Tax Planning

Tax Planning Developments: Essential Worldwide Tax Adjustments

In 2021, a number of significant changes were proposed for international taxation in Canada. In Canada’s 2021 federal budget (2021 budget), three major international tax proposals related to profit cuts, anti-hybrid measures and a tax on digital services were introduced. Taken alone, each proposal represents a significant change in existing practice and raises complex tax issues that affect a wide range of large international corporations. Taken together, they represent an ambitious project that aims to align with some of the key proposals in OECD work on Base Erosion and Profit Shifting (BEPS). The 2021 budget contained descriptions of the expected regulations with varying degrees of specificity, but without specific legal wording.

As Canada and the rest of the world seek to reshape the international tax system, multinational corporations will face many new challenges (and potential planning opportunities).

In addition, Canada continues to work with the OECD, the G20 and around 140 members of the Inclusive Framework on BEPS on important international tax reform proposals (the two-pillar solution or BEPS 2.0).

Proposals to cut profits

The first important proposal is a new limit for the deductibility of interest (based on OECD BEPS Action 4). Its purpose is to reduce loss of earnings by allowing taxpayers to use debt, affiliates, and intra-group debt to obtain interest deductions that the government considers excessive or that fund the generation of tax-exempt or deferred income. A new limit would be created that excludes the deductibility of interest above a specified threshold, which is expected to amount to 30% of EBITDA (calculated according to the new regulation).

Interest expenses that are refused according to the new regulation can be carried forward for up to 20 years or repaid for up to three years. Certain taxpayers – generally smaller taxpayers and most groups of companies that do not include non-resident members – are completely exempt from the limit. Some taxpayers may be able to deduct interest up to a higher limit if the ratio of net third party interest to EBITDA of their consolidated group makes it reasonable (for example, because some sectors or groups may be more leveraged, such as land and infrastructure). The new regulations are to be introduced gradually with an initial fixed percentage of 40% for tax years beginning on or after January 1, 2023, but before January 1, 2024. The limit of 30% applies to the following years.

Regardless, Canada has had low capitalization rules for many years, which generally limit the deductibility of interest when the debt to equity ratio of certain non-resident shareholders exceeds 1.5: 1. The government has proposed to keep the existing undercapitalization rules and apply them in conjunction with the proposed profit reduction rules. The new rules will significantly increase the complexity of cross-border interest deductibility for taxpayers, especially when compared to the relatively straightforward approach under the undercapitalization rules. In addition, contrary to the existing undercapitalization rules, the proposals apply to borrowing from Independent Individuals and Canadian Residents.

Anti-hybrid proposals

The second key proposal concerns new anti-hybrid measures. These are intended to reduce the tax advantages currently available in some situations, which are due to the fact that a company is treated differently by different legal systems (corresponding to the OECD BEPS Action 2). Four types of hybrid mismatch arrangements are sought:

  • “Deduction / Non-Inclusion Mismatch” when an amount is deducted in Country A but not included in Country B income
  • “Double deduction mismatches” where one economic expense results in tax deductions in two or more countries
  • “Imported mismatch” where a company in Country A deducts a payment and a company in Country B includes the payment as ordinary income, but offsets that inclusion through a deduction from an arrangement with a company in Country C.
  • “Industry mismatch” where a taxpayer’s country of residence and the country of their branch office have different views on how income and expenses should be allocated between the branch and the taxpayer

The proposed rules are intended to refuse deductions in relation to such arrangements on a mechanical basis (i.e., regardless of purpose). In particular, the proposals are intended to target certain hybrid inbound structures involving a US parent company and a Canadian subsidiary that have been the subject of CRA review activities.

New tax on digital services

The third major proposal is a 3% Digital Services Tax (DST) on more than $ 20 million Canadian digital service revenue that relies on the engagement, data and content contributions of Canadian users. In-scope sales include sales from online marketplaces, social media, online advertising, and user data. The DST would only apply to corporations whose global sales from all sources in the previous calendar year were at least 750 million euros.

