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International trade and taxation: the GATT and domestic tax policy Rajan, Cindy L. 1995

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INTERNATIONAL TRADE AND  TAXATION:  THE GATT and DOMESTIC TAX POLICY by CINDY L. RAJAN LL.B., U n i v e r s i t y o f C a l g a r y  (Canada),  1992  A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS in THE FACULTY OF GRADUATE STUDIES ( F a c u l t y o f Law) We accept t h i s t h e s i s as conforming to the required  standard.  THE UNIVERSITY OF BRITISH COLUMBIA June 1995 ©Cindy L. Rajan,  1995  In  presenting this  degree at the  thesis  in  University of  partial  fulfilment  of  of  department  this or  thesis for by  his  or  scholarly purposes may be her  representatives.  permission.  of  The University of British Columbia Vancouver, Canada  DE-6 (2/88)  for  an advanced  Library shall make  it  agree that permission for extensive  It  publication of this thesis for financial gain shall not  Department  requirements  British Columbia, I agree that the  freely available for reference and study. I further copying  the  is  granted  by the  understood  that  head of copying  my or  be allowed without my written  11 ABSTRACT The  thesis  international  i s that  trade  to  give  agreements  insufficient  i n developing  r e s u l t i n d i s t o r t i o n s i n international trade. that the objective to  sovereign  However,  to  t a x p o l i c i e s can I t i s not suggested  o f f a c i l i t a t i n g f r e e t r a d e s h o u l d be paramount  interests  the  recognition  which  proposition  is  underlie that  tax policy  in  selecting  decisions. from  among  a l t e r n a t i v e t a x p o l i c i e s , t h e p o l i c y which should be chosen i s t h a t which  achieves  national  objectives  e f f e c t s on i n t e r n a t i o n a l The  goals  particular  of  while  minimizing  distortive  trade.  this  study  tax provisions  a r e : 1)  impede,  to  distort,  determine  o r otherwise  whether have a  n e g a t i v e and u n j u s t i f i a b l e e f f e c t on f r e e t r a d e ; and 2) t o r e f l e c t on  the i n t e r s e c t i n g  Although  many  tax  "discriminatory", international  role  of taxation  policies  may  and i n t e r n a t i o n a l  be  viewed  as  trade.  prima  facie  such d i s c r i m i n a t i o n may be a c c e p t a b l e pursuant t o  agreements,  or overriding  national  interests  may  p r e v a i l . An attempt i s made t o develop a framework f o r examining the e f f e c t s o f t a x a t i o n a  guide  on i n t e r n a t i o n a l t r a d e which can be used as  f o r tax policy  makers i n s e l e c t i n g  domestic c r i t e r i a as w e l l as f a c i l i t a t e f r e e The sets basis  of f i v e chapters.  out t h e methodology, f o r t h e study.  regimes Trade  thesis consists  conceptual  p o l i c i e s which meet trade. The f i r s t  framework  and  chapter theoretical  The next t h r e e c h a p t e r s examine s p e c i f i c t a x  i n the context  o f t h e General Agreement on T a r i f f s and  (the "GATT") and u n d e r l y i n g p r i n c i p l e s o f f r e e t r a d e .  The  Ill  tax regimes a r e : 1) w i t h h o l d i n g taxes f o r payments under  software  l i c e n s i n g arrangements; 2) r e s e a r c h and development t a x i n c e n t i v e s ; and  3)  cross-border  summarizes  the  harmonization GATT  tax  case  transfer  pricing  s t u d i e s and  o u t l i n e s approaches  least  placed  to  five  fiscal  under a f r e e t r a d e regime. The c o n c l u s i o n i s t h a t a  code  may  be  an  appropriate  harmonization f o r c e r t a i n t a x measures. at  p r o v i s i o n s . Chapter  mechanism  f o r achieving  However, i t i s i n f e a s i b l e ,  i n the s h o r t term, t o expect a GATT t a x code w i l l  on the World Trade O r g a n i z a t i o n ' s agenda.  be  Even i f such a  code i s a t t a i n a b l e i n the f u t u r e , u n i l a t e r a l , b i l a t e r a l and o t h e r m u l t i - l a t e r a l approaches t o e l i m i n a t i n g d i s t o r t i v e t a x p o l i c i e s may be more a p p r o p r i a t e i n some cases.  iv TABLE OF CONTENTS  Abstract  i i  T a b l e o f Contents  iv  Acknowledgement  viii  Dedication  ix  CHAPTER 1: INTRODUCTION PART I :  OVERVIEW  6  PART I I :  FREE TRADE  11  PART I I I : TAXATION AND FREE TRADE  19  CHAPTER 2: SOFTWARE LICENSING INTRODUCTION PART I :  34  CROSS-BORDER PAYMENTS UNDER SOFTWARE LICENSING  ARRANGEMENTS  A.  The Canadian Approach  36  B.  Royalty Provisions  39  C.  The Problem o f Double T a x a t i o n  i n Multilateral Treaties  43  D. Recent Developments PART I I : THE GATT AND WITHHOLDING TAX ON PAYMENTS FOR SOFTWARE  45  A.  Introduction  47  B.  The P r i n c i p l e o f N o n d i s c r i m i n a t i o n and I t s I n t e r p r e t a t i o n  48  i. ii.  The P r i n c i p l e Interpretation of A r t i c l e I I I a. I n t e r n a l Taxes: D i r e c t , I n d i r e c t o r Both b. P o l i c y Purpose  48 50 51 55  V  c. C.  Extent o f E f f e c t on Trade  Withholding i. ii. iii. iv.  Tax and A r t i c l e 111:2  Withholding Tax - D i r e c t o r I n d i r e c t I n t e r n a l Taxes - D i r e c t and I n d i r e c t Discriminatory Taxation J u s t i f i a b l e Discrimination?  CONCLUSION  56 57 57 60 62 65 67  CHAPTER 3:  RESEARCH & DEVELOPMENT  INTRODUCTION  69  PART I : R&D TAX INCENTIVES  72  A.  72  The Canadian System i. ii. iii. iv. v. vi. vii.  B.  Overview R&D Pool - D e d u c t i b l e Expenditures ITCs C a p i t a l Expenditures CCPCs - Enhanced ITCs F o r e i g n R&D Summary  Recent Developments  PART I I :  SUBSIDIES AND THE URUGUAY ROUND  72 76 78 82 83 83 85 86 87  A.  Introduction  87  B.  The SCM Agreement  89  i. ii.  89 94  PART I I I :  Overview R&D S u b s i d i e s CANADIAN R&D TAX INCENTIVES: DISCRIMINATORY SUBSIDIES?  A.  Free Trade, D i s c r i m i n a t i o n and R&D Tax S u b s i d i e s  B.  J u s t i f i a b l e Incentives?  107  C.  The Need f o r R e v i s i o n  115  CONCLUSION  98  117  vi CHAPTER 4:  TRANSFER PRICING  INTRODUCTION  120  PART I :  124  THE NATURE OF TRANSFER PRICING  A.  The Tax Avoidance P e r s p e c t i v e  125  B.  The Income Measurement P e r s p e c t i v e  127  C.  Conclusion  128  PART I I :  DISCRIMINATION IN THE TRANSFER PRICING REGIME  131  A.  To Which Taxpayers do T r a n s f e r P r i c i n g Rules Apply?  132  B.  What T r a n s a c t i o n s a r e A f f e c t e d ?  135  C.  How i s t h e T r a n s f e r P r i c e Determined?  13 6  i. ii.  138 143  Arm's Length P r i n c i p l e Methods f o r Determining t h e Arm's Length P r i c e a. Goods and A c q u i s i t i o n s / D i s p o s i t i o n s of I n t a n g i b l e s b. Use o f I n t a n g i b l e s  iii. iv.  T r a n s f e r P r i c i n g and Customs V a l u a t i o n Conclusion  143 147 150 154  D.  What a r e t h e E f f e c t s o f T r a n s f e r P r i c i n g Adjustments?  155  E.  Compliance and P r e v e n t i o n  161  i. ii. iii.  161 164 170  Compliance Prevention Conclusion  PART I I I : JUSTIFICATION FOR DISCRIMINATION & ALTERNATIVES A.  171  Summary o f D i s c r i m i n a t i o n i n t h e T r a n s f e r P r i c i n g Regime  171  B.  J u s t i f i a b l e Discrimination?  173  C.  Alternatives  176  CONCLUSION  181  vii CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS INTRODUCTION  184  PART I : SUMMARY AND CONCLUSIONS  184  A.  Case Study Summaries  184  B.  Conclusions  190  PART I I : RECOMMENDATIONS  191  A.  GATT Tax Code  192  B.  U n i l a t e r a l and B i l a t e r a l Approaches  2 01  SUMMARY  204  BIBLIOGRAPHY  206  viii ACKNOWLEDGMENT  I  would  like  t o thank  Graduate's Dean, P r o f e s s o r  my  thesis  supervisor,  also  our  Pitman P o t t e r f o r h i s encouragement and  guidance from my a p p l i c a t i o n f o r admittance t o t h e LL.M. program through t o completion o f t h i s t h e s i s . H i s comments and a d v i c e were always i n s i g h t f u l and thought provoking, and have generated many ideas f o r f u t u r e Special  research.  thanks t o P r o f e s s o r  Robert Paterson,  as my t h e s i s *  second reader, who reviewed d r a f t s o f manuscripts and p r o v i d e d me w i t h guidance and v a l u a b l e feedback throughout my Master's program. I would a l s o  l i k e t o acknowledge P r o f e s s o r  C l a i r e Young f o r  h e l p f u l comments on t h e t a x a s p e c t s o f my t h e s i s . I  also  Professor Calgary,  want t o acknowledge and express my a p p r e c i a t i o n t o  Catherine  Brown o f t h e F a c u l t y  o f Law, U n i v e r s i t y of  who has been e s p e c i a l l y s u p p o r t i v e  p r o f e s s i o n a l p u r s u i t s s i n c e my LL.B.  o f my academic and  program a t t h e U n i v e r s i t y o f  Calgary, c o n t r i b u t i n g time, r e s o u r c e s , a d v i c e and i n s p i r a t i o n . Finally, Law  I would l i k e t o express my a p p r e c i a t i o n  t o t h e B.C.  Foundation who p r o v i d e d generous f i n a n c i a l support i n p u r s u i n g  t h i s degree. In s p i t e o f a l l t h e support I have had i n s e e i n g  this thesis  through t o completion, t h e s o l e r e s p o n s i b i l i t y f o r any e r r o r s and omissions i s mine alone.  To my  husand and my p a r e n t s f o r t h e i r l o v e and  support.  1 CHAPTER 1 INTERNATIONAL TRADE AND  TAXATION  "The t o p i c , i n my view, i s an important one t h a t has not r e c e i v e d s u f f i c i e n t a t t e n t i o n . I t makes l i t t l e sense t o break down b a r r i e r s t o i n t e r n a t i o n a l t r a d e and t o pursue economic i n t e g r a t i o n , whether i n Europe, North America or the South P a c i f i c , without d e a l i n g w i t h the r e l a t e d t a x issues." 1  Advances i n i n t e r n a t i o n a l t r a d e should not be impeded by tax p o l i c i e s without distort  international  technology. generally  sound j u s t i f i c a t i o n ; y e t t a x p o l i c i e s can and trade  in  capital,  I n t e r n a t i o n a l t a x a t i o n and treated  'globalization  1  as  and  interrelationship  independent  goods,  international  fields  of  f r e e t r a d e are the order  between domestic  tax  study.  removing  in  a l l corners  a l l forms of b a r r i e r s  of  policy  the  to trade  and  world and  trade  and are  However,  2  of the day  t r a d e law takes on more importance i n t h i s g l o b a l Governments  services  do  and  the  international marketplace.  seem  intent  expanding  on  economic  unions and f r e e t r a d e zones i n order t o remain c o m p e t i t i v e i n the g l o b a l marketplace.  3  There can be no doubt t h a t the c o m p l e x i t i e s  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the U n i t e d Kingdom, and the U n i t e d S t a t e s " , Canadian Tax Paper No. 90, (Toronto: Canadian Tax Foundation, 1991) a t x i v . 1  C l e a r l y the s u b j e c t of i n t e r n a t i o n a l a s p e c t s of t a x a t i o n i s not new. However, u n t i l r e c e n t l y , i t has not been necessary t o c o n s i d e r the i n t e r n a t i o n a l r a m i f i c a t i o n s of domestic t a x a t i o n , beyond s p e c i f i c t r a d e i n t e r v e n t i o n s such as customs d u t i e s . See Donald J . S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n : The Canadian P e r s p e c t i v e " , Canadian Tax Paper No. 75 (Toronto: CTF, 1984), x i i i and 1. 2  See L. Denis Desautels, " P l a y i n g w i t h B l o c s " , CA Magazine, January/February 1995 (Toronto: CICA, 1995) 38, i n which the A u d i t o r General of Canada 'examines how our s m a l l , but dynamic, n a t i o n w i l l f i t i n t o the g l o b a l marketplace.' 3  2 of g l o b a l social,  t r a d e can and  be  overwhelming i n view of v a r y i n g  political  conditions;  unilateral,  bilateral  m u l t i l a t e r a l tax regimes add t o the c o n f u s i o n . Yet, t o t a x a t i o n as a n a t i o n a l p r e r o g a t i v e and  economic,  despite  and  claims  complexities involved  in  o v e r l a p p i n g i n t e r n a t i o n a l t r a d e agreements w i t h tax p r a c t i c e s , i t is  e s s e n t i a l t o understand the  international The  i s that  i f not  insufficient  practices  can  have  on  practice  is  trade.  thesis  intimately,  impact tax  international trade  explicitly,  consideration  to  intertwined  entering  and  with taxation;  international  d e v e l o p i n g n a t i o n a l tax laws and  law  trade  to give  agreements  i n t o t r e a t i e s can  the a b i l i t y t o a t t a i n the p o s i t i v e g o a l s of f r e e t r a d e .  impair  Therefore  t h i s study attempts t o develop a framework f o r u n d e r s t a n d i n g effects  of  makers  in  taxation  on  developing  alternative strategies goals  and  trade  minimize  objectives.  furthering The  4  international sound  policies  and  to  guide tax  selecting  counter-productive This  understanding  impacts is  on  also  the  policy  from  those tax measures which promote  international f i s c a l  object  trade  in  among  national  international relevant  to  harmonization.  of t h i s study i s the Canadian income tax system i n  Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra at 1: "As countries cast tax nets beyond their borders, international fiscal overlap is inevitably created with i m p l i c a t i o n s f o r the e f f i c i e n c y of the world economy, f o r the e f f e c t i v e n e s s of domestic tax p o l i c i e s , and f o r the l e v e l and d i s t r i b u t i o n of g a i n s from i n t e r n a t i o n a l economic i n t e g r a t i o n . " 4  3 the broader c o n t e x t of Canada-U.S. t r a d e ; the p e r s p e c t i v e has both 5  national  and  international  dimensions.  s p e c i f i c t a x regimes which may  The  study  focuses  on  impact on r e s e a r c h and development  of technology as w e l l as on the flow of i n t e r n a t i o n a l t r a n s f e r s of technology both between arm's l e n g t h and non-arm's l e n g t h p a r t i e s . The emphasis on t a x p o l i c i e s which have a s p e c i a l r e l a t i o n s h i p to technology  i s grounded  6  i n the r e a l i t i e s  of the  twenty-first  c e n t u r y marketplace.  ' G l o b a l i z a t i o n ' was the buzz word of the  and  the g l o b a l  early  90's;  now  marketplace  i s moving a l o n g  • i n f o r m a t i o n highway' i n t o the ' i n f o r m a t i o n e r a ' . era  is  here  and  technology  is  the  commodity  80's the  The i n f o r m a t i o n of  the  future.  S i g n i f i c a n t p r o g r e s s was made a t the Uruguay Round of the GATT w i t h  Although i t may not be r e a s o n a b l e t o equate Canada and the U n i t e d S t a t e s i n terms of r e s o u r c e s , wealth and power, these c o u n t r i e s are both c o n s i d e r e d t o be developed c o u n t r i e s . Also, Canada has an e s t a b l i s h e d t r a d e r e l a t i o n s h i p w i t h the U n i t e d S t a t e s which i s s i g n i f i c a n t t o the Canadian economy. Trade w i t h Mexico, though a n a t u r a l e x t e n s i o n t o t h i s study g i v e n NAFTA, has not been addressed as issues r e l a t i n g t o t r a d e among developed and d e v e l o p i n g n a t i o n s , though important, are beyond the scope of t h i s study. 5  The d e f i n i t i o n adopted f o r "technology" i s t h a t s e t out i n C A . Brown, "Tax Aspects of The T r a n s f e r of Technology: The A s i a P a c i f i c Rim", Canadian Tax Paper No. 87. (Toronto: Canadian Tax Foundation, 1990) a t 5 - 6: "Technology i s , i n the f i n a l a n a l y s i s , a form of knowledge r e l a t i n g t o i n f o r m a t i o n w i t h s c i e n t i f i c or commercial value. T h i s knowledge may c o n s i s t of know-how, concepts, methodologies, formulas, models, d e s i g n s , p r o t o t y p e s , data bases or products embodying or u t i l i z i n g such knowledge". Brown a l s o r e f e r s t o the following common d e f i n i t i o n s f o r technology (at 6) : "technology as p u b l i c l y or p r i v a t e l y h e l d knowledge, technology as r e l a t i n g t o a p a r t i c u l a r stage of i t s development by the t r a n s f e r o r , technology as r e l a t i n g t o a p a r t i c u l a r stage of the technology r e c i p i e n t ' s needs f o r i t s p r o j e c t development, technology as r e l a t i n g t o a p a r t i c u l a r i n d u s t r y , and technology as c a t e g o r i e s of i n t e l l e c t u a l p r o p e r t y r i g h t s p r o t e c t e d t o v a r i o u s degrees." 6  4 r e g a r d t o improved p r o t e c t i o n of i n t e l l e c t u a l p r o p e r t y r i g h t s on a global  scale.  7  In  part  this  advancement  should  stimulate  the  development o f , and t r a d e i n technology through t h e p r o t e c t i o n and enforcement  of  intellectual  property  rights  outside  the  rights  h o l d e r s * home j u r i s d i c t i o n . I t seems o n l y l o g i c a l t h a t the domestic and  international  impede, t h i s  tax  progress.  structures Yet  impediment t o f r e e t r a d e i n  should  further,  domestic t a x p o l i c i e s technology.  rather  are  than  a possible  8  The methodology used i n t h i s r e s e a r c h i s p r i m a r i l y i n d u c t i v e an attempt i s made t o determine g e n e r a l p r i n c i p l e s about the f u t u r e of tax p o l i c y f o r m u l a t i o n i n the c o n t e x t of the g l o b a l market p l a c e by r e f e r e n c e t o s p e c i f i c case s t u d i e s .  Resource m a t e r i a l s i n c l u d e  s t u d i e s on t a x a t i o n i n the g l o b a l economy by the O r g a n i z a t i o n f o r Economic  Cooperation  and  Development  ("OECD"),  the  Series  on  ' The Agreement on Trade-Related Aspects of on I n t e l l e c t u a l P r o p e r t y R i g h t s ("TRIPs") (Annex IC t o the Agreement E s t a b l i s h i n g the World Trade O r g a n i z a t i o n . Uruguay Round F i n a l A c t , Marrakesh, A p r i l 15, 1994) i s the f i r s t t r a d e agreement which p r o v i d e s f o r comprehensive worldwide protection for and enforcement of i n t e l l e c t u a l property r i g h t s . With r e g a r d t o f r e e t r a d e i n technology, n o n - t a r i f f b a r r i e r s have g e n e r a l l y been used t o c o n t r o l the c o n d i t i o n s under which market access takes p l a c e . N o n - t a r i f f b a r r i e r s are more s u b t l e i n t h e i r a p p l i c a t i o n and p o t e n t i a l l y more r e s t r i c t i v e than t a r i f f s i n t h e i r e f f e c t . Robert B. Cohen, R i c h a r d W. Ferguson, and M i c h a e l F. Oppenheimer, N o n t a r i f f B a r r i e r s t o High-Technology Trade (Boulder: Westview P r e s s , Inc., 1985) a t 13. Although domestic tax p o l i c i e s are not a separate category o f n o n - t a r i f f b a r r i e r s (such as q u a n t i t a t i v e r e s t r i c t i o n s , a d m i n i s t r a t i v e b a r r i e r s t o t r a d e , and government procurement), the extent t o which t a x p o l i c i e s can have s u b t l e and r e s t r i c t i v e e f f e c t s on t r a d e and come w i t h the scope of i n t e r n a t i o n a l t r a d e agreements i s e x p l o r e d . 8  5 I n t e r n a t i o n a l T a x a t i o n , and the Canadian 9  a  variety  of  literature  by  Canadian  and  American  accountants,  lawyers,  Tax Foundation  conference  ("CTF"),  materials,  and  officials  and  government  economists on i n t e r n a t i o n a l law, f i s c a l harmonization, t a x p o l i c y , and technology. detailed  In a d d i t i o n , the p a r t i c u l a r case s t u d i e s compel  analysis  provisions,  of  Canadian  international  1 0  Income  trade  Tax  Act  agreements,  (the and  "ITA")  scholarly  i n t e r p r e t a t i o n s of these documents. Case law and p a n e l d e c i s i o n s of i n t e r n a t i o n a l bodies are a l s o r e f e r r e d t o . The purpose determine  of t h i s study i s t w o f o l d :  whether  the  tax  p r o v i s i o n s under  The  first  review  goal i s to prima  facie  impede, d i s t o r t or otherwise have an u n j u s t i f i a b l e d i s c r i m i n a t o r y effect  on  technology? Agreement  the  global  development  Each t a x p r a c t i c e w i l l on  Tariffs  and  Trade  11  or  international  transfer  be examined under the ("GATT")  to  assess  of  General how  the  T h i s s e r i e s i s p u b l i s h e d by the Kluwer Law and T a x a t i o n P u b l i s h e r s i n Deventer, Netherlands and i s i n t e n d e d f o r use by those engaged i n the p r a c t i c e of i n t e r n a t i o n a l t a x a t i o n . 9  R.S.C. 1952, c. 148 as amended by S.C. as subsequently amended. 10  1970-71-72, c.63  and  October 30, 1947, 61 S t a t . A3, T.I.A.S. No. 1700, 55 U.N.T.S. 187. The emphasis i s on the GATT, d e s p i t e the Canada-U.S. context, as a GATT a n a l y s i s has a more g l o b a l application. Reference w i l l be made t o the North American Free Trade Agreement ("NAFTA") (Ottawa: M i n i s t e r of Supply and S e r v i c e s Canada, 1993). NAFTA came i n t o e f f e c t on January 1, 1994 (see North American Free Trade Agreement Implementation A c t . S.C. 1993, c. 44). As d i s c u s s e d i n Robert K. Paterson and M a r t i n e N. Band, eds., I n t e r n a t i o n a l Trade and Investment Law i n Canada. (2d) (Toronto: C a r s w e l l , 1994) a t 2-6, the FTA [and NAFTA] "do not r e p l a c e the GATT as the i n t e r n a t i o n a l l e g a l f o u n d a t i o n of the t r a d i n g r e l a t i o n s h i p between Canada and the U n i t e d S t a t e s . In many r e s p e c t s the FTA [and NAFTA] can be seen as c l a r i f y i n g the mutual understanding of i t s P a r t i e s as t o t h e i r l e v e l of compliance w i t h t h e i r GATT o b l i g a t i o n s i n 11  6  p r a c t i c e measures up t o t h e p r i n c i p l e s s e t out t h e r e i n .  This  will  r e q u i r e an a n a l y s i s o f each o f t h e t a x p r o v i s i o n s and t h e r e l e v a n t Articles  i n t h e GATT  and t h e Canada-U.S.  Tax Convention.  The  domestic t a x regimes a r e a l s o compared w i t h t h e O r g a n i z a t i o n f o r Economic Cooperation and Development Model Convention Model") when a p p l i c a b l e ,  as w e l l  as o t h e r  foreign  (the "OECD  tax p o l i c i e s  which a s s i s t i n i l l u s t r a t i n g and c l a r i f y i n g t h e i s s u e under review. The  second g o a l o f t h i s study i s much broader and goes beyond  the s p e c i f i c examples under c o n s i d e r a t i o n . the  Uruguay  eliminating the  Round  o f GATT,  and t h e emphasis  a l l b a r r i e r s t o trade,  Therefore,  with  on  reducing  or  i t i s worthwhile t o determine  broader e f f e c t o f d i s c r i m i n a t o r y  marketplace.  With t h e c o n c l u s i o n o f  t a x measures i n t h e g l o b a l  the r e s u l t s  from  the  analysis  d e s c r i b e d above suggestions w i l l be made r e g a r d i n g t h e i n t e r s e c t i n g r o l e of taxation  and i n t e r n a t i o n a l t r a d e i n f i s c a l  harmonization.  PART I : OVERVIEW This introductory the study.  chapter p r o v i d e s a c o n c e p t u a l framework f o r  I t b r i e f l y o u t l i n e s t h e arguments f o r and a g a i n s t  t r a d e i n order t o e s t a b l i s h t h e b a s i s which f a c i l i t a t e f r e e t r a d e .  f o r proposing tax p o l i c i e s  The c o n c e p t u a l framework f o r  the r e l a t i o n s h i p between t a x a t i o n  free  studying  and i n t e r n a t i o n a l t r a d e i s a l s o  outlined. Chapters  2 through  4 contain  the analysis  o f ITA r u l e s i n  s p e c i f i c areas o f t r a d e . Some a l s o r e g a r d c e r t a i n p r o v i s i o n s o f the FTA [and NAFTA] (such as those c o n c e r n i n g t r a d e i n s e r v i c e s and d i s p u t e settlement) as f o r e r u n n e r s o f f u t u r e m u l t i l a t e r a l economic agreements t o be developed under GATT a u s p i c e s . "  7  t h r e e areas i n p a r a l l e l  with  i n t e r n a t i o n a l t a x t r e a t i e s and t h e  GATT. The case s t u d i e s are: 1) t h e w i t h h o l d i n g t a x on c r o s s - b o r d e r payments  f o r licensed  software;  2) t h e s c i e n t i f i c  research  and  development t a x i n c e n t i v e system; and 3) t h e i n t e r n a t i o n a l t r a n s f e r pricing  regime.  These  chapters  are  both  descriptive  and  a n a l y t i c a l ; t h e s p e c i f i c t a x and t r a d e p o l i c i e s under review a r e p r e s e n t e d and t h e i n t e r p l a y between t h e p a r t i c u l a r t a x p o l i c y and i n t e r n a t i o n a l t r a d e r a m i f i c a t i o n s i s examined. As mentioned p r e v i o u s l y , in  part  because  they  these p r o v i s i o n s  impact  on  have been  technology  selected  development  and  technology t r a n s f e r . The p a r t i c u l a r t a x r u l e s under review i n each of t h e case s t u d i e s a r e a l s o o f i n t e r e s t as they a r e c o n t r o v e r s i a l and  continue  recently treaty  t o be t h e s u b j e c t  begun  t o renegotiate  o f ongoing withholding  p a r t n e r s on payments f o r l i c e n s e d  recently  as March  8,  1995, r e l e a s e d  transfer pricing for multinational  f o r stimulating  Furthermore, although o n l y selected  tax provisions  require  Canada has with  some  s o f t w a r e ; t h e OECD, as recommendations  on  e n t e r p r i s e s as t h e outcome o f a  Report has been openly c r i t i c a l  programs and s t r a t e g y  tax rates  draft  major study i n t h i s area; and t h e A u d i t o r 1994  debate.  General o f Canada i n h i s  o f t h e e x i s t i n g government research  and development.  3 case s t u d i e s  a r e reviewed, t h e  an a n a l y s i s o f a v a r i e t y o f GATT  A r t i c l e s under t h e approach taken thereby p r o v i d i n g a broader b a s i s for conclusions flexibility within  and recommendations.  i n the a n a l y s i s .  t h e suggested  A l s o , each case study compels  I t i s hoped t h a t  framework w i l l  this  prove u s e f u l  flexibility  as a s t a r t i n g  8 point f o r future research i n t h i s area. Chapter  2 reviews  the matter  of arm's l e n g t h payments f o r  i n t e r n a t i o n a l t r a n s f e r s of technology i n the s p e c i f i c c o n t e x t of c r o s s - b o r d e r software payments. Revenue Canada t r e a t s c r o s s - b o r d e r payments f o r software under l i c e n s i n g arrangements as and,  therefore,  treatment  income  proposed  by  from  property. This  the  OECD  payments as b u s i n e s s p r o f i t s .  Model  Withholding  tax  may  i s contrary to  which  classifies  the  these  Cross-border r o y a l t y payments are  s u b j e c t t o w i t h h o l d i n g t a x under subparagraph ITA.  royalties,  result  2 1 2 ( 1 ) ( d ) ( i ) of the  i n increased prices  for  the  software t o the t r a n s f e r e e ; or reduce p r o f i t s or cash f l o w s t o the foreign transferor. bilateral  Although  Canada has  recently  concluded  two  conventions which reduce the w i t h h o l d i n g r a t e on these  payments t o 0%, Therefore,  the u n d e r l y i n g c h a r a c t e r i z a t i o n problem  foreign  software  developers  from  remains.  c o u n t r i e s without  r e n e g o t i a t e d t a x t r e a t i e s are p o t e n t i a l l y a t a disadvantage v i s a vis  domestic  disadvantages  producers may  be  of software.  viewed  as  The  e x t e n t t o which  discriminatory  in  these  international  t r a d e terms and a l t e r n a t i v e ways of m i n i m i z i n g or e l i m i n a t i n g such d i s c r i m i n a t i o n are e x p l o r e d . The  f o c u s of  Chapter  3  i s on  the  developmental  stages  of  technology. A c c o r d i n g l y the t a x measures under review are the tax i n c e n t i v e s f o r r e s e a r c h and development ("R&D") s e t out i n s e c t i o n s 37, 127 and 127.1  and r e g u l a t i o n 2900 of the ITA. Canada's R&D  i n c e n t i v e s are among the most generous  tax  i n the world and are viewed  as fundamental t o encouraging t e c h n o l o g i c a l development i n Canada.  9 However,  there  incentives Canadian  are  which  restrictions  favour  resident  on  research  taxpayers  the  availability  carried  carrying  on  on  within  of  these  Canada,  business  in  Canada.  Arguably, these tax i n c e n t i v e s d i s c r i m i n a t e a g a i n s t b u s i n e s s e s research  carried  on  outside  of  Canada  c o u n t e r v a i l a b l e s u b s i d i e s under the new  and  12  may  be  by  viewed  and as  GATT s u b s i d i e s agreement.  The q u e s t i o n of whether these i n c e n t i v e s are j u s t i f i a b l e under the s u b s i d i e s agreement, as w e l l as i n a p u r e l y domestic context, be pursued. The  need f o r r e v i s i o n s t o the  system which may  be more e f f e c t i v e i n a c h i e v i n g n a t i o n a l g o a l s  less vulnerable  e x i s t i n g tax  to i n t e r n a t i o n a l sanctions  Chapter 4 examines the p e r v a s i v e  i s also  will  incentive and  discussed  problem of t r a n s f e r p r i c i n g  i n i n t e r n a t i o n a l t r a d e among members of a m u l t i n a t i o n a l e n t e r p r i s e . When r e l a t e d companies s e t up o p e r a t i o n s transfer  pricing  issues  take  on  i n more than one  even  more  country,  significance  than  domestic t r a n s f e r p r i c i n g concerns. Canada's t r a n s f e r p r i c i n g r u l e s in  subsections  69(2)  between taxpayers and  and  of the  non-residents  d e a l i n g a t arm's l e n g t h . transactions  (3)  ITA,  deal with  transactions  w i t h whom the taxpayer i s not  Although t h e r e are s i m i l a r p r o v i s i o n s f o r  between r e s i d e n t s ,  these are  l i m i t e d i n scope.  The  reason f o r the d i f f e r e n c e , of course, i s t h a t t r a n s f e r p r i c i n g w i t h non-residents  r e s u l t s i n e r o s i o n of the Canadian t a x base, whereas  t r a n s f e r p r i c i n g w i t h r e s i d e n t s r e s u l t s o n l y i n s h i f t i n g of amounts  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t R e s i d e n t s and F o r e i g n A c t i v i t i e s " , supra a t 102. 12  Aliens,  Non-  10 between t a x p a y e r s .  In the  13  c o n t e x t of technology, a r r i v i n g a t  a  "reasonable p r i c e " f o r i n t a n g i b l e s i s s u b j e c t i v e and open t o abuse. Furthermore, the t r a n s f e r p r i c i n g regime which has far  greater  burdens  and  potential  risk  of  evolved  double  places  taxation  on  i n t e r n a t i o n a l non-arm's l e n g t h t r a n s f e r s than on s i m i l a r domestic transfers.  Arguably,  these  transfer  pricing  rules  discriminate  a g a i n s t m u l t i n a t i o n a l e n t e r p r i s e s w i t h b u s i n e s s t r a n s a c t i o n s beyond Canadian b o r d e r s .  Even though the  t h i s type of d i s c r i m i n a t i o n , p r i c i n g issues illuminate  OECD Model does not  prohibit  i t i s worthwhile t o examine t r a n s f e r  i n c o n n e c t i o n w i t h i n t e r n a t i o n a l t r a d e i n order t o  distortive  effects  which  may  arise  and  suggest  improvements t o the t r a n s f e r p r i c i n g regime. F i n a l l y , Chapter 5 summarizes the r e s u l t s of the case and  whether  trade.  these  s p e c i f i c tax  International  taxation  are  not  trade  p o l i c i e s promote  considerations  necessarily  and  conflicting  studies  international  sovereignty domains,  over  and  an  a c c e p t a b l e balance should be a t t a i n a b l e i f the i s s u e s are addressed i n a d i r e c t and coherent manner. The mechanisms and e x t e n t t o which developments international  in  domestic  trade  should  taxation, converge  t r e a t i e s p r o v i d e some a s s i s t a n c e complete s o l u t i o n , addressing  tax  and  fiscal are  harmonization  explored.  i n t h i s regard,  perhaps not  policy ramifications  even an i n the  and  While  they are  not  adequate s o l u t i o n global  market  tax a in  place.  T h i s r e s e a r c h w i l l attempt t o p r o v i d e support f o r the need f o r t h i s global perspective  13  i b i d . . at  i n f i s c a l h a r m o n i z a t i o n . I t i s suggested t h a t a  105.  11 GATT-type  tax  international  code  may  fiscal  be  an  appropriate  harmonization  approach  efforts.  for  Further,  i n t e r i m , domestic tax p o l i c y makers, as w e l l as those tax t r e a t y n e g o t i a t i o n s , should policy  decisions  on  be  aware of the  i n t e r n a t i o n a l trade,  i n t e r n a t i o n a l t r a d e agreements may  future  and  have on t a x  in  engaged i n  impact of of  the  the  their impact  policies.  PART I I : FREE TRADE The  s t a r t i n g point f o r t h i s research i s that "free trade" i s  a g i v e n ; I s h a l l not attempt t o e n t e r i n t o the debate about whether or not  free trade  i s a "good t h i n g " or whether " l i b e r a l  " f r e e r t r a d e " or "managed t r a d e " i s a more a c c u r a t e the  actualities  approach  of  requires  i n t e r n a t i o n a l trade.  no  tariff  or  A  strict  trade",  taxonomy f o r free  n o n - t a r i f f b a r r i e r s to  trade trade.  However, t h i s d i s c u s s i o n i s based on the l e s s pure n o t i o n t h a t the g o a l of " f r e e t r a d e " i s t o minimize the amount of i n t e r f e r e n c e of governments i n t r a d e flows t h a t c r o s s n a t i o n a l The  global  marketplace  is  a  reality  borders. which  14  is  rapidly  expanding, as a few  very r e c e n t examples i n d i c a t e : the new  Trade O r g a n i z a t i o n ,  successor  January 1, 1995;  to  the  World  GATT, came i n t o e f f e c t  the North American Free Trade Agreement i s on i t s  way  t o becoming the Free Trade Agreement of the Americas; and  the  autumn  of  on  1994  the  Canadian  Government  paved  the  way  in for  John H. Jackson, The World T r a d i n g System: Law and P o l i c y of I n t e r n a t i o n a l Economic R e l a t i o n s (Cambridge, Mass., MIT Press, 1989) a t 8 uses t h i s d e f i n i t i o n f o r the n o t i o n of " l i b e r a l t r a d e " . See the d i s c u s s i o n under "Taxation and Free Trade" r e g a r d i n g the n e c e s s i t y f o r adopting t h i s l e s s s t r i n g e n t d e f i n i t i o n of f r e e t r a d e i n the context of t a x a t i o n . 14  12 unprecedented  trade  with  China.  This  section  i s limited  to  p r o v i d i n g a b r i e f overview o f g e n e r a l l y accepted t h e o r e t i c a l b a s i s f o r f r e e t r a d e and an o u t l i n e o f t h e main arguments f o r and a g a i n s t free  trade. Free t r a d e  i s g e n e r a l l y based on two p r e m i s e s :  15  1. The most e f f i c i e n t use o f r e s o u r c e s - and hence t h e maximum combined outputs - o f t r a d i n g n a t i o n s w i l l be achieved i f t r a d e among them i s f r e e d from a r b i t r a r y i n t e r v e n t i o n s by i n d i v i d u a l governments. 2. The p r e s e r v a t i o n o f s o v e r e i g n r i g h t s as expressed i n t h e maintenance o f d i f f e r e n t p o l i t i c o - e c o n o m i c systems and s e t s o f p o l i c i e s among n a t i o n s i s e s s e n t i a l f o r i n c r e a s i n g t h e w e l f a r e of t h e c i t i z e n s o f t h e n a t i o n s concerned. In t h i s study, t h e second premise, t h e n a t i o n a l o b j e c t i v e i s concerned w i t h t h e p a r t i c u l a r s o v e r e i g n  r i g h t s t o be p r e s e r v e d  embodied i n t h e Canadian t a x p o l i c i e s under r e v i e w . The global  as  16  f i r s t premise, t h e f r e e t r a d e o b j e c t i v e , i s based on t h e goal  of  i n t e r n a t i o n a l trade  minimizing  governmental  interference  flows which i s fundamental t o t h e GATT.  in 17  The  H i r o f u m i Shibata, F i s c a l Harmonization under F r e e r Trade: P r i n c i p l e s and T h e i r A p p l i c a t i o n s t o a Canada-U.S. Free Trade Area. ( U n i v e r s i t y o f Toronto Press, 1969) a t 4. "In t h e f i e l d o f p u b l i c f i n a n c e , t h i s second premise means t h a t a f r e e r t r a d e arrangement must not l e a d t o d e n i a l o f t h e f o l l o w i n g two d i f f e r e n c e s : (1) d i f f e r e n c e s t h a t e x i s t among n a t i o n s i n t y p e s and amounts o f p u b l i c goods and s e r v i c e s p r o v i d e d by t h e i r governments, and (2) d i f f e r e n c e s t h a t e x i s t among n a t i o n s i n degrees and p a t t e r n s o f income r e d i s t r i b u t i o n among f e l l o w c i t i z e n s of a sovereign nation..." 15  The o b j e c t i v e s and c r i t e r i a systems a r e d i s c u s s e d below. 16  f o r evaluating  national tax  Canada has been a s t r o n g proponent o f t h e GATT, w i t h t h e primary i n t e r e s t , pre-Uruguay Round, being t o s e c u r e a c c e s s t o t h e U.S. market. With t h e Uruguay Round o f GATT n e g o t i a t i o n s , Canada d i r e c t e d most o f i t s e f f o r t s t o a c h i e v i n g b e t t e r a c c e s s t o markets o u t s i d e o f North America, r e v i t a l i z i n g t h e o v e r a l l system o f 1 7  13 "interventions"  o f concern  are tax p o l i c i e s  which  treat  r e s i d e n t s , m u l t i n a t i o n a l e n t e r p r i s e s and c r o s s - b o r d e r  non-  activities  l e s s f a v o u r a b l y than r e s i d e n t s , domestic e n t e r p r i s e s and a c t i v i t i e s w i t h i n Canadian b o r d e r s . as  "arbitrary"  Whether these i n t e r v e n t i o n s can be viewed  ("discriminatory" t a x a t i o n )  by r e f e r e n c e t o standards  1 8  will  be  and p r i n c i p l e s a r t i c u l a t e d  determined i n t h e GATT  and t h e g o a l o f f r e e t r a d e . The  GATT aims t o achieve  an a c c e p t a b l e  balance  between t h e  s o v e r e i g n i n t e r e s t s o f i t s Members and t h e g l o b a l o b j e c t i v e o f f r e e t r a d e . Thus, t h e norm f o r a s s e s s i n g a r b i t r a r i n e s s i n t h i s study i s that  established, defined  Government  policies  which  and g e n e r a l l y accepted fail  t o achieve  this  by t h e GATT. balance  can be  viewed as an a r b i t r a r y use o f s o v e r e i g n power which f a i l  t o give  due r e g a r d t o i n t e r n a t i o n a l standards which promote f r e e t r a d e . For  example,  tax rules  which  impose  withholding  taxes  on  c r o s s - b o r d e r payments f o r software under l i c e n s i n g arrangements may be viewed as a r b i t r a r y i f t h e e f f e c t o f t h e t a x regime i s c o n t r a r y to III  t h e p r i n c i p l e o f n o n - d i s c r i m i n a t i o n as a r t i c u l a t e d o f t h e GATT ("National Treatment") .  promote  research  arbitrary  and development  in Article  Tax p o l i c i e s which seek t o  i n Canada  may  be  viewed  as  i f t h e t a x i n c e n t i v e s c r e a t e a scheme o f s u b s i d i z a t i o n  multilateral trade regulation, clarifying and strengthening m u l t i l a t e r a l r u l e s r e s p e c t i n g ' u n f a i r t r a d e ' laws, l i m i t i n g t h e t r a d e d i s t o r t i n g impacts o f n o n - t a r i f f measures, and s t r e n g t h e n i n g GATT's d i s p u t e s e t t l e m e n t r u l e s . See Jock F i n l a y s o n , "Canada and I n t e r n a t i o n a l Trade R e g u l a t i o n : The General Agreement on T a r i f f s and Trade" i n R. K. Paterson and M.N. Band, supra, a t 1-47 t o 1-50. 18  The concept o f " d i s c r i m i n a t o r y " t a x a t i o n i s addressed below.  14 f o r r e s e a r c h and development which f a l l s o u t s i d e of i n t e r n a t i o n a l l y agreed upon parameters f o r such s u b s i d i z a t i o n as a r t i c u l a t e d i n the 1994  GATT s u b s i d i e s code.  monitoring  and  viewed  arbitrary  as  consequences a c h i e v e the  Finally,  a t a x regime f o r r e g u l a t i n g ,  enforcing international i f that  regime  transfer  not  only  f o r m u l t i n a t i o n a l e n t e r p r i s e s , but  pricing has  be  undesirable  also  s o v e r e i g n o b j e c t i v e which the p a r t i c u l a r  may  fails tax  to  regime  seeks t o a t t a i n . Free t r a d e i s c o n s i d e r e d t o be b e n e f i c i a l t o a n a t i o n because when each n a t i o n s p e c i a l i z e s  i n making the p r o d u c t s  t h a t i t can  make most e f f i c i e n t l y and t r a d e s f o r the o t h e r p r o d u c t s i t needs, global  welfare  is  increased,  20  though  each  individual  19  nation's  In Canada, f o r example, e x p o r t s of goods and s e r v i c e s are approximately one q u a r t e r of Canada's GDP w i t h one h a l f of a l l n a t u r a l r e s o u r c e s and manufactured goods produced i n Canada being exported. Canada depends d i s p r o p o r t i o n a t e l y on e x p o r t s of r e s o u r c e based p r o d u c t s ( f o r e s t p r o d u c t s , m i n e r a l s , metals, o i l and gas) i n which i t has a comparative advantage. Canada's l e a d i n g imports i n the e a r l y 1990's were motor v e h i c l e p a r t s , passenger cars, e l e c t r o n i c computers, telecommunications and r e l a t e d equipment, and a p p a r e l and a c c e s s o r i e s . 77.6% of merchandise e x p o r t s i n 1992 went t o the U.S.; 70.6% of merchandise imports i n 1992 were from the U.S. (Jock F i n l a y s o n , supra. a t 1-1 t o 1-5). 19  See John H. Jackson and W i l l i a m J . Davey, Economic Theory and I n t e r n a t i o n a l Economic P o l i c y . (St. P a u l , Minn.: West P u b l i s h i n g Co., 2d ed., 1986) a t 15. T h i s t h e o r y of i n t e r n a t i o n a l t r a d e has i t s r o o t s i n David R i c a r d o ' s 'Law of Comparative Advantage' which s t a t e s t h a t a country w i l l export products i n which i t has a g r e a t e r or comparative advantage, and import p r o d u c t s i n which i t has a comparative disadvantage. Some economists b e l i e v e t h a t t h i s t h e o r y has ceased t o be u s e f u l (see f o r example Robert K u t t n e r The End of L a i s s e z - f a i r e : N a t i o n a l Purpose and the G l o b a l Economy A f t e r the C o l d War (New York: Knoft, 1991); John H. Jackson, The World T r a d i n g System: Law and P o l i c y of I n t e r n a t i o n a l Economic R e l a t i o n s , supra. a t 14 - 17 for a d i s c u s s i o n of c h a l l e n g e s t o t h i s c l a s s i c t h e o r y . Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra. a t 32 - 37 d i s c u s s e s c o n v e n t i o n a l t r a d e t h e o r y i n l i g h t of the expansion of f o r e i g n 2 0  15 w e l f a r e w i l l not i n c r e a s e e q u a l l y .  I t i s important  1  t o emphasize  t h a t a l l members o f a country w i l l not n e c e s s a r i l y be b e t t e r o f f w i t h f r e e t r a d e ; however, p r e s e r v a t i o n o f s o v e r e i g n r i g h t s  enables  governments t o ensure t h a t a l l members c o u l d be made b e t t e r o f f i f the i n c r e a s e d n a t i o n a l income i s s u i t a b l y  redistributed.  2 2  Based on t h i s theory, t h e main arguments f o r and a g a i n s t f r e e t r a d e can be summarized as f o l l o w s :  2 3  For 1.  Consumption g a i n s  - d o m e s t i c a l l y , t h e consumer w i l l be  a b l e t o a c q u i r e more goods a t lower 2. previously  Production  gains  inefficiently  -  prices;  importing  produced  products  domestically  which permits  were a  r e a l l o c a t i o n o f r e s o u r c e s i n t o more p r o d u c t i v e i n d u s t r i e s i n which the country has a comparative  advantage;  investment and concludes (at 38) t h a t the i n f l u e n c e of m u l t i n a t i o n a l e n t e r p r i s e and f o r e i g n ownership on t r a d e and the e f f i c i e n c y of trade p o l i c y i s p o t e n t i a l l y s u b s t a n t i a l , not l e a s t i n Canada. These a l t e r n a t i v e p e r s p e c t i v e s a r e acknowledged but not explored i n t h i s research. See John H. Jackson, The World T r a d i n g System, i b i d . . a t 12 f o r economic models showing comparative and a b s o l u t e advantage, and g l o b a l and n a t i o n a l g a i n s w i t h t r a d e between n a t i o n s . T h i s study focuses on t h e g l o b a l b e n e f i t s t o be a t t a i n e d from f r e e t r a d e under the GATT regime. 21  J o e l B. Slemrod, "Free Trade T a x a t i o n and P r o t e c t i o n i s t T a x a t i o n " , I n t e r n a t i o n a l Tax P o l i c y Forum, Tax A n a l y s t s , Tax Notes I n t e r n a t i o n a l A p r i l 1, 1994, 11 a t 12. See a l s o Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra. a t 8 - 9. 2 2  See General Agreement on T a r i f f s and Trade, S t u d i e s i n I n t e r n a t i o n a l Trade. Number 5 (Geneva: 1977) as r e f e r r e d t o by Armando F. B e t e t a , I n t e r n a t i o n a l Trade and L e g a l M o d e r n i z a t i o n : E f f e c t s of Mexico's Membership i n t h e North American Free Trade Agreement ( F a c u l t y o f Law, U n i v e r s i t y o f B r i t i s h Columbia, 1993) [unpublished]. 2 3  16 3.  Economies o f s c a l e - f r e e t r a d e opens up l a r g e r markets,  increasing  demand  f o r products  r e a l i z e d w i t h expansion 4.  and e n a b l i n g  costs  t o be  of production operations;  Competitive domestic  i n d u s t r y - f r e e t r a d e r e s u l t s i n more  d i r e c t c o m p e t i t i o n between domestic domestic  lower  and f o r e i g n producers  p r o d u c t i o n t o become more e f f i c i e n t  forcing  i n o r d e r t o remain  competitive. 5.  Domestic  price  stability  and c o u n t e r - i n f l a t i o n a r y  p r e s s u r e s - these i n d i r e c t r e s u l t s a r e a c h i e v e d as a consequence o f price  reduction with  i n c r e a s e d supply  combined w i t h  competitive  pressures t o c o n t r o l input costs. Against  24  1. F o r e i g n i n t e r f e r e n c e i n domestic  markets h i n d e r s  domestic  growth and standards o f l i v i n g . 2.  Certain  industries  will  pressure  their  governments to,  i n t e r f e r e w i t h f r e e t r a d e i n order t o p r o t e c t t h e domestic i n d u s t r y from f o r e i g n c o m p e t i t i o n ;  a common form o f p r o t e c t i o n i s m i s the  tariff. 3.  Tariff  protection w i l l  g i v e domestic  producers  market share thereby c r e a t i n g jobs f o r t h e domestic 4. labour  Interference with i n developed  nations  free from  trade  economy.  i s necessary  low p a i d  labour  a larger  to protect  i n developing  nations. John H. Jackson and W i l l i a m Davey, Economic Theory and I n t e r n a t i o n a l Economic P o l i c y . s u p r a a t 17 - 19. A l s o see Armando F. B e t e t a , supra, a t 23 - 27; t h e author a l s o d i s c u s s e s c r i t i c i s m s of t h e p r o c e d u r a l a s p e c t s o f f r e e t r a d e i n a d d i t i o n t o t h e c r i t i q u e s o f s u b s t a n t i a l e f f e c t s f r e e t r a d e s e t out here. 2 4  17 5.  T a r i f f s e q u a l i z e c o s t s between the i m p o r t i n g and  exporting  countries. 6.  Certain  achieve n a t i o n a l It  is  trade  r e s t r i c t i o n s are  necessary  in  order  to  objectives.  suggested  that  the  ability  to  access  international  markets f o r goods, s e r v i c e s , technology and c a p i t a l i s c r i t i c a l t o a n a t i o n s economic v i a b i l i t y and  standard of l i v i n g .  Restrictions  on i n t e r n a t i o n a l t r a d e r e s u l t i n l e s s v a r i e t y of p r o d u c t s a v a i l a b l e domestically be  and,  even i f they are a v a i l a b l e , p r i c e s are l i k e l y  i n f l a t e d w i t h the  the  average  inefficient term,  but  result the  r e s u l t t h a t p r o d u c t s are  consumer.  Attempts  to  domestic i n d u s t r i e s may over  the  long  term  term,  In a d d i t i o n  such  case a g a i n s t  to  a  or  t r a d e may  measures  domestic  not  be  I f a country has  commodity,  a  tariff  short will  Even i n the  most  objectives. f r e e trade,  f r e e t r a d e can be made i n the absence of the the economy o p e r a t e s :  for  protect  higher p r i c e s .  p r e v i o u s arguments a g a i n s t  assumptions about how 1.  costs  protectionist  i n t e r f e r i n g with free  t o the  affordable  have some m e r i t i n the  appropriate a l t e r n a t i v e for achieving  key  equalize  i n non-competitive i n d u s t r i e s and  short  not  to  a  following  25  monopoly or monopsony power w i t h r e g a r d or  subsidy  can  enable  the  country  to  J o e l B. Slemrod, "Free Trade T a x a t i o n and P r o t e c t i o n i s t T a x a t i o n " , supra, a t 13. The author a l s o notes t h a t a v a r i e t y of non-economic arguments f o r t r a d e i n t e r v e n t i o n such as foreign p o l i c y or n a t i o n a l s e c u r i t y concerns i n a d d i t i o n t o domestic p o l i t i c a l reasons. 25  18 p r o f i t from 2.  it.  2 6  I f the domestic economy i s d i s t o r t e d (due t o domestic t a x  policy,  for  example),  trade  intervention  could  d i s t o r t i o n thereby i n c r e a s i n g n a t i o n a l income. 3.  In o l i g o p o l i s t i c markets, i t may  offset  27  be p o s s i b l e t o s h i f t some  of the p r o f i t s from f o r e i g n f i r m s t o domestic f i r m s . 4.  Countervailing  means of trade  discouraging  duties other  my  be  strategically  countries  from  using  2 8  useful  as  a  opportunistic  policies. Except f o r the d i s t o r t i o n - o f f s e t t i n g argument, t o the  that  the  national  income  in  perspective,  the  income i s i n c r e a s e d , rest  of  the  these p o l i c i e s are  When f r e e t r a d e w i l l be maximized.  i t i s at  world;  the  therefore,  extent  expense of from  a  the  global  wasteful .  i s p r a c t i s e d by  29  a l l c o u n t r i e s , w o r l d income  Even more important however, i s the r e s u l t t h a t  A monopoly i s the e x c l u s i v e r i g h t or power t o dominate the t o t a l s a l e s of a product or s e r v i c e ; a monopsony i s a market c o n d i t i o n where t h e r e i s one buyer f o r a p a r t i c u l a r good o r s e r v i c e (Blacks Law D i c t i o n a r y , 5 ed., (St. P a u l , Minn. West P u b l i s h i n g Co., 1979)). Slemrod notes t h a t i n the case of monopoly, the country ought t o tax e x p o r t s t o d r i v e up the world p r i c e ; i n the case of monopsony, a t a r i f f should be imposed on imports t o d r i v e down the p r i c e . 