus depreciation rate is gradually reduced from 80% to 20% over the period between 2023 and 2026 (calendar years).
The immediate tax expensing of fixed assets will significantly benefit those in capital-intensive industries, and it will undermine Canada’s ability to attract future investment in these industries since our tax depreciation rules are not as generous.
Comprehensive Canadian tax reform is needed
Economists generally agree that the 2017 Reform will help the Canadian economy indirectly in the short run, but hinder our productivity growth in the long run. How can our governments, at the federal and provincial level, soften the impact?
When looking for a solution, history is often the best teacher. After the last sweeping reform of the US federal tax code in 1986 (the “1986 Reform”), the Canadian government faced the same concerns as today. In response, our government implemented a comprehensive tax reform orchestrated by Finance Minister Michael Wilson based on the findings in The White Paper: Tax Reform 1987. 8The document states, “In an increasingly interdependent world, it is important not to allow Canada’s tax system to put our traders, businesses, investors and highly skilled individuals at a competitive disadvantage with other countries.” Later, it notes: “… our industries are being put at a competitive disadvantage in both domestic and foreign markets.”
The 1986 Reform in the US cut the US federal tax rate from 46% to 35% at a time when the Canadian federal tax rate for general corporations was 36%. The Canadian government responded by gradually dropping this rate several times, bringing it down from 28% in 1989 to the current rate of 15% in 2012. This was a feasible solution in the past, but it’s not clear whether there is still further room to drop the federal tax rate, which means that Canada may need to look to provincial tax rates and other creative mechanisms (e.g., introducing rules similar to the US FDII rules) to improve its tax competitiveness.
In summary, a comprehensive review and reform of our tax system is urgently needed to maintain Canada’s relative tax competitiveness. We note the Canadian federal budget released on February 27, 2018, does not specifically address the 2017 Reform; rather, it includes a commitment to analyze the 2017 Reform’s potential impacts on Canada. As a result, taxpayers will need to stay tuned to find out how our government will respond to these changes.
The Economist, Pocket World in Figures – 2018. China, however, is the world’s largest economy by purchasing power—i.e., GDP PPP (purchasing power parity).
This is based on the assumed average state tax rate of 6%. 38.9%=35%+6% (1-35%) – author calculation.
Jenny Li is an international tax partner with the Vancouver office of PwC Canada. She specializes in cross-border taxation and has extensive experience advising Canadian businesses that are expanding globally and foreign businesses that are entering the Canadian market.
Kevin Too is an international tax senior associate with the Vancouver office of PwC Canada. He is experienced in Canadian and US international tax matters and has helped clients expand their businesses globally with a focus on Canada-US tax planning.