The DST proposal is conceived as a provisional measure pending a global agreement within the framework of the OECD / G20 Pillar 1. An annual return and payment would be required for each group, although all members are jointly and severally liable for the tax. The DST is expected to apply from January 1, 2022, although the tax cannot be collected until 2024 unless a global pillar one deal goes into effect before the end of 2023.

International tax reform – BEPS 2.0

Canada continues to work with the OECD, G20 and the Inclusive Framework on proposals for international tax reforms. A high-level agreement was reached in 2021 and will be refined in 2022. These proposals should generally come into force in 2023.

The agreement is based on two pillars:

  • Pillar one offers market jurisdictions (in which customers are resident) a new right to tax in order to receive a share of the residual profit of a multinational corporation (MNE) (amount A). In addition, the calculation of a fixed rate of return for certain basic and marketing and sales activities in jurisdictions where a multinational company is physically present is considered (amount B). It also includes dispute prevention and resolution mechanisms (referred to as tax security by the OECD).
    • According to this proposal, 25% of the residual profit (defined as profit of more than 10% of sales) is allocated to market areas with sufficient linkage and measured using a sales-based allocation key.
    • The tax will initially apply to multinational companies with a worldwide turnover of over 20 billion euros and a profitability of over 10%. The turnover threshold will be lowered to 10 billion euros until successful implementation (determined seven to eight years after the first pillar comes into force).
    • Profits and losses need to be measured by reference to financial accounting income with a small number of adjustments. Losses are carried forward, although it is currently unclear whether the presentation period is indefinite.
    • The first pillar will be implemented by a multilateral convention to be developed, which is expected to be signed in mid-2022 and come into force in 2023.
    • After implementation, the participating countries will remove all DSTs or similar measures.
  • Pillar two provides a minimum global tax of 15%, which is levied through two national regulations and one contract-based regulation.
    • The Domestic Income Inclusion Rule (IIR) will tax the income of a foreign-controlled company (or a foreign branch) with ongoing taxation if that income was otherwise subject to an effective tax rate that is below a certain minimum rate.
    • The domestic under-taxed payment rule (UTPR) either denies a deduction or requires an equivalent adjustment based on eroding payments, unless the payments are subject to taxation at or above a certain minimum in the recipient’s territory.
    • The convention-based rule known as the Subject-to-Tax Rule (STTR) will allow source countries to impose withholding taxes on certain payments from related parties (particularly interest and royalties) that are subject to US taxation below a minimum rate of 9% are subject to the responsibility of the recipient. STTR taxes are taken into account when determining the effective tax rate for the purposes of the IIR and UTPR.
    • These new rules apply to multinational companies with total consolidated sales of at least EUR 750 million. Countries can also apply the IIR to multinational companies based in their country that do not meet the threshold.
    • The calculation of the effective tax rate in a jurisdiction that promotes the application of the second pillar uses a common definition of the taxes recorded and a tax base determined by reference to the revenue from the financial accounting (with agreed adjustments in line with the tax policy objectives of Pillar Two and Mechanisms for Resolving Time Differences).
    • Certain exclusions and carve-outs will be available. The two main exclusions are (i) a formulaic spin-off that excludes an amount of income that is 5% of the book value of property, plant and equipment and payroll in a jurisdiction, and (ii) a de minimis exception that applies when the multinational company is less than Turnover of EUR 10 million and profit of less than EUR 1 million. The spin-off will be more generous during an initial transition period of 10 years but will fall back to the proposed amounts over the 10 years.
    • It is expected that rules for implementing the Pillar Two changes will be developed by the end of November 2021, with an additional multilateral instrument being developed by mid-2022 and an implementation framework by the end of 2022.

Both pillars come after years of international political negotiations that are still ongoing. Although many details remain to be determined and the final implementation of the pillars is not guaranteed, the International Framework Agreement represents an important milestone on the way to a consistent, global approach to these questions. It will be important to understand these developments – and Canada’s reactions , the United States and other countries – as they could have a significant impact on many multinational corporations.

As Canada and the rest of the world seek to reshape the international tax system, multinational corporations will face many new challenges (and potential planning opportunities). Osler’s national steering group can help determine the best way to anticipate or respond to these changes.

Related Articles