2 6  Slemrod notes t h a t i t i s g e n e r a l l y b e t t e r t o e l i m i n a t e the d i s t o r t i o n t h a t t o c o u n t e r a c t i t w i t h t r a d e p o l i c y , because t r a d e i n t e r v e n t i o n i n t r o d u c e s new d i s t o r t i o n s even i f i t reduces o t h e r s . 2 7  An o l i g o p o l y e x i s t s where a few s e l l e r s s e l l o n l y a s t a n d a r d i z e d product (Black's Law D i c t i o n a r y , s u p r a ) . Slemrod notes t h a t i t i s i m p r a c t i c a l t o d e s i g n a s u c c e s s f u l p o l i c y of s e l e c t i v e i n t e r v e n t i o n t o take advantage of such a s i t u a t i o n . 2 8  J o e l B. Slemrod, T a x a t i o n " , supra. a t 14. 29  "Free Trade T a x a t i o n  and  Protectionist  19 unilateral  adoption  of  free  trade  will  maximize  c o u n t r y ' s n a t i o n a l income, n o t w i t h s t a n d i n g other c o u n t r i e s .  3 0  Based  on  the  current  the  adopting  the t r a d e p o l i c i e s expansion  of  of  free  t r a d e agreements, i t appears t h a t t h e r e i s a c o n t i n u i n g Canadian commitment t o t r a d e  liberalization.  3 1  A c o n c e p t u a l framework f o r a n a l y z i n g t a x a t i o n measures i n the context of f r e e t r a d e i s s e t out i n the next s e c t i o n . PART I I I : TAXATION and FREE TRADE As b a r r i e r s t o i n t e r n a t i o n a l t r a d e and investment  32  fall,  and  i b i d . . a t 13. Slemrod notes t h a t even i f a t r a d i n g p a r t n e r i s s u b s i d i z i n g i t s exports, the importing country i s b e t t e r o f f not t o respond by s h i e l d i n g i t s r e s i d e n t s from world p r i c e s ; as t o c o u n t e r i n g a t r a d i n g p a r t n e r ' s t a r i f f s w i t h t a r i f f s of one's own " i t would be j u s t as s e n s i b l e t o drop r o c k s i n t o our harbours because o t h e r n a t i o n s have rocky c o a s t s " ( a t t r i b u t e d t o Joan Robinson, Essays i n the Theory of Employment (Oxford; B l a c k w e l l , 1947) a t 192). See a l s o Donald J . S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 25: "... economists are c o n t i n u a l l y dismayed t h a t p r i n c i p l e s of f r e e t r a d e are so r e a d i l y v i o l a t e d . They are p u z z l e d by p o l i c i e s t h a t appear t o i g n o r e comparative advantage and the i n t e r n a t i o n a l p r i c e s t r u c t u r e and t h a t t h e r e f o r e i g n o r e the t r u e c o s t s of economic i n t e r v e n t i o n . T a r i f f s and import quotas ... are merely the l e a s t i m a g i n a t i v e form of i n t e r v e n t i o n . " 3 0  See R.K. Paterson and M.N. Band, supra. a t 2-6 r e g a r d i n g Canada's commitment to free trade; Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 2 0 : " U n i l a t e r a l f r e e t r a d e i s b e n e f i c i a l , but m u l t i l a t e r a l f r e e t r a d e i s b e t t e r s t i l l . " ; Dr. A.A. Knechtle, B a s i c Problems i n I n t e r n a t i o n a l F i s c a l Law, (Deventer: Kluwer, 1979) a t 6; G i l b e r t R. Winham, The E v o l u t i o n of Trade Agreements (Toronto: U n i v e r s i t y of Toronto P r e s s , 1992) a t 9 - 10. J o e l B. Slemrod, i b i d . , a t 14, summarizes the t r a d e p o l i c y p r e s c r i p t i o n s f o r the U n i t e d S t a t e s as ( i ) u n i l a t e r a l f r e e t r a d e as a r u l e of thumb, ( i i ) t o l e r a t i o n of s t r a t e g i c use of p r o t e c t i o n i s t measures as a d e v i c e t o e l i m i n a t e t r a d e b a r r i e r s elsewhere, and ( i i i ) support of m u l t i l a t e r a l agreements t o lower t r a d e b a r r i e r s . 31  References t o i n t e r n a t i o n a l t r a d e are g e n e r a l l y intended t o i n c l u d e t r a d e i n goods, s e r v i c e s , i n t e l l e c t u a l p r o p e r t y as w e l l as investment. The Uruguay Round agreement on t r a d e - r e l a t e d investment measures ("TRIMs") s i g n i f i e s that "investment is i n t e r c h a n g e a b l e w i t h t r a d e , and, more important, that trade 3 2  20 national  economies  international international  become  taxation  more  for  markets becomes a  integrated,  the main  the  efficient concern.  importance functioning  33  This  decisions:  of  connection  makes i t more important than ever t o c o n s i d e r i n t e r n a t i o n a l agreements i n making tax p o l i c y  of  trade  3 4  The broad l a c k of i n t e r e s t among g e n e r a l i n t e r n a t i o n a l lawyers in fiscal matters, combined w i t h the diminishing role a t t r i b u t e d t o a c o n c e p t u a l and a n a l y t i c study of i n t e r n a t i o n a l law, has l e d t o an ever widening gap between the f i e l d s of i n t e r n a t i o n a l law and f i s c a l law. As has o f t e n been the case i n the h i s t o r y of i n t e r n a t i o n a l economic r e l a t i o n s , the emergence or i n c r e a s e of a c e r t a i n type of economic a c t i v i t y has drawn a t t e n t i o n t o a p r e v i o u s l y undeveloped area of law. Thus, i t so happens t h a t due t o such f a c t o r s as the i n c r e a s e i n d i r e c t investment by c i t i z e n s of one country i n o t h e r c o u n t r i e s , the r i s e i n the number of persons ' l i v i n g abroad', and the i n t e r n a t i o n a l i z a t i o n of t r a d e , f i s c a l s c h o l a r s have been c o n f r o n t e d w i t h the problem of t a x a t i o n of f o r e i g n income and n o n r e s i d e n t c i t i z e n s . l i b e r a l i z a t i o n alone i s not as e f f e c t i v e as t r a d e l i b e r a l i z a t i o n accompanied by l i b e r a l i z a t i o n of investment regimes" ( G i l b e r t R. Winham, supra. a t 79) . J o e l B. Slemrod, "Free Trade T a x a t i o n and Protectionist T a x a t i o n " , supra, a t 28; Slemrod's d i s c u s s i o n i s r e s t r i c t e d t o the e f f i c i e n t functioning of c a p i t a l markets. See a l s o Douglas J . Sherbaniuk, i n Donald J.S. Brean, "International Issues in T a x a t i o n " , supra. a t i i i : "In the c o n t i n u i n g p r o c e s s of t r a d e l i b e r a l i z a t i o n , as c l a s s i c a l t r a d e r e s t r i c t i o n s such as the t a r i f f have been dismantled, other p r o t e c t i o n i s t measures assume a l a r g e r s i g n i f i c a n c e . One s e t of r e s t r i c t i o n s of i n c r e a s i n g importance i s the i n t e r n a t i o n a l f i s c a l system." 3 3  R u t s e l S i l v e s t r e J . Martha, The J u r i s d i c t i o n t o Tax in International Law; Theory and P r a c t i c e of L e g i s l a t i v e F i s c a l J u r i s d i c t i o n , S e r i e s on I n t e r n a t i o n a l T a x a t i o n , No. 9 (Deventer, Kluwer Law and T a x a t i o n P u b l i s h e r s , 1989) a t 11. See a l s o R i c h a r d M. B i r d , "Some C o n t i n u i n g Issues and an I n t e r n a t i o n a l P e r s p e c t i v e " i n Jack Mintz and John Whalley, eds., "The Economic Impacts of Tax Reform", Canadian Tax Paper No. 84 (Toronto: CTF, 1989) a t 43 5: "But I do want t o emphasize my view t h a t the international dimension of t a x a t i o n should be the s t a r t i n g p o i n t f o r s e r i o u s tax p o l i c y a n a l y s i s i n an open economy such as Canada, not something t o be o p t i o n a l l y added on a t the end." 3 4  21 I t has a l s o been noted t h a t :  3 S  U n t i l r e c e n t l y , i n t e r n a t i o n a l t a x a t i o n has been an arcane s u b s p e c i e s among American t a x lawyers, and i n t e r n a t i o n a l c o n s i d e r a t i o n s have r a r e l y i n f l u e n c e d t h e t h r u s t o f t a x reform. Instead, t a x r u l e s have been c r a f t e d i n c o n s u l t a t i o n w i t h domestic i n t e r e s t ; t a x i n c e n t i v e s have been i n s t i t u t e d t o spur American i n d i v i d u a l s and companies t o work toward perceived n a t i o n a l g o a l s ; and t h e o v e r a l l l e v e l o f t a x c o l l e c t i o n s has been determined on t h e b a s i s o f American b u s i n e s s c o n d i t i o n s . Such a p r o v i n c i a l approach t o t a x p o l i c y may have been a p p r o p r i a t e i n an e a r l i e r e r a , but t h e i n c r e a s i n g economic i n t e g r a t i o n o f t h e world r e q u i r e s a more g l o b a l approach t o t a x p o l i c y . The emphasis i n r e c e n t American t a x reform debates on c o m p e t i t i v e n e s s i s o n l y a p r e c u r s o r t o a time i n which i n t e r n a t i o n a l c o n s i d e r a t i o n s w i l l p l a y a p e r v a s i v e r o l e i n shaping t a x p o l i c i e s . Clearly,  the r e l a t i o n s h i p  between  domestic  i n t e r n a t i o n a l t r a n s a c t i o n s cannot be i g n o r e d .  36  taxation  and  Tax p o l i c i e s take  on s p e c i a l s i g n i f i c a n c e i n t h i s g l o b a l m a r k e t p l a c e .  37  Lawrence H. Summers, "Taxation i n a Small World", i n Herbert S t e i n , ed. , Tax P o l i c y i n t h e T w e n t y - F i r s t Century (New York: John Wiley & Sons, 1988), 64 - 75 a t 64. 35  J o e l B. Slemrod, "Free Trade T a x a t i o n and P r o t e c t i o n i s t T a x a t i o n " , supra a t 12, seeks t o " r e c a s t i n t e r n a t i o n a l t a x p o l i c y i n p a r a l l e l w i t h t h e theory o f i n t e r n a t i o n a l t r a d e " and notes t h a t "there i s a p o t e n t i a l down s i d e t o t h i s s t r a t e g y . I t i s that although t h e p r e f e r e n c e toward f r e e t r a d e i s w e l l e s t a b l i s h e d among economists, [ i t ] i s not w e l l e s t a b l i s h e d elsewhere. On t h e contrary, t h e debate over t r a d e p o l i c y c o n t i n u e s , with the economist's view sometimes p r e v a i l i n g and sometimes n o t p r e v a i l i n g . The down s i d e risk i s that t h e ensconced prejudices and m i s c o n c e p t i o n s r e g a r d i n g t r a d e p o l i c y w i l l simply be a t t a c h e d t o the i s s u e s o f i n t e r n a t i o n a l t a x p o l i c y , b l u r r i n g i s s u e s r a t h e r than sharpening them. But t h i s i s n o t r e a l l y a problem, since i m p l i c i t l y t h i s i s a l r e a d y happening. To make t h e l i n k a g e e x p l i c i t c o u l d , i n my o p i n i o n , o n l y be a p l u s . " See a l s o Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 9. 3 6  See Dr. A.A. Knechtle, supra a t 9 - 10 f o r a d i s c u s s i o n o f c o m p e t i t i v e advantages o r disadvantages due t o f i s c a l measures which may r e s u l t due t o t h e d i f f e r e n c e s i n t h e s t r u c t u r e o f n a t i o n a l t a x systems and i n r a t e s o f t a x . Dr. K n e c h t l e a l s o h i g h l i g h t s t h e dangers o f m u l t i p l e t a x a t i o n o f t r a n s n a t i o n a l a c t i v i t y on g l o b a l economic development. F u r t h e r , R u t s e l S i l v e s t r e J. Martha, supra. at 1 states: "One f a c t which, whether 3 7  22 One  of the objectives  of t h i s  research  i s t o develop  a  framework t o a s s i s t t a x p o l i c y makers i n d e t e r m i n i n g how s p e c i f i c tax  measures should be s e l e c t e d from among a l t e r n a t i v e measures i n  order t o a c h i e v e n a t i o n a l o b j e c t i v e s and minimize impacts  on i n t e r n a t i o n a l  trade. This  emphasis  any d i s t o r t i v e  on m i n i m i z a t i o n ,  r a t h e r than e l i m i n a t i o n , i s necessary f o r t h e simple reason t h a t i t i s n o t f e a s i b l e t o e l i m i n a t e t h e t a x system:  38  There must be t a x revenue, and l o t s o f i t , and a l l taxes (other than those economists c a l l "lump-sum", such as p o l l taxes) d i s t o r t some margin o f c h o i c e , such as t h e w o r k - l e i s u r e c h o i c e , t h e consumption-saving c h o i c e , and t h e investment-ornot c h o i c e , and t h e r e f o r e a r e t h e source o f i n e f f i c i e n c y . In  s e l e c t i n g from among a l t e r n a t i v e t a x measures i t i s f i r s t  necessary  t o determine  measure under r e v i e w .  39  the objective(s)  of the p a r t i c u l a r tax  O b v i o u s l y , revenue r a i s i n g  i s one o f the  main o b j e c t i v e s o f domestic t a x a t i o n .  In an i n t e r n a t i o n a l c o n t e x t ,  the revenue r a i s i n g o b j e c t i v e remains  i n t a c t , but i s c o m p l i c a t e d  by problems which a r i s e i n p r o t e c t i n g a n a t i o n ' s share o f t h e t a x  acknowledged o r not, i s o f t h e utmost importance i n t h e f i e l d o f i n t e r n a t i o n a l t a x a t i o n i s t h e d e t e r m i n a t i v e impact o f g e n e r a l i n t e r n a t i o n a l law on t h e o u t l o o k o f i n t e r n a t i o n a l t a x p r a c t i c e s . " A l s o see Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 1. J o e l B. Slemrod T a x a t i o n " , supra a t 14. 3 8  "Free  Trade  Taxation  and  Protectionist  The f o l l o w i n g i s a b r i e f overview o f t h e main o b j e c t i v e s of t a x a t i o n i n g e n e r a l . Each case study w i l l take a c l o s e r look a t the a p p l i c a b l e o b j e c t i v e ( s ) sought t o be a t t a i n e d , how s u c c e s s f u l the t a x regime i s a t t a i n i n g t h e o b j e c t i v e ( s ) , and look a t a l t e r n a t i v e s t o t h e e x i s t i n g t a x regime which may a c h i e v e the o b j e c t i v e ( s ) w h i l e m i n i m i z i n g u n d e s i r a b l e impacts on i n t e r n a t i o n a l trade. 3 9  23 base i n c r o s s - b o r d e r t r a n s a c t i o n s . and  transfer  revenues,  pricing  but  rules  4 0  For example, w i t h h o l d i n g taxes  attempt  to  preserve  Canadian tax p o l i c i e s may  conflict  Canadian with  the  tax other  n a t i o n ' s t a x p o l i c i e s i n these areas, thereby exposing the taxpayer t o double t a x a t i o n . Tax  policies  objectives resources.  of 41  are  a l s o used  growth and  Tax  as  efficient  expenditures,  a  tool  to  allocation  which  are  promote of  the  economic economy's  equivalent to  spending  programs, are aimed a t a c h i e v i n g such economic, as w e l l as o b j e c t i v e s . For example, investment development research  and  are  revenues  development which,  manage r i s k and Tax  tax  policies  must  be  tax c r e d i t s f o r r e s e a r c h  foregone  in  i n turn,  improve q u a l i t y of  social  life.  evaluated  order  should  to  and  stimulate  create  wealth,  4 2  to  assess  whether  the  o b j e c t i v e s are being a t t a i n e d . There are a number of c r i t e r i a used in  e v a l u a t i n g domestic  tax p o l i c y which have been summarized  as  Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra. a t 7, a l s o notes t h a t , i n a d d i t i o n t o revenue r a i s i n g , taxes are l e v i e d on i n t e r n a t i o n a l t r a d e f o r p r o t e c t i o n or i n r e t a l i a t i o n a g a i n s t p r o t e c t i o n elsewhere. 4 0  For a d i s c u s s i o n of economic o b j e c t i v e s of t a x a t i o n r e f e r t o D.A. Dodge, "Economic O b j e c t i v e s of Tax Reform" i n Jack Mintz and John Whalley, eds., supra. a t 36 - 44. For a g e n e r a l d i s c u s s i o n on the use of the tax system t o achieve p o l i c y o b j e c t i v e s see Satya Poddar, " T a x a t i o n and R e g u l a t i o n " , i n R i c h a r d M. B i r d and Jack M. Mintz, eds., supra. a t 71 - 96. 41  L. Denis D e s a u t e l s , A u d i t o r General of Canada, Report of the A u d i t o r General of Canada t o the House of Commons. 1994, v o l . 1 (Ottawa: M i n i s t r y of Supply and S e r v i c e s , Canada, November 22, 1994) a t 1-17. 4 2  24 follows:  4 3  1. The t a x system should be e f f i c i e n t or n e u t r a l . This c r i t e r i o n r e q u i r e s the tax system t o apply s i m i l a r ( e f f e c t i v e ) r a t e s of t a x a t i o n t o d i f f e r e n t a c t i v i t i e s . The e f f i c i e n c y argument r e s t s on the presumption t h a t the b e s t a l l o c a t i o n of r e s o u r c e s i s achieved by an u n f e t t e r e d market economy. If markets f a i l t o achieve the best a l l o c a t i o n of r e s o u r c e s , e f f i c i e n t tax p o l i c y may call f o r c o r r e c t i v e taxes or subsidies. 2. The tax system should be e q u i t a b l e . For example, i t s h o u l d l e v y taxes a t the same r a t e on i n d i v i d u a l s or f a m i l i e s in similar circumstances (horizontal equity) and apply a p p r o p r i a t e l y h i g h e r r a t e s of t a x t o w e l l - o f f i n d i v i d u a l s or f a m i l i e s than i t a p p l i e s t o the l e s s w e l l - o f f (vertical equity). 3. The tax system should be simple. I t s h o u l d minimize both the a d m i n i s t r a t i v e c o s t s f a c e d by the government and the compliance c o s t s i n c u r r e d by the p r i v a t e s e c t o r . In e v a l u a t i n g i n t e r n a t i o n a l tax p o l i c y , s i m i l a r c r i t e r i a used, but new complicated most  issues arise.  The  standard  i n i n t e r n a t i o n a l markets. The  efficient  allocation  of  outbound  investment.  between domestic  Therefore,  neutrality  on  investment  a  global  scale.  and not encourage  i t i s necessary  and f o r e i g n investment  is  g o a l i s t o promote the  resources  Governments want t o encourage inward  of  are  to  distinguish  o p p o r t u n i t i e s of  domestic  i n v e s t o r s as w e l l as of f o r e i g n i n v e s t o r s . F o r e i g n i n v e s t o r s should pay the same t a x on income earned on an investment a domestic  i n v e s t o r would pay  on t h a t income earned  ( c a p i t a l import n e u t r a l i t y ) ; and domestic same t a x on  income earned  on  investments  R i c h a r d M. B i r d and Jack M. Beyond", Canadian Tax Paper No. Foundation, 1992) a t 1 - 2. 4 3  i n Country X as i n Country  i n v e s t o r s s h o u l d pay whether they  X  the  invest at  Mintz, " T a x a t i o n t o 2000 and 93 (Toronto: Canadian Tax  25 home or abroad The  tax  international taxpayers  ( c a p i t a l export system  should  also  transactions.  In  requires  jurisdiction,  but  where n e c e s s a r y . of how  neutrality),  relief Tax  45  to arrive  that  tax from  be  equitable  this  is  4 4  with  context,  imposed  in  regard  equity at  systems must a l s o g r a p p l e  a t an e q u i t a b l e d i s t r i b u t i o n  with  among  least  double t a x a t i o n must be  to  one  provided the  issue  of t a x revenue  on  c r o s s - b o r d e r t r a n s a c t i o n s among the n a t i o n s i n v o l v e d . Finally,  s i m p l i c i t y remains a v a l i d  criteria  i n t a x a t i o n of  i n t e r n a t i o n a l t r a n s a c t i o n s , y e t a d m i n i s t r a t i o n of the t a x system i s even more d i f f i c u l t the  potential  i n t h i s context due t o the use of t a x havens,  f o r tax  avoidance  and  difficulties  a c c u r a t e and r e l i a b l e i n f o r m a t i o n on taxpayer  in  collecting  activities.  See Donald J.S. Brean, "Here of There?: The Source and Residence P r i n c i p l e s of I n t e r n a t i o n a l T a x a t i o n " , i n R i c h a r d M. B i r d and Jack M. Mintz, supra. 303 a t 310. C a p i t a l import n e u t r a l i t y i s concerned w i t h the i n t e r n a t i o n a l a l l o c a t i o n of s a v i n g s and the a f t e r t a x r a t e of r e t u r n on s i m i l a r investments i n a p a r t i c u l a r market. Capital export neutrality i s concerned with the i n t e r n a t i o n a l a l l o c a t i o n of investment and the p r e - t a x r a t e of return. 4 4  Double t a x a t i o n a r i s e s i n the i n t e r n a t i o n a l c o n t e x t from the o v e r l a p p i n g tax c l a i m s of both the source and r e s i d e n c e country. See Donald S. Brean, "Here or There? The Source and Residence P r i n c i p l e s of I n t e r n a t i o n a l T a x a t i o n " , supra. a t 309. The author d e s c r i b e s 'source' and 'residence' p r i n c i p l e s a t 3 07 - 308: The source p r i n c i p l e of t a x a t i o n of i n t e r n a t i o n a l income a s s i g n s the r i g h t t o t a x t o the country t h a t i s the source o f t h e c a p i t a l income... Source t a x e s . . . i n c l u d e f o r most c o u n t r i e s the c o r p o r a t e tax and w i t h h o l d i n g taxes on payments made t o f o r e i g n e r s . . . The r e s i d e n c e p r i n c i p l e a s s i g n s the r i g h t t o t a x t o the country of r e s i d e n c e of the owners of the c a p i t a l t h a t generates the income... Although the c o r p o r a t e tax i n the f i r s t i n s t a n c e i s a source tax, the r e s i d e n c e country's c o r p o r a t e tax may be d e f i n e d on the r e s i d e n c e p r i n c i p l e ; t h a t i s , the f o r e i g n - s o u r c e income of a r e s i d e n t c o r p o r a t i o n i s l i a b l e f o r (residence) t a x . 4 5  26 A n a t i o n cannot s e t tax the  tax  p o l i c y without t a k i n g  systems of o t h e r c o u n t r i e s ,  partners.  4 6  especially  T h e r e f o r e , any attempt t o r e s o l v e  international  into  account  i t s major  trading  a taxation  dimensions should begin w i t h an  issue with  examination of  the  tax system of the p a r t i c u l a r country. However, i t i s suggested t h a t the  t r a d i t i o n a l c r i t e r i a of n e u t r a l i t y , e q u i t y and  simplicity  are  not  the  paramount c r i t e r i a  administrative  for this  Although these remain v a l i d c r i t e r i a f o r e v a l u a t i n g recent  years  there  has  been  a  shift  in  tax  examination.  tax p o l i c y , i n  philosophy  which  r e c o g n i z e s t h a t the f u t u r e development of tax p o l i c y w i l l depend on many  factors  i d e o l o g y and  including  demography,  p o l i t i c s , and  technology  internationalization.  and 4 7  development,  Indeed, e f f o r t s  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s and F o r e i g n A c t i v i t i e s " , supra, a t 7. Tax t r e a t i e s and model tax conventions are a response t o the l a c k of f i t which a r i s e s between n a t i o n a l tax systems i n d e a l i n g w i t h c r o s s - b o r d e r transactions. A l s o , see Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra a t 4 and 17 r e g a r d i n g the p r i n c i p l e of s o v e r e i g n n a t i o n a l tax systems w i t h a network of b i l a t e r a l t r e a t i e s as the primary vehicle for achieving international fiscal c o o r d i n a t i o n . Tax t r e a t i e s and conventions are n e c e s s a r y as t h e r e is no such thing as an international tax system; rather i n t e r n a t i o n a l t a x a t i o n r e f e r s t o the i n t e r n a t i o n a l i n t e r a c t i o n of n a t i o n a l tax systems. Donald J.S. Brean, "Here or There? The Source and Residence P r i n c i p l e s of I n t e r n a t i o n a l T a x a t i o n " , supra a t 309. 4 6  For a thorough d i s c u s s i o n of each of t h e s e f a c t o r s and how they are i n f l u e n c i n g tax p o l i c y see R i c h a r d M. B i r d and Jack M. Mintz, supra, a t 3 - 26. A l s o see Gary Clyde Hufbauer, U.S. T a x a t i o n of I n t e r n a t i o n a l Income; B l u e p r i n t f o r Reform (Washington, D.C., I n s t i t u t e f o r I n t e r n a t i o n a l Economics, 1992) a t 61 f o r a d i s c u s s i o n of how c a p i t a l n e u t r a l i t y d o c t r i n e i s no l o n g e r the r e l e v a n t a n a l y t i c a l approach f o r i n t e r n a t i o n a l tax p o l i c y i s s u e s . J o e l B. Slemrod, i n "Free Trade T a x a t i o n and Protectionist T a x a t i o n " , supra, a t 12 a l s o moves away from the traditional doctrines: "In the hope of maximizing the g a i n s from a f r e s h p e r s p e c t i v e , i n what f o l l o w s I w i l l p u r p o s e l y not r e f e r t o the standard c a t c h phrases of i n t e r n a t i o n a l tax p o l i c y , such as c a p i t a l 4 7  27 are now  under way  international  t o "seek new  tax  policy  t h e o r y of i n t e r n a t i o n a l  i n s i g h t - indeed a new  by  recasting  trade:"  i t in  language f o r  parallel  with  the  4 8  [A]lthough international t r a d e t h e o r y has been applied p r i n c i p a l l y t o p o l i c y instruments such as t a r i f f s , quotas and dumping, tax p o l i c y can have a t l e a s t as l a r g e an e f f e c t on the flow of goods a c r o s s c o u n t r i e s , the l o c a t i o n of p r o d u c t i v e a c t i v i t y , and the g a i n s from t r a d e as t h e s e t r a d e p o l i c y instruments. Thus i t i s an important o b j e c t of study i n i t s own r i g h t . 4 9  As  indicated  research trade.  i s that  previously, tax  policy  the  underlying  premise  should  facilitate,  not  of  this  hinder,  T r a d i t i o n a l tax p o l i c y c r i t e r i a , even i n the  free  international  t a x a t i o n c o n t e x t , emphasize the i n t e r e s t s of the p a r t i c u l a r n a t i o n . T h e r e f o r e , the p r o p o s a l i s t o e v a l u a t e n a t i o n a l tax p o l i c y s t a r t i n g w i t h an i n t e r n a t i o n a l p e r s p e c t i v e based on a fundamental f e a t u r e of the  international  tax  structure  free trade: non-discrimination. The  principle  export neutrality, neutrality." 4 8  J o e l B.  of  which  i s consistent  global  50  non-discrimination  capital  with  import  Slemrod, i b i d . . a t  pertains  neutrality  to  and  neutrality  national  12.  i b i d . , a t 12. Slemrod i d e n t i f i e s a second reason f o r s t u d y i n g i n t e r n a t i o n a l tax p o l i c y i n p a r a l l e l w i t h i n t e r n a t i o n a l t r a d e t h e o r y : t h e r e i s a long h i s t o r y of r e a s o n i n g p e r t a i n i n g t o t r a d e - the b e n e f i t s of f r e e t r a d e , the c o s t s of p r o t e c t i o n i s m that i s f a i r l y uncontroversial among economists . . . [and] by drawing on this reasoning the murky issues involved in i n t e r n a t i o n a l t a x a t i o n can be c l a r i f i e d . 4 9  i b i d . , a t 21. Slemrod a l s o i d e n t i f i e s r e l i e f from double t a x a t i o n as the o t h e r fundamental f e a t u r e of the i n t e r n a t i o n a l tax s t r u c t u r e which i s c o n s i s t e n t w i t h g l o b a l f r e e t r a d e . 50  28 w i t h i n , as opposed t o among, n a t i o n s :  51  A p o l i c y of n o n - d i s c r i m i n a t i o n promises equal treatment of a l l i n v e s t o r s w i t h i n a n a t i o n , domestic and f o r e i g n a l i k e , and i s a p r e r e q u i s i t e of an a l l o c a t i v e l y e f f i c i e n t open economic system. However, as a n a t i o n a l commitment, n o n - d i s c r i m i n a t i o n seriously constrains e f f o r t s to pursue simultaneously o b j e c t i v e s w i t h r e s p e c t t o domestic i n d u s t r i a l s t r u c t u r e and the d o m e s t i c / f o r e i g n mix of ownership. Canada i n s i s t s on a m o d i f i e d v e r s i o n of n o n - d i s c r i m i n a t i o n . The Canadian approach i s t o t r e a t a l l f o r e i g n i n v e s t o r s i n Canada e q u a l l y but w i t h no promise t o r e f r a i n from t r e a t i n g the c o l l e c t i o n of f o r e i g n i n v e s t o r s d i f f e r e n t l y from Canadian investors. Non-discrimination international  clauses  transactions  are  pertaining generally  to  taxation  provided  for  in  tax  Discrimination generally  has  t r e a t i e s and  commercial t r e a t i e s .  been d e f i n e d  t o mean " t r e a t i n g persons u n f a v o u r a b l y  that  are  unreasonable,  Donald J.S. supra, a t 164. 51  Brean,  5 2  arbitrary  of  or  "International  f o r reasons  irrelevant." Issues  in  5 3  Tax  Taxation",  Kees Van Raad, supra, a t 15. For example, A r t i c l e 24:3 of the 1977 OECD Model Convention reads: " S t a t e l e s s persons who are r e s i d e n t s of a C o n t r a c t i n g S t a t e s h a l l not be s u b j e c t e d i n e i t h e r C o n t r a c t i n g S t a t e t o any t a x a t i o n or any requirement connected t h e r e w i t h , which i s other or more burdensome than the t a x a t i o n and connected requirements t o which n a t i o n a l s of the S t a t e concerned i n the same circumstances are or may be s u b j e c t e d . " Canada has r e s e r v e d t h e i r p o s i t i o n w i t h r e s p e c t t o t h i s A r t i c l e . A r t i c l e 111:1 of the GATT reads: "The contracting p a r t i e s recognize that i n t e r n a l taxes and other i n t e r n a l charges, and laws, r e g u l a t i o n s and requirements ... should not be a p p l i e d t o imported or domestic p r o d u c t s so as t o a f f o r d p r o t e c t i o n t o domestic p r o d u c t i o n . 5 2  i b i d . . a t 11. A l s o d i s c u s s e d by Kees Van Raad, "Nond i s c r i m i n a t i o n i n I n t e r n a t i o n a l Tax Law", S e r i e s on I n t e r n a t i o n a l T a x a t i o n . No. 6 (Deventer, the Netherlands, Kluwer Law and T a x a t i o n P u b l i s h e r s , 1986) a t 7 and 8: the o r i g i n a l meaning of the v e r b 'to discriminate" is neutral, referring to 'distinction' and ' d i f f e r e n t i a t i o n ' ; however, t h i s n e u t r a l meaning has been r e p l a c e d with the notion that the differential treatment has an unreasonable, a r b i t r a r y or i r r e l e v a n t aspect t o i t . Kees Van Raad notes t h a t n o n - d i s c r i m i n a t i o n i s the o p p o s i t e of u n f a v o u r a b l e and 5 3  29 d i s c r i m i n a t i o n has  been d e f i n e d  as "the u n f a v o u r a b l e treatment of  c e r t a i n taxpayers and a c t i v i t i e s f o r reasons t h a t are unreasonable, arbitrary, t a x a t i o n and  or  irrelevant."  5 4  Discrimination  in  the  context  of  i n t e r n a t i o n a l trade r e f e r s p r i m a r i l y to unfavourable  treatment of n o n - r e s i d e n t s and f o r e i g n a c t i v i t i e s as compared w i t h r e s i d e n t s and domestic a c t i v i t i e s which i s not j u s t i f i a b l e on some reasonable  basis.  5 5  To  the  extent  that  tax  treaties  and  i n t e r n a t i o n a l agreements a r t i c u l a t e unacceptable d i f f e r e n t i a t i o n s , the elements of ' a r b i t r a r i n e s s * and  ' i r r e l e v a n c e ' i n the d e f i n i t i o n  of d i s c r i m i n a t i o n are removed, and d i f f e r e n t i a l treatment based on the grounds s p e c i f i c a l l y mentioned c o n s t i t u t e s d i s c r i m i n a t i o n  per  a r b i t r a r y d i f f e r e n t i a l treatment - an i d e a l which i s f a r from c l e a r (at 9) . B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s " , supra. a t 15. Donald J . S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 13 s t a t e s : " . . . t r e a t i e s g e n e r a l l y focus on w i t h h o l d i n g tax r a t e s on i n t e r e s t , d i v i d e n d s , and o t h e r e a r n i n g s on f o r e i g n c a p i t a l because such taxes are levied at the border and are thus, by definition, discriminatory." T h i s suggests t h a t the d e f i n i t i o n of tax d i s c r i m i n a t i o n i n c l u d e s any taxes ' l e v i e d a t the border'. 54  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s " , supra. a t 11. A r n o l d a l s o discusses the difference between direct and indirect tax d i s c r i m i n a t i o n a t 15; P r o v i s i o n s which prima f a c i e d i s c r i m i n a t e on the b a s i s of a taxpayer's r e s i d e n c e are d i r e c t l y d i s c r i m i n a t o r y ; indirect discrimination does not relate to residence, but e f f e c t i v e l y r e s u l t s i n l e s s f a v o u r a b l e treatment of n o n - r e s i d e n t s . A r n o l d p r o v i d e s the f o l l o w i n g examples: Canadian r e s i d e n t s are e n t i t l e d t o d i v i d e n d tax c r e d i t s , but n o n - r e s i d e n t s are not ( d i r e c t d i s c r i m i n a t i o n ) ; provisions that deal with Canadian-controlled p r i v a t e c o r p o r a t i o n s and s m a l l b u s i n e s s c o r p o r a t i o n s which do not d i s c r i m i n a t e a g a i n s t n o n - r e s i d e n t taxpayers d i r e c t l y but a g a i n s t c e r t a i n r e s i d e n t taxpayers t h a t are c o n t r o l l e d by n o n - r e s i d e n t s (indirect discrimination). 55  30 se.  56  Where such t a x d i s c r i m i n a t i o n prima f a c i e e x i s t s ,  t h e r e may  w e l l be circumstances when d i s c r i m i n a t i o n i s j u s t i f i a b l e , e i t h e r as p r o v i d e d f o r s p e c i f i c a l l y i n i n t e r n a t i o n a l agreements o r as p a r t o f the  sovereign  right  national objectives. The  t o achieve  an i d e a l  t a x system which meets  5 7  t a x measures under  review  will  be examined  whether t h e p o l i c i e s d i s c r i m i n a t e a g a i n s t n o n - r e s i d e n t  t o assess or foreign  a c t i v i t i e s and have a n e g a t i v e e f f e c t on f r e e t r a d e . The s p e c i f i c domestic t a x l e g i s l a t i o n w i l l be f i r s t be reviewed. will  move t o i n t e r n a t i o n a l  trade  whether d i s c r i m i n a t i o n e x i s t s . exists,  the • next  stage  5 8  law as a b a s i s If  The a n a l y s i s f o r assessing  discrimination  i s t o determine  whether  arguably  o r n o t such  Kees Van Raad, s u p r a a t 9 - 10 r e f e r r i n g g e n e r a l l y t o Marc Bossuyt, The P r o h i b i t i o n t o D i s c r i m i n a t e i n I n t e r n a t i o n a l Human R i g h t s Law (Emile B r u y l a n t , B r u x e l l e s , 1976) and W. Kewenig, The P r o h i b i t i o n t o D i s c r i m i n a t e i n Modern P a c i f i s t I n t e r n a t i o n a l Law (IX A r c h i v des V o l k e r e c h t s 137, 1961/1962) [both t i t l e s a r e t r a n s l a t i o n s by Van Raad from t h e o r i g i n a l t i t l e s i n f r e n c h and german r e s p e c t i v e l y ] . 5 6  f  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s " , supra, a t 15 suggests t h a t e q u i t y , n e u t r a l i t y , revenue and m i n i m i z a t i o n o f a d m i n i s t r a t i v e and compliance problems a r e t h e a p p r o p r i a t e c r i t e r i a f o r determining whether d i s c r i m i n a t o r y treatment i s j u s t i f i e d . 5 7  Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra. a t 164, suggests that: "To adhere to strict nond i s c r i m i n a t i o n i s t o suppress s e v e r a l degrees o f freedom i n domestic economic p o l i c y ... and most c o u n t r i e s a r e r e l u c t a n t t o r e l i n q u i s h that sovereign r i g h t . The r e s e a r c h a b l e question i n v o l v e s t h e extent t o which t h e s t a b i l i t y , n e u t r a l i t y , and e q u i t y of i n t e r n a t i o n a l t a x arrangements a r e compromised by s t r a t e g i c discrimination within nations." The c u r r e n t proposed a n a l y s i s extends t h i s 'researchable question' beyond t h e borders o f i n t e r n a t i o n a l t a x arrangements t o c o n s i d e r t h e impact o f t a x d i s c r i m i n a t i o n on i n t e r n a t i o n a l t r a d e arrangements. 5 8  31 discrimination  i s permitted  or  justifiable  on  some b a s i s .  5 9  If  The a n a l y s i s proposed here i s s i m i l a r t o a C h a r t e r a n a l y s i s which has been used i n Canadian income tax l i t i g a t i o n . For example, under s e c t i o n 15(1) of the C h a r t e r , tax p r o v i s i o n s t h a t d i s c r i m i n a t e on the b a s i s of r a c e , n a t i o n a l or e t h n i c o r i g i n , c o l o u r , r e l i g i o n , sex, age or mental or p h y s i c a l d i s a b i l i t y can be c h a l l e n g e d (see Lennox I n d u s t r i e s (Canada) v. The Queen. [1987] 1 CT~C 171, 87 DTC 5041 (FCTD); Hodson V . The Queen. [1987] 1 CTC 219, 87 DTC 5113 (FCTD); Century 21 Emos R e a l t y Inc. e t a l . v. The Queen. [1987] 1 CTC 340, 87 DTC 5158 (Ont.CA); Klement v. The Queen. [1987] 2 CTC, 87 DTC 5284 (FCTD); P r i o r v. The Queen. T19881 1 CTC 241, 88 DTC 6207 (FCTD); S t r o m o t i c h v. The Queen. [1988] 1 CTC 252, 88 DTC 6172 (FCTD); The Queen v. K u r i s k o . [1988] 2 CTC 254, 88 DTC 6434 (FCTD); Svmes V . Canada, [1993] 4 SCR 695, [1994] 1 CTC 40, 94 DTC 6001 (SCC); Thibaudeau S. v. Canada [1994] 2 C.T.C. 2497 (FCA) on appeal t o the SCC.) I f an i n f r i n g e m e n t of s e c t i o n 15(1) i s found, the Court then moves t o a s e c t i o n 1 a n a l y s i s (see R±. v. Oakes. [1986] 1 SCR 103, 26 DLR (4th) 200) t o see i f the o f f e n d i n g p r o v i s i o n can be saved. The section 1 a n a l y s i s i s a f o u r stage t e s t : 1. a s s e s s the o b j e c t i v e s sought t o be a c h i e v e d by the impugned p r o v i s i o n and a d e t e r m i n a t i o n of whether they are important enough t o warrant a C h a r t e r breach; 2. the Court must be s a t i s f i e d t h a t t h e r e i s a r a t i o n a l c o n n e c t i o n between the impugned p r o v i s i o n and the l e g i s l a t i v e o b j e c t i v e ; 3. the impugned p r o v i s i o n should m i n i m a l l y impair the C h a r t e r r i g h t ; and 4. t h e r e must be p r o p o r t i o n a l i t y between the i n t e r e s t s of s o c i e t y and the person whose r i g h t s have been i n f r i n g e d . 5 9  No c o u n t r y ' s laws p r o h i b i t tax d i s c r i m i n a t i o n on the b a s i s of c i t i z e n s h i p , residence, or the g e o g r a p h i c a l source of income. " N e v e r t h e l e s s , many c o u n t r i e s have chosen u n i l a t e r a l l y not to d i s c r i m i n a t e on these bases, or t o minimize such d i s c r i m i n a t i o n ; many have entered i n t o b i l a t e r a l tax t r e a t i e s t h a t p r o h i b i t them from d i s c r i m i n a t i n g i n c e r t a i n ways a g a i n s t the n a t i o n a l s or residents of t h e i r t r e a t y partners.'! (Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents and Foreign A c t i v i t i e s " , supra. a t 21; see a l s o Dr. A.A. K n e c h t l e , supra a t 5454) . I t i s suggested t h a t where tax d i s c r i m i n a t i o n does e x i s t , an a n a l y s i s s i m i l a r to a Charter a n a l y s i s w i l l a s s i s t i n assessing whether such d i s c r i m i n a t i o n i s j u s t i f i a b l e . As noted by B r i a n A r n o l d , i b i d , a t 23, "the broad language of the Canadian C h a r t e r of R i g h t s and Freedoms and Canadian human r i g h t s l e g i s l a t i o n i s capable of a p p l y i n g t o the tax treatment of f o r e i g n e r s and nonr e s i d e n t s of Canada. However, i t has not been a p p l i e d i n t h i s way and i t seems v e r y u n l i k e l y t h a t i t w i l l be. The Canadian tax system contains many d i s c r i m i n a t o r y provisions... It is virtually u n t h i n k a b l e t h a t Canadian c o u r t s would s t r i k e down such p r o v i s i o n s , g i v e n t h a t they r e p r e s e n t c l e a r government p o l i c y and are so  32 international  trade  law does  not p r o v i d e  justification  for a  p a r t i c u l a r t a x measure which appears t o be d i s c r i m i n a t o r y , t h e next question quo  w i l l be whether i t i s j u s t i f i a b l e t o m a i n t a i n t h e s t a t u s  i n light  o f an o v e r r i d i n g  sovereign  i n t e r e s t . I n order t o  j u s t i f y t a x d i s c r i m i n a t i o n on t h i s b a s i s , t h e t a x measure s h o u l d be r a t i o n a l l y r e l a t e d t o t h e u n d e r l y i n g domestic o b j e c t i v e and a c h i e v e that  objective  based  on  appropriate  evaluation  criteria.  In  a d d i t i o n , t h e domestic o b j e c t i v e must outweigh t h e broader g l o b a l objective of f a c i l i t a t i n g  free trade.  60  Finally,  among a l t e r n a t i v e t a x measures, t h e g o a l choose t h e a b s o l u t e l y  least  i n choosing from  i s not n e c e s s a r i l y t o  i n t r u s i v e means t o a t t a i n  domestic  o b j e c t i v e s , but t h e means should come w i t h i n a range which r e s t r i c t free trade Tax  as l i t t l e as i s r e a s o n a b l y p o s s i b l e .  p o l i c y plays  a key r o l e i n d e t e r m i n i n g how  adapt t h e i r o p e r a t i o n s t o remain c o m p e t i t i v e . is  an  elusive  competition  ever  increases,  protectionist tolerated  and  changing i t  is  and d i s c r i m i n a t o r y  Though d i s c r i m i n a t i o n  concept,  reasonable taxation  by Canada's t r a d i n g p a r t n e r s .  61  enterprises  as  international  to  expect  regimes,  that  will  not be  The s u g g e s t i o n  i s that  widespread." As noted by Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n Taxation", supra. a t 2, n a t i o n a l p o l i c i e s a r e c o n s t r a i n e d by p o l i c i e s o f other n a t i o n s ( i n c l u d i n g r e t a l i a t o r y p o l i c y ) and by economic c o n s i d e r a t i o n s such as comparative t r a d e advantage and a n a t i o n s need t o import o r c a p a c i t y t o export c a p i t a l . 6 0  "Notes f o r an Address by t h e Honourable Roy MacLaren, Minister f o r International Trade, To t h e GATT M i n i s t e r i a l Conference i n Marrakesh" ( A p r i l 12, 1994), Canada and t h e Uruguay Round. I n f o r m a t i o n K i t (Government o f Canada, A p r i l , 1994) a t 4. The M i n i s t e r i d e n t i f i e d t h e f o l l o w i n g two i n e s c a p a b l e conclusions 61  33 if  nations  unilaterally  and  consciously eliminate  unjustifiable  d i s c r i m i n a t o r y tax p r a c t i c e s , impediments t o f r e e r t r a d e w i l l reduced. Yet Canada's income tax system:  be  62  ... c o n t a i n s s p e c i f i c p r o v i s i o n s t h a t a f f o r d d i f f e r e n t , and o f t e n l e s s f a v o u r a b l e , treatment t o some taxpayers on the grounds of n a t i o n a l i t y , r e s i d e n c e or the g e o g r a p h i c a l l o c a t i o n of activities. To the extent t h a t such treatment is unfavourable and the reasons f o r i t appear t o be unreasonable, a r b i t r a r y , or i r r e l e v a n t , these p r o v i s i o n s can be c o n s i d e r e d discriminatory. The  next  three  Chapters e x p l o r e  d i s c r i m i n a t i o n i n Canada's  tax  system w i t h i n the framework s e t out above.  about m u l t i l a t e r a l i s m : F i r s t , we must g i v e t h e p r i n c i p l e s of f a i r n e s s and mutual advantage new meaning. As our i n t e r e s t s and a s p i r a t i o n s i n c r e a s i n g l y converge, c o - o p e r a t i o n w i l l be the o n l y way t o proceed. Second, we must work harder t o l e a v e u n i l a t e r a l i s m and p r o t e c t i o n i s m behind once and f o r a l l . . . B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s and F o r e i g n A c t i v i t i e s " , supra. a t 1. A r n o l d a l s o notes t h a t up t o the time of h i s study (May, 1990) , t h e Canadian tax system had never been c r i t i c a l l y s t u d i e d from the p e r s p e c t i v e of discrimination against aliens, non-residents, and foreign activities. 6 2  34 CHAPTER 2 CROSS BORDER SOFTWARE PAYMENTS INTRODUCTION This  Chapter  examines t h e Canadian t a x treatment  of cross-  border payments f o r computer software under l i c e n s i n g arrangements i n p a r a l l e l w i t h i n t e r n a t i o n a l t r a d e concepts  1  i n t h e GATT. Canada  has entered i n t o i n t e r n a t i o n a l t r a d e agreements and made amendments to  domestic  facilitate abroad. tax  intellectual  t h e flow  property  of i n t e l l e c t u a l  legislation property  into  in  order  Canada  to from  However, t h e e f f e c t o f Revenue Canada's p o s i t i o n on t h e  treatment  of  i n t e r n a t i o n a l borders  payments  for  computer  software  across  i s t o impede access t o f o r e i g n technology,  not t o s t i m u l a t e i t . Simply  put,  Canada t r e a t s these  payments as r o y a l t i e s , and  t h e r e f o r e income from p r o p e r t y , whereas o t h e r i n t e r n a t i o n a l bodies 2  The form o f t r a n s a c t i o n under c o n s i d e r a t i o n i s t h e s t r a i g h t f o r w a r d d e l i v e r y t o a customer o f pre-packaged software c o n t a i n e d on a computer d i s k . The customer c o u l d be an i n d i v i d u a l who w i l l use t h e software on a home computer o r a business a c q u i r i n g s o p h i s t i c a t e d software f o r use on a l o c a l area network. Payment i s i n exchange f o r the p e r p e t u a l r i g h t t o use t h e software. See M e l v i n S. Adess and Barbara M. Angus, "Knowledge and Technology T r a n s f e r s t o and from t h e U n i t e d S t a t e s : C h a r a c t e r i z a t i o n of T r a n s f e r s o f Computer Software" (July/August 1993) I n t e r n a t i o n a l Bureau o f F i s c a l Documentation a t 414 - 423 f o r a d i s c u s s i o n on a s i m i l a r form o f t r a n s a c t i o n under c o n s i d e r a t i o n by t h e I n t e r n a l Revenue S e r v i c e (the "IRS"). 1  T h i s paper assumes t h a t t h e n o n - r e s i d e n t does not have a permanent e s t a b l i s h m e n t i n Canada and, t h e r e f o r e , i s n o t s u b j e c t t o Canadian t a x a t i o n under P a r t I o f t h e Income Tax A c t . I n p r a c t i c e , few arrangements f o r t h e supply o f technology g i v e r i s e t o a Canadian b u s i n e s s , u n l e s s t h e technology has been developed by t h e n o n - r e s i d e n t i n t h e course o f c a r r y i n g on b u s i n e s s i n Canada (see Nathan Boidman and Bruno Ducharme, T a x a t i o n i n Canada: I m p l i c a t i o n s f o r F o r e i g n Investment, (The Netherlands: Kluwer Law and T a x a t i o n P u b l i s h e r s , 1985) a t 227.) 2  35 treat  them  as  withholding  tax  p r o f i t s are  not.  Revenue  business in  the  Canada  profits.  Royalties  3  cross-border  has  recently  n e g o t i a t i o n s w i t h a t l e a s t two tax r a t e s on such payments.  context  concluded  subject  whereas  to  business  bilateral  treaty  countries to eliminate withholding  However t h i s approach s k i r t s the i s s u e  of the u n d e r l y i n g r o y a l t y c h a r a c t e r i z a t i o n . Although  are  4  t h e r e i s m e r i t t o a b i l a t e r a l approach, i t does not  a s s i s t c o u n t r i e s which e i t h e r do not have t r e a t i e s w i t h Canada or have  not  renegotiated  Therefore,  existing  i t i s preferable  to  bilateral take  a  tax  conventions.  principled  approach  to  r e s o l v i n g the u n d e r l y i n g i s s u e r a t h e r than merely d e a l i n g w i t h the symptoms on policies  in  a case  by  general,  case  basis.  should  T r e a t y n e g o t i a t i o n s , and  reflect,  or  at  least  take  tax into  c o n s i d e r a t i o n , i n t e r n a t i o n a l developments i n t r a d e and t a x a t i o n . Thus, the purpose of t h i s Chapter i s t w o - f o l d .  By  examining  the p a r t i c u l a r t a x p o l i c y presented w i t h i n the framework of GATT, f u r t h e r support change  i s advanced f o r the view t h a t Revenue Canada must  i t s stance  on  this  policy.  In  addition,  the  broader  q u e s t i o n of what i n f l u e n c e i n t e r n a t i o n a l agreements should have on unilateral, 3  bilateral  and  multilateral  taxation policies  is  an  See below "Royalty P r o v i s i o n s i n M u l t i l a t e r a l Tax T r e a t i e s " .  T h i s paper does not attempt t o d e a l w i t h t h e u n d e r l y i n g c h a r a c t e r i z a t i o n problem other than t o suggest t h a t t h e Canadian approach should be harmonized w i t h the i n t e r n a t i o n a l standard t o facilitate cross-border flows of software. An abundance of l i t e r a t u r e has c r i t i c i z e d Revenue Canada's c h a r a c t e r i z a t i o n of such payments as r o y a l t i e s which are s u b j e c t t o w i t h h o l d i n g t a x when paid to nonresidents. Some of t h i s l i t e r a t u r e i s p r e s e n t e d below. 4  36  underlying Part  theme. I s e t s t h e stage f o r t h e s p e c i f i c t a x a t i o n  i s s u e under  c o n s i d e r a t i o n w i t h an overview o f t h e Canadian treatment o f r o y a l t y payments t o n o n r e s i d e n t s . Next, t h e c h a r a c t e r i z a t i o n o f computer software payments i n m u l t i l a t e r a l t a x a t i o n t r e a t i e s i s presented, f o l l o w e d by a d i s c u s s i o n o f t h e p o t e n t i a l f o r double t a x a t i o n . P a r t I  concludes w i t h  a b r i e f update o f some r e c e n t  Canada's b i l a t e r a l t r e a t y n e g o t i a t i o n s Part  outlined  principle  and  some  interpretive  are presented.  how  The  5  Then,  issues  with  pertaining  t h e Canadian  I i s challenged  i t accords  international  of the tax  F i r s t t h e GATT p r i n c i p l e o f n a t i o n a l treatment  p o l i c y outlined i n Part assess  i n t h i s area.  I I develops t h e framework f o r examination  p o l i c y under GATT. is  developments i n  this  within  to  software  that  royalty  t h i s framework t o  fundamental  principle  of  trade.  paper  concludes  that  Revenue  Canada  should  bring i t s  p o s i t i o n on t h e c h a r a c t e r i z a t i o n o f these software payments i n l i n e w i t h t h e i n t e r n a t i o n a l view, n o t only t o harmonize t a x regimes, but as  a further  impetus t o r e d u c i n g  trade  barriers  f o r technology  transfer. PART I CROSS-BORDER PAYMENTS UNDER SOFTWARE LICENSING A.  ARRANGEMENTS  The Canadian approach Software  i s often  transferred  t o end u s e r s  under  licence  The Canada - U.S. Free Trade Agreement ("FTA") and North American Free Trade Agreement ("NAFTA")incorporate A r t i c l e I I I o f the GATT r e g a r d i n g t h e p r i n c i p l e o f n a t i o n a l treatment. 5  37 agreements  which  are  designed  to  protect  the  interest  software developer by r e s t r i c t i n g the end u s e r ' s a b i l i t y the software or make changes t o the source code.  6  of  the  t o copy  Revenue Canada  c l a s s i f i e s payments under these l i c e n s i n g agreements as r o y a l t i e s ; J.A. C h a p i n - F o r t i n , "Revenue (December, 1993), CA Magazine a t 30. 6  Canada  Hard  on  7  Software"  T h i s i n t e r p r e t a t i o n i s c o n t r o v e r s i a l and has been the source of much debate and d i s c u s s i o n . I t i s beyond the scope of t h i s paper t o canvass the case law, l i t e r a t u r e and h i s t o r i c a l development o f Revenue Canada's view. See g e n e r a l l y , M a r t i n L. O'Brien, "Payments f o r the Use o f P r o p e r t y - R o y a l t y - Know How Computer Programs", Canadian C u r r e n t Tax ( i s s u e 36; September 7, 1979) 377; T.E. McDonnell, "Withholding Tax - Computerized Data P r o v i d e d f o r a Fee - Canada-US Tax T r e a t y - R e n t a l s o r R o y a l t i e s " , 28 Canadian Tax J o u r n a l 5 (Toronto: Canadian Tax Foundation, 1980) 607-22, a t 615-17; P a u l Tamaki, "Withholding Tax on Computer Software Payments t o R e s i d e n t s of the U n i t e d S t a t e s " (December, 1983), 1 Canadian Computer Law Reporter 23-25; R i c h a r d G. Trembly, "Canada-US Cross Border Computer Software Fees", Canadian C u r r e n t Tax ( v o l . 1, no. 33) (September, 1986) 163-168; Robert D. Brown, "Tax Aspects o f Technology T r a n s f e r s Between the U n i t e d S t a t e s and Canada; A Canadian Viewpoint", 11 Canada U n i t e d S t a t e s Law J o u r n a l (1986), 227-46; W i l l i a m D. Anderson, "A P o t p o u r r i o f Elements i n Computing Business Income: P a r t 2", i n " C u r r e n t Developments i n Measuring Business Income f o r Tax Purposes", C o r p o r a t e Management Tax Conference, 1987 (Toronto: Canadian Tax Foundation, 1987), 6:131 a t 6:29; P a u l Tamaki, "Revenue Canada's New P o s i t i o n on W i t h h o l d i n g Tax on Computer Software R o y a l t i e s " , 6 Canadian Computer Law Reporter ( A p r i l 1989), 71-73; Robert D ' A u r e l i o , " I n t e r n a t i o n a l I s s u e s : A Revenue Canada P e r s p e c t i v e " , i n Report of Proceedings of the Forty-Second Tax Conference. 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991), 44:1-19; J.A. Chapin-Fortin, supra; Nathan Boidman, " C o n t i n u i n g Cross-Border Software C o n t r o v e r s y " (February 11, 1994), 23 Tax Management I n t e r n a t i o n a l J o u r n a l 90-94; C A . Brown, "Canadian Income Tax Treatment o f Computer Software Payments", 42 Canadian Tax J o u r n a l 3, (Toronto: Canadian Tax Foundation, 1994); Interpretat ion B u l l e t i n IT-303 "Know-how and s i m i l a r payments t o n o n - r e s i d e n t s " A p r i l 8, 1976: MNR v. Wain-Town Gas O i l Co. L t d . . 52 DTC 1138 (SCC) ; U n i t e d G e o p h y s i c a l Co. of Canada v. MNR. 61 DTC 1099 (Ex. C t . ) ; Vauban P r o d u c t i o n s v. The Queen. 75 DTC 5371 (FCTD); S o c i e t e N o u v e l l e de Cinematograph i e Inc. v. MNR. 79 DTC 802 (TRB) ; The Queen v. Farmparts D i s t r i b u t i n g L t d . . 80 DTC 6157 (FCA); Grand Toys L t d . v. MNR. 90 DTC 1059 (TCC) ; The Queen v. S a i n t John S h i p b u i l d i n g & Dry Dock Co. L t d . . 80 DTC 6277 (FCA) ; and Apple Computer Inc. v. Mackintosh Computers L t d . (1990), 71 DLR (4th) 95 7  38 a payment f o r software secret  formula.  i s viewed as a payment f o r t h e use o f a  8  Under subparagraph 2 1 2 ( 1 ) ( d ) ( i ) o f P a r t X I I I o f t h e Canadian Income Tax A c t nonresidents  9  (the "ITA") a 25% w i t h h o l d i n g t a x on payments t o  i s deducted  a t source  and c a l c u l a t e d  on t h e gross  amount o f any " r e n t , r o y a l t y o r s i m i l a r payment... f o r t h e use o f or f o r t h e r i g h t t o use i n Canada any p r o p e r t y ,  invention, trade  name, patent, trade-mark, d e s i g n o r model, p l a n , s e c r e t f o r m u l a . p r o c e s s o r other t h i n g whatever." I t has been suggested  11  (emphasis added)  t h a t t h i s treatment  may be j u s t i f i a b l e  i f t h e f o r e i g n software company p r o v i d e s t r a i n i n g , methodology software  concerning  developers  t h e software who  use  10  the  code  i n s t r u c t i o n or  t o Canadian  knowledge  for  resident  commercial  (SCC) a f f ' g (1988), 16 CIPR 15 (FCA), a f f ' g (1986), 28 DLR (FCTD).  (4th)178  See C A . Brown, supra, a t 601; a f t e r t h e coming i n t o f o r c e of t h e amendments t o t h e C o p y r i g h t A c t i n 1988 which s p e c i f i c a l l y i n c l u d e d computer programs w i t h i n t h e d e f i n i t i o n o f " l i t e r a r y work", Revenue Canada began t o r e c o g n i z e a l i m i t e d exemption from w i t h h o l d i n g t a x where a payment i s made t o a n o n - r e s i d e n t o n l y i n r e s p e c t o f t h e r i g h t t o produce o r reproduce computer software. See a l s o 2 1 2 ( 1 ) ( d ) ( v i ) o f t h e Income Tax A c t . 8  9  R.S.C. 1970 c. 1-5. as amended.  The C o p y r i g h t A c t . R.S.C 1986, c. C-42, as amended, i n c l u d e s computer programs i n t h e d e f i n i t i o n o f " l i t e r a r y work"; a computer program i s not a " s e c r e t formula" under Canadian c o p y r i g h t law. 10  I n t e r p r e t a t i o n B u l l e t i n IT-3 03, "Know-How and S i m i l a r Payments t o Non-Residents", paragraph 10, p r o v i d e s t h a t t h e 25% w i t h h o l d i n g t a x l e v i e d under subparagraph 2 1 2 ( 1 ) ( d ) ( i ) o f t h e ITA "extends t o any payment, i n c l u d i n g a s i n g l e o r lump-sum payment, made t o a n o n - r e s i d e n t f o r t h e r i g h t t o use, i n Canada, any p r o p e r t y . . . . Such payment w i l l be s u b j e c t t o t a x whether o r n o t i t f a l l s w i t h i n t h e category o f r e n t , r o y a l t y o r s i m i l a r payment". 11  39 e x p l o i t a t i o n ; but "the end u s e r o f a software package g a i n s no more knowledge motorist  about  t h e programmer's  l e a r n s about  Arguably,  automotive  Revenue  Canada's  logic  o r methodology  e n g i n e e r i n g by buying approach  does  than  a  a car."  1 2  not r e f l e c t the  commercial r e a l i t i e s o f these l i c e n s i n g agreements o r the i n t e n t o f the p a r t i e s , and t h e r e f o r e i t i s not a p p r o p r i a t e t o s u b j e c t these c r o s s - b o r d e r s a l e s o f pre-packaged more  g e n e r a l l y accepted  view  i s that  t r e a t e d as s a l e proceeds r a t h e r than B.  software t o t a x . such  payments  royalties.  Thus, t h e  1 3  should  be  1 4  R o y a l t y P r o v i s i o n s i n M u l t i l a t e r a l Tax T r e a t i e s There are t h r e e main i n t e r n a t i o n a l model t a x a t i o n agreements:  the O r g a n i s a t i o n f o r Economic C o - o p e r a t i o n and Development ("OECD") Model Tax Convention on Income and on C a p i t a l  (the "OECD Model"),  the  Convention  United  Developed  12  Nations  Model  Double  Taxation  Between  and Developing C o u n t r i e s (the "UN Model") and t h e U n i t e d  J.A. C h a p i n - F o r t i n , supra. a t 32 - 33.  Nathan Boidman, supra. a t 91; J.A. C h a p i n - F o r t i n , supra, a t 31; and Kenneth J . Murray, CA, "Computer Software: Canadian and Cross-Border I s s u e s " , Report o f Proceedings o f F o r t y - F i f t h Tax Conference. 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994) 27:1 a t 27:16. Note t h a t under subparagraph 2 1 2 ( 1 ) ( d ) ( x ) , payments f o r software purchased from U.S. vendors by c o r p o r a t i o n s w i t h branches i n o t h e r c o u n t r i e s a r e exempt from t h i s w i t h h o l d i n g t a x on t h e p o r t i o n o f payments sourced t o non-Canadian o p e r a t i o n s . (James Jones, i n "Correspondence", 42 Canadian Tax J o u r n a l 5 (Toronto: Canadian Tax Foundation, 1994) a t 1444. 13  As noted by Kenneth J . Murray, supra. a t 27:22 Revenue Canada i s s t u d y i n g t h e t a x a t i o n o f payments made t o n o n - r e s i d e n t s f o r t h e r i g h t t o use software: "The reason f o r t h e study was r e p r e s e n t a t i o n s t h a t t h e s a l e o f shrink-wrapped software i s t h e s a l e o f a product r a t h e r than a l i c e n c e . " Mr. Murray a l s o notes t h a t o t h e r c o u n t r i e s t r e a t software payments as s a l e s proceeds r a t h e r than l i c e n c e f e e s (27:23). 14  40 S t a t e s T r e a s u r y Model.  The focus i n t h i s s e c t i o n i s on t h e OECD  Model; b r i e f r e f e r e n c e i s made t o t h e o t h e r models. There has been ongoing debate i n t h e OECD f o r over a decade on i n t e r n a t i o n a l t a x i s s u e s r e g a r d i n g t h e development and t r a n s f e r o f software. the  OECD  treatment  15  These debates Model  culminated i n s i g n i f i c a n t amendments t o  i n 1992, p a r t i c u l a r l y  with  regard  o f software which i s now s p e c i f i c a l l y  t o the tax  addressed  i n the  OECD Model along w i t h r e v i s e d commentary. The r e v i s e d OECD Model d e f i n e s r o y a l t i e s a s : ...payments o f any k i n d r e c e i v e d as a c o n s i d e r a t i o n f o r the use o f , o r t h e r i g h t t o use, any c o p y r i g h t o f literary, artistic or scientific work including cinematograph f i l m s , any patent, t r a d e mark, d e s i g n o r Model, plan, s e c r e t formula or process. or f o r information concerning industrial, commercial or s c i e n t i f i c experience. ^ (emphasis added) 16  The g u i d i n g p r i n c i p l e s f o r i n t e r p r e t a t i o n o f A r t i c l e 12 o f t h e OECD Model a r e summarized as f o l l o w s :  1 7  See f o r example OECD, Working P a r t y on Information, Computer, and Communications P o l i c y , Software: An Emerging I n d u s t r y ( P a r i s : OECD, 1985); "Tax Treatment o f Software" i n OECD, Model Tax Convention: Four R e l a t e d S t u d i e s . Issues i n I n t e r n a t i o n a l T a x a t i o n no. 4 ( P a r i s : OECD, 1992). 15  A r t i c l e 12:2. Note t h a t t h e words " o r f o r t h e use, o r t h e r i g h t t o use, i n d u s t r i a l , commercial o r s c i e n t i f i c equipment" were d e l e t e d i n t h e r e v i s e d OECD Model so t h a t income from t h e l e a s i n g of such equipment would f a l l w i t h i n A r t i c l e 7 (Business P r o f i t s ) r a t h e r than A r t i c l e 12, thereby escaping w i t h h o l d i n g taxes on r o y a l t i e s where c o u n t r i e s do not adhere t o t h e OECD f o r m u l a t i o n o f A r t i c l e 12. See The Honourable J a n Franke, "The New OECD Model Tax Convention", Report o f Proceedings o f t h e F o r t y - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 47:1 - 47:19 a t 47:7. 16  See C A . Brown, supra. a t 595 -596; see a l s o The Honourable Jan Franke, supra. a t 47:16 - 47:17; David G. Broadhurst, Robert J . Dart and David G. Broadhurst (eds.), " R e v i s i o n s t o t h e OECD Model Convention", 40 Canadian Tax J o u r n a l 6 (Toronto: Canadian Tax 1 7  41 1. Payments made i n c o n n e c t i o n w i t h software r e p r e s e n t r o y a l t i e s o n l y where t h e r e i s a l i m i t e d g r a n t o f r i g h t s (not amounting t o a change i n ownership) f o r t h e commercial development o r e x p l o i t a t i o n o f t h e software. 2. Payments f o r software (whether "bundled" o r not) t h a t i s a c q u i r e d f o r t h e p e r s o n a l o r b u s i n e s s use o f t h e a c q u i r o r do not r e p r e s e n t r o y a l t i e s . 1 8  3. Payments made f o r t h e a l i e n a t i o n o f a l l r i g h t s a t t a c h e d t o software do not r e p r e s e n t r o y a l t i e s . 4. Payments made f o r t h e purchase o f some, but n o t a l l , of t h e r i g h t s a t t a c h i n g t o software may r e s u l t i n an alienation, depending on t h e p r e c i s e terms o f t h e relevant contract. I n those circumstances, the c o n s i d e r a t i o n p a i d does not r e p r e s e n t a r o y a l t y . 5. I f payments a r e made under mixed c o n t r a c t s (such as s a l e s o f hardware w i t h b u i l t - i n software, o r s a l e s o f s e r v i c e s w i t h a r i g h t t o use s o f t w a r e ) , e i t h e r t h e payments should be apportioned t o the component p a r t s , o r where some o f t h e p a r t s a r e a n c i l l a r y t o t h e p r i n c i p a l p a r t , the treatment o f the p r i n c i p a l p a r t s h o u l d p r e v a i l . 6. Where a double t a x a t i o n agreement p r o v i d e s f o r source t a x a t i o n i n r e s p e c t o f some, but n o t a l l , r o y a l t i e s , software payments t h a t have t h e c h a r a c t e r i s t i c s o f r o y a l t i e s w i l l normally be c h a r a c t e r i z e d as p a i d i n respect of copyright. T h e r e f o r e , a payment i n r e s p e c t o f software w i l l r a r e l y be a r o y a l t y payment under t h e r e v i s e d OECD Model, even where t h e r e i s only a p a r t i a l t r a n s f e r of r i g h t s .  1 9  An example o f payments t h a t  Foundation, 1992) 1347 - 1363, a t 1347 - 1348 and 1357 - 1358; and the OECD Model A r t i c l e 12 and commentary on A r t i c l e 12, paragraphs 12 - 17 i n p a r t i c u l a r . As noted by C A . Brown, supra. a t 596: " F u r t h e r t o i t s statement t h a t i n most cases income from t h e s a l e o f r i g h t s t o software should be regarded as b u s i n e s s income, p e r s o n a l s e r v i c e income o r c a p i t a l g a i n s , t h e commentary s a y s , • i t i s o f no r e l e v a n c e t h a t t h e software i s p r o t e c t e d by c o p y r i g h t o r t h a t t h e r e may be r e s t r i c t i o n s on t h e use t o which t h e purchaser can p u t i t " . 18  1  1 9  12(14).  See f o o t n o t e  25 and OECD Model,  commentary  to Article  42 are r o y a l t i e s i s where the t r a n s f e r o r i s t h e author o f t h e software and t h e t r a n s f e r o r g r a n t s p a r t i a l r i g h t s t o a t h i r d p a r t y t o enable t h a t t h i r d p a r t y t o develop o r d i s t r i b u t e t h a t s o f t w a r e .  20  The r a t i o n a l e behind the OECD Model a r t i c l e on r o y a l t i e s i s t o encourage and f a c i l i t a t e  international trade.  Even i f a payment  2 1  i s c l a s s i f i e d as a r o y a l t y , o n l y t h e s t a t e o f t h e b e n e f i c i a l owner of t h e r o y a l t y payments has t h e r i g h t t o t a x r o y a l t i e s a r i s i n g i n a contracting state  (the source country) and p a i d t o t h e r e s i d e n t  b e n e f i c i a l owner o f t h e o t h e r c o n t r a c t i n g s t a t e . if  a Canadian company makes r o y a l t y payments  2 2  I n o t h e r words,  t o a U.S. r e s i d e n t  company, which i s t h e b e n e f i c i a l owner, o n l y t h e U n i t e d S t a t e s has the r i g h t t o t a x those r o y a l t i e s p a i d under t h e OECD Model. The UN Model permits t h e use o f a w i t h h o l d i n g t a x where t h e r a t e has been agreed t o i n a b i l a t e r a l t r e a t y . Model  follows  t h e OECD Model  b e n e f i c i a r y country o n l y .  and a l l o w s  2 3  The U.S. T r e a s u r y  f o r taxation  i n the  I n a c t u a l t r e a t i e s s i g n e d by t h e U.S.  the U.S. T r e a s u r y Model i s g e n e r a l l y f o l l o w e d except where i t i s dealing  with  royalties,  2 0  2 4  a  country  which  imposes  withholding  such as t h e Canada-U.S. Tax C o n v e n t i o n .  OECD Model, commentary  to Article  2 2  25  12(13).  J.S. P h i l l i p s , "Tax T r e a t y Networks" Worldwide I n f o r m a t i o n Inc., 1991 a t 389. 21  t a x on  Chur,  Switzerland:  A r t i c l e 12:1 o f t h e OECD Model.  J.S. P h i l l i p s , supra. a t x x i i i and 389. The UN Model p e r m i t s t h e use o f a w i t h h o l d i n g t a x p r o v i d e d t h a t t h e r a t e has been agreed t o between t h e s t a t e s i n t h e i r b i l a t e r a l t r e a t y . 2 3  2 4  i b i d . . a t 389.  43 C.  The Problem o f Double  Taxation  A number o f OECD members, Canada i n c l u d e d , 26  have  expressed  r e s e r v a t i o n s about t h e complete exemption o f r o y a l t i e s from source country  taxation.  In a d d i t i o n  to reserving  on t h i s  general  exemption, OECD members d i f f e r i n t h e i r views on what q u a l i f i e s as a  royalty  i n the f i r s t  instance.  27  I n p a r t i c u l a r , Canada has  a s s e r t e d i t s i n t e n t i o n t o t r e a t payments f o r the use o f software as r o y a l t i e s which a r e s u b j e c t t o t a x i n Canada. t h i s i s exactly opposite  As i n d i c a t e d above,  t o t h e OECD recommendation.  28  I f both s t a t e s i n a b i l a t e r a l t r e a t y f o l l o w t h e OECD Model and exempt these payments from t a x i n t h e source country, no double t a x a t i o n problem w i l l a r i s e ; otherwise, t h e p o t e n t i a l f o r double taxation exists.  F o r example, i n t h e case under review,  cross-  border payments a r e c h a r a c t e r i z e d by Revenue Canada as r o y a l t i e s s u b j e c t t o non-resident  w i t h h o l d i n g t a x w i t h the f o l l o w i n g e f f e c t s :  The Canadian customer g e n e r a l l y must bear the c o s t o f t h e  25  Canada-US Tax Convention, 1980 as amended.  A u s t r a l i a , A u s t r i a , France, Greece, I t a l y , Japan, New Zealand, P o r t u g a l , Spain and Turkey have a l s o expressed v a r i e d r e s e r v a t i o n s about A r t i c l e 12 o f t h e OECD Model. 2 6  F o r example, A u s t r a l i a r e s e r v e s t h e r i g h t t o t a x r o y a l t i e s t h a t , under A u s t r a l i a n law have a source i n A u s t r a l i a (see Commentary t o OECD Model, A r t i c l e 12, paragraph 31) but A u s t r a l i a n T a x a t i o n R u l i n g 93/12 i s s u e d on May 13, 1993 r e s p e c t i n g t h e development and marketing o f computer software determined t h a t payments f o r a s t r a i g h t f o r w a r d o r simple use o f computer software are n o t r o y a l t i e s (see Nathan Boidman, supra. a t 93 p e r Andrew, "World Tax Scene - A u s t r a l i a - Computer Software R u l i n g , " 1993/9 I n t e r t a x 448 (Sept. 1993)). 2 7  CA.  Brown, supra, a t 596 - 597.  44 withholding tax; a f o r e i g n tax c r e d i t may not be a v a i l a b l e t o the s e l l e r i n the source c o u n t r y because of income-sourcing r u l e s i n t h a t country or t h e l a c k of c u r r e n t t a x a b l e income. 2 9  30  To  illustrate,  a  3 1  U.S.  source  sale  arises  when  a  U.S.  software manufacturer exports software t o Canada w i t h t i t l e p a s s i n g south  of  the  manufacturer withholding prepared  to  border.  i s not tax.  32  Under  eligible  these  circumstances  f o r f o r e i g n tax  credit  I t i s u n l i k e l y t h a t the U.S.  bear these  costs  and  p r i c e t o the Canadian end-user.  will,  the on  U.S.  Canadian  manufacturer i s  therefore,  increase  the  33  See a l s o Kenneth J . Murray, supra. a t 27:17: "In many cases, f o r e i g n vendors w i l l i n s i s t t h a t the Canadian customer bear the burden of the w i t h h o l d i n g t a x . " Note a l s o t h a t the w i t h h o l d i n g tax i s based on gross revenue and can r e s u l t i n a v e r y h i g h e f f e c t i v e r a t e of tax on the net r e t u r n t o the l i c e n s o r a f t e r expenses have been taken i n t o account. 2 9  3 0  J.A.  C h a p i n - F o r t i n , supra, a t  30.  31  J.A.  C h a p i n - F o r t i n , supra, a t  32.  In the U n i t e d S t a t e s , the f o r e i g n t a x c r e d i t i s not designed t o p r o v i d e r e l i e f from double t a x a t i o n caused by o v e r l a p p i n g r e s i d e n c e or o v e r l a p p i n g source c l a i m s ; i t o n l y p r o v i d e s r e l i e f from a c o n f l i c t of U.S. r e s i d e n c e j u r i s d i c t i o n w i t h f o r e i g n source jurisdiction. See M i c h a e l J . M c l n t y r e , The I n t e r n a t i o n a l Income Tax Rules of the U n i t e d S t a t e s . (Mass.; Butterworth, 1989) a t 4-5. 3 2  O b v i o u s l y t h i s problem does not a r i s e when the t r e a t y w i t h h o l d i n g r a t e i s n i l . However, o t h e r f o r e i g n j u r i s d i c t i o n s w i t h s i m i l a r s o u r c i n g r u l e s do not have t h i s t r e a t y b e n e f i t . There are a l s o ways t o s t r u c t u r e b u s i n e s s o p e r a t i o n s t o a v o i d t h e w i t h h o l d i n g t a x i s s u e e n t i r e l y . For example, l a r g e f o r e i g n software vendors may choose t o s e t up Canadian s u b s i d i a r i e s t o s e l l t h e i r p r o d u c t s i n Canada. T h i s i s done under d i s t r i b u t i o n agreements which can be designed t o q u a l i f y f o r exemption from the P a r t X I I I Canadian withholding tax. T h i s o p t i o n may not be f e a s i b l e f o r s m a l l e r vendors. T h e r e f o r e , s m a l l e r f o r e i g n companies may choose t o e n t e r i n t o d i s t r i b u t i o n arrangements w i t h Canadian r e s i d e n t software d i s t r i b u t o r s which are s t r u c t u r e d t o meet the P a r t X I I I exemption. Subparagraph 2 1 2 ( 1 ) ( d ) ( v i ) of the ITA p r o v i d e s and exemption from the w i t h h o l d i n g requirement f o r a " r o y a l t y or s i m i l a r payment on or 3 3  45 Even  in  circumstances  when  a  foreign  tax  credit  may  be  claimed, the c o m p l e x i t i e s and d i f f e r e n c e s i n the f o r e i g n t a x c r e d i t systems w i l l immediate  often  not  credit  forthcoming. resident  in full  foreign  integration; a  taxes  withheld  may  full  and  not  be  F u r t h e r any tax c r e d i t o b t a i n e d s t i l l puts the non-  34  at  for  result  a  cash  flow  cost  disadvantage.  Therefore,  the  p o t e n t i a l f o r double t a x a t i o n i s s i g n i f i c a n t . D.  Recent Developments This  scene. devised  problem  has  not  been overlooked  on  international  In the U n i t e d S t a t e s , a c o a l i t i o n of 19 software a  two  step  process  to  solve  the  problem  w i t h h o l d i n g tax on d i r e c t s a l e s t o Canadian end 1.  the  The  c o a l i t i o n would convince  the  developers  of  users:  Canadian  35  [ I n t e r n a l Revenue  i n r e s p e c t of a c o p y r i g h t i n r e s p e c t of the p r o d u c t i o n or r e p r o d u c t i o n of any l i t e r a r y . . . work". However, i f the p r o d u c t i o n s i t e i s not i n Canada, the w i t h h o l d i n g tax w i l l a p p l y w i t h t h e same r e s u l t s as above. A l s o , the a l t e r n a t i v e of d i r e c t l i c e n s i n g t o Canadian customers would a v o i d the P a r t X I I I w i t h h o l d i n g t a x but may s u b j e c t the n o n - r e s i d e n t t o P a r t I t a x on i t s s a l e s i n Canada, depending on the circumstances. A complete a n a l y s i s of the v a r i o u s a l t e r n a t i v e s i s beyond the scope of t h i s paper; see Kenneth J . Murray, supra. a t 27:28 - 27:31. See R.D. Brown, " P e r s p e c t i v e on the T a x a t i o n of Technology T r a n s f e r s Between Canada and the U n i t e d S t a t e s " , D i s c u s s i o n Paper prepared f o r Bureau of P o l i c y C o o r d i n a t i o n Department of Consumer and Corporate A f f a i r s : P r i c e Waterhouse, Toronto, 1987 wherein the author suggests t h a t t h i s i s p a r t i c u l a r l y t r u e f o r new high technology companies which have s u b s t a n t i a l immediate w r i t e - o f f s f o r r e s e a r c h and development, and access t o domestic t a x c r e d i t s and deductions which l i m i t i t s a b i l i t y t o c l a i m f o r e i g n tax credits. 3 4  f  Nathan Boidman, supra. a t 92. Note t h a t c e r t a i n members of the i n d u s t r y , such as IBM and Xerox, were opposed t o t h i s i n i t i a t i v e p u r p o r t e d l y on the b a s i s t h a t i t c o u l d undermine p r o t e c t i o n of p r o p r i e t a r y r i g h t s t o t h e i r software. See a l s o Kenneth J . Murray, supra. a t 27:34 - 27:35. 3 5  46 Service] t o issue a generic r u l i n g taking the p o s i t i o n t h a t such c r o s s - b o r d e r l i c e n s i n g o r s a l e o f prepackaged software should be t r e a t e d under US domestic law as a s a l e o f p r o p e r t y and not t h e l i c e n s i n g o f p r o p e r t y . Such a g e n e r i c r u l i n g would t h e r e f o r e t r e a t any f o r e i g n d i s t r i b u t o r o f prepackaged software ( i n the United States) as being i n r e c e i p t o f proceeds o f s a l e and n o t royalties. 2. Armed w i t h such an IRS r u l i n g , an approach would be made t o Revenue Canada t o have t h e Canadian government adopt a s i m i l a r p o s i t i o n . Although the IRS has n o t y e t i s s u e d t h e r u l i n g , t h e problem i s under review and two r u l i n g s a r e expected of 1994  1994.  36  The u l t i m a t e r u l i n g s w i l l  t o be i s s u e d a t t h e end  be moot as t h e August 31,  P r o t o c o l t o t h e Canada-U.S. t r e a t y  reduces  r a t e on payments f o r t h e use o f software  the withholding  t o 0% from t h e c u r r e n t  r a t e o f 10%. Changes have a l s o been made t o t h e Canada-Netherlands Income Tax Convention which s p e c i f i c a l l y exempts payments made f o r the use of computer software  from w i t h h o l d i n g t a x .  3 7  The problem i s t h a t d e s p i t e these r e c e n t t r e a t y developments, Revenue Canada s t i l l maintains t h e r i g h t t o t a x these payments.  cross-border  The 1993 Canadian f e d e r a l budget s t a t e d the government's  i n t e n t i o n t o exempt c r o s s - b o r d e r software payments f o r w i t h h o l d i n g tax i n i t s upcoming t r e a t y n e g o t i a t i o n s , but f a i l e d t o address t h e underlying 3 6  issue  o f whether  t h e software  payments  should  be  Nathan Boidman, i b i d . . a t 94.  March 4, 1993 P r o t o c o l t o the Canada-Netherlands Income Tax Convention. A r t i c l e 12(3)(a) extended t h e exemption from host country t a x a t i o n o f r o y a l t i e s t o "payments f o r t h e use o f , o r t h e r i g h t t o use, computer software." T h i s broadened t h e p r e v i o u s exemption f o r r o y a l t i e s on software l i c e n c e s which granted t h e r i g h t t o reproduce. 3 7  47 c l a s s i f i e d as r o y a l t i e s i n t h e f i r s t  instance:  Revenue Canada shows no i n c l i n a t i o n t o waver i n i t s i n t e r p r e t a t i o n of the current l e g i s l a t i o n . Concerned, however, t h a t Canadian f i r m s may not be a b l e t o "keep pace w i t h i n n o v a t i v e developments abroad," the government pledged i n t h e 1993 f e d e r a l budget t o " n e g o t i a t e , on a b i l a t e r a l b a s i s , exemptions from w i t h h o l d i n g taxes f o r payments made f o r t h e use o f computer software."... The United States - Canada's major trading partner, especially i n computer software - doesn't need a renegotiated treaty t o conclude that nonresident withholding t a x should not be l e v i e d on software payments. The commitment t o e l i m i n a t e t h e w i t h h o l d i n g t a x on these payments as p a r t o f upcoming t r e a t y n e g o t i a t i o n s can be l i k e n e d t o t r e a t i n g t h e symptoms o f a d i s e a s e r a t h e r than the d i s e a s e i t s e l f . 3 8  Therefore, treaties  software  exporting  o r which have not r e n e g o t i a t e d  Canada on t h i s matter a r e arguably and  countries  may w e l l  which  treaty provisions  a t a competitive  be a t a disadvantage  do not have  f o r quite  with  disadvantage,  some time.  Given  Revenue Canada's r e l u c t a n c e t o modify i t s p o s i t i o n on t h e c r o s s border software policy  in light  persuasive  l i c e n s i n g debate, perhaps a c o n s i d e r a t i o n o f t h i s o f other  i n t e r n a t i o n a l agreements may have some  impact. PART I I  THE A.  GATT AND WITHHOLDING TAX ON PAYMENTS FOR SOFTWARE  Introduction In  this  Part,  the question  under  consideration  i s whether  Revenue Canada's p o s i t i o n on t h e t a x a t i o n o f software has an e f f e c t on  t h e i n t e r n a t i o n a l flow  whether  the e f f e c t J.A.  o f computer  discriminates  Chapin-Fortin,  supra,  against a t 33.  software; imported  specifically software  in  48 favour of d o m e s t i c a l l y produced software.  The q u e s t i o n i s posed i n  the context of the p r i n c i p l e of n o n d i s c r i m i n a t i o n i n the GATT. B.  The  P r i n c i p l e of N o n d i s c r i m i n a t i o n  i.  The  Principle  and  i t s Interpretation  The u n d e r l y i n g GATT p r i n c i p l e of n o n d i s c r i m i n a t i o n i s embodied i n A r t i c l e s I and  III.  The p r i n c i p l e i s p o t e n t i a l l y f a r - r e a c h i n g  and has the a b i l i t y t o d i r e c t l y a f f e c t many domestic p o l i c i e s . A r t i c l e I c o n t a i n s the Most-Favoured-Nation (MFN) MFN  clause.  The  o b l i g a t i o n i s a n o n d i s c r i m i n a t i o n c l a u s e which a p p l i e s t o goods  from d i f f e r e n t member  to  members.  exporting  another  must  c o u n t r i e s ; any be  b e n e f i t extended by  immediately  extended  to  all  one  other  39  A r t i c l e I I I c o n t a i n s the n a t i o n a l treatment o b l i g a t i o n which i s a l s o a n o n d i s c r i m i n a t i o n c l a u s e but w i t h a d i f f e r e n t  emphasis.  N a t i o n a l treatment a p p l i e s as between d o m e s t i c a l l y produced goods and  imported goods  basic  policy  of  40  and  trade  " g e n e r a l l y [ i s ] designed liberalization  t o r e i n f o r c e the  - minimizing  governmental  i n t e r f e r e n c e and d i s t o r t i o n of t r a n s a c t i o n s which c r o s s The  clause  i s i n p a r t designed  t o prevent  from undermining the e l i m i n a t i o n of t a r i f f  the  borders."  importing  import  41  country  barriers vis a  There are a number of exceptions t o the MFN c l a u s e . For example, the NAFTA v i o l a t e s the MFN o b l i g a t i o n , put i s p e r m i t t e d under A r t i c l e 24 of GATT. 3 9  The concept of n a t i o n a l treatment i s a l s o fundamental t o the NAFTA, and i t s predecessor Canada/U.S. Free Trade Agreement. 4 0  John H. Jackson and W i l l i a m J . Davey, L e g a l Problems of I n t e r n a t i o n a l Economic R e l a t i o n s (St. P a u l , Minn.: West P u b l i s h i n g Co.,2d ed., 1986) a t 483. 41  49 v i s i n t e r n a l governmental  mechanisms.  2  A r t i c l e 111:1 s t a t e s t h a t i n t e r n a l t a x e s and laws "should not be  applied  protection because  t o imported t o domestic  of t h i s  o r domestic  products  so as t o  p r o d u c t i o n . " I t has been  language,  i t can be s t r o n g l y  afford  suggested  argued  that  that even  though a t a x may appear t o be n o n d i s c r i m i n a t o r y on i t s f a c e , i f i t has  an e f f e c t  of a f f o r d i n g  protection,  and t h i s  effect  i s not  e s s e n t i a l t o t h e v a l i d r e g u l a t o r y purpose suggested i n A r t i c l e XX, then t h e t a x i s i n c o n s i s t e n t w i t h GATT o b l i g a t i o n s .  4 3  A r t i c l e 111:2 f o c u s e s on i n t e r n a l t a x e s and charges: 2. The p r o d u c t s o f t h e t e r r i t o r y o f any c o n t r a c t i n g party imported into the t e r r i t o r y o f any o t h e r c o n t r a c t i n g p a r t y s h a l l not be s u b j e c t , d i r e c t l y o r i n d i r e c t l y , t o i n t e r n a l t a x e s o r o t h e r i n t e r n a l charges of any k i n d i n excess o f those a p p l i e d , d i r e c t l y o r i n d i r e c t l y , t o l i k e domestic p r o d u c t s . Moreover, no c o n t r a c t i n g p a r t y s h a l l otherwise a p p l y i n t e r n a l t a x e s o r o t h e r i n t e r n a l charges t o imported o r domestic p r o d u c t s i n a manner c o n t r a r y t o t h e p r i n c i p l e s s e t f o r t h i n paragraph 1. 44  The f i r s t sentence i n A r t i c l e 111:2 p r o h i b i t s d i s c r i m i n a t o r y taxes on l i k e p r o d u c t s ; i t does not p r o h i b i t t a x on imports where N a t i o n a l treatment o n l y a p p l i e s t o t r a d e i n p r o d u c t s but t h e o b l i g a t i o n t o void d i s c r i m i n a t o r y i n t e r n a l taxes a p p l i e s t o a l l p r o d u c t s , not j u s t scheduled ones. See a l s o John H. Jackson, World Trade and t h e Law o f GATT. ( C h a r l o t t e s v i l l e , V i r g i n i a : The M i c h i e Company, 1969) a t 280. 4 2  John H. Jackson.World Trade and t h e Law o f GATT. i b i d . . a t 193 and John H. Jackson, " N a t i o n a l Treatment and N o n - T a r i f f B a r r i e r s " , Michigan J o u r n a l o f I n t e r n a t i o n a l Law. Vo. 10, N o . l 207, a t 213. 4 3  As noted by K.W. Dam, The GATT Law and I n t e r n a t i o n a l Economic O r g a n i z a t i o n , (Chicago: The U n i v e r s i t y o f Chicago P r e s s , 1970) a t 118, paragraph 1 does not s e t out " p r i n c i p l e s " but o n l y s t a t e s t h a t i n t e r n a l taxes should not be a p p l i e d "so as t o a f f o r d p r o t e c t i o n t o domestic p r o d u c t i o n . " (emphasis added) 4 4  50 t h e r e i s a d i f f e r e n t i n t e r n a l t a x on l i k e domestic p r o d u c t s which imposes an equal or g r e a t e r burden.  45  F u r t h e r , the  interpretive  note t o paragraph 2 s t a t e s t h a t : A t a x conforming t o the requirements of the first sentence of paragraph 2 would be c o n s i d e r e d t o be i n c o n s i s t e n t w i t h the p r o v i s i o n s of the second sentence o n l y i n cases where c o m p e t i t i o n was i n v o l v e d between, on the one hand, the taxed product and, on the o t h e r hand, a d i r e c t l y c o m p e t i t i v e or s u b s t i t u t a b l e product which was not s i m i l a r l y t a x e d . 46  Therefore,  i f a t a x measure i s i n c o n s i s t e n t w i t h the  first  sentence of paragraph 2, i t i s not necessary t o c o n s i d e r the second sentence.  However, even i f a t a x measure complies w i t h the  sentence,  i t can  contravene  the  second  sentence.  The  first second  sentence d e a l s w i t h o t h e r i n t e r n a l taxes where l i k e p r o d u c t s are not i n v o l v e d but the tax d i s c r i m i n a t e s between d i r e c t l y c o m p e t i t i v e or  s u b s t i t u t a b l e domestic products i n f a c t , not i n f o r m .  ii.  47  I n t e r p r e t a t i o n of A r t i c l e I I I The approach f o r examining c o n f o r m i t y w i t h A r t i c l e 111:2  first  determine  "like"  whether the  imported  and  domestic  i s to  products  are  ( f i r s t sentence) or " d i r e c t l y c o m p e t i t i v e or s u b s t i t u t a b l e "  (second s e n t e n c e ) ; then, whether the t a x a t i o n i s d i s c r i m i n a t o r y 48  i b i d . , a t 117. Note t h a t A r t i c l e I I , paragraph 2(a) p e r m i t s "a charge e q u i v a l e n t t o an i n t e r n a l t a x imposed c o n s i s t e n t l y w i t h the p r o v i s i o n s of paragraph 2 of A r t i c l e I I I . . . " on imported products. 4 5  4 6  I n t e r p r e t i v e Note, Ad. A r t i c l e I I I .  4 7  K.W.  Dam,  supra, a t  118.  T h i s paper does not address the i n t e r p r e t i v e issues r e g a r d i n g the meaning of " l i k e " or " d i r e c t l y c o m p e t i t i v e or s u b s t i t u t a b l e " products which are assessed on a case by case b a s i s 4 8  51 (first  sentence) or p r o t e c t i v e  4 9  (second sentence) .  50  In  addition,  t h e r e are a number of fundamental i n t e r p r e t a t i v e i s s u e s which must be a.  addressed. I n t e r n a l Taxes: D i r e c t , I n d i r e c t or Both The  GATT makes a fundamental d i s t i n c t i o n between t a r i f f s  other taxes,  51  usually c a l l e d internal taxes.  52  A tariff  is a  and tax  u s i n g the f o l l o w i n g c r i t e r i a : the p r o d u c t ' s end uses i n a g i v e n market; consumers' t a s t e s and h a b i t s , which change from country t o country; and the product's p r o p e r t i e s , nature and q u a l i t y (see "Border Tax Adjustments", BISD 18S/97 a t 101-102, paragraph 18 and "Japan - Customs D u t i e s , Taxes and L a b e l l i n g P r a c t i c e s on Imported Wines and A l c o h o l i c Beverages", BISD 34S/83, 85 paragraph 5.6). I t i s assumed t h a t t h i s c r i t e r i a i s met i n the s p e c i f i c c o n t e x t of under review. A r t i c l e 111:2 has the o b j e c t and purpose of promoting nondiscriminatory competition among imported and like domestic p r o d u c t s ; i t was designed w i t h the i n t e n t i o n t h a t i n t e r n a l taxes on goods should not be used as a means of p r o t e c t i o n (Pierre Pescatore, W i l l i a m Davey and Andreas F. Lowenfeld, Handbook of GATT D i s p u t e Settlement (U.S.A.: T r a n s n a t i o n a l J u r i s P u b l i c a t i o n s , Inc., 1991) a t 28 - 29). See a l s o A r t i c l e 111:1 and f o o t n o t e 51. 4 9  "Japan - Customs D u t i e s , Taxes and L a b e l l i n g P r a c t i c e s Imported Wines and A l c o h o l i c Beverages", BISD 34S/83, 85 paragraph 5.5. 50  on at  The common d i s t i n c t i o n i n a GATT a n a l y s i s i s between t a r i f f and n o n t a r i f f b a r r i e r s t o t r a d e . The d i s t i n c t i o n between t a r i f f s and n o n t a r i f f b a r r i e r s i s p a r t i c u l a r l y r e l e v a n t as the GATT philosophy regarding n o n t a r i f f and tariff barriers i s quite d i f f e r e n t ; a c o n t r a c t i n g p a r t y i s not r e q u i r e d t o reduce t a r i f f s i n the absence of a s p e c i a l agreement whereas the g e n e r a l p r i n c i p l e w i t h r e s p e c t t o n o n t a r i f f b a r r i e r s i s one of immediate a b o l i t i o n (see K.W. Dam, supra. a t 19) . The GATT makes no g e n e r a l p r o v i s i o n f o r n e g o t i a t i o n s on the r e d u c t i o n of n o n t a r i f f b a r r i e r s ; see, however, A r t i c l e s IV(d) and XVII. T a r i f f s have h i s t o r i c a l l y been a p r e f e r r e d method t o r e s t r a i n t r a d e f o r a v a r i e t y of reasons. In a d d i t i o n t o being e a s i e r t o administer, a t a r i f f i s h i g h l y v i s i b l e and does not p r o h i b i t imports (although t a r i f f s do e f f e c t i v e l y l i m i t consumer o p t i o n s ) . See a l s o John H. Jackson and W i l l i a m J . Davey, supra, a t 366 f o r a d i s c u s s i o n of why i n t e r n a t i o n a l t r a d e p o l i c y g e n e r a l l y favoured t a r i f f s over a l l o t h e r t y p e s of import restraints. 51  52 or  duty  levied  on  government of the i n t e r n a l charges  imports  and  payable  importing c o u n t r y .  53  by  the  importer  Internal  taxes  to  or  the  other  imposed a t the time or p o i n t of i m p o r t a t i o n , are  regarded as an i n t e r n a l tax or i n t e r n a l charge and are s u b j e c t t o the p r o v i s i o n s of A r t i c l e  III.  5 4  I t i s not e n t i r e l y c l e a r whether A r t i c l e I I I a p p l i e s t o d i r e c t as  well  as  to  indirect  taxes.  The  difference  between  these  c a t e g o r i e s can be d e s c r i b e d as f o l l o w s : The t h e o r y i s t h a t a d i r e c t tax i s a t a x which i s r e a l l y p a i d by the person on whom i t i s l e g a l l y imposed. I t i s assessed a c c o r d i n g t o the p e r s o n a l ' a b i l i t y t o pay' and i s r e l a t e d t o f a c t s which are regarded as b e i n g an o b j e c t i v e and l a s t i n g e x p r e s s i o n of the t a x p a y i n g c a p a c i t y (eg. r e s i d e n c e , landed p r o p e r t y ) . The t a x burden i s d i s t r i b u t e d a c c o r d i n g t o the economic c a p a c i t y of the taxpayers which m a n i f e s t s i t s e l f p a r t i c u l a r l y i n the c a p i t a l (wealth) and income of the l a t t e r . An i n d i r e c t tax, on the o t h e r hand, i s a t a x which i s imposed on one person, but p a i d p a r t l y or w h o l l y by another; eg. i t i s l e v i e d on the t r a d e and s h i f t e d on t o the consumers. I n d i r e c t taxes are aimed a t a s s e s s i n g the a b i l i t y t o pay taxes i n d i r e c t l y and r e l a t e d t o the momentary tax paying c a p a c i t y . The t a x burden i s d i s t r i b u t e d among the consumers i n accordance w i t h t h e i r expenditure. 55  5 2  K.W.  Dam,  i b i d . . at  115.  See John H. Jackson and W i l l i a m J . Davey, supra. a t 364 f o r a d i s c u s s i o n of the t h r e e types of t a r i f f s : ad valorem, s p e c i f i c and mixed. 5 3  I n t e r p r e t i v e note, Ad A r t i c l e I I I . The i n t e r p r e t i v e note r e f e r s t o taxes l e v i e d on both imported and l i k e domestic p r o d u c t s , but g i v e s no guidance where l i k e domestic p r o d u c t s are not i n v o l v e d . Note t h a t the n a t i o n a l treatment o b l i g a t i o n i n A r t i c l e I I I i s d i v i d e d i n t o those r e l a t i n g t o t a x a t i o n and those r e l a t i n g to various other r e g u l a t i o n s . 5 4  A r n o l d A. K n e c h t l e , B a s i c Problems i n I n t e r n a t i o n a l F i s c a l Law. (The Netherlands: A.A. K n e c h t l e , 1979) a t 210 (n.40). See a l s o B l a c k ' s Law D i c t i o n a r y (St. Paul Minn., West P u b l i s h i n g Co. 1979) f o r the d e f i n i t i o n of "tax" ( d i r e c t taxes are a s s e s s e d on the 55  53 The  classification  controversial;  5 6  into  direct  and  indirect  taxes  is  i t i s not always c l e a r whether a t a x belongs  one or the o t h e r c a t e g o r y .  57  to  The i s s u e of whether a t a x i s passed  through t o the e v e n t u a l consumer i s p a r t i c u l a r l y p r o b l e m a t i c .  58  The terms " d i r e c t l y " and " i n d i r e c t l y " a r g u a b l y do not r e f e r t o "direct"  and  "indirect"  taxes,  59  though  i t i s possible  to  argue  p r o p e r t y , person, b u s i n e s s or income of those who pay them; i n d i r e c t taxes are l e v i e d on commodities b e f o r e they r e a c h the consumer and are p a i d by those upon whom they u l t i m a t e l y f a l l as p a r t of the market p r i c e of the commodity); Canadian c o n s t i t u t i o n a l law cases g e n e r a l l y r e f e r t o the t e s t s e t out by J.S. M i l l , P r i n c i p l e s of P o l i t i c a l Economy. (Boston: L i t t l e & J . Brown, 1848) Book V, Chapter 2. D i r e c t taxes t y p i c a l l y i n c l u d e p e r s o n a l and c o r p o r a t e income t a x e s ; i n d i r e c t taxes i n c l u d e the e x c i s e and s a l e s taxes. I t i s worth noting that the mere d e s c r i p t i o n or c a t e g o r i z a t i o n of a t a x under the domestic law i s not d e t e r m i n a t i v e of whether the t a x i s s u b j e c t t o the requirements o f A r t i c l e I I I . See "European Economic Community; R e g u l a t i o n on Imports of P a r t s and Components", BISD S37/132, 193 (May 16, 1990) paragraph 5.7 which a r r i v e s a t t h i s c o n c l u s i o n i n r e g a r d t o the " d e s c r i p t i o n or c a t e g o r i z a t i o n of a 'charge'" and of "the 'product s u b j e c t t o a charge•". The author submits t h a t the same treatment would be accorded t o d e s c r i p t i o n s of taxes under the i n t e r n a l law. 5 6  A. A. K n e c h t l e , supra. a t 30. The c l a s s i f i c a t i o n i n t o d i r e c t and i n d i r e c t a r i s e s o f t e n i n Canadian c o n s t i t u t i o n a l law. For a thorough a n a l y s i s see G.V. L a F o r e s t , "The A l l o c a t i o n of Taxing Power Under the Canadian C o n s t i t u t i o n " , 2 d . , Canadian Tax Paper No. 65 (Toronto: Canadian Tax Foundation, 1981) e s p e c i a l l y Chapter 4: "The Meaning of D i r e c t T a x a t i o n " . 5 7  See John H. Jackson, The World T r a d i n g System; Law and P o l i c y of I n t e r n a t i o n a l Economic R e l a t i o n s . (Cambridge, Mass.: The MIT P r e s s , 1989) a t 196 - 197 f o r a d i s c u s s i o n of the d i f f i c u l t y of a c c u r a t e l y measuring the i n c i d e n c e of a t a x . The i s s u e a l s o a r i s e s head on i n the c o n t e x t of border t a x adjustments where value-addedtaxes have been c o n s i d e r e d by the GATT t o be i n d i r e c t t a x e s which are e l i g i b l e f o r border-tax-adjustment. See John H. Jackson, The World T r a d i n g System, supra. a t 194 - 195. 5 8  K.W. Dam, supra. a t 124. As the author notes, a t a x which a p p l i e s d i r e c t l y t o products i s , i n f a c t , an i n d i r e c t t a x , whereas a t a x which a p p l i e s i n d i r e c t l y t o p r o d u c t s i s a d i r e c t t a x . 5 9  54 t h a t t h e " d i r e c t l y o r i n d i r e c t l y " language i s broad enough t o cover the  discriminatory  effects  of  direct  taxes.  6 0  The  common  i n t e r p r e t a t i o n i s that the reference t o "products" i n A r t i c l e I I I i m p l i e s t h a t i t i s o n l y i n d i r e c t t a x e s which a r e w i t h i n t h e scope of A r t i c l e  III.  6 1  Also, the predecessor  appear t o apply t o d i r e c t t a x e s .  to Article  I I I d i d not  62  I f d i r e c t taxes a r e excluded from A r t i c l e I I I , t h e f o l l o w i n g consequences a r i s e : ... a domestic income [ d i r e c t ] t a x may n o t be o f f s e t by any [ i n d i r e c t ] t a x on imported p r o d u c t s , [and] an income [ d i r e c t ] t a x l e v i e d on importers o r f o r e i g n s e l l e r s need not o f f s e t any domestic t a x . 6 3  F u r t h e r , c o n s i d e r t h e f o l l o w i n g d i s c u s s i o n on whether c e r t a i n income t a x p r i v i l e g e s a r e covered by A r t i c l e I I I : For i n s t a n c e , suppose Xonia g r a n t s an immediate income P i e r r e P e s c a t o r e , W i l l i a m Davey and Andreas F. Lowenfeld, supra, a t 29. Although t h e authors suggest t h a t t h i s argument c o u l d be made, they go on t o say t h a t t h e framers o f GATT p r o b a b l y d i d n o t have t h i s i n t e r p r e t a t i o n i n mind as they g e n e r a l l y d i s t i n g u i s h e d between i n d i r e c t , p r o d u c t - r e l a t e d t a x e s and other, d i r e c t taxes. 6 0  K.W. Dam, supra. a t 124. I n d i r e c t t a x e s a r e g e n e r a l l y c o n s i d e r e d t o be borne by t h e consumer, as compared w i t h d i r e c t taxes (such as income taxes) which a r e absorbed by t h e s e l l e r . An i n t e r p r e t a t i o n t h a t i n d i r e c t taxes are the t a x e s covered by A r t i c l e I I I i s c o n s i s t e n t w i t h these economic assumptions. 61  i b i d . . a t 124 - 125. The author r e f e r s t o t h e A n a l y t i c a l Index, a t 19, r e g a r d i n g a statement i n t h e r e p o r t s on t h e Havana Conference which i n d i c a t e s t h a t t h e p a r t i c u l a r a r t i c l e i n t h e Havana C h a r t e r d i d n o t apply t o income t a x e s . 6 2  i b i d . . a t 125. The l a t t e r p o i n t i s important because [ d i r e c t ] taxes on t h e l o c a l income o f f o r e i g n s e l l e r s a r e common and are f r e q u e n t l y l i m i t e d o n l y by the requirement t h a t t h e f o r e i g n s e l l e r have a "permanent e s t a b l i s h m e n t " i n t h e t a x i n g c o u n t r y . I n a d d i t i o n , such [ d i r e c t ] taxes a r e o f t e n c a l c u l a t e d on a d i f f e r e n t b a s i s from taxes on l o c a l e n t e r p r i s e s . 6 3  55 tax d e d u c t i o n equal t o the p r i c e o f a c e r t a i n machine f o r each such machine purchased from a domestic f i r m , but no such d e d u c t i o n f o r machines imported. I f the d e d u c t i o n or exemption were from a t a x on the machine [ i n d i r e c t t a x ] , then presumably i t would v i o l a t e A r t i c l e I I I . But as an exemption t o a t a x on the f i r m [ d i r e c t t a x ] , would i t also v i o l a t e A r t i c l e III? C l e a r l y the p r o t e c t i o n i s t e f f e c t o f such a p r i v i l e g e , even when i t concerns income taxes on a f i r m , i s o f t e n d e c i s i v e . But i t can be argued from the language o f A r t i c l e I I I , paragraph 2, t h a t such exemption i s not from a t a x "on the p r o d u c t " . Can i t be argued t h a t i t amounts i n e f f e c t t o an " i n d i r e c t " t a x or charge? Or i s t h i s one of the major l o o p h o l e s o f GATT? C e r t a i n l y p r a c t i c e s of many c o u n t r i e s would be a f f e c t e d by any attempt t o c l o s e t h i s l o o p h o l e . 64  The net e f f e c t o f e x c l u d i n g d i r e c t t a x e s from A r t i c l e I I I can be summarized i n the f o l l o w i n g c h a r t : Tax on Imports  Domestic Tax  direct direct indirect indirect  A r t i c l e III Applies?  direct indirect direct indirect  no no yes yes  Although i t appears t h a t A r t i c l e I I I may have been o r i g i n a l l y intended t o apply o n l y t o i n d i r e c t t a x e s ,  65  this interpretation i s  not c l e a r and would r e s u l t i n a l a r g e l o o p h o l e , which i s d i f f i c u l t to j u s t i f y .  T h i s i s s u e i s f u r t h e r c o m p l i c a t e d by d i f f i c u l t i e s i n  c l a s s i f y i n g a p a r t i c u l a r t a x as d i r e c t or i n d i r e c t , b.  Policy  Purpose  GATT p a n e l s have c o n s i d e r e d whether the p o l i c y purpose of an internal  t a x or charge  Articles  I,  expressed  i s relevant  I I , I I I and  that  the  the Note  relevant  fact  i n interpreting to A r t i c l e is  not  the t e x t  I I I . I t has  the  policy  of  been  purpose  a t t r i b u t e d t o the charge or t a x , but whether the charge i s due on i m p o r t a t i o n , a t the time or p o i n t of i m p o r t a t i o n o r whether i t i s  6 4  John H. Jackson, World Trade and the Law of GATT, supra. a t  285. For a d i s c u s s i o n on whether A r t i c l e 111:2 applies to i n d i r e c t t a x e s o n l y , see g e n e r a l l y K.W. Dam, supra, a t 124-125. 6 5  collected  internally:  6 6  the t a x adjustment r u l e s of the General Agreement d i s t i n g u i s h between taxes on p r o d u c t s and t a x e s not d i r e c t l y l e v i e d on p r o d u c t s ; they do not d i s t i n g u i s h between taxes w i t h d i f f e r e n t p o l i c y purposes. c.  Extent of E f f e c t on Trade In  "United S t a t e s - Taxes on Petroleum and C e r t a i n  Substances" the GATT p a n e l determined  that A r t i c l e  111:2  whether or not adverse t r a d e e f f e c t s occur. The f i r s t Article  III  competitive domestic  "obliges  contracting  conditions for  products.  parties  imported  to  U n l i k e some other p r o v i s i o n s  Agreement, i t does not r e f e r t o t r a d e e f f e c t s . "  6 7  in  applies  sentence of  establish  products  Imported  certain  relation  i n the  to  General  Therefore:  68  A change i n the c o m p e t i t i v e r e l a t i o n s h i p c o n t r a r y t o [ A r t i c l e 111:2] must consequently be regarded i p s o f a c t o as a n u l l i f i c a t i o n or impairment of b e n e f i t s a c c r u i n g under the General Agreement. A demonstration t h a t a measure i n c o n s i s t e n t w i t h A r t i c l e 111:2, f i r s t sentence, has no or i n s i g n i f i c a n t e f f e c t s would t h e r e f o r e . . . not be a s u f f i c i e n t demonstration t h a t the b e n e f i t s a c c r u i n g under that provision had not been nullified or impaired... With  regard  to  Article  111:2,  second  sentence,  small  tax  d i f f e r e n c e s can a l s o i n f l u e n c e the c o m p e t i t i v e r e l a t i o n s h i p ,  but  the e x i s t e n c e of p r o t e c t i v e t a x a t i o n must be e s t a b l i s h e d on a case  BISD 34S/136 a t 161; see a l s o " B e l g i a n Family Allowances" BISD IS/59 a t 60; 25S/49, 67 and "E.E.C. R e g u l a t i o n on Imports of P a r t s and Components", 37S/132 a t 192, 193. 6 6  BISD 34S/136 i b i d , a t paragraph 5.1.9. See a l s o " B r a z i l i a n I n t e r n a l Taxes", BISD V o l . 11/185 and John H. Jackson, World Trade and the Law of G a t t . supra a t 193 and John H. Jackson, " N a t i o n a l Treatment and Non-Tariff Barriers", Michigan Journal of I n t e r n a t i o n a l Law. V o l 10, No. 1, 207 a t 213. 6 7  6 8  ibid  57 by  case b a s i s and  t h e r e may  be a minimum l e v e l below which a  tax  ceases t o have the p r o t e c t i v e e f f e c t p r o h i b i t e d by A r t i c l e 111:2, second s e n t e n c e . C.  69  W i t h h o l d i n g Tax  and A r t i c l e  Before embarking on discriminatory  an  111:2  a n a l y s i s of whether the  or p r o t e c t i v e under A r t i c l e 111:2, the  taxation  fundamental  i n t e r p r e t a t i v e i s s u e of the category of tax i s examined. i.  W i t h h o l d i n g Tax  - D i r e c t or  For d o m e s t i c a l l y  70  Indirect?  produced software, income tax i s imposed  r o y a l t y revenue through the  is  c o r p o r a t e tax  on  system. These revenues  form p a r t of the net income c a l c u l a t i o n and c o r p o r a t e income tax i s p a i d on the net income; t h i s i s a d i r e c t tax. The enforcement p r o c e s s i s q u i t e d i f f e r e n t f o r f o r e i g n r o y a l t y payments.  The  withholding  tax mechanism i s a r g u a b l y more a k i n  to  a s a l e s tax on a product than t o a tax on income which i s imposed on a f i r m .  The  amount t o be w i t h h e l d  i s based on the g r o s s revenue  generated from a s i n g l e payment f o r a p a r t i c u l a r product, without any  d e d u c t i o n f o r expenses.  71  "Japan - Customs D u t i e s , Taxes and L a b e l l i n g P r a c t i c e s Imported Wines and A l c o h o l i c Beverages", BISD 34S/83, 85 paragraph 5.11. 6 9  on at  As noted p r e v i o u s l y the f i r s t i s s u e i s whether the domestic and f o r e i g n p r o d u c t s are " l i k e " or " d i r e c t l y c o m p e t i t i v e or s u b s t i t u t a b l e " ; i t i s assumed t h a t t h i s c r i t e r i a i s met. Policy and minimal e f f e c t arguments are a l s o not pursued s i n c e they are not r e l e v a n t t o t h i s a n a l y s i s as d i s c u s s e d i n the p r e v i o u s s e c t i o n . 70  See R i . v. Caledonian C o l l i e r i e s , [1928] A.C. 358, which d i s t i n g u i s h e d between an income tax and a g r o s s revenue tax. The A l b e r t a Mine Owners Tax Act p r o v i d e d t h a t every mine owner should be s u b j e c t t o a tax of 2% of gross revenue r e c e i v e d by him d u r i n g the year. The P r i v y C o u n c i l h e l d t h a t t h i s was an i n d i r e c t tax as 71  58 The  i n t e r p r e t a t i o n o f a t a x as d i r e c t  frequently  of taxing  power between t h e f e d e r a l and p r o v i n c i a l governments.  I n C.P.R.  Saskatchewan.  context  comes up  of the a l l o c a t i o n  v. A.G.  i n t h e Canadian  or i n d i r e c t  72  [1952] 2 S.C.R. 231, Rand J . adopted t h e  f o l l o w i n g t e s t f o r d e t e r m i n i n g whether a t a x i s i n d i r e c t  (at 252):  If the tax i s related or relatable, d i r e c t l y or i n d i r e c t l y t o a u n i t o f t h e commodity o r i t s p r i c e , imposed when t h e commodity i s i n t h e course o f b e i n g manufactured o r marketed, then t h e t a x tends t o c l i n g as a burden t o t h e u n i t o r t h e t r a n s a c t i o n p r e s e n t e d t o t h e market. A l t e r n a t i v e l y , t h e g e n e r a l t e n d e n c i e s o f a t a x and t h e common understanding  as t o those t e n d e n c i e s can be examined i n a s s e s s i n g  whether a t a x i s d i r e c t o r i n d i r e c t .  7 3  The amount o f w i t h h o l d i n g i s d i r e c t l y r e l a t e d t o t h e p r i c e o f the software; i t i s based on t h e g r o s s revenue o r t h e p r i c e o f t h e software.  74  The t a x must be w i t h h e l d when t h e payment i s made -  when t h e software i s marketed i n Canada.  T h e r e f o r e , t h e t a x tends  t o c l i n g as a burden t o t h e u n i t o r t h e t r a n s a c t i o n p r e s e n t e d t o  t h e r e was a g e n e r a l tendency t o pass t h e t a x a l o n g . A l s o r e f e r t o Re Wallace R e a l t y Co. L t d . (1930), 3 D.L.R. 417 (SCC). A l a r g e body o f Canadian case law e x i s t s on t h i s t o p i c . Although Canadian case law would not be d i r e c t l y r e l e v a n t t o a GATT c h a l l e n g e , the g e n e r a l p r i n c i p l e s a r t i c u l a t e d are o f some guidance. For a comprehensive review o f t h e Canadian law i n t h i s a r e a , see G.V. L a F o r e s t , "The A l l o c a t i o n o f Taxing Power Under t h e Canadian C o n s t i t u t i o n " , 2 d . Canadian Tax Paper No. 65. (Toronto: Canadian Tax Foundation, 1981). 7 2  See Simpsons-Sears L t d . v. P r o v i n c i a l S e c r e t a r y o f New Brunswick (1978), 82 D.L.R. (3d) 321 (S.C.C.); Brewers and M a l t s t e r s ' A s s o c i a t i o n v. A.G. O n t a r i o . [1897] A.C. 231. 7 3  1  See The C o r p o r a t i o n o f t h e D i s t r i c t o f Maple Ridge v. A.G. Canada. [1993] 4 S.C.R. 371 (S.C.C.). 7 4  59 the market and, as such,  has t h e c h a r a c t e r i s t i c s  o f an i n d i r e c t  tax. F u r t h e r , i t i s suggested to  t h a t t h e f o r e i g n taxpayer w i l l  pass t h e amount o f t a x on t o t h e customer,  just  d u t i e s tend t o e n t e r i n t o t h e p r i c e o f a p r o d u c t . the  tax i s readily  identifiable  a d j u s t e d f o r t h e t a x . I t i s reasonable  as customs  The amount o f  75  and t h e p r i c e  tend  can e a s i l y  t o conclude  be  t h a t such an  adjustment would be made and t h e g e n e r a l tendency would be t o pass the t a x along. Any such  tax s h i f t  would n o t e n t a i l  a circuitous  p r o c e s s as would be r e q u i r e d t o pass c o r p o r a t e income t a x e s on i n the p r i c e o f goods produced and s o l d d o m e s t i c a l l y . On support  the other  hand,  there  t h e view t h a t such  a r e a number  o f arguments  a tax i s d i r e c t .  l i k e l y than n o t t h a t i t i s t h e f o r e i g n software intended  t o bear  the incidence  First,  which  i t i s more  developer  who i s  o f t h e t a x , n o t t h e Canadian  Kenneth J . Murray, supra. a t 27:17 notes t h a t i n many cases, f o r e i g n vendors w i l l i n s i s t t h a t t h e Canadian customer bear the burden o f t h e w i t h h o l d i n g tax. He a l s o r e f e r s t o Revenue Canada g u i d e l i n e s on how t h e w i t h h o l d i n g i s t o be c a l c u l a t e d " i n t h i s s i t u a t i o n " ; t h e s p e c i f i c Round T a b l e q u e s t i o n i n which t h i s c a l c u l a t i o n was s e t out r e f e r r e d t o gross-up c l a u s e s i n l o a n agreements where t h e i n t e r e s t payment i s s u b j e c t t o w i t h h o l d i n g (see Revenue Canada Round Table, Report o f Proceedings o f t h e F o r t y - F i f t h Tax Conference. 1993 Conference Report, (Toronto: Canadian Tax Foundation, 1994) Question 31 a t 58:16. The g r o s s e d up t o t a l o f w i t h h o l d i n g tax i s c a l c u l a t e d by a p p l y i n g the f o l l o w i n g formula: 75  Required  Payment = [tax rate/100  - t a x r a t e ] * payment.  An example i s a l s o p r o v i d e d : f o r a payment o f $1,000 a t a w i t h h o l d i n g r a t e o f 15% t h e r e q u i r e d payment o f w i t h h o l d i n g t a x i s : [15/100-15] * 1,000 = $176.47  60 consumer. end user,  76  However, i f the person who i s not the one who  tax i s i n d i r e c t . Second, passed  u l t i m a t e l y pays the tax, the  i s intended t o bear the burden,  7 7  i f the t a x can  easily  be  passed  on,  i t may  not  be  on i n an i d e n t i f i a b l e form. I f the p r i c e i s b u r i e d i n the  p r i c e of the goods, even an economic tendency t o pass on a tax not be s u f f i c i e n t t o make the tax ii.  the  indirect.  may  7 8  I n t e r n a l Taxes - D i r e c t and I n d i r e c t ? It  i s has  not been s p e c i f i c a l l y a r t i c u l a t e d by a GATT panel  t h a t i n t e r n a l taxes are l i m i t e d t o i n d i r e c t t a x e s . When the GATT was  d r a f t e d , the focus of a t t e n t i o n was  barriers potential indirect.  to  trade;  impact  of  arguably  not  classifying  Therefore,  there  is  on the r e d u c t i o n of t a r i f f  much thought  was  given  a  tax  as  particular  some  room  for  to  the  direct  or  flexibility  in  S u b s e c t i o n 212(1) i n P a r t X I I I of the ITA s t a t e s : "Every n o n - r e s i d e n t person s h a l l pay an income t a x o f . . . " . Subsection 215(1) r e q u i r e s a person t o w i t h h o l d when the person "pays or c r e d i t s or i s deemed t o have p a i d or c r e d i t e d an amount on which an income tax i s payable under [ P a r t X I I I ] " , however, the payer i s e n t i t l e d t o r e c o v e r the amount from the n o n - r e s i d e n t (see Kenneth Murray, supra, a t 27:26) . T h e r e f o r e , i t appears t h a t i t i s the nonr e s i d e n t who i s intended t o bear the burden of the tax, not the Canadian consumer. 7 6  7 7  23690,  See Reference Re Quebec S a l e s Tax (S.C.C).  (23 June 1994) , S.C.C. no.  In the Canadian context see Bank of Toronto v. Lambe (1887) , 12 A.C. 575; Brewers' and M a l t s t e r s ' A s s o c i a t i o n v. A t t o r n e y General of O n t a r i o . [1897] A.C. 231; C a i r n s C o n s t r u c t i o n L t d . v. Government of Saskatchewan (1959), 16 D.L.R. (2d) 465, Re A n t i I n f l a t i o n A c t . [1976] 2 S.C.R. 373 a t 389-90; A.G.B.C. v. Esquimalt and Nanaimo Ry. Co.. [1950] A.C. 87; C.P.R. v. A.G. - Sask.. [1952] 2 S.C.R. 231, C o l p i t t s Ranches v. A.G. - A l b e r t a . [1954] 3 D.L.R. 121; A.G. - Newfoundland v. Avalon Telephone Co. (1962), 33 D.L.R. (2d) 402; Simpson-Sears L t d . v. P r o v i n c i a l S e c r e t a r y of New Brunswick (1978), 82 D.L.R. (3d) 321 (S.C.C). 7 8  61 interpreting  t h e language, d e s p i t e t h e p r e v a i l i n g  view t h a t t h e  p r o v i s i o n i s intended t o apply o n l y t o i n d i r e c t t a x e s . Should t h e language  be g i v e n  justified?  7 9  Should  as broad  an i n t e r p r e t a t i o n  as i s r e a s o n a b l y  t h e meaning which i s l e a s t t r a d e  restrictive  be adopted? As p r e v i o u s l y d i s c u s s e d , t h e " d i r e c t l y o r i n d i r e c t l y " language in Article  I I I may be broad  enough t o i n c l u d e d i r e c t  taxes.  80  It  would have been easy enough t o use t h e words " i n d i r e c t t a x e s " i n the p l a c e o f " i n t e r n a l t a x e s " i n A r t i c l e I I I i f i t was intended t o exclude d i r e c t taxes from t h i s p r o v i s i o n . Furthermore, even i f A r t i c l e apply  only  to indirect  taxes,  I I I was o r i g i n a l l y  interpreting  g l o b a l market o f today r e q u i r e s a broader, which  recognizes  barriers.  t h e advances  made  intended t o  t h e language  i n the  more f l e x i b l e approach  i n the reduction  of  trade  Twenty-five y e a r s ago i t was noted t h a t some o f t h e GATT  p r o v i s i o n s were  outdated:  [S]ome o f t h e p r o v i s i o n s o f GATT have become outdated because, as t a r i f f s have d e c l i n e d , o t h e r modes o f p r o t e c t i o n o f domestic i n d u s t r y have become r e l a t i v e l y more important, and these have sometimes "slipped through" t h e i n t r i c a c i e s o f t h e complex GATT language. One example i s t h e border t a x adjustment. Others i n c l u d e c e r t a i n s u b s i d i e s , t h e import d e p o s i t scheme, and t h e "loyalty rebate." 81  See American Farm Bureau Assn. v. Canadian Import T r i b u n a l . [1990] 2 S.C.R. 1324 (SCC) f o r comments r e g a r d i n g a " l i b e r a l " i n t e r p r e t a t i o n o f t h e GATT i n t h e c o n t e x t o f t h e S p e c i a l Import Measures A c t . R.S.C. 1985, c.S-15, as amended. 7 9  See P i e r r e Pescatore, Lowenfeld, supra. a t 29. 8 0  Davey  and  Andreas  F.  John H. Jackson, World Trade and t h e Law o f GATT. supra. a t - 770. 81  769  William  62 The view t h a t t h e GATT p r o v i s i o n s were viewed as outdated i n 1969  i s even more pronounced going i n t o t h e 22nd c e n t u r y . Another  example  which  could  be  added  to  the  foregoing  list  i s an  i n t e r p r e t a t i o n o f i n t e r n a l taxes being l i m i t e d t o i n d i r e c t taxes a major l o o p h o l e i n t h e GATT w i t h p o t e n t i a l l y f a r r e a c h i n g on  tax p o l i c i e s .  Tax p o l i c i e s  should  impact  n o t be an impediment t o  i n t e r n a t i o n a l t r a d e when s i g n i f i c a n t advances i n f a c i l i t a t i n g the international this  flow o f i n t e l l e c t u a l  c o u l d be t h e r e s u l t  p r o p e r t y have been made. Yet  i f direct  taxes  slip  through  t h e GATT  c r a c k s because they do not conform t o c e r t a i n language d r a f t e d h a l f a century ago. F i n a l l y , on January  1, 1995 t h e new World Trade O r g a n i z a t i o n  (the "WTO") took over t h e r e i g n s from t h e GATT t o pursue f u r t h e r advances i n i n t e r n a t i o n a l t r a d e .  8 2  Perhaps under t h e a u s p i c e s of  the WTO a broader i n t e r p r e t a t i o n o f t h e meaning o f " i n t e r n a l t a x e s " is  feasible.  iii.  Discriminatory Taxation I f t h e t a x i n i s s u e i s c l a s s i f i e d as an i n d i r e c t tax, o r i f i t  The WTO i n c o r p o r a t e s t h e new agreement on t r a d e - r e l a t e d a s p e c t s o f i n t e l l e c t u a l p r o p e r t y r i g h t s ("TRIPs") which e s t a b l i s h e s standards o f p r o t e c t i o n f o r i n t e l l e c t u a l p r o p e r t y r i g h t s ; i t i s the most comprehensive i n t e r n a t i o n a l agreement i n t h i s a r e a t o date. (Agreement on Trade-Related Aspects of I n t e l l e c t u a l Property R i g h t s , i n c l u d i n g Trade i n C o u n t e r f e i t Goods, Annex IC t o t h e F i n a l A c t Embodying t h e R e s u l t s o f t h e Uruguay Round o f M u l t i l a t e r a l Trade N e g o t i a t i o n s , GATT document MTN/FA (UR-93-0246) (1993)). The TRIPs a l s o p r o v i d e s f o r enforcement o f these standards under n a t i o n a l law and c o n t a i n s p r o v i s i o n s f o r a c c e s s i n g t h e WTO's dispute procedures. See Jock A. Finlayson, "Canada and I n t e r n a t i o n a l Trade R e g u l a t i o n : The General Agreement on T a r i f f s and Trade", i n Robert K. Paterson and M a r t i n e M. Band, I n t e r n a t i o n a l Trade and Investment Law i n Canada. 2d., (Toronto: C a r s w e l l , 1994) a t 1-56 - 1-57. 8 2  63 is  classified  as a d i r e c t t a x and A r t i c l e  III i s interpreted to  address d i r e c t t a x e s , i t must be determined whether t h e t a x a t i o n i s discriminatory. In  "Italian  Machinery" 111:4  8 3  84  that  favourable" internal  Discrimination Against  t h e GATT panel imported than  law.  considered  products  that  The panel  was  Agricultural  the standard  be s u b j e c t  accorded  Imported  in Article  t o "treatment  domestic  products  o f t h e view  that  no  less  i n applying this  standard  r e q u i r e s e f f e c t i v e e g u a l i t y o f o p p o r t u n i t i e s . T h i s focus on e f f e c t i n t h e c o n t e x t o f t h e p r i n c i p l e o f n a t i o n a l treatment  s h o u l d apply  e q u a l l y t o i n t e r n a l taxes as t o o t h e r i n t e r n a l law. necessary  to  establish  whether  the  effects  of  Thus, i t i s the  tax are  discriminatory. C l a s s i f y i n g a payment f o r a software the  same f o r domestic  l i c e n c e as a r o y a l t y i s  and f o r e i g n l i c e n s i n g  arrangements.  Prima  f a c i e , t h e t a x treatment may not appear t o be d i s c r i m i n a t o r y simply because t h e r e  i s a different  c o l l e c t i n g the taxes. of t h e w i t h h o l d i n g  enforcement procedure  i n place f o r  However, i t i s not t h e enforcement mechanism  f o r t h e t a x on t h e r o y a l t y  revenue which i s  d i s c r i m i n a t o r y ; i t i s t h e e f f e c t o f such w i t h h o l d i n g . In  a d d i t i o n , although  the withholding  tax a p p l i e s only t o  Under t h e assumption t h a t l i k e products a r e i n v o l v e d , i t i s o n l y necessary t o determine whether t h e t a x i s d i s c r i m i n a t o r y under the f i r s t sentence. The second sentence a p p l i e s i f t h e products are d i r e c t l y c o m p e t i t i v e o r s u b s t i t u t a b l e . F o r f u r t h e r d i s c u s s i o n on the t h i s p o i n t , see P a r t B. above "The P r i n c i p l e o f N o n d i s c r i m i n a t i o n and i t s I n t e r p r e t a t i o n " . 8 3  8 4  BISD. 7S / 60.  64  imports,  "a t a x a p p l y i n g t o imports  A r t i c l e 111:2] i f another, equal  only i s not unlawful  but d i f f e r e n t ,  o r g r e a t e r burden on l i k e  [within  i n t e r n a l t a x imposes an  domestic p r o d u c t s . "  Therefore,  85  i t i s necessary t o e s t a b l i s h t h a t t h e e f f e c t o f w i t h h o l d i n g i s t h a t a g r e a t e r t a x burden i s p l a c e d on imported w i t h t h e income t a x on domestic In t h e domestic sphere,  software  i n comparison  software.  software  r o y a l t i e s form p a r t o f t h e  net income c a l c u l a t i o n f o r income t a x purposes; t h e t a x payment i s based on n e t income and no w i t h h o l d i n g i s r e q u i r e d . I n t h e c r o s s border t r a n s f e r o f software, w i t h h o l d i n g t a x i s c a l c u l a t e d on t h e gross amount p a i d . Thus, t h e w i t h h o l d i n g t a x can r e p r e s e n t a v e r y h i g h r a t e o f t a x on t h e n e t r e t u r n t o t h e software expenses a r e taken i n t o account;  vendor  after  t h e t a x w i t h h e l d on b e h a l f o f t h e  n o n - r e s i d e n t c o u l d w e l l exceed what would be charged i f t h e income was t a x a b l e  as income i n Canada  86  and have t h e e f f e c t  of being  discriminatory. F u r t h e r , as d i s c u s s e d i n P a r t I, w i t h h o l d i n g t a x on r o y a l t y payments may  result  i n double  t a x a t i o n when n o n - r e s i d e n t s  have  l i t t l e o r no o p p o r t u n i t y t o use t h e f o r e i g n t a x c r e d i t , o r s i m i l a r mechanism,  to offset  Canadian  withholding  taxes.  87  Such  double  t a x a t i o n s u b j e c t s t h e imported  software t o taxes i n excess o f those  a p p l i e d t o domestic software,  c o n t r a r y t o A r t i c l e 111:2.  8 5  K.W.  Dam, supra. a t 117.  8 6  J.S. P h i l l i p s ,  supra, a t x x i i i - x x i v .  As d i s c u s s e d i n P a r t I, even when a f o r e i g n t a x c r e d i t may be claimed, t h e r e i s o f t e n not f u l l i n t e g r a t i o n and, a t a minimum, a cash-flow disadvantage e x i s t s . 8 7  65 Also: ...by v i r t u e o f double t a x a t i o n the t r a n s f e r of technology ceases t o be o f i n t e r e s t i f t h e r e q u i r e d minimum income cannot be achieved . . . the s i t u a t i o n d e t e r i o r a t i n g due t o t a x a t i o n o f t h e g r o s s amount o f some income, eg. ... r o y a l t i e s . Thus t h e taxpayer w i l l a c t a c c o r d i n g t o t a x r a t h e r than economic c r i t e r i a , and as a result i n i t i a t i v e w i l l be r e s t r a i n e d and e f f i c i e n t e n t e r p r i s e s w i l l f i n d i t harder t o o p e r a t e . 88  In  other  economically  words,  the f o r e i g n  producer  may  find  i t i s not  v i a b l e t o t r a n s f e r technology t o Canada o r may d e c i d e  t o pursue more t a x advantageous b u s i n e s s s t r u c t u r e s t o e f f e c t such transactions: The u n d e r l y i n g assumption o f t h e General Agreement indeed, t h e argument f o r f r e e t r a d e i n g e n e r a l - i s t h a t l o c a l laws and r e g u l a t i o n s should not make t h e l o c a t i o n of i n d u s t r y a f a c t o r i n t r a d e . To say t h a t p a r t o f t h e f o r e i g n i n d u s t r y must be moved t o t h e [domestic country] f o r t h e f o r e i g n product t o have t h e same c o m p e t i t i v e p o s i t i o n as t h e domestic product i s t o concede t h a t t h e l e g i s l a t i o n i n question d i s t o r t s i n t e r n a t i o n a l t r a d i n g p a t t e r n s and serves t o " a f f o r d p r o t e c t i o n t o domestic production. 1,89  In summary, a s t r o n g argument can be made t h a t t h e e f f e c t of the w i t h h o l d i n g  t a x mechanism i s t o d i s c r i m i n a t e a g a i n s t  software i n favour  o f domestic software; t h i s i s c o n t r a r y  foreign t o the  p r i n c i p l e o f n a t i o n a l treatment i n A r t i c l e I I I . iv. Justifiable  Discrimination  An i n t e r n a l t a x which i s d i s c r i m i n a t o r y may s t i l l come w i t h i n a  GATT  exception  and not be p r o h i b i t e d .  These  exceptions  are  b r i e f l y canvassed i n t h i s s e c t i o n . I t i s worth b e a r i n g i n mind t h a t Manuel P i r e s , I n t e r n a t i o n a l J u r i d i c a l Double T a x a t i o n o f Income. S e r i e s on I n t e r n a t i o n a l T a x a t i o n , No.11 (The Netherlands; Kluwer Law and T a x a t i o n P u b l i s h e r s , 1989) a t 76. 8 8  K.W.  Dam, supra. a t 130.  66 these e x c e p t i o n s can be a form of hidden p r o t e c t i o n i s m . First, 30,  d i s c r i m i n a t o r y taxes which were i n e f f e c t on  1947 may be continued, but not i n c r e a s e d .  9 0  October  In t h e p a r t i c u l a r  case under review, t h e p r o v i s i o n s of t h e Income Tax A c t which were i n f o r c e i n 1947 d i d not i n c l u d e t h e " s e c r e t formula o r p r o c e s s " language  relied  upon  by Revenue  software l i c e n c e s as r o y a l t i e s .  Canada t o t r e a t y  payments f o r  9 1  Second, i t i s c l e a r t h a t t h e p r i n c i p l e of n a t i o n a l must a l s o be balanced w i t h n a t i o n a l p o l i c y g o a l s . right  of  sovereignty  to  promote  domestic  treatment  This overriding  policy  goals  is  acknowledged i n A r t i c l e s XX (General Exceptions) and XXI ( S e c u r i t y Exceptions).  These  Articles  recognize  governmental  measures which a r e based  necessarily  designed  Legitimate  policy  for  goals,  purposes  including  that  there  are various  on l e g i t i m a t e p o l i c i e s not of those  restraining mentioned  imports. Article  XX  prevent a measure from b e i n g i n c o n s i s t e n t w i t h GATT o b l i g a t i o n s . I t i s u n l i k e l y t h a t e i t h e r of these A r t i c l e s a p p l i e s t o t h e t a x under review, u n l e s s a n a t i o n a l s e c u r i t y i n t e r e s t a r i s e s i n a p a r t i c u l a r software t r a n s a c t i o n . From a domestic p e r s p e c t i v e , i t appears t h a t Revenue Canada's o b j e c t i v e i n imposing t h i s w i t h h o l d i n g t a x i s t o m a i n t a i n c o n t r o l over such c r o s s - b o r d e r payments i n o r d e r t o p r e s e r v e t h e Canadian tax base. 9 0  C e r t a i n l y t h e w i t h h o l d i n g t a x mechanism i s r a t i o n a l l y  i b i d . . a t 119.  See The Income War Tax A c t , c.97 R.S.C. 1927 s s . 24 and 25; The Income Tax A c t . c . 52 S.C. 1948, s. 96(e) and The Income Tax A c t , c. 148 R.S.C. 1952, s. 106(6). 91  67  r e l a t e d t o a c h i e v i n g t h i s o b j e c t i v e , and i s e f f e c t i v e i n a c h i e v i n g it.  However, t h i s case study suggests t h a t t h i s domestic o b j e c t i v e  does not outweigh the broader domestic and i n t e r n a t i o n a l o b j e c t i v e s of f a c i l i t a t i n g f r e e t r a d e i n technology.  With t h e r e c e n t Canadian  t r e a t y r e - n e g o t i a t i o n s r e d u c i n g the w i t h h o l d i n g t a x r a t e t o n i l i n f o r these payments, and g i v e n the g e n e r a l l y accepted i n t e r n a t i o n a l position  on t h i s  justification  matter,  i t i s suggested  f o r Revenue  Canada  that  t o continue  there  is  little  t o maintain  this  policy. The  alternatives  a r e t o : 1)  maintain  the  s t a t u s quo  and  c o n t i n u e p u r s u i n g t r e a t y r e - n e g o t i a t i o n s on a case by case b a s i s ; or 2) t o t r e a t these payments as b u s i n e s s p r o f i t s , not income from property.  I t i s suggested  t h a t the l a t t e r a l t e r n a t i v e  i s a more  p r i n c i p l e d a l t e r n a t i v e t o reducing withholding rates to n i l , while promoting  free  trade  i n technology  and  the p r i n c i p l e  of  non-  d i s c r i m i n a t i o n i n the GATT. CONCLUSION In t h i s case study, w i t h h o l d i n g t a x puts t h e f o r e i g n software producer  a t a disadvantage v i s a v i s domestic  software  producers  who a r e not s u b j e c t t o the w i t h h o l d i n g t a x ; t h i s i s c o n t r a r y t o the n a t i o n a l treatment p r i n c i p l e i n GATT. technology  being  less  Canadian purchaser prices  accessible  of software  f o r , o r reduced  access  I t also results i n foreign  t o the Canadian  may  consumer.  The  be p e n a l i z e d w i t h i n c r e a s e d  to, foreign  software.  This i s  c o n t r a r y t o the o b j e c t i v e of Canadian government t o f a c i l i t a t e the f r e e flow o f technology.  68 While  Revenue Canada has made some p r o g r e s s  i n t h e area o f  c r o s s border software payments w i t h t h e U.S. and t h e Netherlands through r e n e g o t i a t e d t a x t r e a t i e s , perhaps i t i s time t o accept t h e i n t e r n a t i o n a l norm and stop t r e a t i n g t h e s e payments as r o y a l t i e s . B i l a t e r a l t r e a t y n e g o t i a t i o n s c e r t a i n l y go some way t o a m e l i o r a t i n g the  u n d e r l y i n g problem  but a r e n o t a cure  all.  Revenue  Canada  should b r i n g i t s p o s i t i o n on t h e c h a r a c t e r i z a t i o n o f t h e s e software payments i n l i n e w i t h t h e i n t e r n a t i o n a l view, n o t o n l y t o harmonize tax regimes,  but as a f u r t h e r impetus t o r e d u c i n g t r a d e b a r r i e r s  f o r technology  transfer.  69 CHAPTER 3 RESEARCH AND DEVELOPMENT The g l o b a l economy i s i n c r e a s i n g l y d r i v e n by knowledgebased i n d u s t r i e s . According t o the S e c r e t a r i a t f o r Science and Technology Review, i n c o n s t a n t - d o l l a r terms, g l o b a l p r o d u c t i o n by h i g h - t e c h n o l o g y i n d u s t r i e s more than doubled between 1980 and 1990. T h i s compares w i t h a 23 p e r c e n t i n c r e a s e i n o t h e r manufacturing i n d u s t r i e s . Research and development i s a v i t a l t o o l i n t h e l e a p from a resource-based economy t o one based on meeting consumer needs f o r s e r v i c e s and p r o d u c t s . I t i s an i n t e g r a l p a r t of any n a t i o n ' s g l o b a l c o m p e t i t i v e n e s s . 1  INTRODUCTION Research  and development  experimental development,  ("R&D" o r s c i e n t i f i c  r e s e a r c h and  "SR&ED") can be viewed as a commodity, a  s t o c k o f accumulated knowledge d e r i v e d from R&D e x p e n d i t u r e s t h a t d e p r e c i a t e s as new products and p r o c e s s e s r e p l a c e o l d ones.  2  R&D  conducted i n one s e c t o r can have p r o d u c t i v i t y enhancing e f f e c t s on the  p e r f o r m i n g s e c t o r as w e l l as o t h e r s e c t o r s , and can c o n t r i b u t e  indirectly its  t o p r o d u c t i v i t y growth i n t h e e x t e r n a l economy through  i n t e r a c t i o n w i t h o t h e r i n p u t s and through t h e i n t e r a c t i o n o f  supply and demand.  3  The importance o f commercial, h i g h - t e c h n o l o g y i n i t i a t i v e s t o L. Denis D e s a u t e l s , A u d i t o r General o f Canada, Report o f t h e A u d i t o r General o f Canada t o t h e House o f Commons, 1994 v o l . 1 (Ottawa: M i n i s t r y o f Supply and S e r v i c e s , Canada, November 22, 1994) a t 1-17 (the "1994 AG's R e p o r t " ) . See a l s o M i c h a e l Wilson, M i n i s t e r o f Finance, Canada, Department o f Finance, Budget Papers, Budget Speech, May 23, 1985, a t 7; and Research. Development and Economic Growth (Canada: M i n i s t r y o f S t a t e , S c i e n c e and Technology, 1985) a t 1, r e g a r d i n g t h e Canadian government's p r i o r i t y i n encouraging r e s e a r c h and development. 1  P i e r r e Mohnen, The R e l a t i o n s h i p Between R&D and P r o d u c t i v i t y Growth i n Canada and Other Major I n d u s t r i a l i z e d C o u n t r i e s (Ottawa: M i n i s t r y o f Supply and S e r v i c e s , Canada, 1992) a t 3. 2  3  i b i d . . a t 3.  70 the i n t e r n a t i o n a l c o m p e t i t i v e n e s s , economic h e a l t h and growth i n productivity  of  a nation  has  l o n g been r e c o g n i z e d .  4  In  Canada,  c o n t i n u a l changes t o the ITA r e f l e c t the government's d e s i r e commitment  to  stimulate  r e s e a r c h and  development  Canada. Indeed, Canada's t a x i n c e n t i v e s f o r R&D 5  as  among  the  most  generous  i n the  world  6  activities  and in  a r e g e n e r a l l y seen  and  Revenue  Canada  George K l e i n f e l d and David Kaye, "Red L i g h t , Green L i g h t ? The 1994 Agreement on S u b s i d i e s and C o u n t e r v a i l i n g Measures, Research and Development A s s i s t a n c e , and U.S. P o l i c y " , (December 1994) J o u r n a l of World Trade. V o l . 28, No. 6, 43 a t 55; Mark A.A. Warner and A l a n M. Rugman, "Recent U.S. P r o t e c t i o n i s t R&D P o l i c i e s : Are Canadian M u l t i n a t i o n a l s Exempted?", Canadian B u s i n e s s Law J o u r n a l . v o l . 23 (1994) a t 395 - 431; James H u t c h i s o n , "Canadian Tax Incentives for Scientific Research and Experimental Deve1opment", Report of Proceedings of the F o r t i e t h Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 26:1 - 26:22 a t 26:1; and Tom C. Routley, "Research and Development Tax I n c e n t i v e P o l i c y : A C a l l t o A c t i o n " , Report o f Proceedings of the T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 24:1 - 24:16 a t 24:2. 4  A l K a t i y a , "Proposed Changes t o the SR & ED Program Under the Income Tax A c t " , (1994) 42 Canadian Tax J o u r n a l 2, 309 - 326 a t 326. The o v e r a l l impact of the 1992 changes t o the R&D system was expected t o e n r i c h the program by about $230 m i l l i o n over a f i v e year p e r i o d (W. Steven C l a r k , Gerry G o o d c h i l d , Bob Hamilton, and B i l l Toms, "Canada's R&D Tax I n c e n t i v e s : Recent Developments", Report o f Proceedings o f the F o r t y - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 32:1 32:29, a t 32:2) . 5  See W.S. C l a r k , e t . a l . , supra. a t 32:1; Roy Shultis, "Revenue Canada's A d m i n i s t r a t i o n of R&D Tax I n c e n t i v e s : Overview of Current A d m i n i s t r a t i v e P r a c t i c e s " , Report o f P r o c e e d i n g s o f the F o r t y - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 33:1 - 33: 11, a t 33:2. Kenneth J . Murray, "Recent Developments i n Research and Development Tax Incentives", Report of Proceedings o f the Forty-Second Tax Conference. 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991) 9:1 - 9:22, a t 9:1; Jacek Warda, I n t e r n a t i o n a l Competitiveness of Canadian R&D Tax I n c e n t i v e s : An Update. Conference Board of Canada Report no. 55-90 (Ottawa: The Conference Board of Canada, 1990) a t v i ; and Donald G. M c F e t r i d g e and Jacek P. Warda, "Canadian R&D I n c e n t i v e s : T h e i r Adequacy and Impact", Canadian Tax Paper No. 70 (Toronto: Canadian Tax Foundation, 1983) 6  71 continues  t o amend a d m i n i s t r a t i v e p r a c t i c e s i n o r d e r t o  access t o these i n c e n t i v e s . The generally  rational for on  the  7  providing  "spillover"  of  tax R&D  support benefits  for  fund  8  is  based  external  to recover  their  Based on the tendency f o r p r i v a t e i n d u s t r y t o under  long-term,  high  risk  R&D,  government  a s s i s t a n c e i n i n i t i a t i n g p r i v a t e i n n o v a t i o n i n R&D  at  R&D  i n t o the  economy and the i n a b i l i t y of the performers of R&D investment.  facilitate  involvement  and  has been seen as  75.  See Roy S h u l t i s , supra f o r an overview of Revenue Canada's responsibilities, administrative p r a c t i c e s , communication and p u b l i c a t i o n i n i t i a t i v e s , and program r e s u l t s f o r R&D. 7  W.S. C l a r k , e t . a l . , supra. a t 32:3. Mohnen, supra. a t 3 discusses spillover effects: "First, e x t e r n a l i t i e s may occur because a downstream user d e r i v e s d i r e c t b e n e f i t from the R&D without h a v i n g t o pay the f u l l v a l u e of the i n p u t - as when a bank purchases personal computers that enable i t to streamline operations. In t h i s example, the b e n e f i t s t o the bank measured a g a i n s t the c o s t of the computers are worth s u b s t a n t i a l l y more t o the bank than the price paid f o r them. A l s o , q u a l i t a t i v e improvements may not be e n t i r e l y r e f l e c t e d i n the new p r i c e of an enhanced product or s e r v i c e because of c o m p e t i t i o n , monitoring c o s t s and, f r e q u e n t l y , l i m i t e d or incomplete i n f o r m a t i o n on the p a r t of the developer w i t h r e s p e c t t o the r e a l v a l u e of the enhanced product t o the end u s e r . The second type of s p i l l o v e r r e l a t e s t o the i n s p i r a t i o n a r e s e a r c h p r o j e c t , t e c h n i c a l d i s c o v e r y or i n n o v a t i o n i n one s e c t o r can s t i m u l a t e i n another s e c t o r . New ideas o f t e n t r i g g e r new avenues of r e s e a r c h and r e n d e r e s t a b l i s h e d methods uneconomical or i n e f f i c i e n t . For example, the development of s y n t h e t i c f i b r e technology by the chemical i n d u s t r y found wide a p p l i c a t i o n i n the t e x t i l e i n d u s t r y . Research undertaken by NASA f o c u s i n g on space e x p l o r a t i o n , c l e a r e d the way f o r many i n n o v a t i o n s and new developments i n the automobile and computer i n d u s t r i e s . A d i s t i n c t i o n i s thus made i n the l i t e r a t u r e between p r i v a t e and s o c i a l r a t e s of r e t u r n , i . e . , those t h a t are a p p r o p r i a t e d by the developer or performer and those t h a t cannot be a p p r o p r i a t e d . In the l a t t e r case, s o c i e t y a t l a r g e enjoys a maximum r a t e of r e t u r n a t apparent minimum c o s t . " Mohnen a l s o concludes, a t 43, t h a t the s p i l l o v e r e f f e c t s can be s u b s t a n t i a l g e n e r a t i n g s o c i a l r a t e s of r e t u r n 50 t o 100 percent i n excess of the p r i v a t e r a t e s of r e t u r n . 8  72 e s s e n t i a l t o a t t a i n i n g a s o c i a l l y optimum l e v e l end,  the  Canadian  of R&D. To 9  governments commits approximately  $1  this  billion  1 0  i n t a x i n c e n t i v e s f o r R&D per year, r e p r e s e n t i n g over 10 p e r c e n t of the annual f e d e r a l revenues from c o r p o r a t i o n income t a x , f o r t h r e e basic  purposes:  11  . . . c r e a t i n g wealth, managing r i s k and improving q u a l i t y of l i f e , and advancing knowledge through b a s i c r e s e a r c h . Wealth c r e a t i o n i n v o l v e s , f o r example, the development of new t e c h n o l o g i e s t o i n c r e a s e the c o m p e t i t i v e n e s s of the Canadian economy. Managing r i s k and improving q u a l i t y of l i f e i n c l u d e s r e s e a r c h t o support r e g u l a t i o n i n environmental health a r e a s . . . Advancement of knowledge i n v o l v e s b a s i c s c i e n t i f i c research. PART I RESEARCH AND A.  The Canadian  i.  Overview  DEVELOPMENT TAX  INCENTIVES  System  The r e l e v a n t t a x r u l e s p e r t a i n i n g t o r e s e a r c h and development are  contained  i n ITA  section  37,  127  and  127.1  and  regulation  J . Hutchison, supra, a t 26:1; W.S. C l a r k , e t . a l . , supra. a t 32:3; T. Routley, supra. a t 24:2; and Canada, Department of Finance, Budget Papers, Research and Development P o l i c i e s : A Paper f o r C o n s u l t a t i o n , A p r i l 1983, 11. 9  Joanne A. Hausch, "Maximizing R&D C r e d i t s and Refunds" i n "Corporate Tax P l a n n i n g i n a Changing Business Environment", Corporate Management Tax Conference. 1994 (Toronto: Canadian Tax Foundation, 1994) 14:1 - 14:24, a t 14:1 f o r 1993. An annual investment of $1 b i l l i o n i n t a x i n c e n t i v e s f o r s c i e n c e and technology i s a l s o r e p o r t e d i n the 1994 AG's Report, supra. v o l . 1 , at 1-17, i n a d d i t i o n t o $6 b i l l i o n i n o t h e r program support f o r R&D. 10  11  1994  AG's  Report, supra. v o l . 1, a t  1-17.  73 2900.  12  research  Subsection and  37(2)  contains  research  for  development e x p e n d i t u r e s i n c u r r e d o u t s i d e  I n f o r m a t i o n C i r c u l a r 86-4R3, on  special provisions  and  development  e s s e n t i a l c r i t e r i a f o r R&D, a p r o j e c t t o be  and  13  current  of Canada.  s e t s out Revenue Canada's views discusses  the  following  a l l of which must be met  e l i g i b l e f o r the R&D  three  i n order f o r  tax b e n e f i t s : s c i e n t i f i c  or  t e c h n o l o g i c a l u n c e r t a i n t y , s c i e n t i f i c or t e c h n o l o g i c a l advancement, and  s c i e n t i f i c and  technical content.  14  For  example, w i t h  respect  Only f e d e r a l R&D i n c e n t i v e s are c o n s i d e r e d here, although a number of p r o v i n c e s , i n c l u d i n g O n t a r i o , Nova S c o t i a , and Quebec, have i n c e n t i v e s f o r R&D. ( See W.S. C l a r k , e t . a l . , supra a t 32:13 32:15 f o r an summary of the f e d e r a l R&D tax c r e d i t s , d i s t r i b u t i o n of f e d e r a l c r e d i t s by r a t e and p r o v i n c e , and an overview of the p r o v i n c i a l i n c e n t i v e s . ) T h i s Chapter i s based on amendments t o the ITA up t o B i l l C-9, An Act To Amend the Income Tax A c t , which r e c e i v e d r o y a l assent on May 12, 1994 (now S.C. 1994, c . 8 ) . This Bill implemented measures contained i n the December 2, 1992 economic statement and the A p r i l 26, 1993 f e d e r a l budget. B i l l C27, An Act To Amend the Income Tax A c t , the Income Tax A p p l i c a t i o n Rules, the Canada Pension P l a n , the Canada B u s i n e s s C o r p o r a t i o n s Act, the E x c i s e Tax Act, the Unemployment A c t , and C e r t a i n R e l a t e d A c t s , r e c e i v e d r o y a l assent on June 15, 1994. T h i s B i l l (now SC 1994, c.21) i n c l u d e s one measure from the February 22, 1994 f e d e r a l budget p e r t a i n i n g t o new R&D filing deadlines which are not addressed here. 12  " S c i e n t i f i c Research and Experimental Development", August 29, 1986, updated as IC 86-4R2, August 29, 1988, and IC 86-4R3, May 24, 1994. The f i r s t r e l e a s e p r o v i d e d two i n d u s t r y s p e c i f i c papers which are not i n c l u d e d i n IC 86-4R3: Appendix B.'l A p p l i c a t i o n Paper - Computer Software and Appendix B.2 A p p l i c a t i o n Paper - Food and Beverage. Per J . Hausch, supra a t 14:7, f n 30, the computer software a p p l i c a t i o n paper i s b e i n g r e v i s e d and w i l l be r e i s s u e d s e p a r a t e l y as a supplement. A l s o r e f e r t o Western Plywood Co. L t d . v. MNR. 51 DTC 392 (TAB); I n t e r n a t i o n a l N i c k e l Co. of Canada L t d . [No.21 v. MNR. 71 DTC 5332 (FCTD); and Sass M a n u f a c t u r i n g L i m i t e d v. MNR. 88 DTC 1363 (TCC) which d e a l w i t h the d e f i n i t i o n of s c i e n t i f i c r e s e a r c h f o r tax purposes. For an overview of the f i r s t IC 86-4, see T. Routley, supra. a t 24:8 - 24:11. 13  For f u r t h e r d i s c u s s i o n of these c r i t e r i a , see J . Hausch, supra, a t 14:8; I n f o r m a t i o n C i r c u l a r IC 86-4R3, supra. P a r t 6 " C r i t e r i a f o r I d e n t i f y i n g E l i g i b l e A c t i v i t i e s i n Computer S c i e n c e 14  74 t o computer s o f t w a r e :  13  The development of a new software a p p l i c a t i o n w i l l be e l i g i b l e f o r SR&ED o n l y i f t h e r e i s an i d e n t i f i e d technological u n c e r t a i n t y and the p r o j e c t attempts t o r e s o l v e t h a t problem. U n c e r t a i n t y i n software or systems development may be due t o an o p e r a t i n g environment t h a t p l a c e s s p e c i a l and unusual demands on the system. For example, t e c h n o l o g i c a l c h a l l e n g e s may a r i s e when response times are c r i t i c a l and t r a n s a c t i o n volumes are h i g h . The development of new or improved t o o l s or p r o c e s s e s t o s o l v e t h i s t e c h n o l o g i c a l problem may be SR&ED. The a p p l i c a t i o n of new t o o l s or a new a p p l i c a t i o n of standard t o o l s may i n d i c a t e u n c e r t a i n t y . System u n c e r t a i n t y may occur where new technologies are combined or where known t e c h n o l o g i e s are combined i n a new way. Where a change i n one area a f f e c t s performance i n o t h e r areas, system u n c e r t a i n t y may e x i s t . I f the s o l u t i o n s t o these problems add t o the knowledge of computer technology w i t h i n the c o n t e x t of the business environment of the taxpayer, a t e c h n o l o g i c a l advancement i s a c h i e v e d and the p r o j e c t may be SR&ED. The s c i e n t i f i c and t e c h n o l o g i c a l content i s g e n e r a l l y a c h i e v e d i f the p r o j e c t i s undertaken by q u a l i f i e d p e r s o n n e l u s i n g a s y s t e m a t i c approach such as SDLC (system development l i f e c y c l e ) . As w i t h any p r o j e c t , t h i s s y s t e m a t i c approach must be supported by documentation of the p l a n and of the design, b u i l d , t e s t , e v a l u a t e and modify c y c l e . In a d d i t i o n , c e r t a i n b a s i c t e s t s must be met be e n t i t l e d t o c l a i m b e n e f i t s under the  ITA:  f o r a taxpayer t o  16  and A s s o c i a t e d T e c h n o l o g i e s " ; and G e o f f r e y G. B r i a n t , " A d v i s i n g the Technology C l i e n t : The May 23, 1985 Amendments and I n f o r m a t i o n C i r c u l a r 86-4", Report of Proceedings of t h e T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 23:1 - 23:30, a t 23:24 - 23:27. 15  J . Hausch, supra. a t  14:9.  Postamble t o subparagraph 3 7 ( 1 ) ( a ) ( i i ) ; J . Hausch, supra. a t 14:2; Deborah Duncan, "A Review of Recent Administrative Positions", Report of Proceedings of the Forty-Fifth Tax Conference. 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994) 47:1 - 47:22 a t 47:3 - 47:4. 16  75 - the SR&ED a c t i v i t i e s must be c a r r i e d on i n Canada; - the SR&ED must be r e l a t e d t o a b u s i n e s s  18  17  of t h e taxpayer;  - where the a c t i v i t i e s are undertaken by t h i r d p a r t i e s , (other than p a r t i e s performing R&D on b e h a l f of t h e t a x p a y e r ) , the taxpayer must have the c o n t r a c t u a l r i g h t t o e x p l o i t the results; 1 9  2 0  - the taxpayer must c l a i m the b e n e f i t s by f i l i n g a p r e s c r i b e d form. 21  Finally,  research  and  development a c t i v i t i e s must come w i t h i n the meaning o f the  term  "scientific regulation  as  a  preliminary  r e s e a r c h and  consideration,  experimental development" as d e f i n e d i n  2900(1):  s y s t e m a t i c i n v e s t i g a t i o n or s e a r c h c a r r i e d out i n a f i e l d of S u b s e c t i o n 37(1). See s u b s e c t i o n treatment of c u r r e n t e x p e n d i t u r e s i n c u r r e d o u t s i d e Canada. 1 7  37(2) f o r the t a x on R&D c a r r i e d on  Subparagraph 37(1) (a) ( i ) , c l a u s e 37(1) (a) ( i i i ) (A) , paragraph 37(8) (b) , and paragraph 37(8) (c) . I n t e r p r e t a t i o n B u l l e t i n IT-151R4, " S c i e n t i f i c Research and Experimental Development", August 16, 1993, paragraphs 8 and 9; and A l K a t i y a , supra, a t 325: "To meet t h i s t e s t the taxpayer must show t h a t the R&D, i f s u c c e s s f u l , w i l l r e s u l t i n some d i r e c t and b e n e f i c i a l a p p l i c a t i o n t o a b u s i n e s s t h a t i s c a r r i e d on the taxpayer." 1 8  Subparagraph 3 7 ( 1 ) ( a ) ( i i ) . See D. Duncan, supra. a t 47:4 47:8 f o r a d i s c u s s i o n of Revenue Canada's p o s i t i o n r e g a r d i n g payments t o "approved" e n t i t i e s . J . Hausch, supra. a t 14:2, FN 6: "The words "on b e h a l f o f " imply d i r e c t s u p e r v i s i o n and c o n t r o l of the work. I t i s o f t e n d i f f i c u l t t o e v a l u a t e whether a payment i s e l i g i b l e under subparagraph 3 7 ( 1 ) ( a ) ( i ) or 3 7 ( 1 ) ( a ) ( i i ) . " 19  Subparagraph 3 7 ( 1 ) ( a ) ( i i ) ; Claude Desy, ed., Access t o Canadian Income Tax (Markham, Ont.: Butterworths) (looseleaf), paragraph C20-1060; I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra. paragraph 12; and Revenue Canada Round T a b l e , 1993 Conference Report, supra, Question 2, a t 58:2 - 58:3. 2 0  Form T661(E) (rev. 93), "Claim f o r S c i e n t i f i c Research and Experimental Development Expenditures C a r r i e d on i n Canada"; I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra, paragraph 6; J . Hutchison, supra. a t 26:16 - 26:17. 21  76 s c i e n c e or technology by means of experiment or a n a l y s i s , t h a t i s t o say, (a) basic research, namely, work undertaken advancement of s c i e n t i f i c knowledge without a p r a c t i c a l a p p l i c a t i o n i n view,  for the specific  (b) applied research, namely, work undertaken f o r the advancement of s c i e n t i f i c knowledge w i t h a s p e c i f i c p r a c t i c a l a p p l i c a t i o n i n view, (c) experimental development, namely, work undertaken f o r the purposes of a c h i e v i n g t e c h n o l o g i c a l advancement f o r the purposes of c r e a t i n g new, or improving e x i s t i n g , m a t e r i a l s , devices, products or processes, including incremental improvements t h e r e t o , or (d) work with r e s p e c t t o e n g i n e e r i n g , d e s i g n , operations r e s e a r c h , mathematical a n a l y s i s , computer programming, data c o l l e c t i o n , t e s t i n g and p s y c h o l o g i c a l r e s e a r c h where t h a t work i s commensurate w i t h the needs, and d i r e c t l y i n support of the work d e s c r i b e d i n paragraph ( a ) , (b) or ( c ) , but does not i n c l u d e work w i t h r e s p e c t t o (e) market r e s e a r c h or s a l e s promotion, (f) q u a l i t y c o n t r o l or r o u t i n e t e s t i n g of m a t e r i a l s , d e v i c e s , products or processes, (g) r e s e a r c h i n the s o c i a l s c i e n c e s or the (h) p r o s p e c t i n g , e x p l o r i n g or d r i l l i n g m i n e r a l s , petroleum or n a t u r a l gas,  humanities,  f o r , or  producing,  (i) the commercial p r o d u c t i o n of a new or improved m a t e r i a l , d e v i c e or product or the commercial use of a new or improved process, 22  (j) s t y l e changes, or (k) r o u t i n e data ii.  The R&D  collection.  Pool - D e d u c t i b l e  Expenditures  Regarding expenditures r e l a t e d t o commercial p r o d u c t i o n see Karen Wensley, "SR & ED: An Update", Report of Proceedings of the F o r t y - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 31:1 - 31:16, a t 31:7 - 31:9; and Les C u l t u r e s Laflamme (1984) Inc. v. MNR 93 DTC 603 (TCC). 2 2  77 Section  37 and r e g u l a t i o n  2900  describe  what  constitutes  q u a l i f y i n g R&D f o r Canadian income tax purposes and p r o v i d e v a r i o u s r u l e s f o r t h e computation  o f R&D e x p e n d i t u r e s :  23  [T]hese p r o v i s i o n s d e t a i l t h e t a x treatment o f c u r r e n t and capital expenditures as w e l l as t h e apportionment of e x p e n d i t u r e s between e l i g i b l e and n o n - e l i g i b l e a c t i v i t i e s . S p e c i f i c a l l y , t o ensure t h a t a taxpayer's Canadian SR&ED e x p e n d i t u r e p o o l i s i n c r e a s e d o n l y t o t h e e x t e n t o f an amount i n c u r r e d from SR&ED a c t i v i t i e s , c l a u s e 3 7 ( 7 ) ( c ) ( i i ) ( A ) [now c l a u s e 3 7 ( 8 ) ( a ) ( i i ) ( A ) ] r e q u i r e s t h a t t h e expense ( c a p i t a l o r c u r r e n t ) s u b s t a n t i a l l y r e l a t e t o t h e p r o s e c u t i o n o f SR&ED o r the p r o v i s i o n o f premises, f a c i l i t i e s , o r equipment f o r t h e p r o s e c u t i o n o f SR&ED. Thus, where a taxpayer can demonstrate t h a t an expenditure was i n c u r r e d , s u b s t a n t i a l l y ( g e n e r a l l y i n t e r p r e t e d t o be 90 p e r c e n t o r more) f o r t h e p r o s e c u t i o n o f SR&ED o r the p r o v i s i o n o f SR&ED f a c i l i t i e s f o r t h e p r o s e c u t i o n of SR&ED, t h e e n t i r e amount o f t h e e x p e n d i t u r e may be added t o the SR&ED expenditure p o o l . Where a c a p i t a l e x p e n d i t u r e does not meet the s u b s t a n t i a l t e s t , none o f t h e c o s t s r e l a t e d t o i t q u a l i f i e s as SR&ED. A c u r r e n t e x p e n d i t u r e may, however, be added t o t h e SR&ED p o o l by v i r t u e o f c l a u s e 3 7 ( 7 ) ( c ) ( i i ) ( B ) [now subclause 37 (8) ( a ) ( i i ) ( B ) ( I I ) ] , provided that the expenditure i s d i r e c t l y a t t r i b u t a b l e t o t h e prosecution of SR&ED f a c i l i t i e s pursuant t o r e g u l a t i o n s 2900(2) and ( 3 ) . The f o l l o w i n g expenditures a r e " d i r e c t l y a t t r i b u t a b l e " t o t h e p r o s e c u t i o n o f R&D:  24  (a) t h e c o s t o f m a t e r i a l s consumed i n such p r o s e c u t i o n ; (b) where an employee d i r e c t l y undertakes, s u p e r v i s e s or supports such p r o s e c u t i o n , t h e p o r t i o n o f t h e amount i n c u r r e d f o r s a l a r y o r wages o f t h e employee t h a t can r e a s o n a b l y be c o n s i d e r e d t o be i n r e s p e c t o f such p r o s e c u t i o n ; and (c) other expenditures, o r those portions of other e x p e n d i t u r e s , t h a t a r e d i r e c t l y r e l a t e d t o such p r o s e c u t i o n 2 3  A l K a t i y a , supra, a t 310.  R e g u l a t i o n 2900(2) which a p p l i e s f o r the purposes f o r c l a u s e 37(8) (a) ( i ) (B) and subclause 37 (8) (a) ( i i ) (B) (II) [note typographical error i n the regulation refers t o subclause 37 (8) (a) ( i i ) (A) (II) which does n o t e x i s t i n t h e I T A ] . See Karen Wensley, supra, a t 31:5 - 31:6 r e g a r d i n g e x p e n d i t u r e s d i r e c t l y a t t r i b u t a b l e t o SR&ED; and Imapro C o r p o r a t i o n v. The Queen. 92 DTC 6487 (FCTD). 2 4  78 and t h a t would not have been i n c u r r e d i f such p r o s e c u t i o n had not o c c u r r e d . The  f o l l o w i n g expenditures are d i r e c t l y a t t r i b u t a b l e t o the  p r o v i s i o n of R&D  facilities,  premises  (a) the c o s t of maintenance f a c i l i t i e s or equipment; and  or equipment:  and  upkeep  of  25  such  premises,  (b) o t h e r expenditures, or those p o r t i o n s t h e r e o f , t h a t are d i r e c t l y r e l a t e d t o t h a t p r o v i s i o n and t h a t would not have been i n c u r r e d i f those premises or f a c i l i t i e s or t h a t equipment had not e x i s t e d . The taxpayer i s p e r m i t t e d t o c l a i m an immediate d e d u c t i o n of up t o 100% of the amount of both c u r r e n t and c a p i t a l e x p e n d i t u r e s added t o i t s R&D  p o o l i n computing i t s income the t a x a t i o n year.  The  d e d u c t i o n may  any  unused p o r t i o n remaining  indef i n i t e l y . iii.  26  be a p p l i e d a g a i n s t income from any i n the p o o l t o be  source  with  carried  forward  credit  ("ITC")  2 7  Investment Tax C r e d i t s The  ITA  contains  generous  p r o v i s i o n s f o r q u a l i f i e d R&D expenditures  29  at  rates  investment  expenditures  ranging  from  28  20%  tax  o t h e r than p r e s c r i b e d to  30%.  30  Unused  R e g u l a t i o n 2900(3) a p p l i e s f o r the purposes of subclause 3 7 ( 8 ) ( a ) ( i i ) ( B ) ( I I ) [note t y p o g r a p h i c a l e r r o r i n the r e g u l a t i o n r e f e r s t o subclause 3 7 ( 8 ) ( a ) ( i i ) ( A ) ( I I ) which does not e x i s t i n the ITA] . 25  See paragraph 37(1)(a) c a p i t a l expenditures. 2 6  for  f o r current expenditures;  37(1)(b)  See s u b s e c t i o n 37(1); and I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra, paragraphs 15 - 25 r e g a r d i n g c u r r e n t e x p e n d i t u r e s and paragraphs 2 6 - 3 0 r e g a r d i n g c a p i t a l e x p e n d i t u r e s . The d e d u c t i o n i s s u b j e c t t o o v e r a l l l i m i t a t i o n s i n s u b s e c t i o n 37(1). 2 7  2 8  S u b s e c t i o n 127(9) d e f i n e s " q u a l i f i e d  2 9  R e g u l a t i o n 2902.  expenditure".  7? investment for  tax c r e d i t s can be c a r r i e d back t h r e e y e a r s or  ten years.  fully  31  Beginning a f t e r 1993,  ITC c l a i m s may  o f f s e t f e d e r a l income taxes otherwise p a y a b l e .  32  forward  be used  to  I t i s also  p o s s i b l e t o o b t a i n a r e f u n d of taxes p a i d or deemed t o have been p a i d f o r purposes For  of the r e f u n d , i n c e r t a i n  taxation  years  ending  p r o v i s i o n s r e g a r d i n g overhead  after  circumstances.  December  only  incurred Now,  incremental i f the R&D  overhead,  had  not  been c a r r i e d  on,  amount".  the R&D  B e f o r e December 2,  c o s t s t h a t would  the system p r o v i d e s f o r a n o t i o n a l overhead  " p r e s c r i b e d proxy  1992,  c o s t s t h a t can be a l l o c a t e d t o  p r o j e c t s f o r ITC c a l c u l a t i o n s were s i m p l i f i e d . 1992  2,  33  not  c o u l d be  have been claimed.  amount c a l l e d the  34  S u b s e c t i o n 127(9) d e f i n e s " s p e c i f i e d percentage". Subject to t r a n s i t i o n a l r u l e s , the February 22, 1994 f e d e r a l budget proposed t o amend the r a t e s i n A t l a n t i c Canada from 3 0% t o 2 0% f o r e x p e n d i t u r e s i n c u r r e d a f t e r 1994. 3 0  S u b s e c t i o n 127(9), d e f i n i t i o n of "investment t a x c r e d i t " . Note t h a t q u a l i f i e d expenditures b e f o r e A p r i l 20, 1983 o n l y had a f i v e year c a r r y forward p e r i o d . 31  S u b s e c t i o n 127(5). P r e v i o u s l y c l a i m s f o r non-refundable ITCs were l i m i t e d t o 75 p e r c e n t of f e d e r a l t a x e s otherwise payable f o r a t a x a t i o n year p l u s 3 p e r c e n t of t a x a b l e income s u b j e c t t o the small business deduction (the "annual investment tax credit limit"). 3 2  3 3  S u b s e c t i o n 127.1(1).  See "CCPCs - Enhanced ITCs" below.  S u b s e c t i o n 127(9) , d e f i n i t i o n of " q u a l i f i e d e x p e n d i t u r e " and R e g u l a t i o n s 2900(4) t o (10) s e t out how t o determine the s a l a r y base, 65% of which i s the " p r e s c r i b e d proxy amount" ( s u b j e c t t o an o v e r a l l cap s e t out i n r e g u l a t i o n 2900(6)). The proxy e l e c t i o n i s o p t i o n a l , but must be f i l e d w i t h i n new f i l i n g d e a d l i n e s s e t out i n s u b s e c t i o n 37(10) on form T661. For f u r t h e r d i s c u s s i o n of the proxy e l e c t i o n , see J . Hausch, supra. a t 14:15 - 14:16; A l K a t i y a , supra, a t 317 - 322; K. Wensley, supra. a t 31:12 - 31:14; and W.S. C l a r k , e t . a l . , supra. a t 32:19 -32:23. 3 4  80 The  proxy  purposes, is  amount i s a q u a l i f y i n g  i t i s n o t added t o t h e R&D p o o l .  made, t h e c o s t s which  subsection travel,  expenditure  37(1) p o o l  office  may  3 5  only  I f t h e proxy  be t r e a t e d as R&D  and f a c i l i t i e s  maintenance,  ITC  election  costs  do not i n c l u d e a d m i n i s t r a t i v e  expenses  for  f o r the salaries,  which a r e  r e p l a c e d by t h e proxy amount. A " q u a l i f i e d e x p e n d i t u r e " i s d e f i n e d i n s u b s e c t i o n 127(9) o f the ITA and i n c l u d e s both c u r r e n t and c a p i t a l e x p e n d i t u r e s on R&D c a r r i e d on i n Canada. under  subsection  However, an e x p e n d i t u r e which i s d e d u c t i b l e  37(1) may  e x p e n d i t u r e f o r t h e ITC. to  36  not  necessarily  be  a  qualified  Q u a l i f i e d e x p e n d i t u r e s which a r e added  t h e s u b s e c t i o n 37(1) p o o l and which a r e i n c l u d e d i n t h e ITC  claim calculation are:  3 7  - the cost of purchasing or l e a s i n g property that i s a l l or substantially  all  3 8  used  f o r R&D  activities  (other than  general  purpose o f f i c e eguipment and f u r n i t u r e ) ; A c t u a l overhead w i l l e i t h e r been deducted i n t h e c u r r e n t year as an o r d i n a r y b u s i n e s s expense o r may be c a p i t a l i z e d and e l i g i b l e f o r c a p i t a l c o s t allowance. 3 5  See I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra, paragraph 46. For example, q u a l i f i e d expenditures do n o t i n c l u d e p r e s c r i b e d e x p e n d i t u r e s i n R e g u l a t i o n 2902. 3 6  3 7  Clause 37(8) (a) ( i i ) (B) .  " S u b s t a n t i a l l y a l l " i s g e n e r a l l y c o n s i d e r e d t o mean a t l e a s t 90 percent. See I n t e r p r e t a t i o n Bulletin IT-151R4, supra. paragraphs 8, 14, 29; Douglas Wood v. MNR. 87 DTC 312; and Kenneth J . Murray, "Complying With t h e R&D Rules", i n "Income Tax Enforcement, Compliance, and A d m i n i s t r a t i o n " , Corporate Management Tax Conference 1988. (Toronto: Canadian Tax Foundation, 1988) 6:1 - 6:17, a t 6:2 - 6:4 f o r a d i s c u s s i o n o f t h e " s u b s t a n t i a l l y a l l " requirement and i t s i n t e r p r e t a t i o n by t h e Department and by t h e courts. 3 8  81 - expenditures i n r e s p e c t of R&D of  the  approved  taxpayer  (eg.  payments  to  r e s e a r c h a s s o c i a t i o n and  -  salaries  activities;  and  wages of  contractors, subcontractors,  equipment (other than g e n e r a l  furniture); employees d i r e c t l y  i n R&D  engaged  in  R&D  3 9  - c o s t of m a t e r i a l s consumed i n - 1/2  on b e h a l f  universities);  - c a p i t a l expenditures f o r R&D purpose o f f i c e equipment and  d i r e c t l y undertaken  R&D;  of the c o s t of l e a s i n g p r o p e r t y t h a t i s p r i m a r i l y  4 0  used  activities.  ITC c l a i m s are based p r e s c r i b e d proxy equipment"  41  amount.  on the above R&D ITCs may  e x p e n d i t u r e s p l u s the  a l s o be earned  on  a t one-half the taxpayer's r a t e f o r R&D  E l i g i b l e c o r p o r a t i o n s t h a t i n c u r l a r g e R&D  "shared-use  expenditures.  expenditures e a r l y  on i n a p r o j e c t can maximize the r e l a t e d t a x b e n e f i t s by c l a i m i n g  S a l a r i e s do not have t o be p a i d t o be e l i g i b l e f o r ITCs as q u a l i f y i n g e x p e n d i t u r e s ( A l K a t i y a , supra, a t 326; I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra, paragraph 17 and Revenue Canada Round T a b l e , 1993 Conference Report, supra. Question 4 a t 58:4 - 58:5.) 3 9  40 iip im iiy» means more than percent. r  ar  50 p e r c e n t , but  l e s s than  90  Shared-use equipment i s new equipment purchased after December 2, 1992 t h a t i s used more than 50 p e r c e n t but l e s s than 90 p e r c e n t of i t s o p e r a t i n g time i n q u a l i f y i n g R&D a c t i v i t i e s , and the balance devoted t o n o n - q u a l i f y i n g a c t i v i t i e s . See J . Hausch, supra, a t 14:17; A l K a t i y a , supra, a t 314 - 316; K. Wensley, supra. a t 31:14 - 31:16; s u b s e c t i o n 127(9) ( d e f i n i t i o n s of " q u a l i f i e d expenditure", " f i r s t term shared-use-equipment", and "second term shared-use equipment"), subsection 127(11.1)(e), subsection 127.1(2) ( d e f i n i t i o n of " r e f u n d a b l e investment t a x c r e d i t " ) , and s u b s e c t i o n 127(11.2). Such ITCs cannot be c l a i m e d on b u i l d i n g s and p i l o t p l a n t s and equipment t h a t w i l l be used i n commercial p r o d u c t i o n a f t e r the s t a r t up phase ( r e g u l a t i o n 2900(11)). 41  82 ITCs d u r i n g  t h a t p e r i o d and  pool to l a t e r iv.  years.  d e f e r r i n g the d e d u c t i o n from the  R&D  42  C a p i t a l Expenditures As  mentioned  previously,  expenditures  used a l l or s u b s t a n t i a l l y a l l f o r R&D from income. P r i o r t o December 2, meant t h a t 90 percent  may  1992,  for  capital  assets  be immediately deducted a l l or s u b s t a n t i a l l y a l l  of the u s e f u l l i f e of the a s s e t must be used  for  R&D  or t h a t 90 percent  in.  or a t t r i b u t a b l e t o the time d u r i n g which the p r o p e r t y was  for  R&D  of the c o s t of the a s s e t was  consumed  a c t i v i t i e s . A f t e r t h i s date, t h i s requirement w i l l be  i f i t was  4 3  intended t h a t the a s s e t s would be used f o r R&D  used met  during a l l  or s u b s t a n t i a l l y a l l of i t s o p e r a t i n g time i n i t s expected u s e f u l life,  or  a l l or  s u b s t a n t i a l l y a l l consumed  R&D  activities  in  Kenneth J . Murray, "Recent Developments i n R&D Tax I n c e n t i v e s " , supra, a t 9:20: " T h i s can be accomplished by d e f e r r i n g o n l y the amount of R&D expenditures r e q u i r e d t o reduce t a x a b l e income t o a l e v e l j u s t below the $200,000 [annual b u s i n e s s l i m i t ] l i m i t a t i o n f o r f e d e r a l tax purposes. The t a x on t h i s income can be o f f s e t by f e d e r a l ITCs... The b e n e f i t s of t h i s s t r a t e g y are generated by two f a c t o r s . The f i r s t i s t h a t the company has g r e a t e r access t o the low r a t e of f e d e r a l tax. The second i s t h a t i t may be p o s s i b l e t o use the a d d i t i o n a l d e d u c t i o n s d e f e r r e d t o subsequent y e a r s t o keep a t l e a s t one a d d i t i o n a l y e a r s t a x a b l e income below $200,000. For q u a l i f y i n g c o r p o r a t i o n s , t h i s w i l l i n c r e a s e the subsequent y e a r ' s ITC r a t e by 15 p e r c e n t (from 20 t o 35 percent on the f i r s t $2 m i l l i o n of R&D expenditures) and a l l o w the ITCs on the expenditures t o be refunded i f they are not used t o o f f s e t taxes payable." Note t h a t t h e r e have been r e c e n t amendments to the availability of the enhanced rate for qualifying c o r p o r a t i o n s ( C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s ) which are d i s c u s s e d below under "Recent Developments". 4 2  1  Other than land and b u i l d i n g s or l e a s e h o l d i n t e r e s t i n buildings (subparagraph 3 7 ( 8 ) ( d ) ( i ) ; note the exception for "prescribed special-purpose b u i l d i n g " as d e f i n e d i n r e g u l a t i o n 2903. 4 3  83 Canada. v.  CCPCs - Enhanced ITCs C e r t a i n C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s (CCPCs) are  e l i g i b l e f o r an enhanced ITC r a t e of 35 p e r c e n t , s u b j e c t t o c e r t a i n limits. year  4 5  The  with  ITC can be used t o o f f s e t a l l f e d e r a l t a x e s f o r the any  excess  100  percent  refundable  for  current  expenditures, 4 0 percent refundable f o r c a p i t a l expenditures. amount refunded reduces the balance of the R&D CCPCs have a v a r i e t y careful  mix  deductions, allowance. vi.  of loss  pool.  4 7  The  46  Therefore,  of tax p l a n n i n g o p p o r t u n i t i e s r e q u i r i n g  claims  for  carrybacks  investment or  tax  credits,  carryforwards  and  section  capital  a 37  cost  48  Foreign  R&D  Research and development which i s c a r r i e d on o u t s i d e of Canada Subclause 37 (8) (a) ( i i ) ( B ) ( I I I ) ; A l K a t i y a , supra. a t 316 and W.S. C l a r k , e t . a l . , supra, a t 32:23 - 32:27.  4 4  317;  -  Subsections 127(10.1) and (10.2) .'Interpretation B u l l e t i n IT151R4, paragraphs 61 and 64 - 67; J . Hausch, supra. a t 14:18 14:19; and A l K a t i y a , supra, a t 324 - 325. 4 5  Paragraph 127(11.1)(e) and s u b s e c t i o n 127.1(2) ( d e f i n i t i o n of " r e f u n d a b l e investment tax c r e d i t " ) . The CCPC i s s u b j e c t t o a t a x a b l e income t e s t t o determine e l i g i b i l i t y f o r the enhanced r a t e . In a d d i t i o n , the 35 p e r c e n t r a t e o n l y a p p l i e s up t o the CCPCs annual expenditure limit (subsection 127(10.2)); for R&D expenditures i n excess of t h i s expenditure l i m i t , the ITC r a t e i s reduced t o 20 p e r c e n t . For an overview of these l i m i t s and an example of how t o c a l c u l a t e the expenditure l i m i t , r e f u n d a b l e and non-refundable ITC, see J . Hausch, supra, a t 14:19 - 14:20. 4 6  T h i s r e d u c t i o n of the R&D p o o l e f f e c t i v e l y i n c l u d e s the ITC r e f u n d i n income i n subsequent y e a r s by r e d u c i n g the balance of deductible expenditures. 4 7  For an example see Kenneth J . Murray, "Complying With the Rules", supra. a t 6:16 - 6:17. 4 8  R&D  84 does n o t b e n e f i t from many o f t h e R&D t a x i n c e n t i v e s . such  R&D  activities  are not included  i n t h e R&D  The c o s t s o f pool  under  s u b s e c t i o n 37(1), and a r e not q u a l i f i e d e x p e n d i t u r e s f o r ITCs. There a r e s p e c i a l r u l e s f o r c u r r e n t e x p e n d i t u r e s f o r f o r e i g n R&D  s e t out i n s u b s e c t i o n  37 ( 2 ) .  4 9  Current  expenditures f o r  f o r e i g n R&D a r e d e d u c t i b l e o n l y i n t h e year i n c u r r e d and cannot be c a r r i e d forward.  50  The nature and l o c a t i o n o f t h e a c t i v i t i e s  i n d i c a t e where R&D i s c a r r i e d on f o r t h e purposes 37 (1) o r 37 (2) . According  will  of subsections  5 1  t o Revenue  Canada, t h e o n l y f o r e i g n  t h a t a r e i n c l u d e d i n s u b s e c t i o n 37(1) a r e :  expenditures  5 2  - t h e c o s t o f c a p i t a l equipment imported t o Canada f o r SR&ED; _ t h e c o s t o f m a t e r i a l s imported t o Canada f o r SR&ED; - t h e wage, t r a v e l , t r a i n i n g , and conference c o s t s f o r employees r e c e i v i n g SR&ED t r a i n i n g o u t s i d e Canada; and - t h e wage and t r a v e l c o s t s f o r employees i n v e s t i g a t i n g f o r e i g n technology t h a t r e l a t e s t o an SR&ED p r o j e c t i n Canada. 53  There a r e no s p e c i a l r u l e s f o r c a p i t a l e x p e n d i t u r e s i n these circumstances; they are not deductible under section 37 ( I n t e r p r e t a t i o n B u l l e t i n IT-151R4, s u p r a paragraph 38). 4 9  f  See g e n e r a l l y I n t e r p r e t a t i o n B u l l e t i n IT-151R4, paragraphs 38 - 40 and J . Hausch, supra a t 14:20 - 14:21. 5 0  51  5 2  supra,  I n t e r p r e t a t i o n B u l l e t i n IT-151R4, supra. paragraph 38. J . Hausch, supra. a t 14:21.  Wage and t r a v e l c o s t s o f Canadian employees s o j o u r n i n g o u t s i d e o f Canada d u r i n g t e s t i n g and data c o l l e c t i o n q u a l i f y o n l y under s u b s e c t i o n 37(2) (Revenue Canada Round T a b l e , 1993 Conference Report, supra, Question 1, 58:1 - 58:2; t h e Department has a l s o taken t h e p o s i t i o n t h a t t r a v e l , i n c l u d i n g s a l a r y o r wages and r e l a t e d b e n e f i t s , o f a Canadian employee u n d e r t a k i n g f o r e i g n t r a v e l r e l a t i n g t o R&D c a r r i e d on o u t s i d e o f Canada q u a l i f i e s under 5 3  85 There  have  been  recent  t e s t i n g and data c o l l e c t i o n . included  i n the d e f i n i t i o n  ITA changes  which  affect  foreign  T e s t i n g and d a t a c o l l e c t i o n o f SR&ED  i n regulation  i s now  2900(1)(d).  P r e v i o u s l y , these c o s t s were i n c l u d e d i n s u b s e c t i o n 37(1) were f o r support a c t i v i t i e s f o r a Canadian R&D p r o j e c t .  i f they Now t h a t  t e s t i n g and data c o l l e c t i o n are i n c l u d e d i n t h e d e f i n i t i o n o f SR&ED in  regulation  2900,  the costs  of  foreign  testing  c o l l e c t i o n must be i n c l u d e d i n s u b s e c t i o n 37(2)  and  data  even i f necessary  t o a Canadian R&D p r o j e c t . T h e r e f o r e , t h e impact o f t h i s change has been t o i n c l u d e t h e c o s t s o f f o r e i g n t e s t i n g and data c o l l e c t i o n i n subsection project. vii.  37(2),  even i f they  a r e necessary  t o a Canadian  R&D  5 4  Summary Q u a l i f y i n g R&D expenditures c a r r i e d on i n Canada a r e pooled  and may be deducted forward)  as claimed  ( i e . may be i n d e f i n i t e l y  carried  i n c l u d i n g expenditures f o r c e r t a i n c a p i t a l a s s e t s which  may be immediately deducted from income f o r t a x purposes. R&D e x p e n d i t u r e s ,  including  an amount f o r overhead,  Certain  may a l s o be  e l i g i b l e f o r an ITC t o reduce taxes otherwise payable. ITCs claimed and  refunded  reduce  taxation year.  55  t h e R&D p o o l  available  CCPCs a r e e l i g i b l e  f o r deduction  f o r an enhanced ITC r a t e o f  s u b s e c t i o n 37(2).) A l s o see Kenneth J . Murray, "Complying R&D Rules", supra, a t 6:11 - 6:12. 5 4  in a  with the  J . Hausch, supra, a t 14:20.  Other government a s s i s t a n c e r e c e i v e d o r r e c e i v a b l e i n r e s p e c t o f R&D expenditures must a l s o be a p p l i e d a g a i n s t t h e balance i n the p o o l o r i n c l u d e d i n income under paragraph 1 2 ( 1 ) ( x ) . 55  86  3 5%,  subject  to  certain  limits.  A  100  enhanced ITC i s a v a i l a b l e f o r c u r r e n t R&D for  percent  refund  of  the  e x p e n d i t u r e s ; 40 p e r c e n t  c e r t a i n c a p i t a l e x p e n d i t u r e s . The r e f u n d mechanism p r o v i d e s a  significant  advantage  to  CCPCs as  a  source  of  cash  and  as  an  a d d i t i o n a l tax p l a n n i n g t o o l Only c u r r e n t expenditures f o r R&D  c a r r i e d on o u t s i d e of Canada  are d e d u c t i b l e from income and o n l y i n the year i n c u r r e d . B.  Recent Developments The  February  22,  1994  p r o p o s a l s r e l a t i n g t o R&D. proposed  on  enhanced  commencing a f t e r 1995.  f e d e r a l budget c o n t a i n e d a number of In p a r t i c u l a r , some r e s t r i c t i o n s were  incentives for  CCPCs  for  taxation  years  By l i n k i n g the s m a l l b u s i n e s s d e d u c t i o n t o  t a x a b l e c a p i t a l f o r an a s s o c i a t e d group of companies, a c c e s s t o r e f u n d s w i l l be l i m i t e d f o r l a r g e r CCPCs.  R&D  56  The February 27, 1995 f e d e r a l budget a l s o proposed a number of amendments t o the R&D f o r R&D of  r u l e s . In p a r t i c u l a r , the e l i g i b i l i t y  e x p e n d i t u r e s f o r i n f o r m a t i o n technology  software,  hardware  process,  s t o r e and  Based  the  on  expenditures  and  communication  disseminate  outcome of i n c u r r e d by  this  review,  financial  d e a l e r s f o r i n f o r m a t i o n technology R&D  ( i n c l u d i n g the use  technology  information)  rules  to  are t o be  i t i s proposed  institutions  and  collect, reviewed. that  such  securities  w i l l not q u a l i f y as R&D  for  T h i s consequence a r i s e s due t o the flow through of s m a l l b u s i n e s s d e d u c t i o n annual b u s i n e s s l i m i t c a l c u l a t i o n s t o the d e t e r m i n a t i o n of the ITC r a t e . See J . Hausch, supra. a t 14:22 14:23 f o r a d e s c r i p t i o n of t h i s proposed amendment and other proposed amendments i n the February 22, 1994 f e d e r a l budget which may impact on R&D a c t i v i t i e s . 5 6  87 tax  purposes.  This  Canada's l a r g e s t  proposal  arose  out o f concern  t h a t most o f  banks were c l a i m i n g t h e b e n e f i t s o f these  i n c e n t i v e s f o r software  R&D  development t h a t may have been performed  even without t h e i n c e n t i v e s .  5 7  PART I I SUBSIDIES AND THE URUGUAY ROUND A.  Introduction S u b s i d i z a t i o n r e f e r s t o t h e p r a c t i c e s o f governments whereby  f i n a n c i a l a s s i s t a n c e o r o t h e r i n c e n t i v e s a r e p r o v i d e d t o producers and/or e x p o r t e r s . barrier  58  Although  subsidization  of increasing significance,  i s a non-tariff  there  is still  a  trade  l a c k of  i n t e r n a t i o n a l consensus r e g a r d i n g t h e nature o f s u b s i d i e s .  5 9  There a r e two s u b - c a t e g o r i e s o f subsidy: t h e "export" subsidy which i s granted o n l y on goods d e s t i n e d f o r export; and "domestic" or " p r o d u c t i o n " s u b s i d i e s which a r e granted f o r t h e manufacture o r production  o f goods r e g a r d l e s s o f t h e i r  ultimate destination.  6 0  S u b s i d i e s f o r r e s e a r c h and development might be viewed as domestic  Stikeman's Canadian F e d e r a l Budget, February 27, 1995. Canada Tax S e r v i c e (Toronto: C a r s w e l l , 1995) a t 1-16 t o 1-17. A l s o r e f e r t o T. Corcoran, "R&D Tax C r e d i t a F i a s c o W a i t i n g t o Happen", The Globe & M a i l (16 December 1994). 5 7  Robert K. Paterson and M a r t i n e M.N. Band, e t . al., I n t e r n a t i o n a l Trade and Investment Law i n Canada (2d), (Toronto: C a r s w e l l , 1994) a t 8-5. 5 8  i b i d . . a t 8-5. F o r a d i s c u s s i o n o f t h e d e f i n i t i o n o f subsidy under Canadian law, r e f e r t o R. Paterson and M. Band, a t 8-55 f f . and American Farm Bureau A s s o c i a t i o n v. Canadian Import T r i b u n a l . [1990] 2 S.C.R. 1324. 5 9  6 0  i b i d . . a t 8-5.  88 s u b s i d i e s o r export s u b s i d i e s , depending on t h e c i r c u m s t a n c e s . The  1979  "subsidies",  Subsidies  but sought  Code  t o regulate  negatively  they  impacted  recognized  that  many  important  instruments  policy objectives"  6 4  did  62  on  trade.  domestic  not  subsidies The  63  subsidies  f o r t h e promotion  and p e r m i t t e d  attempt  to  define  depending  on how  1979 were  Subsidies "widely  of s o c i a l  subsidies  s i x desirable  encourage r e s e a r c h  policy  goals  used  as  "used by governments  including  6 5  The Code  subsidies  "to  and development programmes, e s p e c i a l l y i n t h e  f i e l d of high-technology i n d u s t r i e s " . The  Code  and economic  t o promote important o b j e c t i v e s o f n a t i o n a l p o l i c y " . outlined  61  1994 Agreement on S u b s i d i e s  6 6  and C o u n t e r v a i l i n g  Measures  i b i d . . a t 8-5; t h e authors suggest t h a t domestic s u b s i d i e s "might i n c l u d e r e s e a r c h and development g r a n t s t o i n d u s t r i e s . " The argument t h a t R&D t a x i n c e n t i v e s might be viewed as export s u b s i d i e s i s developed below. 61  Agreement on I n t e r p r e t a t i o n and A p p l i c a t i o n o f A r t i c l e s V I , XVI and XXIII. A n t i - S u b s i d i e s Code. GATT (1980), BISD, 26th Supp., a t 56 (the "1979 S u b s i d i e s Code"). 6 2  See 1979 S u b s i d i e s Code, A r t i c l e 8. The t h r e e e f f e c t s which c o u l d a t t r a c t compensatory measures under t h e 1979 S u b s i d i e s Code were: 1. i n j u r y t o t h e domestic i n d u s t r y o f another GATT Member; 2. n u l l i f i c a t i o n o r impairment o f GATT b e n e f i t s ; o r 3. s e r i o u s p r e j u d i c e t o t h e i n t e r e s t s o f another Member. A l s o see R. P a t e r s o n and M. Band, supra. a t 8-6 t o 8-8 f o r an overview o f t h e 1979 S u b s i d i e s Code; Gary C. Hufbauer and Joanna S h e l t o n Erb, S u b s i d i e s i n I n t e r n a t i o n a l Trade. (Cambridge, MA: MIT P r e s s , 1984), Chapter 2; and John J . B a r c e l o , " S u b s i d i e s , C o u n t e r v a i l i n g D u t i e s and Anti-dumping A f t e r t h e Tokyo Round" (1980), 13 C o r n e l l I n t . L . J . 257. 6 3  1979  Subsidies  Code, A r t i c l e 11.  1979  S u b s i d i e s Code, Preamble.  1979  Subsidies  Code, A r t i c l e  11(1)(d).  89 (the "SCM Agreement ) 11  attempts t o r e f i n e , c l a r i f y and e n f o r c e the  67  p r e v i o u s l y vague d i s t i n c t i o n s between s u b s i d i e s t h a t d i s t o r t and  those t h a t do n o t .  for  Canadian R&D t a x i n c e n t i v e s and h i g h - t e c h n o l o g y p o l i c y .  68  This Part provides  trade  These refinements may have i m p l i c a t i o n s  an overview o f t h e SCM Agreement w i t h an  emphasis on i t s R&D p r o v i s i o n s . B. i.  The SCM Agreement Overview The  new SCM Agreement,  69  u n l i k e i t s predecessor,  d e f i n e s and  c a t e g o r i z e s s u b s i d i e s and e s t a b l i s h e s a b i n d i n g d i s p u t e r e s o l u t i o n procedure f o r each category A  "subsidy"  o f subsidy.  i s defined  according  t o two  tests:  7 0  1.  a  F i n a l A c t Embodying t h e R e s u l t s o f t h e Uruguay Round of Multilateral Trade N e g o t i a t i o n s . Agreement on S u b s i d i e s and C o u n t e r v a i l i n g Measures, 15 A p r i l 1994 i n The R e s u l t s o f t h e Uruguay Round o f M u l t i l a t e r a l Trade N e g o t i a t i o n s : The L e g a l Texts (Geneva: GATT S e c r e t a r i a t , June 1994) a t 264. 6 7  6 8  George K l e i n f e l d and David Kaye, supra.  a t 43.  See Terence P. Stewart, ed., The GATT Uruguay Round: A N e g o t i a t i n g H i s t o r y (1986 - 1992) v o l . 1 (Cambridge, MA.: Kluwer Law and T a x a t i o n P u b l i s h e r s , 1993) a t 809 - 958 f o r a review o f the GATT n e g o t i a t i n g h i s t o r y on s u b s i d i e s and c o u n t e r v a i l i n g measures. See R. Paterson and M. Band, supra, a t 8-9 t o 8-10 f o r an overview of dumping and subsidy n e g o t i a t i o n s i n t h e FTA and NAFTA. 6 9  7 0  SCM Agreement, A r t i c l e 1.1 deems a subsidy  to exist i f :  (a)(1) t h e r e i s a f i n a n c i a l c o n t r i b u t i o n by a government o r any p u b l i c body w i t h i n t h e t e r r i t o r y o f a Member... i . e . where: (i) a government p r a c t i c e i n v o l v e s a d i r e c t t r a n s f e r of funds (eg. g r a n t s , loans and e q u i t y i n f u s i o n ) , p o t e n t i a l d i r e c t t r a n s f e r s o f funds o r l i a b i l i t i e s , (eg. loan guarantees) ;  90 government must e i t h e r c o n t r i b u t e f i n a n c i a l l y ,  directly  from the  government or through another p u b l i c body o r mechanism, o r p r o v i d e income o r p r i c e support; and 2. the c o n t r i b u t i o n o r support must c o n f e r a b e n e f i t upon t h e r e c i p i e n t . F u r t h e r , i n o r d e r f o r a s u b s i d y t o be s u b j e c t t o d i s c i p l i n a r y action  i t must  certain  meet a s p e c i f i c i t y  industries  or  test;  companies.  71  If  i t must the  be  limited  granting  to  authority  e x p l i c i t l y l i m i t s access t o a s u b s i d y t o c e r t a i n e n t e r p r i s e s , i t i s specific. criteria  7 2  If a or  strictly  subsidy  conditions,  adhered  i s granted 7 3  which  are  on  the b a s i s of  clearly  spelled  objective out  and  t o , and t h e r e i s no reason t o b e l i e v e t h a t the  ( i i ) government revenue t h a t i s o t h e r w i s e due i s foregone or not c o l l e c t e d , (eg. f i s c a l i n c e n t i v e s such as t a x credits) [except where l i k e products destined f o r domestic p r o d u c t i o n are s i m i l a r l y exempt from d u t i e s or t a x e s ; SCM Agreement; f o o t n o t e 1 ] ; ( i i i ) a government p r o v i d e s goods o r s e r v i c e s o t h e r than g e n e r a l i n f r a s t r u c t u r e , or purchases o f goods; (iv) a government makes payments t o a f u n d i n g mechanism, or e n t r u s t s o r d i r e c t s a p r i v a t e body t o c a r r y out one or more of t h e type o f f u n c t i o n s i l l u s t r a t e d i n ( i ) t o ( i i i ) above, which would normally be v e s t e d i n t h e government and t h e p r a c t i c e , i n no r e a l sense, d i f f e r s from p r a c t i c e s normally f o l l o w e d by governments; o r (a) (2) t h e r e i s any form of income or p r i c e sense of A r t i c l e XVI o f the GATT 1994; and  support  i n the  (b) a b e n e f i t i s thereby c o n f e r r e d . SCM Agreement, A r t i c l e 1.2. A l s o d e t a i l e d t e s t f o r determining s p e c i f i c i t y . 71  7 2  2  for a  SCM Agreement, A r t i c l e 2 ( a ) .  SCM Agreement, A r t i c l e must be a u t o m a t i c . 7 3  see A r t i c l e  2(b); e l i g i b i l i t y  f o r the subsidy  91 subsidy  i s i n fact  specific,  i t i s not s u b j e c t t o d i s c i p l i n e .  However, n o t w i t h s t a n d i n g any appearance o f n o n - s p e c i f i c i t y ,  other  f a c t o r s may be c o n s i d e r e d such as: use o f t h e s u b s i d y program by a limited  number  of c e r t a i n  e n t e r p r i s e s , predominant  use o f t h e  subsidy program by c e r t a i n e n t e r p r i s e s , d i s p r o p o r t i o n a t e l y l a r g e amounts t o c e r t a i n e n t e r p r i s e s , o r t h e d i s c r e t i o n e x e r c i s e d by t h e granting a u t h o r i t y i n providing the subsidy. The  SCM  Agreement  identifies  prohibited  ("red  permissable  ("green l i g h t " ) .  light"  approach  different  light"),,  levels  of  ("yellow  subsidy:  light")  and  T h i s i s r e f e r r e d t o as t h e " t r a f f i c 7 5  resolution  c o u n t e r v a i l i n g measures.  three  actionable  to subsidies.  dispute  74  Each  category  procedures  gives and  rise  to  permissable  76  SCM Agreement, A r t i c l e 2 ( c ) . A l s o see Gary H o r l i c k and Peggy Clarke, "The 1994 WTO S u b s i d i e s Agreement", Annual I n t e r n a t i o n a l Trade Update. Georgetown U n i v e r s i t y Law Center, (June 1994) . 7  See George K l e i n f e l d and David Kaye, supra. a t 44. The authors note t h a t t h e SCM does not e x p l i c i t l y r e f e r t o t h i s t r a f f i c l i g h t approach, but t h i s metaphor has been i n use s i n c e t h e Tokyo Round ( r e f e r a l s o t o T. Stewart, supra. a t 830 and 855.) 75  See SCM Agreement, A r t i c l e s 4 and 7. A l s o see George K l e i n f e l d and David Kaye, supra. a t 46, and f o o t n o t e s 20 - 22, f o r a summary o f these p r o v i s i o n s ; In t h e case o f p r o h i b i t e d o r a c t i o n a b l e s u b s i d i e s , a Member i n i t i a t e s t h e p r o c e s s o f WTO d i s p u t e r e s o l u t i o n by r e q u e s t i n g c o n s u l t a t i o n s w i t h t h e a l l e g e d l y o f f e n d i n g government. (In t h e case o f a c t i o n a b l e s u b s i d i e s , a complaining Member must a l s o show evidence o f t h e n e g a t i v e e f f e c t s caused by the s u b s i d y ; A r t i c l e 7.2). I f t h e p a r t i e s do not r e a c h a "mutually a c c e p t a b l e s o l u t i o n " w i t h a c e r t a i n p e r i o d (30 days f o r p r o h i b i t e d s u b s i d i e s , and 60 days f o r a c t i o n a b l e s u b s i d i e s ; A r t i c l e s 4.4 and 7.4), e i t h e r may r e f e r t h e matter t o t h e D i s p u t e Settlement Body (DSB) f o r r e s o l u t i o n by a p a n e l under WTO r u l e s . I f a p a n e l i s convened, i t w i l l review t h e f a c t s and submit a r e p o r t f i r s t t o t h e p a r t i e s and then t o t h e DSB f o r a d o p t i o n . I f t h e p a n e l f i n d s t h e e x i s t e n c e o f a p r o h i b i t e d subsidy, " i t s h a l l recommend t h a t t h e 7 6  92 The  red. l i g h t p r o h i b i t s " s u b s i d i e s c o n t i n g e n t ,  i n law o r i n  f a c t , whether s o l e l y o r as one o f s e v e r a l o t h e r c o n d i t i o n s , upon export  performance  including  those  illustrated  i n Annex  I " and  " s u b s i d i e s c o n t i n g e n t , whether s o l e l y o r as one o f s e v e r a l other c o n d i t i o n s , upon t h e use o f domestic over imported goods". I t o t h e SCM Agreement s e t s out an i l l u s t r a t i v e subsidies  list  77  Annex  o f export  including:  (e) The f u l l o r p a r t i a l exemption, r e m i s s i o n o r d e f e r r a l s p e c i f i c a l l y r e l a t e d t o exports, of d i r e c t t a x e s or s o c i a l w e l f a r e charges p a i d o r payable by i n d u s t r i a l o r commercial enterprises. 7 8  And (f) The allowance o f s p e c i a l d e d u c t i o n s d i r e c t l y r e l a t e d t o e x p o r t s o r export performance, over and above those granted i n r e s p e c t t o p r o d u c t i o n f o r domestic consumption, i n the c a l c u l a t i o n o f t h e base on which d i r e c t t a x e s a r e charged. The  yellow  light  cautions  governments  against  granting  s u b s i d i z i n g Member withdraw t h e subsidy without d e l a y " ( A r t i c l e 4.7) ; i n cases i n v o l v i n g a c t i o n a b l e s u b s i d i e s , a f i n d i n g by t h e p a n e l o f adverse e f f e c t s would o b l i g a t e t h e o f f e n d i n g Member t o "remove t h e adverse e f f e c t s " o r "withdraw t h e s u b s i d y " ( A r t i c l e 7.8) . E i t h e r p a r t y t o a panel d e t e r m i n a t i o n may choose t o appeal i t t o an A p p e l l a t e Body, whose r e p o r t t h e DSB may a c c e p t o r r e j e c t . Subseguent t o these procedures, i f a Member does n o t f o l l o w t h e DSB recommendations, t h e DSB " s h a l l grant a u t h o r i z a t i o n t o the complaining Member t o take a p p r o p r i a t e countermeasures" ( A r t i c l e s 4.10 and 7.9. Note t h a t as an a l t e r n a t i v e t o m u l t i l a t e r a l enforcement o f s u b s i d i e s d i s c i p l i n e s , Members a l s o have t h e o p t i o n of imposing c o u n t e r v a i l i n g d u t i e s on imports b e n e f i t i n g from p r o h i b i t e d o r a c t i o n a b l e s u b s i d i e s under domestic law i f t h e requirements o f P a r t V ( A r t i c l e s 10 - 23) a r e met ( f o o t n o t e 35). 7 7  SCM Agreement, A r t i c l e 3.  SCM Agreement, f o o t n o t e 58 d e f i n e s " d i r e c t t a x e s " f o r t h e purpose o f t h e Agreement as "taxes on wages, p r o f i t s , i n t e r e s t s , r e n t s , r o y a l t i e s , and a l l other forms o f income, and t a x e s on t h e ownership o f r e a l p r o p e r t y " . Also "remission" of taxes includes "the r e f u n d o r r e b a t e o f t a x e s . " 7 8  93 s u b s i d i e s which cause "adverse e f f e c t s " t o t h e i n t e r e s t s o f other Members.  79  "Adverse e f f e c t s " a r e d e f i n e d  injury  to  the  nullification  domestic  or  industry  impairment  i n A r t i c l e 5.1 a s :  of  another  of benefits  accruing  indirectly  t o other  prejudice  t o t h e i n t e r e s t s o f another Member."  will  8 0  a r i s e only  serious prejudice  Member;  "(a) (b)  directly  or  Members under GATT 1994...; and (c) s e r i o u s Serious  i n c e r t a i n l i m i t e d circumstances.  prejudice  F o r example,  i s deemed t o e x i s t i n t h e case o f s u b s i d i e s t o  cover o p e r a t i n g l o s s e s s u s t a i n e d by an i n d u s t r y .  81  However, s e r i o u s  p r e j u d i c e would not be found i f t h e Member demonstrates t h a t t h e subsidy  i n question  enumerated  has n o t r e s u l t e d  i n paragraph  3 of A r t i c l e  i n any 6,  of the e f f e c t s  including  import- or  e x p o r t - d i s t o r t i n g e f f e c t s , o r when t h e e f f e c t o f t h e s u b s i d y increase  t h e world market share o f t h e s u b s i d i z i n g c o u n t r y  p a r t i c u l a r s u b s i d i z e d primary product o r commodity.  i s to in a  82  F i n a l l y , A r t i c l e 8, t h e green l i g h t , s t i p u l a t e s t h a t s u b s i d i e s which a r e not s p e c i f i c , o r a r e s p e c i f i c but a r e w i t h i n one o f t h e f o l l o w i n g c l a s s e s o f s u b s i d i e s , a r e n o t a c t i o n a b l e under c e r t a i n  79  SCM Agreement, A r t i c l e 5.  " S e r i o u s p r e j u d i c e " i s d e f i n e d i n SCM Agreement A r t i c l e 6 and i n c l u d e s t h r e a t o f s e r i o u s p r e j u d i c e (SCM Agreement, f o o t n o t e 13) . 8 0  81  SCM Agreement, A r t i c l e  6.1(b).  R. P a t e r s o n and M. Band, supra, a t 8-9, f n . 28; and SCM Agreement, A r t i c l e 6.3. A l s o r e f e r t o SCM Agreement A r t i c l e 6.7 f o r other e x c e p t i o n s t o t h e s e r i o u s p r e j u d i c e p r o v i s i o n s . 8 2  94 conditions: firms  or  assistance  8 3  by  higher  contract  basis,  domestic  territory  pursuant  to  assistance  a to  for  research  education  assistance of  general  or  to  the  research  subsidizing  framework  of  requirements.  of  ii.  R&D  Subsidies  As  mentioned  government f i n a n c i n g of R&D cautioned effects  to on  f o r e i g n R&D The for  SCM  green  "weigh, trade"  8 7  as and  regional  the  facilities  Subsidies  programs . 86  and  to  new  programs  are  were  Code  supported  However, governments were  practicable...  Members  territory  85  1979  f a r as  a the  development;  subsidy  by  on  within  government's  However, t h e s e  above,  conducted  regions  existing  subject to n o t i f i c a t i o n requirements.  8 4  establishments  disadvantaged  promote a d a p t a t i o n  environmental  activities  permitted  possible to  adverse  countervail  s u b s i d i e s t h a t harmed t h e i r domestic i n d u s t r i e s .  8 8  Agreement reduces the t h r e a t of c o u n t e r v a i l i n g a c t i o n light  subsidies.  Fundamental  research  of  a  non-  SCM Agreement, A r t i c l e 8.1. Products c o n t a i n i n g l e s s than a one p e r c e n t ad valorem subsidy are a l s o not c o u n t e r v a i l a b l e under Article 11.9. 8 3  8 4  See  "R&D  85  SCM  Agreement, A r t i c l e  86 8 7  1 9 7 9  1979  Subsidies"  below f o r f u r t h e r 8.3.  s u b s i d i e s Code, A r t i c l e Subsidies  discussion.  Code, A r t i c l e  11(3). 11(2).  Imports b e n e f i t i n g from i n d u s t r y or product s p e c i f i c R&D s u b s i d i e s were not exempted from c o u n t e r v a i l i n g d u t i e s . See George K l e i n f e l d and David Kaye, supra, a t 46 - 47. The authors a l s o r e f e r t o the f o l l o w i n g U.S. cases i n v o l v i n g f o r e i g n R&D s u b s i d i e s : O p t i c L i q u i d L e v e l Sensing Systems from Canada. 44 Fed. Reg. 1728 (1979); C e r t a i n S t e e l Products from Belgium, 47 Fed. Reg. 39304 (1982); Agrexco v. U n i t e d S t a t e s , 604 F. Supp. 1328 (1985). 8 8  95 commercial and n o n - i n d u s t r i a l nature conducted by e d u c a t i o n a l r e s e a r c h e s t a b l i s h m e n t s f a l l s o u t s i d e the SCM such  research  scientific  and  is  targeted  toward  the  t e c h n i c a l knowledge not  commercial o b j e c t i v e s . "  Agreement as l o n g as  "enlargement linked  to  establishments  research"  competitive  development  91  or  50  five  percent  activity".  pre-competitive  r e q u i r i n g a demonstration Only  and  on  f i r m s or  a contract basis  by  with  f o r up t o 75 p e r c e n t of c e r t a i n c o s t s of  90  "industrial  beyond the  general  8 9  or r e s e a r c h  firms i s also permitted  of  industrial  A s s i s t a n c e f o r r e s e a r c h a c t i v i t i e s conducted by educational  and  of  development  c a t e g o r i e s of R&D  costs  Therefore,  9 2  of adverse  certain  stage  any  of  "pre-  subsidy  becomes a c t i o n a b l e  effects.  costs q u a l i f y  f o r green  light  SCM Agreement, f o o t n o t e 26. George K l e i n f e l d and David Kaye, supra, a t 47 f o o t n o t e 32 a l s o r e f e r t o C e r t a i n S t e e l Products From Belgium. Appendix 2, 47 Fed. Reg. 39316 e t seq. (1982). 8 9  SCM Agreement A r t i c l e 8.2(a). Where a p r o j e c t c o n t a i n s both i n d u s t r i a l r e s e a r c h and p r e - c o m p e t i t i v e development a c t i v i t y , the a l l o w a b l e l e v e l of n o n - a c t i o n a b l e a s s i s t a n c e s h a l l not exceed the simple average (62.5 percent) of the two c a t e g o r i e s , c a l c u l a t e d on the b a s i s of a l l e l i g i b l e c o s t s (SCM Agreement, A r t i c l e 8, f o o t n o t e 30) . 9 0  "Industrial research" i s planned search or critical i n v e s t i g a t i o n aimed a t d i s c o v e r i n g new knowledge w i t h the o b j e c t i v e t h a t such knowledge may h e l p i n the development of new or improved p r o d u c t s , processes or s e r v i c e s (SCM Agreement, f o o t n o t e 28). 91  " P r e - c o m p e t i t i v e development a c t i v i t y " t r a n s f o r m s i n d u s t r i a l r e s e a r c h i n t o a " p l a n , b l u e p r i n t or d e s i g n f o r new, m o d i f i e d or improved p r o d u c t s , processes or s e r v i c e s " i n c l u d i n g the f i r s t noncommercial p r o t o t y p e . Note t h a t r o u t i n e or p e r i o d i c a l t e r a t i o n s of e x i s t i n g products i s c o n s i d e r e d t o go beyond the terms of the green l i g h t . (SCM Agreement, f o o t n o t e 29). 9 2  96 treatment:  93  1. p e r s o n n e l ,  including researchers,  s t a f f employed e x c l u s i v e l y i n r e s e a r c h  t e c h n i c i a n s and  support  activity;  2. instruments, equipment, land and b u i l d i n g s used e x c l u s i v e l y and permanently f o r the r e s e a r c h 3.  consultancy  and  activity;  equivalent  9 4  s e r v i c e s used e x c l u s i v e l y f o r  the p r o j e c t , i n c l u d i n g bought i n r e s e a r c h , t e c h n i c a l knowledge and patents; 4.  overhead  research 5.  costs  activity;  and  the  of  cost  incurred  directly  as  a  materials,  supplies  and  result  other  i s not  a c t i o n a b l e under A r t i c l e 8,  the  operating  expenses i n c u r r e d d i r e c t l y as a r e s u l t of the r e s e a r c h I f a subsidy  of  activity. i t is  still  open t o c h a l l e n g e under other p r o v i s i o n s i n the SCM Agreement which apply e q u a l l y t o a l l s u b s i d i e s , i n c l u d i n g R&D cases,  an A r t i c l e 8 green l i g h t subsidy  red l i g h t v i o l a t i o n . contingent  on  9 5  subsidies.  c o u l d be c o n v e r t e d i n t o a  A r t i c l e 3, f o r example, r e g a r d i n g  export performance or on  In such  the  use  subsidies  of domestic  over  imported goods a p p l i e s e q u a l l y t o government a s s i s t a n c e f o r R&D.  96  F u r t h e r , A r t i c l e 9.1  p r o v i d e s f o r a c h a l l e n g e of a program which i s  SCM Agreement, A r t i c l e 8 . 2 ( a ) ( i ) - ( v ) and George K l e i n f e l d and David Kaye, supra. a t 48. The allowable l e v e l s of nona c t i o n a b l e a s s i s t a n c e i s e s t a b l i s h e d by r e f e r e n c e t o the t o t a l e l i g i b l e c o s t s i n c u r r e d over the d u r a t i o n of the p a r t i c u l a r project. 93  9 4  Except when "disposed  95  George K l e i n f e l d and  9 6  i b i d . , at  49.  of on a commercial b a s i s " . David Kaye, supra. a t  49.  97 consistent with A r t i c l e 8  97  i f t h e subsidy  e f f e c t s t o t h e domestic i n d u s t r y  causes " s e r i o u s adverse  [of another Member] such as t o  cause damage which would be d i f f i c u l t t o r e p a i r " . There  are a  pertaining  t o R&D  few  other  subsidies  provisions  i n t h e SCM  which a r e o f i n t e r e s t .  encourages Members t o p r o v i d e or maintained; n o t i f i c a t i o n  i s n o t mandatory.  S e c r e t a r i a t may be requested,  followed  arbitration.  SCM  Finally,  Agreement Article  n o t i f i c a t i o n o f any s u b s i d y  wants t o q u e s t i o n another Member's R&D s u b s i d y  1 0 0  9 8  the  99  granted  I f a government  a review by t h e WTO  by a r e q u e s t  Agreement  25  f o r binding  requires  the  WTO  Committee on S u b s i d i e s  and C o u n t e r v a i l i n g Measures t o review t h e  Article  rules,  8 R&D  categories, force.  subsidy  within  18  including  months o f  the d e f i n i t i o n s of the  t h e Agreement  entering  into  1 0 1  The d i s p u t e r e s o l u t i o n procedures a r e m o d i f i e d i n these c i r c u m s t a n c e s as s e t out i n SCM Agreement A r t i c l e s 9.1 - 9.4. 9 7  "Serious adverse e f f e c t s " i s not d e f i n e d i n t h e SCM Agreement. See above f o r A r t i c l e 5 d e f i n i t i o n o f "adverse e f f e c t s " and A r t i c l e 6 d e f i n i t i o n o f " s e r i o u s p r e j u d i c e " . George K l e i n f e l d and David Kaye, supra. a t 50, note t h a t t h e U.S. government p o s i t i o n i s t h a t t h e s e r i o u s adverse e f f e c t s standard i s h i g h e r than t h e normal s e r i o u s p r e j u d i c e o r i n j u r y s t a n d a r d . 9 8  SCM Agreement, A r t i c l e 25.2 and f o o t n o t e 35. A r t i c l e 25.3 s t a t e s t h a t n o t i f i c a t i o n s must s p e c i f y t h e form o f a subsidy, i t s amount, policy objective, duration and impact on trade. Notification f o r R&D subsidies, i n p a r t i c u l a r , should be s u f f i c i e n t l y d e t a i l e d t o permit other Members t o determine whether the p r o j e c t s a t i s f i e s t h e c o n d i t i o n s o f A r t i c l e 8 ( A r t i c l e 8.3). 9 9  100  SCM Agreement, A r t i c l e 8.4 and 8.5.  SCM Agreement, Representative, Mickey Administration intend t o has not been abused." 101  footnote 25. Note t h a t U.S. Trade Kantor, has s t a t e d that the Clinton use t h e review " t o ensure t h e p r o v i s i o n (Hearing o f t h e House Subcommittee on  98 PART I I I CANADIAN R&D TAX INCENTIVES: DISCRIMINATORY SUBSIDIES? In t h i s P a r t an assessment i s made as t o whether Canada's R&D tax i n c e n t i v e s a r e d i s c r i m i n a t o r y based on whether such i n c e n t i v e s would be s u b j e c t t o d i s c i p l i n e under t h e SCM Agreement. j u s t i f i c a t i o n s f o r any such d i s c r i m i n a t i o n a r e e x p l o r e d , f a c t o r s t o consider A.  the  free  interests.  trade 1 0 2  p r e v i o u s l y , f r e e t r a d e i s based on two premises: objective  and  e f f e c t s on a g l o b a l  subsidization  prohibition,  Incentives  preservation  of  A l l subsidies are a n t i t h e t i c a l t o free trade  trade-distorting above,  as w e l l as  i n r e v i s i n g Canadian R&D t a x i n c e n t i v e s .  Free Trade, D i s c r i m i n a t i o n and R&D Tax As d i s c u s s e d  Possible  has  not  been  level.  1 0 3  subject  national causing  Yet, as i n d i c a t e d to  i n r e c o g n i t i o n of o v e r r i d i n g sovereign  outright  GATT  objectives:  1 0 4  Rather, t h e GATT o b j e c t i v e has been t o manage and reduce current l e v e l s o f s u b s i d i z a t i o n i n world t r a d e and t o e s t a b l i s h minimum standards f o r t h e r e t a l i a t o r y c o u n t e r v a i l i n g Commerce, Consumer P r o t e c t i o n and Competitiveness, 23 March 1994 as c i t e d i n George K l e i n f e l d and David Kaye, supra, a t 47, f o o t n o t e 31) . 102  See Chapter 1.  R. Paterson and M. Band, supra a t 8-5 and 8-63. The authors note t h a t "the q u e s t i o n o f whether o r not t h e use o f s u b s i d i e s t o f o s t e r domestic p r o s p e r i t y i s e c o n o m i c a l l y a d v i s a b l e i n t h e long term remains open. By c o n t r a s t , arguments have a l s o been made t h a t t h e r e may w e l l be n e t g a i n s t o a domestic economy from f o r e i g n s u b s i d i e s and n e t l o s s e s from t h e i m p o s i t i o n o f countervailing duties." 103  i b i d . , a t 8-5. A l s o r e f e r t o Kenneth Dam, The GATT Law and I n t e r n a t i o n a l Economic O r g a n i z a t i o n (London: U n i v e r s i t y o f Chicago Press, 1970), Chapter 7, f o r a g e n e r a l d i s c u s s i o n on s u b s i d i e s . 104  99 duty measures t h a t s u b s i d i e s o f t e n provoke. No attempt has been made t o g i v e a p r e c i s e d e f i n i t i o n of what a subsidy i s i n vacuo. Rather, the i s s u e of s u b s i d i z a t i o n i s viewed as a f a c t u a l or c o n t e x t u a l one, the focus being upon i t s u l t i m a t e e f f e c t on the i n t e r n a t i o n a l market. Adhering t o the concept t h a t some domestic s u b s i d i e s are l e g i t i m a t e t o o l s of domestic economic p l a n n i n g and development, they are, f o r c e r t a i n purposes, t r e a t e d somewhat more f l e x i b l y under GATT than are export s u b s i d i e s . Notwithstanding a f l e x i b l e GATT a t t i t u d e , Canada must a l s o be aware of U.S.  opinion  on  the  SCM  Agreement as the  United  States  remains the o n l y n a t i o n which uses c o u n t e r v a i l i n g duty laws t o significant support  extent.  for  subsidies, aggressive  Despite  105  expansion the  1 0 6  U.S.  approach  Administration  has  of  the  green  Clinton light  Administration to  R&D  determined t h a t :  Administration's  provisions  intends  subsidies.  any  For  to  for  R&D  maintain example,  an the  1 0 7  . . . s u b s i d i e s which exceed the green l i g h t parameters... w i l l be c o u n t e r v a i l a b l e i n f u l l , not j u s t w i t h r e s p e c t t o the amount of a s s i s t a n c e which exceeds the green l i g h t l e v e l s . F u r t h e r U.S. of the SCM  t r a d e n e g o t i a t o r s i n s i s t t h a t the R&D  Agreement:  provisions  108  105  R.  Paterson and M.  Band, supra. a t  8-63.  106  See George K l e i n f e l d and David Kaye, supra. a t 50 -  56.  i b i d . . a t 53: "In other words, i f a government p r o v i d e s i n d u s t r i a l r e s e a r c h a s s i s t a n c e beyond the 75 p e r c e n t cap, or p r e c o m p e t i t i v e development a s s i s t a n c e beyond the 50 p e r c e n t cap, or i f a p o r t i o n of the funding i n v o l v e s u n a u t h o r i z e d e x p e n d i t u r e s under A r t i c l e 8, the U n i t e d S t a t e s w i l l , under domestic law, c o u n t e r v a i l the f u l l measure of government a s s i s t a n c e t o the p r o j e c t . " The authors note however, t h a t under these c i r c u m s t a n c e s , an A r t i c l e 8 subsidy would be c l a s s i f i e d as an A r t i c l e 5 a c t i o n a b l e subsidy f o r which countermeasures, i f a u t h o r i z e d , have t o be "commensurate w i t h the degree and nature or the adverse e f f e c t s determined t o e x i s t . " 1 0 7  i b i d . . at  54.  100 . . . p r o t e c t the type of technology programmes the U n i t e d S t a t e s c u r r e n t l y has, w h i l e e x c l u d i n g the type of development and p r o d u c t i o n a s s i s t a n c e which o t h e r c o u n t r i e s t y p i c a l l y grant. I f f o r e i g n abuses of the green l i g h t p r o v i s i o n s w i l l not tolerated  by  programs  will  States.  1 0 9  the  United  be  States,  subject  Indeed,  the  to  this  likely  careful  Canadian  means Canada's  monitoring  government  has  by  the  be R&D  United  recognized  that  along w i t h the g r e a t e r c e r t a i n t y p r o v i d e d by the SCM Agreement f o r promoting government o b j e c t i v e s i n R&D, of a s s i s t a n c e i n excess  comes t h e r i s k t h a t l e v e l s  of the a r t i c u l a t e d t h r e s h o l d s w i l l  the e n t i r e subsidy t o c o u n t e r v a i l i n g a c t i o n .  expose  1 1 0  There are c e r t a i n f e a t u r e s of the Canadian t a x system r e l a t e d t o R&D trade  which may ideal  be v u l n e r a b l e t o a t t a c k as c o n t r a r y t o the f r e e  underlying  the  SCM  Agreement.  In  particular,  the  enhanced ITC f o r CCPCs w i l l now be assessed f o r such d i s c r i m i n a t i o n w i t h i n the framework s e t out i n the SCM A r t i c l e 1.1 "government collected".  of the SCM  revenue 1 1 1  The  that  specific  agreement.  Agreement deems a s u b s i d y t o e x i s t i f is  otherwise  example  such as tax c r e d i t s ; ITCs f o r R&D  due  given  is is  forgone  fiscal  or  not  incentives  conducted by CCPCs can be used t o  See Mark A.A. Warner and A l a n M. Rugman, supra, a t 405 412 r e g a r d i n g the U.S. N a t i o n a l Competitiveness A c t . 1993 and U.S. technology which, i n p a r t , p r o v i d e s f o r a mechanism t o monitor f o r e i g n technology c a p a b i l i t i e s r e l a t i v e t o the U.S. and to i d e n t i f y and respond t o " c o m p e t i t i v e o p p o r t u n i t i e s and c h a l l e n g e s " (at 406) . 1 0 9  "New Rules and I n s t i t u t i o n s " , Canada and t h e Uruguay Round (Ottawa: Government of Canada, A p r i l , 1994) a t 7 - 8. 110  111  SCM  Agreement, A r t i c l e  1.1(a)(1)(H).  101 offset  a l l f e d e r a l taxes f o r the c u r r e n t year w i t h any excess  100  p e r c e n t r e f u n d a b l e f o r c u r r e n t e x p e n d i t u r e s , 40 p e r c e n t r e f u n d a b l e for capital  expenditures.  Article Clearly, payable  1.1  also  requires  that  a  benefit  CCPCs b e n e f i t from being a b l e t o deduct from  a l l sources,  from  the p o t e n t i a l  is  conferred.  ITCs from  f o r cash  flow  taxes from  r e f u n d s , and from the f l e x i b i l i t y p r o v i d e d w i t h i n the system t o tax p l a n w i t h the ITCs i n combination w i t h s e c t i o n 37 d e d u c t i o n s ,  loss  c a r r y b a c k s or c a r r y f o r w a r d s and c a p i t a l c o s t allowance. T h e r e f o r e , the  subsidy deeming p r o v i s i o n s s e t out  apply t o ITCs f o r CCPCs.  in Article  1.1  appear t o  112  However, A r t i c l e 1.2  of the SCM  Agreement a l s o r e q u i r e s t h a t  such s u b s i d i e s be " s p e c i f i c " i n accordance  w i t h the p r o v i s i o n s of  A r t i c l e 2, b e f o r e the subsidy i s s u b j e c t t o the p r o v i s i o n s r e l a t i n g to  prohibited  s u b s i d i e s , a c t i o n a b l e s u b s i d i e s or  countervailing  measures. In t u r n , A r t i c l e 2 s t a t e s t h a t a s u b s i d y must be  specific  t o an e n t e r p r i s e or i n d u s t r y or group of e n t e r p r i s e s or i n d u s t r i e s within  the  particular:  jurisdiction  of  the  granting  authority.  In  1 1 3  Where the g r a n t i n g a u t h o r i t y , or the l e g i s l a t i o n pursuant t o which the g r a n t i n g a u t h o r i t y operates, e x p l i c i t l y l i m i t s access t o a subsidy t o c e r t a i n e n t e r p r i s e s , such s u b s i d y s h a l l be s p e c i f i c . The  enhanced r a t e f o r ITCs i s e x p r e s s l y l i m i t e d  to  certain  Note t h a t the same c o n c l u s i o n can be reached r e g a r d i n g ITCs f o r non-CCPCs, even though the r e f u n d a b l e a s p e c t i s not p r e s e n t i n t h a t case. 1 1 2  1 1 3  SCM  Agreement, A r t i c l e 2.1  (a).  102 enterprises,  those e n t e r p r i s e s  b e i n g e l i g i b l e CCPCs.  114  s u b s i d y which f a l l s w i t h i n the p r o v i s i o n s of A r t i c l e 3, t o be  specific. Article  which are  3  Also,  any  i s deemed  1 1 5  are  the  red  light  p r o h i b i t e d under the  SCM  most s t r i n g e n t r e m e d i a l p r o v i s i o n s . which are c o n t i n g e n t  subsidies;  1 1 6  Agreement and  those  subsidies  subject  to  the  A r t i c l e 3 prohibits subsidies  i n law or i n f a c t , whether s o l e l y or as one  of  s e v e r a l o t h e r c o n d i t i o n s , upon export performance. A r t i c l e 3 a l s o p r o h i b i t s subsidies contingent, other  conditions,  upon the  use  whether s o l e l y or as one of s e v e r a l of  domestic  goods over  imported  Note t h a t A r t i c l e 2.1(b) of the SCM Agreement, s t a t e s t h a t "Where the g r a n t i n g a u t h o r i t y , or the l e g i s l a t i o n pursuant t o which the g r a n t i n g a u t h o r i t y operates, e s t a b l i s h e s o b j e c t i v e c r i t e r i a or c o n d i t i o n s governing the e l i g i b i l i t y f o r , and the amount of, a subsidy, s p e c i f i c i t y s h a l l not e x i s t , p r o v i d e d t h a t the e l i g i b i l i t y i s automatic and t h a t such c r i t e r i a and c o n d i t i o n s are s t r i c t l y adhered t o . The c r i t e r i a or c o n d i t i o n s must be c l e a r l y s p e l l e d out i n law, r e g u l a t i o n , or o t h e r o f f i c i a l document, so as t o be capable of v e r i f i c a t i o n . " Although the c r i t e r i a g o v e r n i n g the e l i g i b i l i t y f o r the enhanced ITCs may be s a i d t o meet t h e s e requirements, f o o t n o t e 2 of the SCM Agreement goes on t o s t a t e : "Objective c r i t e r i a or c o n d i t i o n s , as used h e r e i n , mean c r i t e r i a or c o n d i t i o n s which are n e u t r a l , which do not favour c e r t a i n e n t e r p r i s e s over others, and which are economic i n n a t u r e and horizontal in application, such as number of employees or size of the e n t e r p r i s e . " Therefore, the c r i t e r i a f o r CCPCs q u a l i f y i n g f o r enhanced ITCS are not " o b j e c t i v e " a c c o r d i n g t o the SCM Agreement as c e r t a i n e n t e r p r i s e s , CCPCs, are favoured. 114  T h i s A r t i c l e should be c o n s i d e r e d f o r o t h e r R&D tax i n c e n t i v e s which are arguably not e n t e r p r i s e or i n d u s t r y s p e c i f i c . In such cases, the p r o v i s i o n s of A r t i c l e 3 must be examined c l o s e l y t o see whether or not the subsidy would be deemed t o be s p e c i f i c under A r t i c l e 2.3. 115  A r t i c l e 8 green l i g h t s u b s i d i e s f o r R&D w i l l be addressed below. Note t h a t the SCM Agreement does not d i r e c t l y address c o n f l i c t s between A r t i c l e s 3 and 8. However, the A r t i c l e 3 p r o h i b i t i o n i s a b s o l u t e and A r t i c l e 8 does not p r o v i d e f o r a waiver, e i t h e r d i r e c t l y or i n d i r e c t l y , of A r t i c l e 3 c o n s t r a i n t s . (See George K l e i n f e l d and David Kaye, supra, a t 59). 116  103 goods. With r e s p e c t t o s u b s i d i e s c o n t i n g e n t on export performance, illustrative Annex  I  list  i s p r o v i d e d i n Annex I t o the  i n c l u d e s the  full  or  partial  exemption,  SCM  an  Agreement.  remission  or  d e f e r r a l s p e c i f i c a l l y r e l a t e d t o e x p o r t s , of d i r e c t t a x e s p a i d or payable.  117  Arguably, the p r o v i s i o n s r e l a t e d t o R&D  tax  incentives  g e n e r a l l y are r e l a t e d t o e x p o r t s , as one of the s t a t e d purposes of providing  such  technologies economy.  incentives  to  increase  i s t o c r e a t e wealth the  competitiveness  the  Canadian  technology, t h e s e i n c e n t i v e s may  be  as b e i n g r e l a t e d t o e x p o r t s .  Alternatively,  with  respect  to  the  reguirements of A r t i c l e 3, p a r t i c i p a t i o n i n R&D l i m i t e d t o CCPCs, or c o n t i n g e n t on R&D based  of  new  To the e x t e n t t h a t such c o m p e t i t i v e a c t i v i t y i s d i r e c t e d  t o g l o b a l markets f o r the R&D viewed  by d e v e l o p i n g  facilities  subject  t o an  SCM  or otherwise  domestic  content  a s s i s t a n c e which i s  b e i n g conducted  f a v o u r i n g Canadian  i n Canadian  i n p u t s , may  be  c h a l l e n g e . Even though c e r t a i n f o r e i g n - s o u r c e  i n p u t s are p e r m i t t e d ,  118  a dispute r e s o l u t i o n panel could construe  SCM Agreement, Annex I, paragraph (e) . D i r e c t taxes i s d e f i n e d t o i n c l u d e taxes on a l l forms of income. Note t h a t paragraph (f) of Annex I, p e r t a i n s t o s p e c i a l d e d u c t i o n s d i r e c t l y r e l a t e d t o e x p o r t s or export performance over and above those granted f o r domestic p r o d u c t i o n , i n c a l c u l a t i n g the t a x base on which d i r e c t taxes are charged. T h i s p r o v i s i o n may be a p p l i c a b l e w i t h r e g a r d t o the immediate w r i t e o f f of c a p i t a l e x p e n d i t u r e s f o r Canadian R&D, i f i t can be argued t h a t t h e s e d e d u c t i o n s are directly related to stimulating export performance i n high t e c h n o l o g y i n d u s t r i e s , f o r example. 1 1 7  As d i s c u s s e d above, t h e r e are r e s t r i c t i o n s on t h e f o r e i g n e x p e n d i t u r e s which are e l i g i b l e f o r i n c l u s i o n i n the s e c t i o n 37 p o o l and f o r the ITC c l a i m . Deductions f o r f o r e i g n R&D are a l s o s e v e r e l y r e s t r i c t e d under s u b s e c t i o n 37(2). 1 1 8  104 b a r r i e r s t o p a r t i c i p a t i o n by  foreign-owned companies, a l o n g  with  n a t i o n a l o b j e c t i v e s of job c r e a t i o n and p r e s e r v a t i o n and enhancing Canadian  competitiveness  in  the  particular  m a n i f e s t a t i o n s of an i m p l i c i t domestic content T h e r e f o r e , i t i s arguable t h a t Canadian R&D CCPCs are d i s c r i m i n a t o r y and p r o v i s i o n s of the SCM  come w i t h i n the  industry,  requirement.  as  119  tax incentives f o r p r o h i b i t e d subsidy  Agreement.  As a f u r t h e r a l t e r n a t i v e , although the A r t i c l e 3 p r o h i b i t i o n appears t o o v e r r i d e the p r o v i s i o n s of A r t i c l e 8, t o c o n s i d e r whether the c e r t a i n R&D  i t i s worthwhile  tax i n c e n t i v e s come w i t h i n the  green l i g h t p r o v i s i o n s r e l a t e d t o R&D.  Article  8  non-actionable  s u b s i d i e s are those s u b s i d i e s which are not s p e c i f i c , or which are s p e c i f i c but meet a l l of the c o n d i t i o n s p r o v i d e d f o r i n A r t i c l e With r e s p e c t t o r e s e a r c h a c t i v i t i e s , the a s s i s t a n c e must not more than percent  75  of  Canadian R&D  percent  the  of the  c o s t s of  c o s t s of p r e - c o m p e t i t i v e  t a x i n c e n t i v e s may  i n combination,  industrial  research  research.  The  8.  cover or  50  various  w e l l exceed these l i m i t s , alone or  depending on the circumstances.  F u r t h e r , i t may  t h a t the types of r e s e a r c h which q u a l i f y under t h e Canadian R&D  be tax  See George K l e i n f e l d and David Kaye, supra. a t 59 f o r such an argument p e r t a i n i n g t o the U n i t e d S t a t e s R&D i n i t i a t i v e s f o r the P a r t n e r s h i p f o r a New Generation of V e h i c l e s (PNGV). The PNGV i s a p a r t n e r s h i p between the government and t h e " b i g t h r e e " (General Motors, Ford and C h r y s l e r ) U.S. auto-makers t o develop t e c h n o l o g i e s t h a t improve f u e l e f f i c i e n c y and emissions c o n t r o l and " t o h e l p ensure the U.S. jobs are not t h r e a t e n e d " and t h a t " p u r s u i t of such g o a l s w i l l t r a n s l a t e i n t o a demand f o r U.S. p r o d u c t s , not f o r e i g n p r o d u c t s " (at 57 - 58) . A l s o see Mark A.A. Warner and A l a n M. Rugman, supra, f o r an a n a l y s i s of r e c e n t U.S. a n t i t r u s t and R&D p o l i c y i n i t i a t i v e s under NAFTA, the GATT and o t h e r i n t e r n a t i o n a l instruments. 1 1 9  105 r u l e s are broader than those under the SCM Agreement. a p r o j e c t must meet t h r e e c r i t e r i a uncertainty, scientific  scientific or  technical  or  (scientific  technological  content)  to  be  For example,  or t e c h n o l o g i c a l advancement,  eligible  for  R&D  and tax  i n c e n t i v e s , but these c r i t e r i a have been a p p l i e d b r o a d l y , as i n the case  of Canadian banks a c c e s s i n g the tax  software  development.  d e f i n i t i o n s i n the SCM thereby  restricting  120  On  the  other  incentives for certain  hand,  with  be  that  the  Agreement w i l l be c o n s t r u e d more narrowly,  the  R&D  green  light  r e s e a r c h a c t i v i t i e s which are aimed a t "new Finally,  i t may  respect to A r t i c l e  8,  subsidy  provisions to  knowledge". assistance i s  limited  e x c l u s i v e l y t o enumerated c o s t s which are much more r e s t r i c t e d than c o s t s enumerated i n the ITA. c o s t s of p e r s o n n e l ,  For example, A r t i c l e 8 r e q u i r e s t h a t  instruments,  equipments, l a n d and  buildings,  and c o n s u l t a n c y be used e x c l u s i v e l y f o r r e s e a r c h a c t i v i t y . other hand, the  ITA  provisions generally require that  On the  qualified  expenditures be a l l or s u b s t a n t i a l l y a l l used f o r R&D  activities.  The  to  proxy  p r o v i s i o n s f o r overhead  may  be  contrary  the  SCM  In 1994 s e v e r a l Canadian banks f i l e d taxpayer requested adjustments f o r R&D expenditures made back t o 1986 i n the f i e l d of computer software (1994 AG's Report, supra, v o l . 6 a t 32-15). The f a c t t h a t these c l a i m s were not f i l e d u n t i l e i g h t y e a r s a f t e r the expenditures were i n c u r r e d suggests t h a t such R&D was performed, and would be performed, i n s p i t e of any t a x i n c e n t i v e s . The February 27, 1995 budget proposes a c l o s e examination of the R&D system w i t h r e g a r d t o these a p p l i c a t i o n s f o r about $3 00 m i l l i o n i n R&D tax c r e d i t s (see Clyde Graham, "Government w i l l Get i t s Share of Bank P r o f i t s , M a r t i n Says", Ottawa (CP), December 15, 1994.) A l s o r e f e r t o L i n d a McQuaig, Behind C l o s e d Doors (Markham, Penguin Books, 1987) Chapter 9, f o r a d i s c u s s i o n of the s c i e n t i f i c r e s e a r c h tax c r e d i t "quick f l i p s " of the mid-1980's f o r another example of abuse of p r e v i o u s the tax p r o v i s i o n s f o r r e s e a r c h and development. 1 2 0  106 Agreement  requirement  that  additional  overhead  i n c u r r e d d i r e c t l y as a r e s u l t o f t h e r e s e a r c h  costs  must  be  a c t i v i t y . Also, the  a b i l i t y t o deduct expenditures f o r c a p i t a l a s s e t s  intended  t o be  used i n R&D a c t i v i t i e s may go beyond t h e e l i g i b l e c o s t parameters s e t out i n A r t i c l e 8 o f t h e SCM Agreement. I t should  be noted t h a t even i f such i n c e n t i v e s do meet t h e  green l i g h t p r o v i s i o n s and a r e not p r o h i b i t e d s u b s i d i e s , reviews of these  incentives  Agreement. the  yellow  launch  a  establish  121  can  Also, light  i f neither  actionable  complaint that  still  be  requested  Article  under  the  8 nor A r t i c l e  SCM  3 applies,  s u b s i d i e s p r o v i s i o n s may be used t o  i n cases  where  another  t h e use o f any subsidy  Member  i s able  to  has i n j u r e d t h e domestic  i n d u s t r y o f t h a t Member, caused s e r i o u s p r e j u d i c e t o t h e i n t e r e s t s of  that  Member,  o r otherwise  nullified  or  impaired  benefits  a c c r u i n g t o t h a t Member under t h e GATT. In c o n c l u s i o n ,  t h e r e a r e reasonable grounds f o r a n t i c i p a t i n g  t h a t t h e U n i t e d S t a t e s , i n p a r t i c u l a r , w i l l be m o n i t o r i n g Canadian R&D programs, i n c l u d i n g t a x i n c e n t i v e s , t o ensure compliance w i t h the SCM Agreement.  The above assessment, though c u r s o r y ,  indicates  t h a t t h e r e a r e reasonable arguments t o be made t h a t such s u b s i d i e s may be p r o h i b i t e d under t h e SCM Agreement. I n other words, t h e R&D tax  incentives  residents  may  be  viewed  as d i s c r i m i n a t i n g  and f o r e i g n a c t i v i t i e s  and c o n t r a r y  o b j e c t i v e . The next s e c t i o n c o n s i d e r s R&D a r e j u s t i f i a b l e notwithstanding  121  against  non-  t o the free  trade  whether t a x i n c e n t i v e s f o r  any such d i s c r i m i n a t i o n .  See SCM Agreement A r t i c l e s 9.1 and 8.5.  107 B.  J u s t i f i a b l e Incentives? I t may  be t h a t WTO  o t h e r Members' R&D  Members may  be d e t e r r e d from c h a l l e n g i n g  subsidy programs f o r a number o f reasons. F i r s t ,  an "uneasy t r u c e " c o u l d p r e v a i l w h i l e each Member pursues t h e i r  own  e x c l u s i o n a r y R&D  tax  initiatives.  1 2 2  I t i s not uncommon f o r such  i n c e n t i v e s t o be r e s t r i c t e d t o domestic  research a c t i v i t i e s  1 2 3  and  most i n d u s t r i a l i z e d c o u n t r i e s r e l y on the income t a x system as an efficient  and  equitable  means  of  delivering  R&D  support.  Second, the b e n e f i c i a l s p i l l o v e r e f f e c t s of one c o u n t r i e s R&D be  seen  to  forestalling T h i r d , R&D  outweigh the  negative  initiation  of  effects  of  any  dispute resolution  tax i n c e n t i v e programs may  bounds of the SCM  1 2 2  the  Agreement. F i n a l l y ,  such  124  may  subsidy  mechanisms.  125  q u i t e simply come w i t h i n the i t may  be t h a t even i f tax  George K l e i n f e l d and David Kaye, supra. a t  60.  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the U n i t e d Kingdom, and the U n i t e d S t a t e s " , Canadian Tax Paper No. 90 (Toronto: Canadian Tax Foundation, 1991) a t 102. 1 2 3  1 2 4  W.S.Clark, e t . a l . , supra. a t  32:5.  see Laura D'Andrea Tyson, Remarks b e f o r e t h e Economic S t r a t e g y I n s t i t u t e . F e d e r a l News S e r v i c e , 9 March 1994, as quoted i n George K l e i n f e l d and David Kaye, supra. a t 56: "On the i s s u e of whether or not our p o s i t i o n i n the GATT, the Uruguay Round, on R&D s u b s i d i e s would touch o f f a subsidy c o m p e t i t i o n , I t h i n k . . . t h i s i s one area where economic t h e o r y would suggest t h a t the s p i l l o v e r b e n e f i t s from R&D s u b s i d i e s - both the g l o b a l s p i l l o v e r b e n e f i t s and the l o c a l s p i l l o v e r b e n e f i t s - are measured t o be v e r y h i g h You don't want i n t e r n a t i o n a l r u l e s t o d i s c o u r a g e s u b s i d i e s which would a c t u a l l y generate b e n e f i t s , not j u s t f o r you but f o r the world. And t h i s i s j u s t an e f f o r t t o t r y and f i g u r e out where t h a t l i n e would be. No one e x a c t l y knows where i t w i l l be, but... we took a s e n s i b l e p o s i t i o n i n those n e g o t i a t i o n s t o draw the l i n e t o a l l o w governments t o support these programmes, but t o s e t some l i m i t s on how they c o u l d support." 125  108 incentives  f o r research  discriminatory incentives  may  and be  and  contrary  development to  justifiable  the  can  free  based  be  viewed  trade  on  as  ideal,  overriding  being these  domestic  objectives. I t i s submitted t h a t i n the case of R&D, objectives  must  be  of  primary  concern  due  the s t a t e d n a t i o n a l to  the  profound  s i g n i f i c a n c e of these a c t i v i t i e s t o the s o c i a l and economic aims of Canada. However, even w i t h i n t h i s p u r e l y domestic c o n t e x t t h e r e arguments t o be made t h a t the e x i s t i n g R&D  are  t a x i n c e n t i v e s cannot be  j u s t i f i e d as e i t h e r being r a t i o n a l l y connected w i t h , or capable of achieving,  these s t a t e d n a t i o n a l o b j e c t i v e s .  In e v a l u a t i n g t a x i n c e n t i v e s f o r r e s e a r c h and development, i t is  important  to  emphasize t h a t  these i n c e n t i v e s  are e s s e n t i a l l y  p u b l i c spending programs d e l i v e r e d through the t a x system by way foregone tax  revenues:  of  126  I t i s g e n e r a l l y accepted t h a t , as i n d i r e c t government spending programs, such p r o v i s i o n s must be e v a l u a t e d on the b a s i s of budgetary r a t h e r than tax p o l i c y c r i t e r i a . I t makes no sense t o a s s e s s tax e x p e n d i t u r e p r o v i s i o n s on the b a s i s of tax p o l i c y c r i t e r i a such as e q u i t y , n e u t r a l i t y , or revenue. Tax e x p e n d i t u r e s are i n h e r e n t l y and i n t e n t i o n a l l y i n e q u i t a b l e and n o n - n e u t r a l ; they are designed t o b e n e f i t c e r t a i n t a x p a y e r s or a c t i v i t i e s i n preference to others. Further, they are intended not t o r a i s e revenue, but r a t h e r t o spend i t i n the form of forgone tax.  ***  Although t a x e x p e n d i t u r e s t h a t d i s c r i m i n a t e a g a i n s t a l i e n s , n o n - r e s i d e n t s or f o r e i g n a c t i v i t i e s cannot be j u s t i f i e d on the b a s i s of tax p o l i c y c r i t e r i a , they are n e v e r t h e l e s s tax p r o v i s i o n s i n the sense t h a t they form p a r t of the tax legislation. As a r e s u l t , they are covered by the nond i s c r i m i n a t i o n a r t i c l e i n b i - l a t e r a l tax t r e a t i e s . Since, B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , R e s i d e n t s , and F o r e i g n A c t i v i t i e s " , supra. a t 128 - 129. 1 2 6  Non-  109 however, tax e x p e n d i t u r e s are i n substance i n d i r e c t spending programs, i t i s i n a p p r o p r i a t e t o a s s e s s them on t h i s b a s i s ; as s t a t e d above, they must be judged by r e f e r e n c e t o budgetary criteria. A c c o r d i n g l y , a tax e x p e n d i t u r e t h a t d i s c r i m i n a t e s a g a i n s t a l i e n s , n o n - r e s i d e n t s , or f o r e i g n a c t i v i t i e s may be j u s t i f i e d i f an e q u i v a l e n t d i r e c t p u b l i c spending program t h a t d i s c r i m i n a t e s i n the same way can be j u s t i f i e d . For example, d i r e c t p u b l i c spending t o encourage s c i e n t i f i c r e s e a r c h i n Canada would be seen by most people as d e s i r a b l e p u b l i c p o l i c y . The r e s t r i c t i o n of the program t o r e s e a r c h i n Canada would be viewed as an e s s e n t i a l f e a t u r e of the program f o r s e v e r a l reasons, i n c l u d i n g the c o s t of f u n d i n g research o u t s i d e Canada and the b e n e f i t s of the spending program f o r Canadian u n i v e r s i t i e s and o t h e r r e s e a r c h i n s t i t u t i o n s and f o r Canadian r e s e a r c h s c i e n t i s t s . Therefore,  one c r i t e r i a f o r R&D  e v a l u a t i n g and  justifying  tax  i n c e n t i v e s i s whether these " e x p e n d i t u r e s " are a c h i e v i n g the s t a t e d o b j e c t i v e s of wealth c r e a t i o n , managing r i s k and of  life,  and  advancing knowledge through b a s i c r e s e a r c h .  the r e c o g n i z e d stimulating  need f o r R&D,  R&D  is  which measure the R&D  improving q u a l i t y  not  Despite  the e f f e c t i v e n e s s of tax i n c e n t i v e s i n  conclusive.  impact of tax  1 2 7  Studies  i n c e n t i v e s on the  have  been  "user c o s t "  c a p i t a l and combining t h i s measurement w i t h an e s t i m a t e of  sensitivity cost.  1 2 8  of  These  Canada has  one  R&D  capital  studies  are  investment used  to  to  support  of the most generous tax  changes the  done  in  of the  i t s user  statement  incentive structures  that for  See the 1994 AG's Report, supra. v o l . 6 a t 32-16 t o 32-17 r e g a r d i n g the l a c k of i n f o r m a t i o n a v a i l a b l e i n the Department of Finance and Revenue Canada t o be a b l e t o monitor and e v a l u a t e tax i n c e n t i v e s on a systematic b a s i s . 1 2 7  W.S. C l a r k , e t . a l . , supra. a t 32:8 - 32:10 f o r an overview f o r a number of these s t u d i e s . A l s o see D. M c F e t r i d g e and J . Warda, supra; J . Warda, supra; and P. Mohnen, supra. 128  110 R&D  i n the w o r l d .  129  However, g e n e r o s i t y of t a x  i n c e n t i v e s does not  r e s u l t i n the s o c i a l l y o p t i m a l l e v e l of R&D is  b e i n g a t t a i n e d , which  the g o a l which p r o v i d e s the economic r a t i o n a l e  incentives  i n the f i r s t p l a c e . I t i s d i f f i c u l t  e f f e c t i v e n e s s of tax-based i n c e n t i v e s f o r R&D expenditures  are  actually  creating  necessarily  f o r such  tax  to establish  the  and whether t h e s e t a x  technologically  innovative  p r o d u c t s or whether the i n c e n t i v e s have any i n f l u e n c e on b u s i n e s s decisions. changes  1 3 0  It  i s also  i n the u s e r c o s t  difficult from  tax  to  estimate  incentives  on  the  impact  of  the  investment  W.S. C l a r k , e t . a l . , supra. summarize Warda's "B-index" s t u d i e s a t 32:17. The "B-index" i s an a n a l y t i c t o o l used t o rank the r e l a t i v e a t t r a c t i v e n e s s of a c o u n t r y ' s R&D t a x system. I t accounts f o r the i n f l u e n c e of R&D t a x c r e d i t s on the a f t e r - t a x c o s t of u n d e r t a k i n g R&D as w e l l as the i n f l u e n c e of income t a x r a t e s i n d e t e r m i n i n g both the v a l u e of q u a l i f y i n g R&D d e d u c t i o n s and the a f t e r - t a x v a l u e of the r e t u r n s from R&D. Other t h i n g s b e i n g equal, the lower the B-index, the g r e a t e r the amount o f R&D a f i r m w i l l undertake. Canada has the lowest B-index of developed c o u n t r i e s . See D. M c F e t r i d g e and J . Warda, supra. f o r the i n i t i a l study which examined the f a v o u r a b l e n e s s of the Canadian t a x system toward R&D; and the f o l l o w - u p study by J . Warda, supra, which c o n c l u d e s , a t 18 " t h a t r e l a t i v e t o o t h e r c o u n t r i e s examined, Canada's t a x treatment of R&D remains the most f a v o u r a b l e because i t o f f e r s t h e taxpayer a v a r i e t y of b e n e f i t s a t both the f e d e r a l and p r o v i n c i a l l e v e l s . " Note t h a t Warda's study i s l i m i t e d t o the B-index a n a l y s i s and does not address the adequacy of R&D t a x treatment i n Canada. 1 2 9  J.R. Roberts and William Leiss, " T e c h n o l o g i c a l and A c c o u n t i n g I n n o v a t i o n : Can They Mesh?", Report of Proceedings of the T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 25:1 - 25:8 a t 25:2. A l s o see R i c h a r d M. B i r d , "Tax I n c e n t i v e s f o r Investment: The S t a t e of the A r t " , Canadian Tax Paper No. 64 (Toronto: Canadian Tax Foundation, 1980) f o r a g e n e r a l study on investment t a x i n c e n t i v e s , the u s e f u l n e s s of i n c e n t i v e s e x i s t i n g a t the date o f the study and s u g g e s t i o n s f o r u s e f u l r e s e a r c h i n the area of i n c e n t i v e s . 1 3 0  Ill behaviour One  o f R&D performers  and on broader  spillover  effects.  1 3 1  r e c e n t study has even concluded t h a t t h e r e i s s t r o n g evidence  t h a t h i g h e r r a t e s o f r e t u r n a r e o b t a i n e d on p r i v a t e l y - f u n d e d R&D than on p u b l i c l y funded A  further  R&D.  132  justification  f o r Canada's  generous  R&D t a x  i n c e n t i v e s i s t h a t t h e a f t e r - t a x c o s t o f p e r f o r m i n g R&D i n Canada offers  significant  performers.  competitive  These advantages,  advantages  to  Canadian  R&D  i t i s suggested, may be e x p l o i t e d by  Canadian companies t o "carve a n i c h e " f o r themselves  i n performing  R&D f o r f o r e i g n based c o r p o r a t i o n s , and m u l t i n a t i o n a l e n t e r p r i s e s ("MNEs") Canada  should  t o take  consider advantage  having  R&D  o f these  operations competitive  centralized i n advantages.  133  W.S. C l a r k , e t . a l . , supra. a t 32:8. The authors r e f e r t o a number o f s t u d i e s and, i n p a r t i c u l a r J e f f r e y B e r s t e i n , "The E f f e c t of D i r e c t and I n d i r e c t Tax I n c e n t i v e s on Canadian I n d u s t r i a l R&D E x p e n d i t u r e s " (September, 1986), 12 Canadian P u b l i c P o l i c y 438-48. As summarized a t 32:10, u s i n g 1984 parameters, B e r s t e i n "estimates t h a t a 1 p e r c e n t r i s e i n t h e ( e f f e c t i v e ) R&D t a x c r e d i t r a t e reduces t h e user c o s t o f R&D c a p i t a l by 0.07 p e r c e n t . Combining t h i s r e s u l t with h i s empirical f i n d i n g s i n d i c a t e s that a 1 percent i n c r e a s e i n t h e ( e f f e c t i v e ) R&D t a x c r e d i t r a t e s s t i m u l a t e s t h e demand f o r R&D c a p i t a l by about 0.01 p e r c e n t , o r over $1,045 m i l l i o n i n t h e s h o r t run, based on an e s t i m a t e d R&D c a p i t a l s t o c k f i g u r e i n 1984 o f $10 b i l l i o n . When t h e induced output supply e f f e c t i s taken i n t o account, t h e s t i m u l u s i s as h i g h as $2.2 m i l l i o n , depending on t h e assumed s e n s i t i v i t y o f output demand t o p r i c e changes. I n r e l a t i o n t o budgetary c o s t , t h e R&D t a x c r e d i t r a t e i s found t o c r e a t e $.80 o f a d d i t i o n a l R&D e x p e n d i t u r e s p e r d o l l a r o f forgone ( f e d e r a l and p r o v i n c i a l ) t a x revenues. When output expansion e f f e c t s are taken i n t o account, t h e a d d i t i o n a l R&D e x p e n d i t u r e s a r e found t o i n c r e a s e by more than t h e d o l l a r c o s t t o government." 131  1 3 2  P. Mohnen, supra, a t 44.  See Kenneth J . Murray, "Recent Developments i n R&D Tax I n c e n t i v e s " , supra, a t 9:21 f o r a c a l c u l a t i o n o f a f t e r - t a x c o s t t o a l a r g e US company o f p e r f o r m i n g R&D i n house o r c o n t r a c t e d out t o another l a r g e US R&D performer v e r s u s t h e a f t e r t a x c o s t t o 1 3 3  112 However,  given  differences  i n national  t a x systems,  and t h e  i n t e r a c t i o n o f those systems, i t may be d i f f i c u l t t o use such t a x e x p e n d i t u r e s t o induce f o r e i g n f i r m s t o move t h e i r R&D a c t i v i t i e s t o Canada. tax  134  A l s o , i f a MNE c a r r i e s out R&D a c t i v i t i e s  jurisdiction,  greater  than  relatively country.  the e f f e c t i v e  after-tax  cost  of that  i t i f were done i n a h i g h t a x c o u n t r y  higher  value  i n a lowR&D i s  due t o t h e  of the tax i n c e n t i v e s i n the high tax  Therefore, a l l other things being equal, the g l o b a l tax-  m i n i m i z i n g s t r a t e g y o f an MNE would r e q u i r e R&D t o be performed i n the  high-tax  another  country  division  transfer price.  1 3 5  and t h e technology  o f t h e MNE  t o be t r a n s f e r r e d t o  i n a low t a x c o u n t r y  Consider t h e f o l l o w i n g :  at a  minimal  1 3 6  In r e g a r d t o Canada's p o s i t i o n as h o s t t o many foreign-owned s u b s i d i a r i e s , t h e charge i s f r e q u e n t l y made t h a t these s u b s i d i a r i e s do n o t do t h e amount o f R and D i n Canada t h a t c o u l d be expected o f them g i v e n t h e i r s i z e and i n d u s t r i a l character. S i n c e Canada i s t h e "low-tax c o u n t r y " from t h e vantage p o i n t o f most s u b s i d i a r i e s here, t h i s a l l o c a t i o n o f R and D a c t i v i t y appears t o be c o n s i s t e n t w i t h t h e g l o b a l t a x m i n i m i z i n g s t r a t e g y o u t l i n e d above. However, i t i s an empirical question whether domestic taxation or the international structure of taxation influence, either p o s i t i v e l y o r n e g a t i v e l y , t h e c u r r e n t s t a t e o f Canada's aggregate R and D e f f o r t . That s t a t e , t o be a b i t more s p e c i f i c , i s r e f l e c t e d i n t h e f a c t t h a t R and D e x p e n d i t u r e i n Canada as a percentage o f GNP accounts f o r approximately h a l f what i t i s i n o t h e r i n d u s t r i a l i z e d c o u n t r i e s . The p r i v a t e i n d u s t r i a l s e c t o r undertakes about 40 p e r c e n t o f t h e t o t a l amount o f R and D. Canadian R&D performers. 1 3 4  D. McFetridge and J . Warda, supra. a t 91 - 92.  1 3 5  See Chapter  4 f o r a d i s c u s s i o n of t r a n s f e r p r i c i n g .  Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n : The Canadian P e r s p e c t i v e " , Canadian Tax Paper No. 75 (Toronto: Canadian Tax Foundation, 1984), 132 - 133. 1 3 6  113 Another c o n s i d e r a t i o n i n seeking t o j u s t i f y R&D t a x i n c e n t i v e s i s t h a t , d e s p i t e Canada o f f e r i n g some o f t h e most generous domestic tax  policies  regarding  R&D  expenditures,  the r e l a t i v e l y  poor  investment i n r e s e a r c h and development by Canadian p r i v a t e i n d u s t r y may be e x p l a i n e d  p r i m a r i l y by t h e s m a l l Canadian m a r k e t :  137  Canadian i n d u s t r y i s a t a comparative disadvantage i n R and D. The expected b e n e f i t s from i n n o v a t i o n a r e s m a l l due t o t h e s i z e o f t h e Canadian market and l i k e w i s e t h e c o s t o f R and D, s i m i l a r t o any overhead, i s h i g h on a u n i t b a s i s because i t must be spread over a s m a l l e r income base. I t i s q u e s t i o n a b l e whether Canadian t a x i n c e n t i v e s , d e s p i t e v a r i o u s forms and i n c r e a s i n g g e n e r o s i t y , a r e a b l e t o o f f s e t s u b s t a n t i a l l y these fundamental c o s t c o n s i d e r a t i o n s . The i n t e r n a t i o n a l s t r u c t u r e o f t a x a t i o n encourages t h e growth of f o r e i g n investment i n Canada. M u l t i n a t i o n a l f i r m s i n Canada are g e n e r a l l y r e s e a r c h - i n t e n s i v e . Although t h i s brings technology t o Canada, i t does not b r i n g as much o f t h e p r o c e s s f o r d e v e l o p i n g technology as might be expected. The reason i s that multinational corporations c e n t r a l i z e t h e i r research a c t i v i t y , which u s u a l l y means they do i t a t home. While t h i s i s p r i m a r i l y e x p l a i n e d by t h e economics o f R and D, an a d d i t i o n a l c o n s i d e r a t i o n i s t h e f a c t t h a t i n c e n t i v e s f o r R and D i n t h e home country do not apply t o r e s e a r c h done abroad. Of course, r e s e a r c h done i n Canada i s rewarded by Canadian t a x write-offs. One can conclude t h a t R and D c a r r i e d out by f o r e i g n s u b s i d i a r i e s i n Canada e i t h e r must be done here because o f p a r t i c u l a r l o c a l c o n d i t i o n s o r i s done here e s s e n t i a l l y t o c a p i t a l i z e on t a x i n c e n t i v e s t h a t exceed i n c e n t i v e s a t home. In t h e f i r s t case, i n c e n t i v e s become g i f t s . In t h e second, t h e g i f t s a r e t h e i n c e n t i v e . In e i t h e r case, Canada pays t o have R and D c a r r i e d out here when i t c o u l d r e c e i v e t h e t e c h n o l o g i c a l b e n e f i t s a t no e x t r a f i s c a l cost. Finally,  i t has been suggested t h a t t h e p o s s i b i l i t y  exists  t h a t i n a l l c o u n t r i e s R&D a c t i v i t i e s t h a t a r e s o c i a l l y b e n e f i c i a l are not undertaken because they a r e not p r i v a t e l y b e n e f i c i a l - a  i b i d . , a t 135 - 136. A l s o see 1994 AG's Report, supra. v o l . 6 a t 9-12 r e g a r d i n g Canada's poor performance i n s c i e n c e and technology. 1 3 7  114 problem t h a t cannot be s o l v e d by Canada a l o n e :  1 3 8  Indeed, as a l r e a d y i n d i c a t e d , i t i s not n e c e s s a r i l y i n Canada's i n t e r e s t t o p r o v i d e f o r s u b s t a n t i a l l y more generous tax treatment of R&D than do o t h e r i n d u s t r i a l c o u n t r i e s . In a world where technology can be developed i n one l o c a t i o n and used without compensation i n many o t h e r s , one may appeal t o the taxpayers of a s m a l l country t o p r o v i d e a h i g h l e v e l of support f o r R&D on a l t r u i s t i c grounds. An appeal based on s e l f - i n t e r e s t would be much more d i f f i c u l t t o s u s t a i n . Research  and development are important  growth r a t e , y e t s t i m u l a t i n g R&D of t a x  incentives:  t o Canada's economic  depends on more than the p r o v i s i o n  1 3 9  Tax i n c e n t i v e s f o r R and D v e n t u r e s are one u s e f u l p o l i c y tool. However, alone they w i l l tend t o be relatively i n e f f e c t i v e i n enhancing Canada's R and D e f f o r t s and i n t u r n the a b i l i t y of Canadian f i r m s t o compete i n t e r n a t i o n a l l y . 1 4 0  1 3 8  D. McFetridge and J . Warda, supra. a t  91.  F r e d Lazar, The New P r o t e c t i o n i s m : N o n - T a r i f f B a r r i e r s and T h e i r E f f e c t s on Canada (Toronto: James Lorimer & Company i n a s s o c i a t i o n w i t h the Canadian I n s t i t u t e f o r Economic P o l i c y , 1981), at 71. 1 3 9  Lazar, i b i d . suggests, a t 71 - 73, t h a t "government c o u l d enhance i t s R and D tax i n c e n t i v e s by u n d e r t a k i n g programs aimed a t r a t i o n a l i z i n g Canadian f i r m s and i n c r e a s i n g t h e i r domestic markets t o enable them t o grow l a r g e enough t o support a continuous R and D program independently... Thus a major component of an o v e r a l l i n d u s t r i a l s t r a t e g y should be a package or programs t h a t enhances the procurement and supply p o t e n t i a l f o r Canadian f i r m s i n the domestic economy." Lazar suggests a number of o p t i o n s t o t h i s end i n c l u d i n g : the f e d e r a l government c o u l d d i r e c t a l l i t s p u r c h a s i n g , wherever p o s s i b l e and reasonable, towards C a n a d i a n - c o n t r o l l e d f i r m s and f o r e i g n c o n t r o l l e d f i r m s t h a t comply w i t h a code of good c o r p o r a t e behaviour; the f e d e r a l government c o u l d i n s i s t t h a t i t s crown c o r p o r a t i o n s pursue the same procurement p o l i c y ; the f e d e r a l government c o u l d use i t s r e g u l a t o r y agencies t o t r y t o i n c r e a s e the share of the domestic market a v a i l a b l e t o C a n a d i a n - c o n t r o l l e d f i r m s of f o r e i g n f i r m s meeting the code of good c o r p o r a t e behaviour; the f e d e r a l government c o u l d e x p l o r e the f e a s i b i l i t y of r e s t r u c t u r i n g the c o r p o r a t e tax system t o encourage companies t o i n c r e a s e t h e i r use of Canadian f i r m s as s u p p l i e r s of c a p i t a l goods and p a r t s ; and any f i r m r e c e i v i n g government l o a n s , g r a n t s or o t h e r forms of a s s i s t a n c e should be r e q u i r e d by c o n t r a c t t o g i v e p r e f e r e n t i a l access t o Canadian s u p p l i e r s . Lazar i s a l s o of t h e view, a t 79, 1 4 0  f  115 F a c t o r s such as h i s t o r i c a l and c o r p o r a t e development,  social  s t r u c t u r e s , c u l t u r a l f a c t o r s , i n t e r n a t i o n a l marketing c a p a b i l i t i e s , and  government p o l i c i e s  entrepreneurship  aimed a t promoting e x p o r t s ,  and p r i v a t e e n t e r p r i s e ,  as w e l l  as  investment, developing  human c a p i t a l through s c i e n c e , e d u c a t i o n and manpower p o l i c i e s a l l impact  on t h e l e v e l  o f R&D.  141  Therefore,  i t i s worthwhile t o  e x p l o r e a l t e r n a t i v e s t o t h e e x i s t i n g R&D t a x programs. C. The Need For R e v i s i o n In 1994, t h e N a t i o n a l A d v i s o r y Board on S c i e n c e and Technology recommended t h a t t h e government o f Canada manage i t s investment i n s c i e n c e and technology  as a d i s t i n c t s t r a t e g i c a s s e t .  I t appeared  t o t h e Board t h a t budget d e c i s i o n s o f t h e f e d e r a l government have "reflected  historical  incrementalism  rather  than  strategic  management o f a n a t i o n a l a s s e t . " I t a l s o appeared t o t h e Board t h a t "the  government  technology  resources  objectives. the  1 1 1 4 2  Secretary  launched  lacks  a  activities.  the c a p a b i l i t y i n a way  that  t o a l l o c a t e science reflects  broad  and  government  On June 28, 1994, t h e M i n i s t e r o f I n d u s t r y and of State  major  f o r Science,  review  of  Research  federal  and Development,  science  and  technology  T h i s study i s expected t o p r o v i d e a c r i t i c a l b a s i s f o r  t h a t : "The Canadian government should go ahead and formulate an i n d u s t r i a l strategy regardless of the p o s s i b i l i t y that c e r t a i n p o l i c y measures may v i o l a t e GATT and c o u l d l e a d t o r e t a l i a t i o n by the U n i t e d S t a t e s . " In my o p i n i o n , though some o f these suggestions may have had some m e r i t i n 1981, they a r e not f e a s i b l e today g i v e n the nature o f t h e g l o b a l market p l a c e , t h e expansion o f f r e e t r a d e and developments i n NAFTA and GATT s i n c e 1981. 141  i b i d . . a t 59.  1 4 2  1994 AG's Report, supra, v o l . 1, a t 1-18.  116 Canada's f u t u r e R&D  strategy.  1 4 3  Thus, i t appears t h a t t h e e x i s t i n g R&D t a x i n c e n t i v e program i s f a r from immutable. I f t h e c u r r e n t t a x i n c e n t i v e program i s not meeting t h e s t a t e d o b j e c t i v e s , and i f t h e r e  i s a possibility  that  Canadian R&D t a x i n i t i a t i v e s may be s u b j e c t t o d i s c i p l i n a r y a c t i o n under t h e SCM Agreement, t h e system i s i n need o f r e v i s i o n . Given  that  Canada has o n l y  modest  resources  to invest i n  s c i e n c e and technology compared w i t h other developed n a t i o n s , i t i s e s s e n t i a l that resources potential  payback.  well focused. of  return  research publicly  144  Yet t h e c u r r e n t  R&D  tax incentives  a r e not  F o r example, i t has been shown t h a t h i g h e r  145  a r e obtained or  be i n v e s t e d i n areas o f g r e a t e s t need and  from  development,  funded  R&D  147  146  basic from  and from  R&D  research company geared  than  from  financed t o new  rates  applied  R&D  over  p r o c e s s e s as  i b i d . . v o l . 6 a t 9-12. T h i s Report i s expected t o be complete i n 1995, but was not a v a i l a b l e a t t h e time o f w r i t i n g . 143  i b i d . , v o l . 6, 9-16. The Report suggests t h e need t o boost c o o p e r a t i o n between f e d e r a l and p r o v i n c i a l governments, i n d u s t r y and u n i v e r s i t i e s . A c e n t r a l o f f i c e t o monitor technology p r o j e c t s throughout t h e government i s a l s o recommended. 1 4 4  145  i b i d . . v o l . 6, a t 9-16 t o 9-17.  P. Mohnen, supra. a t 44, concludes t h a t b a s i c r e s e a r c h i s l i k e l y t o have t h e h i g h e s t s o c i a l r a t e s o f r e t u r n and be l e s s privately-appropriable. 146  i b i d . . a t 44; Mohnen concludes t h a t d e s p i t e t h e s t r o n g evidence o f a h i g h e r r a t e o f r e t u r n on p r i v a t e l y - f u n d e d R&D, u s e f u l p u b l i c support i n b a s i c r e s e a r c h i s important f o r " t o t a l f a c t o r p r o d u c t i v i t y growth", and t h a t t h e knowledge c o n t r i b u t i o n from government agencies and r e s e a r c h l a b s i s a s i g n i f i c a n t determinant of R&D i n t e n s i t y . 1 4 7  117 opposed  to  new  e f f e c t s of R&D R&D  support  products.  Further,  148  are s u b s t a n t i a l , i t may  at  c e r t a i n key  sectors  s o c i a l r a t e s of r e t u r n are the Another  factor  that  has  of  the  spillover  economy where  these  1 4 9  determined  important i n a c h i e v i n g h i g h r a t e s of r e t u r n on R&D s c i e n t i f i c knowledge b a s e :  the  be more e f f e c t i v e t o t a r g e t  highest. been  although  to  be  extremely  support, i s the  150  In t h i s r e s p e c t , the l o c a t i o n of r e s e a r c h l a b s near c e r t a i n types of academic r e s e a r c h c e n t e r s , the f u n d i n g of academic r e s e a r c h and, where p o s s i b l e , the l o c a t i o n a l c o n c e n t r a t i o n of academic f a c i l i t i e s i n order t o induce p r i v a t e r e s e a r c h might be wise d e c i s i o n s . . . P o l i c y d e c i s i o n s f o r s t i m u l a t i n g R&D  should take these f a c t o r s  i n t o c o n s i d e r a t i o n as w e l l as i n t e r n a t i o n a l agreements such as SCM  Agreement  effective  at  to  ensure  achieving  that  national  revised  tax  objectives  incentives  are  while minimizing  exposure of such programs t o i n t e r n a t i o n a l s a n c t i o n s .  the more the  151  CONCLUSION To  succeed  i n the  g l o b a l marketplace  e i t h e r a s t r a t e g i c i n t e r e s t i n the R&D  1 4 8  i b i d . . at  businesses  must  have  e f f o r t s of o t h e r s which can  43.  i b i d . , a t 43. Mohnen's study concluded t h a t these key s e c t o r s i n c l u d e chemicals, n o n - e l e c t r i c a l machinery and s c i e n t i f i c instruments. 149  150  i b i d . . at  44.  See Mark A.A. Warner and A l a n M. Rugman, supra who suggest t h a t Canada should "pursue an a p p r o p r i a t e i n t e r n a t i o n a l d i s c i p l i n e for p r o t e c t i o n i s t investment, a n t i - t r u s t and R&D policies" notwithstanding recent U.S. initiatives which may violate fundamental p r i n c i p l e s i n the GATT (at 428). 151  118 be  incorporated  l e a d i n g t o new which  enable  into their  more  152  or  indigenous  efficient  production.  Tax  153  R&D  advancements support  for  i s b e l i e v e d t o a s s i s t t e c h n o l o g i c a l development i n  a number of ways:  154  direct  knowledge  operations,  product development or t e c h n o l o g i c a l  indigenous R&D  1.  own  benefits  leading  development of new  to  to  the  reduced  R&D  unit  performer  production  of  increased  costs  and  the  p r o d u c t s and p r o c e s s e s f o r s a l e or a p p l i c a t i o n ;  2.  b e n e f i t s of s p i n o f f t e c h n o l o g i c a l a p p l i c a t i o n s ;  3.  pushing f i r m s t o t e c h n o l o g i c a l f r o n t i e r s a l l o w i n g them t o  imitate guickly; 4.  and  spillover  benefits conferred  upon those c o n d u c t i n g  the  R&D. Despite i n d u s t r y has other open  Canada's generous tax performed p o o r l y  industrial nations. to  attack  t a x p a y e r s , and  under not  over the p a s t If  155  the  SCM  achieving  incentives  the  Canada's  that  Canada's R&D  tax  tax  policies  subj e c t  to  abuse  to are by  stated objectives, i t i s timely  t h a t Canada's o v e r a l l s t r a t e g y f o r R&D be  Canadian  20 y e a r s r e l a t i v e R&D  Agreement,  f o r R&D,  incentives  i s being reviewed. are  not  the  most  It  may  effective  Government p o l i c i e s which enhance market a c c e s s and f a c i l i t a t e flow of c a p i t a l i n f l u e n c e the a d o p t i o n and d i f f u s i o n of new technology. W.S. C l a r k , e t . a l . , supra. a t 32:3. 1 5 2  153  i b i d . . at  32:2.  154  i b i d . . a t 32:3  -  32:4.  J u d i t h Maxwell, C h a i r of the Economic C o u n c i l of Canada ( c l o s e d i n June 1992) i n foreword t o P. Mohnen, supra. a t v i i ; and 1994 AG's Report, supra. v o l . 16 a t 9-12. 155  119 means of Canadian  stimulating research government  does not  a f f o r d t o support a l l R&D; R&D  compared w i t h  they are spending  other  and  development  have the  luxury  i n Canada. of  being  The  able  Canada has modest r e s o u r c e s t o i n v e s t i n industrialized  c o u n t r i e s so must  ensure  t o Canada's economic and  social  effectively.  Given the importance of R&D  agenda, these n a t i o n a l o b j e c t i v e s must be g i v e n p r i o r i t y over f r e e t r a d e o b j e c t i v e , but The  SCM  to  Agreement  the  latter  establishes  should  be  disregarded. what  its  s i g n a t o r i e s c o n s i d e r t o be a c c e p t a b l e s u b s i d i z a t i o n , f o r R&D,  and  promotes g e n e r a l p r i n c i p l e s  of  parameters  not  the  free  trade.  regarding  To  the  extent  that  these parameters and p r i n c i p l e s are adaptable t o a r e v i s e d Canadian agenda f o r R&D,  the SCM Agreement may  provide u s e f u l guidelines i n  r e v i s i n g Canadian tax i n c e n t i v e s f o r R&D w h i l e l i m i t i n g exposure of these i n c e n t i v e s t o i n t e r n a t i o n a l s a n c t i o n .  120 CHAPTER 4 TRANSFER PRICING T r a n s f e r p r i c i n g i s one o f t h e most c o n t r o v e r s i a l t a x i s s u e s of t h e 1990s. During t h e l a s t decade, n a t i o n a l b a r r i e r s t o the f r e e flow o f i n t e r n a t i o n a l t r a d e and investment have been s u b s t a n t i a l l y eased and i n many cases removed a l t o g e t h e r . The g l o b a l i z a t i o n o f t h e economy has p r o v i d e d multinational e n t e r p r i s e s w i t h i n c r e a s e d o p p o r t u n i t i e s t o minimize t a x by s e l e c t i v e l y a l l o c a t i n g income and expenses among domestic and foreign entities. National governments have become i n c r e a s i n g l y concerned about p r o t e c t i n g t h e i r domestic t a x bases from t h i s type o f t a x avoidance. Moreover, both governments and m u l t i n a t i o n a l e n t e r p r i s e s must c o n f r o n t t h e problem o f a l l o c a t i n g t a x revenues among c o u n t r i e s on an equitable basis. 1  INTRODUCTION Many t r a n s a c t i o n s take p l a c e between members o f m u l t i n a t i o n a l  B r i a n J . A r n o l d and Thomas E. McDonnell, "Report on t h e I n v i t a t i o n a l Conference on T r a n s f e r P r i c i n g : The A l l o c a t i o n o f income and Expenses Among C o u n t r i e s " (1993), v o l . 41, No. 5 Canadian Tax J o u r n a l 899-922, a t 901. The OECD has been working f o r s e v e r a l y e a r s on t r a n s f e r p r i c i n g r u l e s and has p u b l i s h e d a number of r e p o r t s which a r e r e f e r r e d t o throughout t h i s Chapter: OECD, T r a n s f e r P r i c i n g and M u l t i n a t i o n a l E n t e r p r i s e s . Report o f t h e OECD Committee on F i s c a l A f f a i r s ( P a r i s : OECD, 1979), (the "1979 R e p o r t " ) ; OECD, T r a n s f e r P r i c i n g and M u l t i n a t i o n a l E n t e r p r i s e s : Three T a x a t i o n Issues. Report o f t h e OECD Committee on F i s c a l A f f a i r s ( P a r i s : OECD, 1984) (the "1984 R e p o r t " ) ; OECD, Tax Aspects of T r a n s f e r P r i c i n g W i t h i n M u l t i n a t i o n a l E n t e r p r i s e s : The U n i t e d S t a t e s Proposed R e g u l a t i o n s . Report o f t h e Committee on F i s c a l A f f a i r s on t h e Proposed R e g u l a t i o n s Under S e c t i o n 482 IRC ( P a r i s : OECD, 1993) (the "1993 Report"); OECD, Intercompany Transfer P r i c i n g R e g u l a t i o n s Under US S e c t i o n 482 Temporary and Proposed R e g u l a t i o n s ( P a r i s : OECD, 1993). A r e v i s i o n o f t h e 1979 and 1984 r e p o r t s i s expected t o be completed by mid-1995; a d i s c u s s i o n d r a f t on P a r t I ( " P r i n c i p l e s and Methods"), OECD T r a n s f e r P r i c i n g G u i d e l i n e s f o r M u l t i n a t i o n a l E n t e r p r i s e s and Tax A d m i n i s t r a t i o n s ( P a r i s : OECD, 1994) (the "1994 D r a f t , P a r t I") was r e l e a s e d on J u l y 8, 1994 and reproduced i n "Tax P o l i c y Forum", Tax Notes I n t e r n a t i o n a l , J u l y 18, 1994, 155 - 187; a d i s c u s s i o n d r a f t on P a r t I I ( " A p p l i c a t i o n s " ) , (the "1994 D r a f t , P a r t II") was r e l e a s e d on March 8, 1995 and reproduced i n "Tax A n a l y s t s " , Tax Notes I n t e r n a t i o n a l . March 16, 1995 (on L e x i s : 95 TNI 51-1). 1  121 enterprises  ("MNEs"),  2  including  sale  o f goods,  i n t a n g i b l e s and t h e p r o v i s i o n o f s e r v i c e s . that  major MNEs w i l l  transactions  have,  3  l i c e n s i n g of  I t has been e s t i m a t e d  a t any one time,  i n excess  o f 200  between e n t i t i e s which may be s e n s i t i v e t o t r a n s f e r  p r i c i n g i n a number o f c o u n t r i e s .  4  The term " t r a n s f e r p r i c i n g " i s  1979 Report, supra. a t 11, f o o t n o t e 2. The OECD has n o t found i t necessary to define precisely the expression "multinational enterprise" i n reference to transfer pricing g u i d e l i n e s , but r e f e r t o t h e OECD G u i d e l i n e s f o r M u l t i n a t i o n a l E n t e r p r i s e s , paragraph 8: 2  A p r e c i s e l e g a l d e f i n i t i o n o f m u l t i n a t i o n a l e n t e r p r i s e s i s not r e q u i r e d f o r t h e purposes o f t h e g u i d e l i n e s . These u s u a l l y comprise companies o r o t h e r e n t i t i e s whose ownership i s p r i v a t e , S t a t e o r mixed, e s t a b l i s h e d i n d i f f e r e n t c o u n t r i e s and so l i n k e d t h a t one o r more o f them may be a b l e t o e x e r c i s e a s i g n i f i c a n t i n f l u e n c e over t h e a c t i v i t i e s o f o t h e r s and, i n p a r t i c u l a r , t o share knowledge and r e s o u r c e s w i t h t h e o t h e r s . The degree o f autonomy o f each e n t i t y i n r e l a t i o n t o t h e o t h e r s v a r i e s w i d e l y from one m u l t i n a t i o n a l e n t e r p r i s e t o another, depending on t h e nature o f t h e l i n k s between such e n t i t i e s and t h e f i e l d s o f a c t i v i t y concerned. A l s o see J i l l C. Pagan and J . S c o t t W i l k i e , T r a n s f e r P r i c i n g S t r a t e g y i n a G l o b a l Economy (The N e t h e r l a n d s : IBFD P u b l i c a t i o n s , 1993), a t 22 - 26 f o r an overview o f t h e e s s e n t i a l s o f a MNE. R a r e l y w i l l t h e r e be t r a n s a c t i o n s between e n t i t i e s o f a m u l t i n a t i o n a l e n t e r p r i s e which i n v o l v e t h e s a l e o r purchase o f f i n i s h e d goods without any support s e r v i c e s , o r a t l e a s t without i m p l i c i t t r a n s f e r s o f i n t e l l e c t u a l p r o p e r t y and o t h e r i n t a n g i b l e s developed w i t h i n a MNE. Examples i n c l u d e t h e s h a r i n g o f c o s t s f o r the development o f technology, o r know-how, and how i n t r a - g r o u p p r i c i n g o f t h e f i n i s h e d p r o d u c t s o r s e r v i c e s r e f l e c t s t h i s ; and t h e e s t a b l i s h m e n t o f t h e p r i c e f o r access t o technology, o r know-how, or product d i s t r i b u t i o n , o r p r o d u c t i o n r i g h t s , as, f o r example, r e f l e c t e d i n t h e b a s i s o f a r o y a l t y r a t e charged f o r a l i c e n c e . ( J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 9 9 ) . 3  J i l l C. Pagan and J . S c o t t W i l k i e , supra, a t 102. A l s o see Donald J.S. Brean, "Here o r There: The Source and Residence P r i n c i p l e s o f I n t e r n a t i o n a l T a x a t i o n " , i n " T a x a t i o n t o 2000 and Beyond", Canadian Tax Paper No. 93 (Toronto: Canadian Tax Foundation, 1992) 303 a t 321 which e s t i m a t e s more than 70% o f Canada-US b i l a t e r a l t r a d e i s non-arm's l e n g t h i n t r a - f i r m t r a d e (Brean c i t e s A l a n M. Rugman, M u l t i n a t i o n a l s and Canada-United 4  122 generally  used  t o describe  corporate  p r o f i t s f o r t a x purposes  between members o f a MNE.  and r e p o r t i n g  arising  from  r e s u l t s i n income t o t h e t r a n s a c t i o n  of  transactions  An a c c e p t a b l e t r a n s f e r p r i c e  5  that  t h e measurement  i s one  p a r t i c i p a n t s which i s  r e a s o n a b l y commensurate w i t h t h e i r p r o d u c t i v e c a p a c i t i e s as members of,  and w i t h t h e i r a c t u a l It  prices  i s generally charged  contributions  accepted  f o r transfers  that  to,  t h e economic  tax factors  unit.  6  may a f f e c t t h e  between members o f a MNE.  7  Indeed,  shrewd s e l e c t i o n o f a t r a n s f e r p r i c e may enable a MNE t o i n c r e a s e overall  after  jurisdictions. theoretically firms.  8  tax earnings This  ability  by  shifting  t o manipulate  profits transfer  to  low t a x  prices  p u t MNEs a t a comparative advantage over  may  domestic  However, t h e Canadian and i n t e r n a t i o n a l t r a n s f e r p r i c i n g  S t a t e s Free Trade (Columbia, SC: U n i v e r s i t y o f South C a r o l i n a P r e s s , 1990) chapter 3) . See a l s o t h e 1993 Report, supra. a t 1, which s t a t e s t h a t MNEs "have come t o p l a y a dominant r o l e i n t h e i n t e r n a t i o n a l t r a d e arena, a c c o u n t i n g f o r more t h a t 50 p e r cent o f international transactions. F o r s t a t i s t i c s on t h e importance o f t r a n s f e r p r i c i n g t o Canada see Roger Y.W. Tang, T r a n s f e r P r i c i n g i n the 1990s: Tax and Management P e r s p e c t i v e s . ( C o n n e c t i c u t : Quorum Books, 1993) a t 33 - 37. 11  5  Jill  C. Pagan and J . S c o t t W i l k i e ,  6  i b i d . . a t 229.  1979 Report, supra. a t 7. nature o f t h e payments. 7  supra. a t 99 - 100.  Tax f a c t o r s may a l s o a f f e c t t h e  G.F. Mathewson and G.D. Q u i r i n , F i s c a l T r a n s f e r P r i c i n g i n M u l t i n a t i o n a l E n t e r p r i s e s (Toronto: U n i v e r s i t y o f Toronto P r e s s , 1979) a t 1. The authors conclude, however (Chapter 9) t h a t t h e r e i s an o f f s e t t i n g nature t o taxes and t a r i f f s ( i f t r a n s f e r s p r i c e s are manipulated so as t o r e s u l t i n h i g h p r o f i t s i n a low t a x j u r i s d i c t i o n , t h e t a r i f f a t t h e border w i l l be h i g h which o f f s e t s the low income t a x ) . T h i s s e l f - p o l i c i n g mechanism d i s a p p e a r s as t a r i f f b a r r i e r s are eliminated. See a l s o 1994 D r a f t , P a r t I , supra. a t 171 r e g a r d i n g o f f s e t t i n g i n c e n t i v e s i n s e t t i n g v a l u e s f o r 8  123 regimes attempt t o remove any i n c e n t i v e MNEs may have t o manipulate transfer  prices  f o r tax  purposes.  Indeed,  in  economic  terms,  t r a n s f e r p r i c i n g has the p o t e n t i a l t o be as g r e a t , or g r e a t e r , a trade  barrier  welfare.  1 0  than  customs  F u r t h e r , the  distinguish  ITA  duties  rules  between r e s i d e n t s and  customs and income t a x  9  and  relating  may  reduce  to transfer  non-residents,  and  global pricing,  appear  on  purposes.  Norman C. Loveland, Canadian Issues i n T r a n s f e r P r i c i n g under the North American Free Trade Agreement, paper p r e s e n t e d a t the International F i s c a l Association, 1994 Annual Congress, Toronto, Canada, August, 1994 a t 5. 9  Robert Z. A l i b e r , " T r a n s f e r P r i c i n g : A Taxonomy of Impacts on Economic Welfare", i n A. Rugman and L. Eden, eds., M u l t i n a t i o n a l s and T r a n s f e r P r i c i n g (London: Croom Holm, 1985), 82 - 97, a t 96: " I f c o r p o r a t e t a x r a t e s are i d e n t i c a l a c r o s s c o u n t r i e s , no i n c e n t i v e e x i s t s t o manage t r a n s f e r p r i c i n g t o s h i f t income among t a x j u r i s d i c t i o n s ; a f t e r - t a x r a t e s of r e t u r n are i d e n t i c a l . I f t a x r a t e s are r a i s e d or lowered i n one country, a wedge i s d r i v e n between b e f o r e - t a x r a t e s of r e t u r n i n the s e v e r a l c o u n t r i e s , and c a p i t a l flows towards the c o u n t r y w i t h t h e lower t a x rates. The consequence of t h i s s h i f t adjustment i s t h a t economic w e l f a r e d e c l i n e s on both a g l o b a l b a s i s and i n t h e h i g h e r t a x country. The impact of t r a n s f e r p r i c i n g by the m u l t i n a t i o n a l f i r m t o s h i f t income from the h i g h t a x j u r i s d i c t i o n t o the low t a x j u r i s d i c t i o n i s t o undo p a r t i a l l y or r e v e r s e the w e l f a r e - r e d u c i n g impact of the i n c r e a s e i n the t a x r a t e , so l e s s p r o d u c t i o n i s d i v e r t e d from t h i s j u r i s d i c t i o n . T r a n s f e r p r i c i n g a l s o reduces the r e s e r v e s of the t a x c o l l e c t o r i n the h i g h - t a x j u r i s d i c t i o n w h i l e i n c r e a s i n g economic w e l f a r e . The d i s t r i b u t i o n of the g a i n s r e a l i z e d from the t a x s a v i n g s a t t r i b u t a b l e t o t r a n s f e r p r i c i n g depends on the c o m p e t i t i v e n e s s of goods markets and of f a c t o r markets; i f taxes are s h i f t e d forward, t h e g a i n s w i l l be r e a l i z e d by the consumers i n the form of lower p r i c e s . T h i s r e s u l t appears p e r v a s i v e a c r o s s the v a r i o u s measures t h a t segment n a t i o n a l markets. Measures t h a t segment n a t i o n a l markets f o r goods or f a c t o r s r a i s e economic w e l f a r e i n the c o u n t r y a d o p t i n g these measures but a t the expense of g l o b a l w e l f a r e . T r a n s f e r p r i c i n g tends t o l e s s e n the g l o b a l w e l f a r e - r e d u c i n g impact of these measures, and thus undercuts the e f f o r t s of the s t a t e t o e x e r c i s e i t s monopoly power. C r i t i c i s m s of t r a n s f e r p r i c i n g as a w e l f a r e d e c r e a s i n g a c t i v i t y are e x e r c i s e s i n m i s p l a c e d c o n c r e t e n e s s . " 1 0  124 t h e i r face t o discriminate against This and  non-residents.  Chapter reviews and e v a l u a t e s  relevant  international  provisions,  11  t h e Canadian ITA r u l e s , pertaining  to transfer  p r i c i n g t o determine the p o t e n t i a l l y d i s c r i m i n a t o r y consequences o f the c u r r e n t t r a n s f e r p r i c i n g regime on t h e a l l o c a t i o n o f r e s o u r c e s and  economic a c t i v i t y o f MNEs.  12  PART I THE  NATURE OF TRANSFER PRICING  T r a n s f e r p r i c i n g i s an important i s s u e f o r t a x a u t h o r i t i e s and MNEs a l i k e .  Tax a u t h o r i t i e s f a c e p o t e n t i a l e r o s i o n  of t h e i r tax  base, l o s s o f t a x revenues and i n c u r time and expense  administering  and i n v e s t i g a t i n g compliance w i t h t r a n s f e r p r i c i n g p r o v i s i o n s . MNEs are c o n f r o n t e d  with uncertainty  i n s e l e c t i n g and a p p l y i n g  transfer  p r i c i n g methods ( d e s p i t e t a x a u t h o r i t y e f f o r t s t o d e l i n e a t e how and when t o apply a c c e p t a b l e methods), h i g h compliance c o s t s and r i s k of p e n a l t i e s , i n t e r e s t and double t a x a t i o n . Despite  t h e importance  of transfer  1 3  pricing,  the  current  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t A l i e n s , NonR e s i d e n t s , and F o r e i g n A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the U n i t e d Kingdom, and t h e U n i t e d S t a t e s " , Canadian Tax Paper No. 90, (Toronto: Canadian Tax Foundation, 1991) a t 12. 11  U n l i k e t h e p r e v i o u s two Chapters, t h i s Chapter does not engage i n a d e t a i l e d a n a l y s i s o f any p a r t i c u l a r GATT p r o v i s i o n . Rather t h e s o v e r e i g n t y / f r e e - t r a d e dichotomy i s e x p l o r e d g e n e r a l l y through examination o f a v a r i e t y o f t r a n s f e r p r i c i n g i s s u e s which may a f f e c t MNEs thereby s h i f t i n g t h e balance i n f a v o u r of p r o t e c t i o n i s m over f r e e t r a d e . 12  See L. Franko, M. Patton, J . Wheeler and C. T r i p l e t t , "The I n t e r n a t i o n a l Tax Showdown", The I n t e r n a t i o n a l Tax J o u r n a l , Vol.20, No. 3, Summer 1994, 1 f o r an i n f o r m a t i v e , open forum debate on t r a n s f e r p r i c i n g i s s u e s , p a r t i c u l a r l y t h e U.S. r e g u l a t i o n s and t h e impetus behind those r e g u l a t i o n s . 13  125 t r a n s f e r p r i c i n g regime l a c k s a coherent d e f i n i t i o n nature of t r a n s f e r p r i c i n g :  of the  very  1 4  A consequence of t h i s i s t h a t f i r m s (MNEs), even o u t s i d e the context of d e l i b e r a t e p r i c i n g m a n i p u l a t i o n , f i n d i t d i f f i c u l t t o d e t e c t a s u f f i c i e n t l y coherent u n d e r l y i n g r e g u l a t o r y theme to allow them t o a s s e s s the fiscal a s p e c t s of their o r g a n i z a t i o n s i n a r e l i a b l e s t r a t e g i c way. An e f f e c t i v e t r a n s f e r p r i c i n g r u l e , or a t l e a s t the r e c o g n i t i o n among n a t i o n a l t a x a u t h o r i t i e s of the s i g n i f i c a n c e of t r a n s f e r p r i c i n g r e g u l a t i o n s . . . would reduce the a b i l i t y of n a t i o n a l j u r i s d i c t i o n s t o d i s g u i s e the use of the t a x system t o a c h i e v e other p o l i t i c a l and economic o b j e c t i v e s . Therefore,  i t i s important  at  the  outset  to  consider  the  nature of t r a n s f e r p r i c i n g b e f o r e e v a l u a t i n g the e x i s t i n g regime's impact on MNEs. A. The  Tax  Avoidance  Transfer system  used  essentially  15  Perspective  p r i c i n g has to a  price neutral  i t s roots  transfers concept.  i n anti-avoidance,  between 16  In  the  related  14  Jill  entities  international  t r a n s f e r p r i c i n g i s o f t e n used i n a n e g a t i v e p r i c i n g d e c i s i o n by a MNE  yet  way  a  i t is context  to allude to  which s h i f t s income from one  C. Pagan and J . S c o t t W i l k i e , supra a t  as  a  member of  238.  I t i s g e n e r a l l y agreed t h a t the broad purpose of t r a n s f e r p r i c i n g r u l e s i s t o ensure t h a t the a l l o c a t i o n of income and expenses of a MNE among i t s members i s r e a s o n a b l e . Although t h e r e i s agreement about t h i s g e n e r a l purpose, t h e r e i s no general agreement about whether these r u l e s should be regarded as a n t i avoidance r u l e s or as b a s i c income measurement r u l e s . See B. J . A r n o l d and T. E. McDonnell, supra, a t 904. 15  Despite i t s anti-avoidance i n c l u d e a motive t e s t ; i t i s an p r i c i n g of a t r a n s a c t i o n r e f l e c t s Pagan and J . S c o t t W i l k i e , supra. 16  r o o t s , t r a n s f e r p r i c i n g does not o b j e c t i v e t e s t of whether the arm's l e n g t h d e a l i n g s . J i l l C. a t 52.  126 the group t o another t o take advantage o f d i f f e r e n t t a x r e g i m e s . Although affected,  the o v e r a l l pre-tax the s h i f t i n g  profitability  of p r o f i t s  o f t h e MNE  17  i s not  between e n t i t i e s i n d i f f e r e n t  c o u n t r i e s r e s u l t s i n t h e t a x base o f one c o u n t r y s h r i n k i n g t o t h e b e n e f i t of the other. way t o a v o i d  Thus, t r a n s f e r p r i c i n g i s o f t e n viewed as  18  o r minimize t a x a t i o n ,  thereby maximizing p r o f i t s o f  the MNE as a whole. In order t o m a i n t a i n t h e i n t e g r i t y o f t h e t a x base,  Canada  seeks t o prevent t h i s type o f t a x avoidance by r e q u i r i n g an arm's length  price  f o r transfers  between members o f a MNE.  19  result  i n adjustments  o f goods,  services  and  intangibles  An a n t i - a v o i d a n c e f o c u s w i l l i n e v i t a b l y  which  will  increase  taxable  profit  and,  i b i d . . a t 15. See a l s o Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n : The Canadian P e r s p e c t i v e " , Canadian Tax Paper No. 75 (Toronto: Canadian Tax Foundation, 1984) a t 108 - 110 f o r a d i s c u s s i o n o f i n c e n t i v e s f o r t r a n s f e r p r i c i n g m a n i p u l a t i o n s beyond m i n i m i z i n g t h e o v e r a l l income t a x l i a b i l i t y o f a MNE. 1 7  J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 17. The authors note that by t h e mid-1970's, increased communication and t e c h n o l o g i c a l advances meant t h a t developed n a t i o n s ( g e n e r a l l y h i g h tax c o u n t r i e s ) had a problem p r e s e r v i n g t h e i r t a x base. T h i s r e c o g n i t i o n l e d t o t h e development o f t r a n s f e r p r i c i n g e x p e r t i s e and o t h e r means t o a t t a c k t h e use o f t a x havens (such as t h e Canadian " f o r e i g n a c c r u a l p r o p e r t y rules"). However, g e n e r a l t r a n s f e r p r i c i n g g u i d e l i n e s , as s e t out i n t h e 1979 Report, a r e e q u a l l y a p p l i c a b l e t o t r a n s a c t i o n s between e n t i t i e s i n developed c o u n t r i e s o r e n t i t i e s i n developed and d e v e l o p i n g c o u n t r i e s (1979 Report, supra, a t 10) . 18  S e c t i o n 69 o f t h e ITA i s d i s c u s s e d below. Such a n t i avoidance t a x l e g i s l a t i o n i s common throughout t h e w o r l d and has been t h e t o p i c o f much debate i n t e r n a t i o n a l l y , p a r t i c u l a r l y i n recent y e a r s due t o changes i n t h e U.S. t r a n s f e r p r i c i n g r e g u l a t i o n s . See J i l l C. Pagan and J . S c o t t W i l k i e , supra a t 17 22 f o r an overview o f t h e h i s t o r y o f t r a n s f e r p r i c i n g . A l s o see the 1979 Report, supra; 1984 Report, supra; and t h e 1993 Report, supra. 19  127 t h e r e f o r e , domestic t a x revenues. I r o n i c a l l y , such an approach on a  global  s c a l e may r e s u l t i n double t a x a t i o n  and reduce  global  a f t e r t a x p r o f i t s o f t h e MNE.  20  B. The Income Measurement Transfer  Perspective  p r i c i n g by MNEs may be used  not only  taxes but a l s o t o improve t h e e f f i c i e n c y o f worldwide  t o minimize operations.  21  To suggest t h a t MNEs make t r a n s f e r p r i c i n g d e c i s i o n s p r i m a r i l y t o minimize tax l i a b i l i t y i s not s u b s t a n t i a t e d . A c c o u n t i n g , marketing, business  policy,  performance  i n t e r n a t i o n a l business,  evaluation  and l e g a l  transfer pricing decisions. unlikely pressures members  2 0  2 2  economics and f i n a n c e ,  considerations  also  F o r example, t a x c o n s i d e r a t i o n s a r e  t o be paramount where MNEs a r e s u b j e c t from v a r i o u s of  Jill  the  MNE  government departments, are  impact on  subject  to  23  to conflicting where d i f f e r e n t  scrutiny  by  minority  C. Pagan and J . S c o t t W i l k i e , supra. a t 32.  Ramy E l i t z u r and Jack Mintz, T r a n s f e r P r i c i n g Rules and Corporate Tax Competition. (Toronto: Department o f Economics and I n s t i t u t e f o r P o l i c y A n a l y s i s , 1994) a t 4. 21  Roger Y.W. Tang, supra. a t 12 and 104. A l s o see L o r r a i n e Eden, "Free Trade, Tax Reform, and T r a n s f e r P r i c i n g " , (1991) 39 Canadian Tax J o u r n a l 1, 90 a t 92 and 111; J i l l C. Pagan and J . S c o t t W i l k i e , supra a t 227 - 228; Jean-Thomas Bernard and Robert J . Weiner, " M u l t i n a t i o n a l s , T r a n s f e r P r i c e s , and Taxes" i n A s s a f Raz i n and J o e l Slemrod, eds., T a x a t i o n i n t h e G l o b a l Economy (Chicago: U n i v e r s i t y o f Chicago Press, 1990) 12 3 - 154 f o r a s y s t e m a t i c e m p i r i c a l a n a l y s i s o f t r a n s f e r p r i c e s i n t h e petroleum i n d u s t r y which i n d i c a t e s t h a t t h e r e l a t i o n between t r a n s f e r p r i c e / arm's l e n g t h p r i c e d i f f e r e n t i a l s and c o r p o r a t e t a x r a t e s i s weak; Donald J.S. Brean " F i n a n c i a l Dimensions o f T r a n s f e r P r i c i n g " i n A. Rugman and L. Eden, eds., supra. 149 - 169, a t 149; and G.F. Mathewson and G.D. Q u i r i n , supra, a t 4. 2 2  1979 Report, supra. a t 8. F o r example, customs a u t h o r i t i e s or exchange c o n t r o l o f f i c e s i n t h e home and host c o u n t r i e s . 23  128 shareholders,  or  where  members  of  autonomy and managers are e v a l u a t e d An  a l t e r n a t i v e , and  the  MNE  have  considerable  on t h e i r performance.  more balanced,  view c o n s i d e r s  24  transfer  p r i c i n g merely as p a r t of the o p e r a t i o n a l p r i c i n g s t r u c t u r e of a MNE  which  i s governed  desire to avoid  by  taxation:  commercial  considerations,  not  by  the  2 5  Today t r a n s f e r p r i c i n g i s about the a l l o c a t i o n of income of a MNE between nations. It applies to virtually all i n t e r n a t i o n a l t r a n s a c t i o n s w i t h i n a MNE w o r l d group and, because of t e c h n o l o g i c a l advancements and s p l i t f u n c t i o n s , a MNE has more i n t e r n a t i o n a l t r a n s a c t i o n s than ever b e f o r e . Tax avoidance, i f present, i s a t the margins, not a t the c e n t r e . C.  Conclusion The n a t u r e of t r a n s f e r p r i c i n g i s a c o n t e n t i o u s  is  a  fundamental  determination  which  impacts  issue, yet i t issues  about  r e g u l a t i o n . Presumably i f t r a n s f e r p r i c i n g r u l e s are c o n s i d e r e d be  anti-avoidance  r u l e s , they should  only  be  applied  to  i n abusive  See Wagdy M. A b d a l l a h , International Transfer P r i c i n g P o l i c i e s : D e c i s i o n Making G u i d e l i n e s f o r M u l t i n a t i o n a l Companies (Connecticut: Greenwood Press Inc., 1989) a t 8 - 12; and S y l v a i n R. F. P l a s s c h a e r t , T r a n s f e r P r i c i n g and M u l t i n a t i o n a l C o r p o r a t i o n s : An Overview of Concepts. Mechanisms and R e g u l a t i o n s (Great B r i t a i n : ECSIM, 1979) a t 12 - 13. 2 4  J i l l C. Pagan and J . S c o t t W i l k i e , supra a t 15 - 16. Also see the 1979 Report, supra. a t 9: " I t i s important t o bear i n mind, moreover, t h a t the need t o a d j u s t the a c t u a l p r i c e t o an arm's l e n g t h p r i c e , i n order t o a r r i v e a t a proper l e v e l of t a x a b l e profits, arises i r r e s p e c t i v e of any contractual obligation undertaken by the p a r t i e s t o pay a p a r t i c u l a r p r i c e or of any i n t e n t i o n of the p a r t i e s t o minimise t a x . Hence, the c o n s i d e r a t i o n of t r a n s f e r p r i c i n g problems should not be confused w i t h the c o n s i d e r a t i o n of problems of t a x f r a u d or t a x avoidance, even though t r a n s f e r p r i c i n g p o l i c i e s may be used f o r such purposes." 25  129 cases.  26  I f t r a n s f e r p r i c i n g r u l e s are  basic  income measurement  r u l e s , they would apply i n every case where t h e r e are between a s s o c i a t e d  enterprises.  2 7  Yet,  as  the  transactions  next P a r t  of  this  Chapter w i l l attempt t o demonstrate, the p r e s e n t system, r o o t e d i n a n t i - a v o i d a n c e , i s not  l i m i t e d t o abusive c a s e s :  28  The need t o address the problem of a l l o c a t i o n of income of a MNE f o r t a x a t i o n purposes cannot be i g n o r e d . The global economy i s d e v e l o p i n g apace and the problem of t r a n s f e r p r i c i n g moving towards t a k i n g a d i s p r o p o r t i o n a t e amount of time and e f f o r t of both taxpayer and tax g a t h e r e r . . . In g e n e r a l , t h e r e i s r e c o g n i t i o n t h a t the problem e x i s t s , but because i t i s so complex and t h e r e i s no easy s o l u t i o n , d i s c u s s i o n tends t o descend i n t o a n a l y s i s of the d e t a i l of methodology and l o s e s i g h t of the r e a l i s s u e . . . T a x a t i o n i n t h i s area i s an a r t , and no amount of complex methodology can t u r n i t i n t o an exact s c i e n c e . In my o p i n i o n , pricing  as  i t i s p r e f e r a b l e t o view the n a t u r e of t r a n s f e r  concerned  with  the  international  r e s o u r c e s , v a l u e and p r o f i t w i t h i n a MNE, a v e h i c l e f o r tax even  more  allocation  r a t h e r than p r i m a r i l y  avoidance. However, t h i s does not  complex  and  procedures i s necessary.  detailed  set  of  rules  mean t h a t  and  of as an  compliance  Rather, by u n d e r s t a n d i n g the  n a t u r e of  B. J . A r n o l d and T. E. McDonnell, supra a t 904 and a t 919: "The need f o r i n t e r n a t i o n a l c o o p e r a t i o n may be somewhat l e s s important i f t r a n s f e r - p r i c i n g r u l e s are c o n s i d e r e d t o be a n t i avoidance r u l e s t h a t apply only i n abusive s i t u a t i o n s . In e i t h e r case, however, such c o o p e r a t i o n i s much more important today than i t was when the OECD l a s t c o n s i d e r e d t r a n s f e r - p r i c i n g r u l e s . " F u r t h e r , i t has been suggested t h a t perhaps a l e s s d e t a i l e d s e t of r u l e s would be r e q u i r e d i f t r a n s f e r p r i c i n g r u l e s are viewed as a n t i - a v o i d a n c e r u l e s (at 919). Whether t h i s i s the t r u e i s debatable i n l i g h t of U.S. t r a n s f e r p r i c i n g developments (see f o o t n o t e 83, i n f r a . f o r a l i s t of sources on U.S. t r a n s f e r p r i c i n g regulations). 2 6  2 7  i b i d . . at Jill  904.  C. Pagan and  J . Scott Wilkie,  supra. a t  16.  130 t r a n s f e r p r i c i n g i n t h i s way, a more c l e a r l y d e f e n d a b l e t r a n s f e r p r i c i n g regime c o u l d be developed t o enable MNEs t o conduct t h e i r b u s i n e s s i n t h e g l o b a l economy  while:  29  - reducing " f i s c a l nationalism" with respect t o the a n a l y s i s of t r a n s f e r p r i c e s and t h e f o r m u l a t i o n o f t a x p o l i c y i n t h i s area; - h a v i n g the c a p a c i t y t o generate a l e v e l o f i n t e r n a t i o n a l t a x h a r m o n i z a t i o n by d i m i n i s h i n g f i s c a l n a t i o n a l i s m ; - r e c o g n i z i n g t h e economic nature o f MNEs, and i n c i d e n t a l l y reducing t h e v a l u e o f engaging i n p r i c i n g m a n i p u l a t i o n d i r e c t e d t o "tax avoidance"; - r e c o g n i z i n g and p r e s e r v i n g n a t i o n a l t a x bases a c c o r d i n g t o the economic c h a r a c t e r i s t i c s o f n a t i o n a l economies; - limiting decisions/  the intervention and  3 0  of tax regulations  i n business  - a d d r e s s i n g t h e movement o f income and p r o f i t s through MNEs without g i v i n g undue concern t o n a t i o n a l t a x systems and without r e q u i r i n g t h e a d o p t i o n o f c o n t e n t i o u s formulary methods o f income a l l o c a t i o n t o r e p l a c e e x i s t i n g t r a n s f e r p r i c i n g methods. 31  The pricing  following regime  discussion  i s based  of d i s c r i m i n a t i o n  on t h e nature  i n the transfer  of transfer  p r i c i n g as  concerned w i t h t h e i n t e r n a t i o n a l a l l o c a t i o n o f r e s o u r c e s , than w i t h t a x avoidance.  To t h e e x t e n t t h a t t h e t r a n s f e r p r i c i n g  regime seeks t o p r e s e r v e n a t i o n a l members  o f MNEs  rather  a r e open  t a x bases,  to protectionist  transactions and  among  discriminatory  i b i d . , a t 236 - 237 f o r a more complete d e s c r i p t i o n o f these p o s s i b l e outcomes. 2 9  i b i d . . The authors suggest t h a t t h i s b e n e f i t may be l i m i t e d t o developed economies. 3 0  i b i d . . The authors suggest t h a t t h e s u b s t a n t i a l r e l o c a t i o n by MNEs o f economic a c t i v i t y i n response t o t a x c o n s i d e r a t i o n s would, presumably, remain o f concern t o governments, but not on t r a n s f e r p r i c i n g grounds. 31  131 measures  which  transactions.  would Part  have  II  no  parallel  reviews  key  for  similar  principles,  domestic  methods  and  p r o c e d u r a l a s p e c t s of the e x i s t i n g t r a n s f e r p r i c i n g system w i t h a view t o i d e n t i f y i n g unreasonable, a r b i t r a r y or i r r e l e v a n t standards or procedures which have a n e g a t i v e impact on MNEs.  Part  existing  I I I considers  whether any  global  such d i s c r i m i n a t i o n  t r a n s f e r p r i c i n g system i s j u s t i f i a b l e  overriding considers  objective  of  protecting  alternatives  which  may  i n t e r e s t s of tax a u t h o r i t i e s and  trading  the more  in  the  of  the  base  and  balance  the  in light  domestic equitably  by  tax  MNEs thereby f a c i l i t a t i n g  global  trade. PART I I DISCRIMINATION IN THE The  TRANSFER PRICING REGIME  t h e s i s i s t h a t the e x i s t i n g t r a n s f e r p r i c i n g r u l e s have a  p r o t e c t i o n i s t o r i e n t a t i o n ; they are aimed a t m a i n t a i n i n g f i s c a l sovereignty system has  on  decrease the  national  without s u f f i c i e n t r e c o g n i t i o n of the impact the  MNEs. A  p o t e n t i a l outcome of  e f f i c i e n c y and  effectiveness  t h i s emphasis  of MNE  is  operations  to and  reduce the p o s i t i v e e f f e c t s of s e t t i n g up g l o b a l o p e r a t i o n s which otherwise b e n e f i t from f r e e In  t h i s Part,  the  trade.  following  g u e s t i o n s are  Canada's t r a n s f e r p r i c i n g l e g i s l a t i o n , and the  how  used t o  evaluate  i t operates  within  i n t e r n a t i o n a l t r a n s f e r p r i c i n g regime, t o a s s e s s whether  l e g i s l a t i o n discriminates  against  MNEs:  A.  To which taxpayers do t r a n s f e r p r i c i n g p r o v i s i o n s  B.  What t r a n s a c t i o n s  are  the  "affected?  apply?  132 C.  How i s the t r a n s f e r p r i c e determined?  D.  What are the consequences o f t r a n s f e r p r i c e adjustments?  E. What compliance measures a r e r e q u i r e d t o e n f o r c e t h e provisions? What other s t e p s , such as advance p r i c i n g agreements, a r e suggested t o a v o i d a p p l i c a t i o n of the provisions? A. To which taxpayers do t r a n s f e r p r i c i n g p r o v i s i o n s  apply?  The t r a n s f e r p r i c i n g r u l e s f o r t r a n s a c t i o n s between r e s i d e n t s and  non-residents  a r e s e t o u t i n s e c t i o n 69 o f t h e ITA:  32  (2) Where a taxpayer has p a i d o r agreed t o pay t o a nonr e s i d e n t person w i t h whom t h e taxpayer was n o t d e a l i n g a t arm's l e n g t h as p r i c e , r e n t a l , r o y a l t y o r o t h e r payment f o r o r for t h e use o r r e p r o d u c t i o n o f any p r o p e r t y , o r as c o n s i d e r a t i o n f o r the c a r r i a g e o f goods o r passengers o r f o r other s e r v i c e s , an amount g r e a t e r than t h e amount ( i n t h i s s u b s e c t i o n r e f e r r e d t o as "the r e a s o n a b l e amount") t h a t would have been reasonable i n the circumstances i f the n o n - r e s i d e n t person and the taxpayer had been d e a l i n g a t arm's l e n g t h , t h e r e a s o n a b l e amount s h a l l , f o r t h e purpose o f computing t h e taxpayer's income under t h i s P a r t , be deemed t o have been the amount t h a t was p a i d o r i s payable t h e r e f o r . (3) Where a non-resident person has n e i t h e r p a i d nor agreed t o pay t o a taxpayer w i t h whom the person was n o t d e a l i n g a t arm's l e n g t h as p r i c e , r e n t a l , r o y a l t y o r other payment f o r o r for t h e use o r r e p r o d u c t i o n o f any p r o p e r t y o r as c o n s i d e r a t i o n f o r t h e c a r r i a g e o f goods o r passengers o r f o r other s e r v i c e s , an amount equal t o o r g r e a t e r than the amount t h a t would have been a r e a s o n a b l e amount i n the circumstances i f t h e non-resident person and the taxpayer had been d e a l i n g a t arm's l e n g t h , t h a t r e a s o n a b l e amount s h a l l , f o r the purposes o f computing the taxpayer's income under t h i s P a r t , be deemed t o have been r e c e i v e d o r r e c e i v a b l e by the taxpayer t h e r e f o r , (emphasis added) Subsection  69(2)  means, i n e f f e c t ,  t h a t t h e amount t h a t t h e  Other ITA p r o v i s i o n s which may be a p p l i c a b l e i n a p a r t i c u l a r case, but which are n o t addressed here, i n c l u d e s e c t i o n 67 (which d i s a l l o w s unreasonable expenses), s u b s e c t i o n 245(1) (the g e n e r a l anti-avoidance p r o v i s i o n which d e a l s w i t h undue o r a r t i f i c i a l reductions of income), subsection 15(1) (shareholder a p p r o p r i a t i o n s ) and P a r t X I I I (tax on income from Canada o f a nonresident) . 3 2  133 Canadian taxpayer has p a i d or agreed t o pay t o the n o n - r e s i d e n t not,  f o r tax  subsection  69(3)  non-arm's Canadian  purposes,  a  reasonable  taxpayer arm's  non-resident may  not,  length  has  for  price.  ITA  transfer  paid  tax 3 3  t r a n s a c t i o n by t r a n s a c t i o n b a s i s . The  arm's l e n g t h  price;  means t h a t the amount ( i n c l u d i n g a n i l amount) a  length,  reasonable  exceed  may  or  agreed  purposes,  These  to  be  pay  less  provisions  apply  to  a  than  a  on  a  3 4  pricing  provisions  require  certain  t r a n s a c t i o n s t o occur a t a reasonable  p r i c e i n c i r c u m s t a n c e s where  a r e s i d e n t and  dealing at  The  arm's  components  non-resident  length and  test  embraces  are  not  contains natural  both  factual  persons  36  and  "arm's and  length".  35  substantive  corporations . 37  Information C i r c u l a r 87-2, " I n t e r n a t i o n a l T r a n s f e r P r i c i n g and other I n t e r n a t i o n a l T r a n s a c t i o n s " , February 27, 1987, paragraph 6. 3 3  i b i d . . paragraph 56. T h i s approach i s n e c e s s a r y as the ITA a p p l i e s t o each t r a n s a c t i o n between the v a r i o u s r e l a t e d p a r t i e s and not t o any g e n e r a l measure of p r o f i t a b i l i t y . 3 4  i b i d . . Note t h a t p r i o r t o May 9, 1985, t h i s p r o v i s i o n o n l y a p p l i e d i f the taxpayer was c a r r y i n g on b u s i n e s s i n Canada. "Arm's length" i s defined i n s e c t i o n 251 of the ITA; also see I n t e r p r e t a t i o n B u l l e t i n IT-419, "Meaning of Arm's Length" ( J u l y 10, 1978) . 3 5  "Related persons" ( i e . persons connected by blood r e l a t i o n s h i p , marriage or adoption; paragraph 251(2)(a)) do not d e a l a t arm's l e n g t h . 3 6  R e l a t i o n s h i p s between i n d i v i d u a l s and c o r p o r a t i o n s , or among c o r p o r a t i o n s depend on " c o n t r o l " t o determine whether the p a r t i e s d e a l a t arm's l e n g t h (see s u b s e c t i o n s 251(1) t o ( 5 ) ) . " C o n t r o l " i s a f a c t u a l d e t e r m i n a t i o n not d e f i n e d i n the ITA, but by case law, and g e n e r a l l y means ownership of more than 50% of the shares of a c o r p o r a t i o n having f u l l v o t i n g r i g h t s . See Nathan Boidman, "Canadian P e r s p e c t i v e s on Intercompany T r a n s f e r P r i c i n g " , Tax Management. S p e c i a l Report, V o l . 2, No. 1, Report No. 5, May 12, 1993 (Washington, D.C.: BNA, 1993) a t 6, f o o t n o t e 14. 3 7  134 Parties  not dealing  a t arm's  length  include,  f o r example,  transactions  between a parent and s u b s i d i a r y o r between any two  corporations  c o n t r o l l e d by the same person o r group o f p e r s o n s .  38  These r u l e s are d i f f e r e n t from, but s u b s t a n t i a l l y s i m i l a r t o , the  r u l e s with respect  t o non-arm's l e n g t h  r e s i d e n t taxpayers s e t o u t i n s u b s e c t i o n Although relationship  the tests exists  f o r assessing  transactions  69(1). whether  between  39  an arm's  do n o t d i f f e r e n t i a t e between  length  f o r e i g n and  domestic persons, the a p p l i c a t i o n o f the t r a n s f e r p r i c i n g r u l e s i s r e s t r i c t e d t o t r a n s a c t i o n s between a r e s i d e n t t a x p a y e r and a non-  F a c t s must be c a r e f u l l y analyzed t o a s s e s s whether s t r a t e g i c a l l i a n c e s , j o i n t ventures o r t r a n s a c t i o n s w i t h l o o s e l y a s s o c i a t e d p a r t i e s would be a t arm's l e n g t h . To t h e e x t e n t t h a t d i f f e r e n t c o u n t r i e s impose v a r y i n g standards i n a s s e s s i n g when t r a n s f e r p r i c i n g p r o v i s i o n s come i n t o p l a y , u n c e r t a i n t y e x i s t s f o r the MNE and t h e o p p o r t u n i t i e s o r p i t f a l l s w i l l depend upon t h e f a c t s and circumstances o f each case (see J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 44). 3 8  Subsection 69(1): Except as e x p r e s s l y o t h e r w i s e p r o v i d e d i n Act, (a) where a taxpayer has a c q u i r e d anything from a person w i t h whom the taxpayer was not d e a l i n g a t arm's l e n g t h a t an amount i n excess o f t h e f a i r market v a l u e t h e r e o f a t t h e time t h e taxpayer so a c q u i r e d i t , the taxpayer s h a l l be deemed t o have a c q u i r e d i t a t t h a t f a i r market v a l u e : (b) Where a taxpayer has d i s p o s e d o f a n y t h i n g (i) t o a person w i t h whom the taxpayer was n o t d e a l i n g at arm's l e n g t h f o r no proceeds o f f o r proceeds l e s s than the f a i r market v a l u e t h e r e o f a t the time the taxpayer so disposed of i t , or ( i i ) t o any person by way o f g i f t i n t e r v i v o s . the taxpayer s h a l l be deemed t o have r e c e i v e d proceeds o f d i s p o s i t i o n t h e r e f o r equal t o t h a t f a i r market v a l u e ; and (c) where a taxpayer has a c q u i r e d p r o p e r t y by way o f g i f t , bequest o r i n h e r i t a n c e , the taxpayer s h a l l be deemed t o have a c q u i r e d the p r o p e r t y a t i t s f a i r market v a l u e a t the time the taxpayer so a c q u i r e d i t . 3 9  this  135 resident person. between  40  residents  residents,  and  extent  such  of  The and  i s prima  tax  regime  for  non-residents  pricing  differs  facie discriminatory.  discrimination  i s explored  transactions  from 4 1  that  among  The n a t u r e  i n the  and  following  sections. B. What t r a n s a c t i o n s should  be a f f e c t e d ?  S u b s e c t i o n s 69(2) and 69(3) a r e much broader than 69(1)  i n t h e range o f t r a n s a c t i o n s t h a t a r e a f f e c t e d :  subsection  4 2  Some t r a n s a c t i o n s between r e s i d e n t s - d i s p o s i t i o n s and a c q u i s i t i o n s o f p r o p e r t y - a r e s u b j e c t t o s i m i l a r r u l e s . Many s i m i l a r t r a n s a c t i o n s between r e s i d e n t s a t l e s s o r more than an arm's l e n g t h p r i c e a r e not a d j u s t e d t o an arm's l e n g t h amount, although Y _ may r e s u l t i n other disadvantageous t a x consequences. The reason f o r t h e d i f f e r e n c e , o f course, i s t h a t t r a n s f e r p r i c i n g w i t h n o n - r e s i d e n t s r e s u l t s i n e r o s i o n of the Canadian t a x base, whereas t r a n s f e r p r i c i n g w i t h r e s i d e n t s r e s u l t s o n l y i n t h e s h i f t i n g o f amounts between t a x p a y e r s , (emphasis added) tne  Further,  the t r a n s f e r p r i c i n g r u l e s  apply  t o t r a n s f e r s of  s e r v i c e s , t a n g i b l e and i n t a n g i b l e p r o p e r t y , when: a) a taxpayer has p a i d o r agrees t o pay t o an non-resident,  non-arm's l e n g t h person,  an amount g r e a t e r than a r e a s o n a b l e amount; and b) a non-arm's  length  person  has  neither  paid  or  non-resident,  agreed  t o pay  a  S u b s e c t i o n s 69(2) and (3) o v e r r i d e s e c t i o n 69(1) i n the case o f t r a n s a c t i o n s between Canadian taxpayers and n o n - r e s i d e n t s (Information C i r c u l a r 87-2, supra. paragraph 6 ) . 4 0  B r i a n J . A r n o l d , "Tax D i s c r i m i n a t i o n A g a i n s t R e s i d e n t s and F o r e i g n A c t i v i t i e s " , supra. a t 12. 41  4 2  A l i e n s , Non-  i b i d . . a t 105.  i b i d . . a t 105, f o o t n o t e 214: "For example, i f a c o r p o r a t i o n performs s e r v i c e s f o r a shareholder f o r l e s s than f a i r market v a l u e , t h e b e n e f i t c o n f e r r e d must be i n c l u d e d i n t h e s h a r e h o l d e r ' s income under subsection 15(1)." Payment f o r services i s s p e c i f i c a l l y i n c l u d e d i n s u b s e c t i o n s 69(2) and 69(3). 4 3  136 reasonable  amount  taxpayer's  taxable  otherwise  t o a taxpayer. income  In these  44  i s presumably  circumstances, the  less  than  i t would  be, had t h e t r a n s a c t i o n o c c u r r e d w i t h an arm's l e n g t h  person. T h e r e f o r e , t h e p r o v i s i o n s a r e d r a f t e d  i n such a way t h a t  the o n l y t r a n s a c t i o n s which a r e a f f e c t e d a r e t h o s e where t r a n s f e r p r i c i n g adjustments with  l e a d t o an i n c r e a s e i n p r o f i t f o r t h e taxpayer,  a corresponding  i n c r e a s e i n t h e domestic  t a x base.  It  is  submitted t h a t r e s t r i c t i n g t h e a p p l i c a t i o n o f t h e t r a n s f e r p r i c i n g rules  i n this  domestic  way d i s c r i m i n a t e s a g a i n s t MNEs v i s a v i s s i m i l a r  transactions:  4 5  Two independent b u s i n e s s e n t i t i e s w i t h a l o n g h i s t o r y o f doing b u s i n e s s t o g e t h e r may f i n d some arrangements o r b u s i n e s s d e a l i n g s f a r more p r o f i t a b l e t o one than t o t h e o t h e r . However, over t h e y e a r s they average out... However, t r a n s f e r p r i c i n g l e g i s l a t i o n ... does n o t t e c h n i c a l l y accept a v e r a g i n g out over t h e y e a r s , so MNEs a r e p o t e n t i a l l y a t a disadvantage. P r i c e s may be a d j u s t e d f o r those t r a n s a c t i o n s where i n t r a group p r i c e s may be s a i d not t o meet t h e arm's l e n g t h c r i t e r i a and r e s u l t i n a decrease i n income o r i n c r e a s e i n e x p e n d i t u r e ; no r e g a r d would be g i v e n t o s i m i l a r t r a n s a c t i o n s i n p r e v i o u s y e a r s where p r i c i n g may have r e s u l t e d i n g r e a t e r p r o f i t than a p p r o p r i a t e i f a s t r i c t arm's l e n g t h p r i c e were t o be substituted. T h e r e f o r e , by i n c l u d i n g a broader range  o f t r a n s a c t i o n s and  a p p l y i n g o n l y t o t r a n s a c t i o n s which i n c r e a s e t h e domestic t a x base, the  cross-border  transfer  pricing  rules  can  be  viewed  as  discriminatory. C. How i s t h e t r a n s f e r p r i c e The  transfer  pricing  determined? rules  The q u e s t i o n o f what a addressed below. 4 4  45  Jill  provide  that  "reasonable  "the reasonable  amount"  i s will  C. Pagan and J . S c o t t W i l k i e , supra. a t 51,  be  137 amount",  the  circumstances,  amount  would  have  been  reasonable  i n the  s h a l l be deemed t o have been t h e amount t h a t was  paid or payable. length  that  T h i s reasonable  46  principle.  4 7  amount i s r o o t e d  The presumption  i s that  l e n g t h p r i c e would be a f a i r market v a l u e  4 8  a  i n t h e arm's  reasonable  arm's  and t h e most p e r s u a s i v e  evidence o f t h i s amount i s from t h e market t o which t h e t r a n s f e r i s  This  section  provides  an  overview  Subsections 69(2) and 69(3); supra. paragraphs 5 - 7 . 4 6  of  the  Information  arm's  length  Circular  87-2,  The arm's l e n g t h p r i n c i p l e i s d i s c u s s e d below. See g e n e r a l l y i b i d . . paragraph 9; 1979 Report, supra; 1984 Report, s u p r a : 1993 Report, supra; A r t i c l e 9(1) o f t h e OECD Model; and "Tax T r e a t i e s between Developed and Developing C o u n t r i e s " (United N a t i o n s , 1978) at 62. 4 7  Revenue Canada uses t h e same t h e o r i e s and p r i n c i p l e s o f t r a n s f e r p r i c i n g t o determine f a i r market v a l u e under s e c t i o n 69(1) f o r domestic non-arm's l e n g t h t r a n s a c t i o n s ( I n f o r m a t i o n C i r c u l a r 87-2, supra. paragraph 5 ) . However, t h e language o f s u b s e c t i o n s 69(2) and 69(3) "of both a reasonableness standard and a c i r c u m s t a n t i a l context suggests a b a s i s f o r a c c e p t i n g i n t r a - g r o u p p r i c i n g t h a t may depart from " f a i r market v a l u e " as i n t e r p r e t e d c o n v e n t i o n a l l y f o r arm's l e n g t h t r a n s a c t i o n s , but n e v e r t h e l e s s may be a p p r o p r i a t e t a k i n g i n t o account t h e nature and c h a r a c t e r i s t i c s of a m u l t i - n a t i o n a l e n t e r p r i s e , p r o v i d e d t h a t t h e r e i s no evidence of a t a x avoidance m o t i v a t i o n . " ( J . Scott Wilkie, "Transfer P r i c i n g : R e a l i z i n g Corporate G o a l s " , Tax A s p e c t s o f Canada-United S t a t e s Business T r a n s a c t i o n s ( M i s s i s s a u g a : I n s i g h t P r e s s , 1991) Tab 5 a t 12) . 4 8  The arm's l e n g t h p r i c e i s determined from t h e p e r s p e c t i v e of t h e t r a n s f e r o r ' s d e s t i n a t i o n market which may o r may not be equal t o " f a i r market v a l u e " , t h e standard which i s imposed i n a p u r e l y domestic non-arm's l e n g t h t r a n s a c t i o n . I n f o r m a t i o n C i r c u l a r 87-2, supra. paragraph 7 g i v e s t h e example o f a s u p p l i e r attempting to i n c r e a s e market share, so t h e s u p p l i e r might t e m p o r a r i l y e s t a b l i s h an arm's l e n g t h p r i c e t h a t was below f a i r market v a l u e . See a l s o J . H o f e r t L i m i t e d v. MNR, 62 DTC 50 (TAB) ; Indalex L i m i t e d v. The Queen. 86 DTC 6039 (FCTD), 88 DTC 6053 (FCA); and The Queen v. I r v i n g O i l L i m i t e d . 91 DTC 5106 (FCA); and J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 233. 4 9  138 p r i n c i p l e and  the g e n e r a l l y accepted methods f o r a r r i v i n g a t  arm's  transfer  price.  well  difficulties  length  principle  as  methods are  as  discussed  Problems  i n the  in  context  with  the  applying of  arm's  the  the  length  prescribed  discrimination  against  MNEs. i.  Arm's l e n g t h p r i n c i p l e When independent e n t i t i e s conduct b u s i n e s s w i t h each  market  forces  generally  determine  commercial and f i n a n c i a l r e l a t i o n s . forces  the  conditions  other,  of  their  MNEs can d i s t o r t t h e s e market  i n a number of ways, i n c l u d i n g s h i f t i n g  profits  from  one  j u r i s d i c t i o n t o another i n order t o reduce the o v e r a l l t a x burden. The  arm's  length  principle tries  t r e a t i n g each member of a MNE On Release  January 7, 51  to  determining  clarify  eliminate  length  this  as a s e p a r a t e e n t i t y .  effect  by  5 0  the Department of Finance i s s u e d a Press the  Canadian  rules  and  t r a n s f e r p r i c e s between members of  c o r p o r a t e group. "arm's  1994  to  guidelines an  for  international  Canada r e q u i r e s t r a n s f e r p r i c e s t o conform t o the  principle"  members of a MNE  52  that  prices  for  transactions  between  be e q u i v a l e n t t o those which would be s e t by  two  See Diane Hay, Frances Horner, and J e f f r e y Owens, "Past and Present Work i n the OECD on T r a n s f e r P r i c i n g and S e l e c t e d Issues", Tax Notes I n t e r n a t i o n a l , Tax A d v i s o r s Forum, J u l y 25, 1994 249 at 253. A l s o see Donald J.S. Brean " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra, a t 112. 5 0  Press Release 93-003, " T r a n s f e r P r i c i n g Rules and Clarified". 51  Guidelines  T r a n s a c t i o n s between members of a MNE are a l s o r e f e r r e d t o as the " c o n t r o l l e d t r a n s a c t i o n " . For a d i s c u s s i o n on whether of not the arm's l e n g t h p r i n c i p l e n e c e s s i t a t e s the e x i s t e n c e of a t r a n s a c t i o n i n order t o apply see B.J. A r n o l d and T.E. McDonnell, 5 2  139 unrelated  companies engaged  i n the  same or  similar  transactions  under the same or s i m i l a r c o n d i t i o n s i n the open market. The  arm's  l e n g t h p r i n c i p l e has been i n c o r p o r a t e d i n a l l Canadian t a x t r e a t i e s and  i s o f f i c i a l l y recommended by the OECD. There are a number of reasons why  has  been  officially  recommended.  demand are c o n s i d e r e d  the arm's l e n g t h p r i n c i p l e  Market  t o be the b e s t way  reward e f f o r t . A l s o , the equal treatment f o r MNE  54  53  forces  of  supply  and  to a l l o c a t e resources  and  arm's l e n g t h p r i n c i p l e p r o v i d e s  groups and independent e n t e r p r i s e s thereby  a v o i d i n g the c r e a t i o n of tax advantages by c o n c e n t r a t i n g power i n l a r g e MNE  broadly  economic  groups. F i n a l l y , the arm's l e n g t h p r i n c i p l e has  been a p p l i e d w i t h success i n p r a c t i c e . There principle.  are 5 5  a  number  MNEs may  e n t e r p r i s e s would not supra.  of  engage  problems  with  the  i n transactions  arm' s  which  engage i n making i t d i f f i c u l t  length  independent t o apply  the  905.  See the 1979 Report, supra; the 1984 Report, supra; the 1993 Report, supra; and the 1994 D r a f t P a r t I, supra, which favour the arm's l e n g t h method and r e j e c t a g l o b a l method of apportionment ( d i s c u s s e d below). I t has been suggested t h a t the t e n s i o n between these two approaches i s viewed as l a r g e l y p o l i t i c a l and i t i s r e c o g n i z e d t h a t t h e r e are a v a r i e t y of methods f o r r e s o l v i n g t r a n s f e r p r i c i n g i s s u e s . (B.J. A r n o l d and T.E. McDonnell, supra. a t 920). There i s s u b s t a n t i a l concern about the use of predetermined formulas t o a l l o c a t e income among members of a MNE and i t i s u n c l e a r whether the arm's l e n g t h p r i n c i p l e p e r m i t s the use of p r o f i t based methods i n a d d i t i o n t o the t r a n s a c t i o n based methods which are d i s c u s s e d i n s e c t i o n i i ) below. For a d i s c u s s i o n see B.J. A r n o l d and T.E. McDonnell, supra. a t 905-906. 5 3  See supra. 5 4  I,  Diane Hay,  e t . a l . , supra. a t 253  and  1994  Draft,  Part  See g e n e r a l l y J i l l C. Pagan and J . S c o t t W i l k i e , supra, a t 28 and Norman C. Loveland, supra. a t 2. 55  140 arm's l e n g t h p r i n c i p l e where comparable t r a n s a c t i o n s do not e x i s t in  the  market  uncontrolled  place.  It  is  unlikely  transaction w i l l  be  that  a  truly  a v a i l a b l e f o r such  e s p e c i a l l y i n the case of i n t a n g i b l e s .  5 6  comparable comparison,  I t i s also u n l i k e l y that  t h e r e i s going t o be a s i n g l e arm's l e n g t h p r i c e ; r a t h e r t h e r e w i l l be  a commercially  f e a s i b l e range of  prices.  The  5 7  arm's  p r i n c i p l e i s a l s o i n h e r e n t l y flawed i n t h a t i t adopts the e n t i t y approach which may inter-relation  of d i v e r s e  length  separate  not account f o r economies of s c a l e or the activities  by  MNEs.  58  When comparable  t r a n s a c t i o n s do e x i s t , a s i g n i f i c a n t amount of d a t a i s r e q u i r e d i n order t o compare these t r a n s a c t i o n s t o a c t i v i t i e s of the MNE. data may  be  when the MNE  i n a c c e s s i b l e , incomplete and  difficult  i s e s t a b l i s h i n g t r a n s f e r p r i c e s , but  w i l l compare the i n f o r m a t i o n  to interpret  Revenue Canada  a f t e r the f a c t when r e l e v a n t data i s  B.J. A r n o l d and T.E. McDonnell, supra, a t 900; Romano, T a x a t i o n and the North American Free Trade Area, p r e s e n t e d a t the I n t e r n a t i o n a l F i s c a l A s s o c i a t i o n , 1994 Congress, Toronto, Canada, August, 1994, a t 4; 1979 Report, a t 13 and 46; and 1994 D r a f t , P a r t I I , supra. a t paragraph 5 6  This  Emilio paper Annual supra. 1.  I f i t i s recognized t h a t the arm's l e n g t h p r i n c i p l e contemplates an a c c e p t a b l e range of p r i c e s , r a t h e r than a s i n g l e " r i g h t " p r i c e , i t may be necessary t o develop " s a f e harbour" r u l e s f o r p r i c e s f a l l i n g w i t h i n the a c c e p t a b l e range. See B.J. A r n o l d and T.E. McDonnell, i b i d , a t 915 and a t 915 - 916 r e g a r d i n g safe harbour r u l e s g e n e r a l l y ; and 1994 Draft, Part I I , i b i d . . at paragraphs 204 - 233 i n which the OECD does not recommend the use of s a f e harbours. 5 7  For example, the arm's l e n g t h p r i n c i p l e i s d i f f i c u l t t o apply i n a l l o c a t i n g c o s t s f o r r e s e a r c h and development a c t i v i t i e s c a r r i e d on by one member of the MNE f o r the b e n e f i t of one or more other members of the MNE (see the 1979 Report, supra. a t 45 - 71). 5 8  141 easier  to  o b t a i n and  Revenue Canada uses  identify.  5 9  industry-wide  Finally,  to  the  extent  standards  to  assess  an  that arm's  l e n g t h p r i c e , i t i s u n l i k e l y t h a t these standards w i l l r e f l e c t the particular review. An  circumstances  of  MNE  and  the  transaction  under  60  alternative  apportionment. methods reference  of  61  a  the  Emilio v. The Queen. L i m i t e d v. The d i s c l o s u r e of  arm's  length  Formulary apportionment  profit  to  to  allocation,  predetermined  s a l e s , p a y r o l l and a s s e t s . 5 9  the  6 2  or  is  formulary  r e f e r s t o g l o b a l or d i r e c t  fixing  formula  Advocates  approach  based  transfer on  prices  factors  of t h i s approach  such  by as  claim that  Romano, supra, a t 4. See a l s o Amp of Canada. L t d . 87 DTC 5157 (FCTD); and Crestbrook F o r e s t I n d u s t r i e s Queen. 91 DTC 5521 (FCA) r e g a r d i n g t a x p a y e r s s e e k i n g documents used by Revenue Canada.  There may be sound b u s i n e s s reasons f o r e s t a b l i s h i n g a t r a n s f e r p r i c e which i s a t odds w i t h the " i n d u s t r y s t a n d a r d " , such as to gain entry into a market. The "reasonable i n the c i r c u m s t a n c e s " language of s u b s e c t i o n s 69(2) and (3) p r o v i d e s some measure of p r o t e c t i o n f o r the MNE i n t h i s r e g a r d . 6 0  See B.J. A r n o l d and T.E. McDonnell, supra. a t 904 - 908. T h i s method i s a l s o r e f e r r e d t o as the u n i t a r y approach because i t t r e a t s members of a MNE as a member of a s i n g l e , u n i f i e d b u s i n e s s r a t h e r than as a separate e n t i t y under the arm's l e n g t h approach. The 1994 D r a f t , P a r t I, supra. c a u t i o n s (at 185 - 186) t h a t g l o b a l formulary apportionment methods (which use a formula t h a t i s predetermined f o r a l l taxpayers t o a l l o c a t e p r o f i t s ) s h o u l d not be confused w i t h p r o f i t methods (which compare, on a case by case b a s i s , the p r o f i t s of one or more a s s o c i a t e d e n t e r p r i s e s w i t h the p r o f i t e x p e r i e n c e t h a t comparable independent e n t e r p r i s e s would have sought t o a c h i e v e i n comparable c i r c u m s t a n c e s ) . These g l o b a l methods are a l s o d i s t i n g u i s h e d from cases of s e l e c t e d a p p l i c a t i o n of a formula developed by both t a x a u t h o r i t i e s i n c o o p e r a t i o n w i t h a MNE after careful a n a l y s i s of the p a r t i c u l a r facts and circumstances ( f o r example, under mutual agreement procedures or advance p r i c i n g agreements). 61  See J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 32 r e g a r d i n g the d i s t i n c t i o n between p r o f i t a l l o c a t i o n under an arm's l e n g t h t r a n s f e r p r i c i n g system ( i n which a f u n c t i o n a l a n a l y s i s of 6 2  142 it  would  provide  compliance  costs  greater and  administrative  certainty  for  convenience,  taxpayers.  reduced  Advocates  also  b e l i e v e t h a t t h i s approach i s more i n l i n e w i t h economic r e a l i t y of the h i g h l y i n t e g r a t e d r e l a t i o n s h i p s among members of MNEs. The  OECD has  r e s u l t s and  r e j e c t e d t h i s approach as  to  be  the  potential  international  consensus  formulae  composition  and  9 of the OECD  a c c e p t s the arm's l e n g t h b a s i s .  most s i g n i f i c a n t problem w i t h g l o b a l said  producing a r b i t r a r y  b e i n g i n c o m p a t i b l e w i t h A r t i c l e s 7 and  Model which b r o a d l y  problems w i t h  global  requirements,  lack  of  for  and of  methods uniform  formulary  double  the  tax  include  on  unit.  due  the  6 5  compliance  accounting  6 4  However, the  apportionment  taxation  coordination  63  to  lack  is of  predetermined  Other costs  standards  and  perceived and  data  lack  of  the a c t u a l o p e r a t i o n s and s i m i l a r types of t r a n s a c t i o n s has a r o l e t o p l a y ) as compared w i t h a g l o b a l formulary apportionment method ( i n which a f u n c t i o n a l a n a l y s i s i s supplanted by, f o r example, a formula a p p l i e d t o a d j u s t e d f i g u r e s from the n a t i o n a l and g l o b a l accounts.) 6 3  1994  D r a f t , P a r t I, supra, a t  186.  The 1979 Report, supra. a t 14, r e p o r t s t h a t the r e s u l t i s a r b i t r a r y because these methods d i s r e g a r d market c i r c u m s t a n c e s , the p a r t i c u l a r circumstances of the MNE and managements a l l o c a t i o n of resources. Therefore, these methods are s a i d t o l e a d t o an a l l o c a t i o n of p r o f i t which may bear no sound r e l a t i o n s h i p t o economic f a c t s (see the 1979 Report a t 14 f o r examples). However, t h i s r e s u l t i s a l s o p o s s i b l e under the arm's l e n g t h standard, p a r t i c u l a r l y w i t h regard t o i n t a n g i b l e s where comparable arm's l e n g t h t r a n s a c t i o n s are u n l i k e l y t o e x i s t . 6 4  1994 D r a f t , P a r t I, supra. a t 186 - 187. S i m i l a r problems of double t a x a t i o n a l s o e x i s t under the arm's l e n g t h p r i n c i p l e , however, r e g a r d i n g d i f f e r i n g standards and l a c k of c o n s i s t e n c y i n a p p l i c a t i o n of methods. I f compensating adjustments are not forthcoming, double t a x a t i o n w i l l r e s u l t . These concerns are d i s c u s s e d below. 65  143 flexibility  i n a p p l y i n g pre-determined formulae.  O v e r a l l , s t r i c t a p p l i c a t i o n o f e i t h e r s t a n d a r d i s l i k e l y t o be unreasonably  costly  and burdensome f o r MNEs, r e q u i r i n g  an undue  amount o f time and e f f o r t t o support an a r b i t r a r y t r a n s f e r  price  which may s t i l l be s u b j e c t t o adjustment. I t i s suggested t h a t t h e f o l l o w i n g methods f o r d e t e r m i n i n g an arm's l e n g t h p r i c e exacerbate these  problems.  arbitrary  I n an attempt  by imposing  specific  t o make t r a n s f e r  transfer  pricing  less  p r i c i n g methods, a l e s s  a r b i t r a r y r e s u l t i s not n e c e s s a r i l y t h e outcome, ii.  Methods f o r Determining an Arm's Length P r i c e  a.  T r a n s f e r o f Goods; A c q u i s i t i o n s o r D i s p o s i t i o n s o f I n t a n g i b l e s There a r e t h r e e g e n e r a l l y accepted methods f o r d e t e r m i n i n g an  arm's l e n g t h p r i c e f o r . t h e t r a n s f e r o f goods, and t h e a c q u i s i t i o n or d i s p o s i t i o n o f i n t a n g i b l e s :  6 6  t h e comparable u n c o n t r o l l e d p r i c e ,  r e s a l e p r i c e and c o s t - p l u s methods.  67  I n f o r m a t i o n C i r c u l a r 87-2, supra, paragraph 13. Methods f o r e s t a b l i s h i n g an arm's l e n g t h p r i c e f o r t h e use o f i n t a n g i b l e s (the "arm's l e n g t h r o y a l t y r a t e " ) a r e d i s c u s s e d below and a t paragraphs 40 through 47 o f I n f o r m a t i o n C i r c u l a r 87-2. 6 6  The f o l l o w i n g d i s c u s s i o n i s a b r i e f overview o f t h e methods. For a more complete d e s c r i p t i o n , r e f e r t o : I n f o r m a t i o n C i r c u l a r 872, i b i d . ; J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 104 - 110; J . S c o t t W i l k i e , " T r a n s f e r P r i c i n g : R e a l i z i n g Corporate Goals", supra; Diane Hay, e t . a l . , supra; Nathan Boidman, "Canadian P e r s p e c t i v e s on Intercompany T r a n s f e r P r i c i n g " , supra; David G. Broadhurst, "Developing a P o l i c y f o r Intercompany P r i c i n g " (1989) 37 Canadian Tax J o u r n a l 1, 128 - 140; Nathan Boidman, "Revenue Canada's T r a n s f e r P r i c i n g C i r c u l a r : S e l e c t e d Commentary" (1988) 3 6 Canadian Tax J o u r n a l 2, 405 - 427; Robert F. L i n d s a y , "Cross-Border T r a n s f e r P r i c i n g : General P r i n c i p l e s " , Report o f Proceedings o f t h e T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 20:1- 20:25; 1979 Report, supra; 1984 Report, supra; 1993 Report, supra; and 1994 D r a f t , P a r t I, supra. F o r Canadian case law r e l e v a n t t o t r a n s f e r p r i c i n g see I r v i n g O i l L i m i t e d v. The Queen. 88 DTC 6138 (FCTD), a f f ' d 91 DTC 6 7  144 The  primary method t o e s t a b l i s h an arm's l e n g t h p r i c e i s t o  a r r i v e a t an exact comparable u n c o n t r o l l e d p r i c e which i s e i t h e r :  6 8  i. the p r i c e a group member charges an arm's l e n g t h p a r t y f o r the same item, i n the same q u a n t i t y , under the same c o n d i t i o n s and i n the same market; or i i . the p r i c e s e t by two t h i r d p a r t i e s f o r the same item, i n the same q u a n t i t y , under the same c o n d i t i o n s and i n the same market. In  cases  where  differences  in  circumstances  between  a  c o n t r o l l e d and u n c o n t r o l l e d t r a n s a c t i o n do not a f f e c t p r i c e , or are minor or can be reasonably  q u a n t i f i e d , i t i s a p p r o p r i a t e t o use  i n e x a c t comparable u n c o n t r o l l e d p r i c e .  an  6 9  Where exact or i n e x a c t comparable u n c o n t r o l l e d p r i c e s are not available,  Revenue  Canada  will  generally  accept  either  " r e s a l e minus" or " c o s t p l u s " t r a n s a c t i o n a l methods.  70  The  of  the  resale  5106 (FCA) (leave t o appeal t o SCC denied Sept. 1991); C o n s o l i d a t e d Bathurst L i m i t e d v. The Queen. 85 DTC 5120 (FCTD); Stubart Investments L i m i t e d v. The Queen. 84 DTC 6305 (SCC); Indalex L i m i t e d v. The Queen. 83 DTC 89 (TRB); Spur O i l L t d . v. The Queen. 81 DTC 5168 (FCA); Dominion B r i d g e Co. L t d . v. The Queen. 75 DTC 5150 (FCTD), a f f ' d 77 DTC 5367 (FCA); J . H o f e r t L t d . V . MNR. 62 DTC 50 (TAB); and C e n t r a l Canada F o r e s t Products L t d . v. MNR. 52 DTC 539 (TAB). A number of these cases are d i s c u s s e d by Robert A. F r i e s e n i n "Contemporary Issues i n Cross-Border T r a n s a c t i o n s " , Report of Proceedings of the T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 22:1 22:7; and see Memorandum, R u l i n g s D i r e c t o r a t e , " S u b s i d i a r y Doing B u s i n e s s i n Canada - T r a n s f e r P r i c i n g " (December 1, 1992). 6 8  Press Release No.  93-003, supra.  "Backgrounder".  Information C i r c u l a r 87-2, supra. paragraph 14. Factors which may be used i n a s s e s s i n g c o m p a r a b i l i t y i n c l u d e product d e f i n i t i o n , g u a n t i t y , q u a l i t y , market d e f i n i t i o n , c r e d i t terms, r e l i a b i l i t y of supply, t r a d e l e v e l s , and o t h e r terms of t r a d e . 6 9  For U n i t e d S t a t e s examples where c o u r t s have not accepted the proposed comparable, see L i l l y & Co. v. Comm'r. 84 TC 996 (1985), 856 F.2d 855,88-2 USTC 85,457 (7th C i r . 1988); G.D. Searle & Co. v. Commr. 88 TC 252 (1987), H o s p i t a l C o r p o r a t i o n of America 7 0  145 minus method i s used where no a c c e p t a b l e comparable e x i s t s and the taxpayer adds l i t t l e v a l u e t o a product. T h i s approach b e g i n s w i t h an arm's l e n g t h s a l e s p r i c e and  deducts  an a p p r o p r i a t e  mark-up  71  t o cover the taxpayers c o s t s and earn a p r o f i t . By comparison,  the  c o s t p l u s method begins w i t h the c o s t of the p r o d u c t and adds on an a p p r o p r i a t e mark-up. Where  neither  transactional  the  applied,  methods  i n c l u d e some form  methods  based  a  variety  of  profits  the  by  w i t h i n the  group  nor  a l l o c a t e d based on a proper remuneration of f u n c t i o n s performed  on  be  methods  be  entities  can  price  should  different  methods  uncontrolled  c o r p o r a t e group. profit  of  split  factors  72  P o s s i b l e other  analysis,  important  d e c i s i o n , or y i e l d or r a t e of r e t u r n a n a l y s i s .  to  or a  global pricing  7 3  I t has been suggested t h a t whether or not a comparable e x i s t s , tax a u t h o r i t i e s and c o u r t s w i l l be concerned  about some n o t i o n of  v. Comm'r. 81 TC 520 (1983), Ciba-Geiqy Corp. v. Comm'r. 85 TC 172 (1985), E . I . Dupont de Nemours & Co. v. U.S.. 608 F.2d 445 ( C l . c t . 1979) , U n i t e d S t a t e s S t e e l v. Comm'r. TC Memo 1977-140 r e v ' d , 617 F.2d 942 (2d C i r . 1980), PPG I n d u s t r i e s Inc. v. Comm'r. 55 TC 928 (1970). A l s o see J . H o f e r t L t d . v. MNR. 62 DTC 50 (TAB) f o r a Canadian case on p r o f i t s p l i t s . For examples where t h e CUP method was a p p l i e d see Indalex L t d . v. The Queen [1988] 1 CTC 60 (FCA) i n Canada and Bausch & Lomb. Inc. v. Comm'r. 91-1 USTC 87,974 (CA 2d C i r . ) a f f ' g 92 TC 525, i n the U n i t e d S t a t e s . See I n f o r m a t i o n C i r c u l a r 87-2, supra. paragraphs 15 and f o r comments on the word " a p p r o p r i a t e " i n t h i s c o n t e x t . 71  7 2  P r e s s Release 93-003, supra, and I n f o r m a t i o n C i r c u l a r  17  87-2,  ibid. J i l l C. Pagan and J . S c o t t W i l k i e , supra, a t 38. The authors note t h a t these o t h e r methods are more d i r e c t l y r e l a t e d t o a f a c t s and circumstances review of a f f e c t e d t a x p a y e r s , but, as d i s c u s s e d above, are g e n e r a l l y denounced by t a x a u t h o r i t i e s and the OECD. 7 3  146 profit  split:  7 4  Not o n l y do the r e c e n t US c o u r t cases suggest a t l e a s t an u n d e r l y i n g s e n s i t i v i t y , i f not o b j e c t i v e , i n t h i s r e g a r d , but t h e r e are a number of i n s t a n c e s where o f f i c i a l s of tax a u t h o r i t i e s have u n o f f i c i a l l y accepted t h a t the i s s u e of profit split i s always p r e s e n t . For example, at an I n t e r n a t i o n a l F i s c a l A s s o c i a t i o n Canadian branch conference i n May 1991, an o f f i c i a l of the Canadian revenue a u t h o r i t i e s , e x p r e s s i n g h i s remarks as p e r s o n a l views, commented t h a t the standard f o u r t e s t s are perhaps not a p r o d u c t i v e a n a l y t i c a l premise and observed t h a t t h e r e may be a tendency t o favour some s o r t of p r o f i t s p l i t on the b a s i s of "common sense". He suggested, in this connection, that the conventional methodologies may fail t o g i v e adequate r e c o g n i t i o n to elements of i n t e g r a t e d o p e r a t i o n and t h a t , notwithstanding r e s e r v a t i o n s about a p r o f i t s p l i t approach, the i n a d e q u a c i e s of other methods are d r i v i n g the a n a l y s i s i n t h i s d i r e c t i o n . Despite  the g e n e r a l  opposition to a p r o f i t  s p l i t method, i n  p r a c t i c e i t i s taken i n t o account by Revenue Canada i n e v a l u a t i n g transfer prices:  7 5  The most f r e q u e n t l y used i s the group p r o f i t a l l o c a t i o n method. Although d e n i g r a t e d i n t e r n a t i o n a l l y (by the OECD) , i n practice the profit split approach is applied guite f r e q u e n t l y . . . as a l a s t r e s o r t . Gross p r o f i t s r e a l i z e d from the non-arm's l e n g t h s a l e s t o the customer are aggregated and d i v i d e d amount the r e l a t e d p a r t i e s . T h i s a l l o c a t i o n of p r o f i t s can be accomplished i n a number of ways such as p r o p o r t i o n of Canadian s a l e s t o group s a l e s or Canadian c o s t s t o group c o s t s . I t i s extremely important t h a t the a l l o c a t i o n formula be reasonable and r e f l e c t a l l m a t e r i a l f a c t s and c i r c u m s t a n c e s of the case. In a d d i t i o n , i t i s a d v i s a b l e t o have o b j e c t i v e evidence such as . .. i n d u s t r y p r o f i t s t a t i s t i c s t o support the p r o p r i e t a r y a l l o c a t i o n . It  appears  that  Revenue  Canada  acknowledges  that  transfer  p r i c i n g a n a l y s i s i s fundamentally f a c t u a l and the u l t i m a t e purpose of the t r a n s f e r p r i c i n g a n a l y s i s i s t o e v a l u a t e p r i c e s i n l i g h t of actual 7 4  economic circumstances w i t h i b i d . . at  the  r e s u l t being  fair  and  94.  Revenue Canada a u d i t i n g g u i d e l i n e s Pagan and J . S c o t t Wilkie,' i b i d . . a t 109 75  a  as quoted 110.  in J i l l  C.  147 reasonable  attribution  presumption  i s that  of  a  group  specific,  profit  among  thoughtfully  members. and  The  thoroughly  c o n s i d e r e d and documented commercial t r a n s f e r p r i c i n g s t r a t e g y i s a  basis  and r a t i o n a l e  retrospective  f o r intercompany  explanation  or p l a u s i b l e  Revenue Canada ' s p u r p o s e s . b.  rather  justification  than  a  t o meet  76  Use o f I n t a n g i b l e s Transfer  use  pricing  p r i c i n g problems r e l a t i n g t o t r a n s a c t i o n s  of intangibles  involving  a r e e s p e c i a l l y p r o b l e m a t i c due t o t h e unigue  nature o f most i n t a n g i b l e s .  7 7  Comparable t r a n s a c t i o n s  a r e o f t e n not  a v a i l a b l e , y e t t h e i n t a n g i b l e may be v e r y v a l u a b l e  and p r o f i t a b l e  so  7 8  t h e conseguences  of p r i c i n g  are s i g n i f i c a n t .  I t has been  suggested t h a t any attempt t o v a l u e i n t a n g i b l e s by r e f e r e n c e  t o the  i b i d . , a t 230 - 231. The authors r e f e r t o t h e Revenue Canada view t h a t p r i c i n g statements "should be based on a thorough f u n c t i o n a l a n a l y s i s o f t h e a c t i v i t i e s and c o n t r i b u t i o n o f each group member and should c l a r i f y and q u a n t i f y t h e v a r i o u s f a c t o r s which were c o n s i d e r e d i n e s t a b l i s h i n g t h e t r a n s f e r p r i c e s , eg. t e c h n i c a l a s s i s t a n c e , access t o technology, reward f o r economic r i s k , financing assistance, e t c . " (Information C i r c u l a r 87-2, supra, paragraph 15). 7 6  Kenneth J . Murray, supra. a t 27:31 - 27:32; see a l s o t h e 1979 Report, supra. 1993 Report, supra, and I n f o r m a t i o n C i r c u l a r 87-2, i b i d . , paragraphs 40 - 47. 7 7  B.J. A r n o l d and T.E. McDonnell, supra, a t 908. The use o f comparables i s c o n s i d e r e d t o be t h e p r e f e r r e d method, but t h e r e i s disagreement about whether comparables should be viewed b r o a d l y o r narrowly. In a d d i t i o n , i t i s d i f f i c u l t f o r one taxpayer t o know the p r o f i t p o t e n t i a l o f another taxpayer's i n t a n g i b l e p r o p e r t y , t h e p r o f i t p o t e n t i a l o f i n t a n g i b l e s may be a t t r i b u t a b l e t o many o r g a n i z a t i o n a l f a c t o r s t h a t a r e d i f f i c u l t t o segregate, and i f t h e r o y a l t y e s t a b l i s h e d f o r i n t a n g i b l e p r o p e r t y i s t o o low, should t h e r o y a l t y be a d j u s t e d o r should a t a x be imposed on an imputed g a i n on t h e o r i g i n a l t r a n s f e r o f t h e i n t a n g i b l e . Revenue Canada r e q u i r e s the use o f an arm's l e n g t h comparable r o y a l t y where a v a i l a b l e (Information C i r c u l a r 87-2, i b i d . . paragraph 46). 7 8  148 arm's l e n g t h p r i n c i p l e i s u n l i k e l y t o be w o r k a b l e . there  i s no o b j e c t i v e  transfer  economic  p r i c i n g problem  solution  f o r intangibles  t o the  t h e absence  o f comparable  In many cases  intra-corporate  and t h e a l l o c a t i o n o f  p r o f i t s w i t h i n a MNE must be seen as a r b i t r a r y . In  79  8 0  transactions,  Revenue  Canada  expects comparisons w i t h r o y a l t y r a t e s  i n t h e same i n d u s t r y  similar  industry  s i m i l a r products,  market  conditions  involving relatively and  similar  licensing  arrangements.  or a  similar 81  In  p r a c t i c e , t h e t r a n s f e r p r i c i n g method a p p l i e d w i l l l i k e l y be some form o f p r o f i t The allow  split.  United  8 2  States  transfer p r i c i n g regulations  specifically  f o r t h e use o f a p r o f i t s p l i t method: t h e comparable p r o f i t  method  ("CPM"),  83  Unlike  t h e r e s a l e minus and c o s t p l u s methods,  B.J. A r n o l d and T.E. McDonnell, i b i d . . a t 906. The treatment of i n t a n g i b l e s under formulary apportionment a l s o came under s c r u t i n y : "One p o s s i b i l i t y i s t o t r e a t i n t a n g i b l e s as an a t t r i b u t e of t h e e n t i r e e n t e r p r i s e ; t h e r e f o r e , t h e income from and expenses a s s o c i a t e d w i t h i n t a n g i b l e s would be a l l o c a t e d on t h e b a s i s o f t h e other f a c t o r s . Another p o s s i b i l i t y i s t o take t h e c o s t s o f d e v e l o p i n g i n t a n g i b l e s i n t o account as a s s e t s . Such an approach may be j u s t i f i a b l e because t h e c o u n t r y t h a t a l l o w s d e d u c t i o n s f o r the c o s t s o f r e s e a r c h and development has a l e g i t i m a t e c l a i m t o t a x the p r o f i t s o f t h e e n t e r p r i s e a t t r i b u t a b l e t o e x p l o i t i n g t h e intangibles." 7 9  Donald J.S. Brean, supra. a t 111. 8 0  "International  Issues  in  Taxation",  I n f o r m a t i o n C i r c u l a r 87-2, supra. paragraph 45. The taxpayer should a l s o be prepared t o demonstrate t h e reasonableness of intercompany r o y a l t i e s (paragraph 47). 81  B.J. A r n o l d and T.E. McDonnell, supra. a t 908.; J i l l Pagan and J . S c o t t W i l k i e , supra. a t 101 - 102. 8 2  C.  A review o f t h e US t r a n s f e r p r i c i n g r e g u l a t i o n s i s beyond the scope o f t h i s paper. R e f e r t o Dora K. Cheng, "Transfer P r i c i n g : U.S R e g u l a t i o n s and OECD D i s c u s s i o n D r a f t Compared", Tax 8 3  149 the  CPM  allocates  income  among  group  members  on t h e b a s i s o f  comparable p r o f i t s r a t h e r than comparable p r i c e s . Use o f t h e CPM i s  Notes I n t e r n a t i o n a l . January 16, 1995, a t 199 - 202; E l i z a b e t h K i n g and S c o t t D. Newman, "Taxonomy o f P r i c i n g Problems Involving I n t a n g i b l e s and T h e i r Treatment Under t h e O l d and New s.482 R e g u l a t i o n s " , Tax Notes I n t e r n a t i o n a l . December 12, 1994, a t 1851 1860; W. Gordon W i l l i a m s o n , " T r a n s f e r P r i c i n g Update", T a x a t i o n of Outbound Investments (Toronto: I n s i g h t P u b l i c a t i o n s , 1994), Tab 5; 1993 Report, supra; David R. T i l l i n g h a s t , "The Great American T r a n s f e r P r i c i n g Saga, A c t I I , Scene I I I : The 1993 R e g u l a t i o n s and the L e g i s l a t i v e Outlook, w i t h Some Comments on Advance P r i c i n g Agreements and A u d i t s " i n "Tax P l a n n i n g f o r Canada-US and I n t e r n a t i o n a l T r a n s a c t i o n s " , Corporate Management Tax Conference 1993 (Toronto: Canadian Tax Foundation, 1994) 7:1 - 7:15); P e t e r G l i c k l i c h and Seth B. G o l d s t e i n , "Changes i n US T r a n s f e r - P r i c i n g R e g u l a t i o n s I n c r e a s e Compliance Burdens f o r M u l t i n a t i o n a l s and up the A n t i i n T r a n s f e r - P r i c i n g D i s p u t e s " (1993), 41 Canadian Tax J o u r n a l 2, 382; B . J . A r n o l d and T.E.McDonnell, s u p r a ; David R. Black, " S p l i t t i n g P r o f i t s : F i n d i n g t h e R i g h t T r a n s f e r P r i c i n g Methodology" (1993), 41 Canadian Tax J o u r n a l 1, 140; P h i l i p D. M o r r i s o n , "US T r a n s f e r - P r i c i n g P o l i c y : P r o s p e c t s f o r C o n t i n u i n g Controversy", Report o f Proceedings o f t h e F o u r t y - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 46:1; Jean P o t v i n , " T r a n s f e r P r i c i n g and t h e Proposed R e g u l a t o r y Amendments t o S e c t i o n 482 o f t h e I n t e r n a l Revenue Code", Report o f Proceedings o f t h e F o u r t v - F o u r t h Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 5:58 - 5:64; C h a r l e s S. T r i p l e t t , "Intercompany P r i c i n g " , Report o f Proceedings o f the Forty-Second Tax Conference. 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991) 39:5 - 39:22; C h a r l e s S. T r i p l e t t , "The P o l i c y R a t i o n a l e f o r t h e P r o p o s a l s on T r a n s f e r P r i c i n g and an IRS P e r s p e c t i v e on t h e A d m i n i s t r a t i o n o f t h e Measures", Report o f Proceedings o f t h e F o r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 41:1; J.A. Calderwood, "Impact o f t h e IRS S e c t i o n 482 White Paper: A P e r s p e c t i v e from Revenue Canada, T a x a t i o n " , Report o f Proceedings o f t h e F o r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 42:1; Robert J . P a t r i c k , J r . , " P r i c i n g f o r I n t a n g i b l e s : A US P r a c t i t i o n e r ' s P e r s p e c t i v e " , Report o f Proceedings o f t h e F o r t i e t h Tax Conf erence. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 43:1; Nathan Boidman, "The American Super R o y a l t y Rule: A Canadian P e r s p e c t i v e " , Report o f P r o c e e d i n g s o f t h e F o r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 44:1; and Percy Woodard, J r . , " T r a n s f e r P r i c i n g R u l e s : S e c t i o n 482 o f the I n t e r n a l Revenue Code", Report o f Proceedings o f t h e T h i r t y - E i g h t h Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 21:1.  150 not a c c e p t a b l e transfer  f o r Canadian tax purposes as i t may  price  principle.  which  is  Further,  8 4  relationships  in the  accordance CPM  does  between members of an  possibility  countries, countries  as  with  the  the  total  could  easily  CPM of  exceed  the  not  arm's  account  if  it  is  company u s i n g the CPM corresponding iii.  for  applied  allocations to  the the  total  income  IRS  reassess  by  all  the  various  the  group.  of  U n f o r t u n a t e l y , Revenue Canada's p o s i t i o n on the CPM may, l e a d t o double t a x a t i o n where the  length  F i n a l l y , double t a x a t i o n i s  method, the  the  i n t e r n a t i o n a l group and  f u n c t i o n s c a r r i e d on by the members. a  with  not generate a  a U.S.  in itself, affiliate  r u l e s , and Revenue Canada does not p r o v i d e  adjustment.  T r a n s f e r P r i c i n g and  85  a  86  Customs V a l u a t i o n  There i s a l a c k of c o o r d i n a t i o n between customs v a l u a t i o n and transfer  pricing  on  the  international  scene  which  has  been  Press Release No. 93-003, supra. T h i s would occur where t h e r e are f a c t o r s which make p r o f i t performance comparisons d e f e c t i v e i n c l u d i n g : v a r y i n g c o s t e f f i c i e n c i e s such as d i f f e r e n c e s i n age of p l a n t and equipment; d i f f e r e n c e s i n the q u a l i t y of management; d i f f e r e n c e s i n the c o s t of c a p i t a l where some companies r e l y s u b s t a n t i a l l y on i n t e r n a l l y generated funds, w h i l e o t h e r s may borrow h e a v i l y ; and the degree of business experience s i n c e mature companies w i l l g e n e r a l l y have d i f f e r e n t r e s u l t s than s t a r t - u p companies. 8 4  i b i d . . T h i s over t a x a t i o n c o u l d a r i s e because each would compare r e s u l t s with independent f i r m s o p e r a t i n g jurisdiction. 85  8 6  below.  See s e c t i o n D.)  country in i t s  "Consequences of T r a n s f e r P r i c e Adjustments"  151 identified,  8 7  uncontrolled  but  for  remedied.  comparables  more r e s t r i c t e d result  not  than  88  For  example,  the  use o f  f o r customs v a l u a t i o n purposes  f o r transfer  pricing  purposes.  i s much This  i n an arm's l e n g t h comparable used t o s e t t r a n s f e r  income t a x purposes  v a l u a t i o n purposes. customs purposes a u d i t even begins.  w h i l e another method i s used  may  prices  f o r customs  A l s o , time l i m i t s f o r r e a p p r a i s i n g v a l u e f o r  are l i k e l y  t o e x p i r e long b e f o r e an income t a x  I f Revenue Canada reduces t h e t r a n s f e r p r i c e t o  the Canadian buyer, a corresponding r e d u c t i o n i n customs v a l u e may  1 9 9 4 D r a f t , P a r t I, supra. a t 171 - 172; L o r r a i n e Eden, "Free Trade, Tax Reform, and T r a n s f e r P r i c i n g " , supra. a t 100 -101; Robert F. Lindsay, supra. a t 20:14; Donald J.S. Brean, " I n t e r n a t i o n a l Issues i n T a x a t i o n " , supra. a t 105 - 106; G. F. Mathewson and G.D. Q u i r i n , supra. a t 15 - 16; and E m i l i o Romano, supra. a t 4 - 5: "The a l t e r n a t i v e mechanisms t h a t each system provides f o r the determination of the r e l e v a n t p r i c e i n t r a n s a c t i o n s between r e l a t e d parties are d i f f e r e n t i n many respects. Some d i f f e r e n c e s a r e due t o t h e v e r y nature o f t h e t a x a b l e base. An example o f t h i s s i t u a t i o n i s t h e e x c l u s i o n o f t h e v a l u e o f any " a s s i s t " p r o v i d e d from t h e c o u n t r y o f i m p o r t a t i o n from the customs v a l u e o f an imported good. Some o t h e r d i f f e r e n c e s c o u l d be harmonized, making t h e customs r u l e s f o r i d e n t i c a l o r s i m i l a r goods, and t h e r e s a l e and r e c o n s t r u c t e d v a l u e c r i t e r i a , as c l o s e as p o s s i b l e t o t h e i r corresponding t a x methods. The i n t e g r a t i o n o f income t a x p r i c i n g adjustments w i t h d u t i e s and s a l e s taxes i s common i n Mexico where d i r e c t and i n d i r e c t t a x e s , as w e l l as customs d u t i e s , a r e a d m i n i s t e r e d by t h e same a u t h o r i t i e s . . . The s a v i n g s and i n c r e a s e d e f f i c i e n c y o b t a i n e d from such s t r u c t u r e a r e complemented by t h e a b i l i t y t o make complimentary adjustments on i n d i r e c t taxes and d u t i e s payable by a taxpayer as a consequence o f income t a x adjustments." 8 7  B.J.Arnold and T.E.McDonnell, supra. a t 906, r e p o r t t h a t t h e f o l l o w i n g q u e s t i o n s were r a i s e d a t t h e I n v i t a t i o n a l Conference on Transfer P r i c i n g f o r future research during a d i s c u s s i o n concerning the GATT r u l e s f o r determining t h e v a l u e o f goods f o r custom purposes: 1. Are t h e r e aspects o f t h e GATT r u l e s t h a t c o u l d be u s e f u l l y adopted f o r income t a x purposes? 2. Should t h e income t a x and GATT r u l e s be c o o r d i n a t e d i n some way; and 3. More g e n e r a l l y , can t r a d e c o n s i d e r a t i o n s a s s i s t t h e development o f workable t r a n s f e r p r i c i n g r u l e s , (emphasis added). 8 8  152 not  be  forthcoming from  customs o f f i c i a l s  s u b j e c t t o excess t a x a t i o n .  and  the MNE  could  be  8 9  Revenue Canada's p o s i t i o n on t h i s i s s u e i s as f o l l o w s :  9 0  As a r e s u l t of the i n t e g r a t i o n of both Customs and T a x a t i o n i n t o one department coupled w i t h the i n i t i a t i o n of the advance p r i c i n g concept, we have r e c e i v e d a number o f i n q u i r i e s as t o whether or not the department would r e c o g n i z e and a c c e p t one " v a l u a t i o n " or " p r i c e " f o r both customs and t a x a t i o n purposes. There are b e n e f i t s t o be gained by our major i m p o r t i n g c l i e n t s (and s i m i l a r l y f o r those importers i n o t h e r c o u n t r i e s ) from the implementation o f such an approach. However. t h e r e are many p o i n t s t o c o n s i d e r ( f o r example, domestic l e g i s l a t i v e requirements and i n t e r n a t i o n a l commitments and t r e a t i e s such as the g e n e r a l agreement on t a r i f f s and t r a d e ) . Because the i m p l i c a t i o n s of b e i n g a b l e t o secure a "one f i g u r e " approach t h a t would s a t i s f y a l l areas a r e f a r r e a c h i n g , I do not b e l i e v e t h a t we w i l l be a b l e t o a r r i v e a t a "quick and simple answer" t o t h i s p a r t i c u l a r i s s u e , (emphasis added) I t i s of i n t e r e s t t o note the Agreement on Implementation A r t i c l e VII preamble system  ( V a l u a t i o n f o r Customs Purposes)  r e c o g n i z e s the for  the  need  valuation  of  f o r "a goods  fair, for  o f the GATT. uniform  customs  and  91  of The  neutral  purposes  that  p r e c l u d e s the use of a r b i t r a r y o r f i c t i t i o u s v a l u e s " and which i s "based on simple and e q u i t a b l e c r i t e r i a c o n s i s t e n t w i t h commercial p r a c t i c e s and v a l u a t i o n procedures". A r t i c l e  7:2(g)  specifically  Robert F. L i n d s a y , supra. a t 20:15. The Canadian Customs A c t . R.S.C. 1985 (2nd Supp) , c l , does not c u r r e n t l y permit downward adjustments of v a l u a t i o n f o r customs purposes after importation where t h e r e have been t r a n s f e r p r i c e adjustments (Norman C. Loveland, supra. a t 6 and paragraph 48(5) (c) of the Customs A c t ) . 8 9  Denis L e f e b v r e , "Recent Revenue Canada I n i t i a t i v e s " , Report of Proceedings of the F o r t y - F i f t h Tax Conference. 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994), 6:1 a t 6:8. 9 0  91  BISD (26 Supp.) 116.  153 disallows values".  92  customs  values  based  on  "arbitrary  or  fictitious  The f a c t t h a t t h e buyer and s e l l e r a r e r e l a t e d  i s not  c o n s i d e r e d , i n i t s e l f , t o be grounds f o r r e g a r d i n g t h e t r a n s a c t i o n v a l u e t o be u n a c c e p t a b l e :  93  In such case t h e circumstances s u r r o u n d i n g t h e s a l e s h a l l be examined and t h e t r a n s a c t i o n v a l u e s h a l l be accepted p r o v i d e d the r e l a t i o n s h i p d i d not i n f l u e n c e t h e p r i c e . I f . . . the customs a d m i n i s t r a t i o n has grounds f o r c o n s i d e r i n g t h a t t h e r e l a t i o n s h i p i n f l u e n c e d t h e p r i c e , i t s h a l l communicate i t s grounds t o t h e importer and he s h a l l be g i v e n a r e a s o n a b l e o p p o r t u n i t y t o respond. The  importer o n l y has t o demonstrate t h a t t h e v a l u e  "closely  GATT, A n a l y t i c a l Index: Guide t o GATT Law and P r a c t i c e . 6th ed., (1994) a t 240. The Agreement on Implementation o f A r t i c l e VII o f t h e GATT was s i g n e d on A p r i l 12, 1979 and e n t e r e d i n t o f o r c e on January 1, 1981. The t e x t o f t h e Agreement and t h e P r o t o c o l appear a t 26S/116. The Agreement s e t s out f i v e a c c e p t a b l e v a l u a t i o n methods, ranked i n a h i e r a r c h i c a l o r d e r : "The primary b a s i s f o r customs v a l u e under t h e Agreement i s " t r a n s a c t i o n v a l u e " as d e f i n e d i n A r t i c l e 1: 'the p r i c e a c t u a l l y p a i d o r payable f o r t h e goods when s o l d f o r export t o t h e country o f i m p o r t a t i o n ' , s u b j e c t t o c e r t a i n s p e c i f i e d adjustments (eg. t h e c o s t o f packaging, and r o y a l t i e s r e l a t e d t o t h e goods b e i n g v a l u e d t h a t t h e buyer must pay as a c o n d i t i o n o f s a l e ) . When t h e customs v a l u e s cannot be determined under t h e p r o v i s i o n s o f A r t i c l e 1, t h e r e s h o u l d n o r m a l l y be a p r o c e s s o f c o n s u l t a t i o n between t h e customs a d m i n i s t r a t i o n and the importer w i t h a view t o a r r i v i n g a t a b a s i s o f v a l u e under A r t i c l e 2 ( t r a n s a c t i o n v a l u e o f i d e n t i c a l goods) o r A r t i c l e 3 ( t r a n s a c t i o n v a l u e o f s i m i l a r goods). When t h e customs v a l u e cannot be determined on t h i s b a s i s , r e s o r t may be made t o d e d u c t i v e v a l u e ( A r t i c l e 5) o r computed v a l u e ( A r t i c l e 6 ) , a t t h e c h o i c e o f the importer. A r t i c l e 7 p r o v i d e s a f a l l - b a c k method: u s i n g reasonable means c o n s i s t e n t w i t h t h e p r i n c i p l e s and g e n e r a l p r o v i s i o n s o f t h i s Agreement and o f A r t i c l e V I I o f t h e [GATT] and on t h e b a s i s o f data a v a i l a b l e i n t h e c o u n t r y o f i m p o r t a t i o n . " There a r e a number o f o t h e r s p e c i f i c a l l y d i s a l l o w e d bases f o r customs v a l u a t i o n i n c l u d i n g : (a) t h e s e l l i n g p r i c e i n t h e country of i m p o r t a t i o n o f goods produced i n such c o u n t r y ; (b) a system which p r o v i d e s f o r t h e acceptance f o r customs purposes o f t h e h i g h e r o f two a l t e r n a t i v e v a l u e s ; (c) t h e p r i c e o f goods on t h e domestic market o f t h e country o f e x p o r t a t i o n ; and (d) t h e c o s t o f p r o d u c t i o n o t h e r than computed v a l u e s which have been determined f o r i d e n t i c a l o r s i m i l a r goods i n accordance w i t h t h e p r o v i s i o n s o f A r t i c l e 6. 9 2  9 3  related  A r t i c l e 1:2 o f t h e Agreement on Implementation parties.  deals with  154 approximates" methods,  or  importer and may  to  any  one  of  " t e s t s " are  to  four be  enumerated  used  at  methods,  the  94  and  the  of  the  initiative  o n l y f o r purposes of comparison; s u b s t i t u t i v e v a l u e s  not be e s t a b l i s h e d under these p r o v i s i o n s . To  the  extent  that  i n the  future there  i s harmonization  v a l u a t i o n s f o r customs and income t a x purposes, c u r r e n t transfer  prescribed  p r i c i n g methods which r e s u l t i n a r b i t r a r y v a l u e s  substituted  for  commercial  transfer  prices  may  of  have  being to  be  e l i m i n a t e d , r e v i s e d , or, a t a minimum, a p p l i e d more f l e x i b l y a t the option  of the MNE,  and  i n a more r e s t r i c t e d manner f o r t r a n s f e r  p r i c i n g adjustments a t the hands of tax a u t h o r i t i e s , iv.  Conclusion The g e n e r a l l y accepted methods f o r d e t e r m i n i n g "the reasonable  amount" or  arm's l e n g t h  p r i c e , do  economic c h a r a c t e r i s t i c s of a MNE.  not  effectively  economic r e a l i t y  penalized and  by  with  the  MNEs e x i s t t o a v o i d the economic  r e s t r i c t i o n s of independent d e a l i n g , are  adequately d e a l  9 5  y e t f o r income t a x purposes  Revenue Canada which  imposes an  artificial,  and  ignores  i n most  this cases,  a r b i t r a r y arm's l e n g t h p r i c e . It  i s highly  transactions  u n l i k e l y that  under e x a c t l y  the  unconnected  parties  same c i r c u m s t a n c e s as  carry  out  controlled  t r a n s a c t i o n s . I f they d i d , the whole economic r a t i o n a l e f o r a  MNE  The f o u r methods are b a s i c a l l y the exact comparable, i n e x a c t comparable, r e s a l e minus and c o s t p l u s methods. 9 4  95  Jill  C. Pagan and J . S c o t t W i l k i e , supra, a t  227.  155 would be i n doubt.  Where comparable t r a n s a c t i o n s  96  do e x i s t , a  g r e a t d e a l o f time and expense i s r e q u i r e d t o make adjustments t o inexact  comparables i n order  despite  t h e commercial  t o a r r i v e a t an a c c e p t a b l e  realities  o f t h e arrangement.  price MNEs may  become p r e o c c u p i e d w i t h s a t i s f y i n g tax a u t h o r i t i e s and end up u s i n g a t r a n s f e r p r i c i n g methodology t h a t i s commercially Finally, countries  lack  may  lead  of harmonization to  double  ineffective.  of acceptable  taxation,  lack  9 7  methods by  of  consistent  a p p l i c a t i o n o f a c c e p t a b l e methods may l e a d t o double t a x a t i o n , and lack of coordination  w i t h customs v a l u a t i o n s  may l e a d t o excess  taxation. O v e r a l l , t h e t r a n s f e r p r i c i n g methods a r e a r g u a b l y a r b i t r a r y and  uncertain  (despite  their  systematic  approach),  require  an  unreasonable amount o f time and e f f o r t t o produce and s u b s t a n t i a t e (by MNEs and t a x a t i o n a u t h o r i t i e s ) , may be redundant o r i r r e l e v a n t for  customs  valuations  (depending  on how p a r t i c u l a r government  a u t h o r i t i e s apply v a l u a t i o n s t a n d a r d s ) ,  and can l e a v e a MNE open t o  p o s s i b l e double t a x a t i o n . D. What a r e t h e e f f e c t s o f t r a n s f e r p r i c i n g adjustments? Because o f problems i n h e r e n t intangibles adjustments.  are p a r t i c u l a r l y 98  Research  9 6  i b i d . . a t 27.  9 7  i b i d . . a t 28.  and  i n valuing intangible  vulnerable development  to  property,  transfer  ("R&D")  pricing  activities  The s e n s i t i v i t y t o p o t e n t i a l t a x leakage due t o u n d e r l y i n g technology t r a n s f e r r e d abroad i s seen i n t h e US s u p e r - r o y a l t y p r o v i s i o n s o f t h e 1986 Tax Reform A c t (Pub.L. no. 99-514, 100 S t a t . 9 8  156 conducted i n a h i g h t a x c o u n t r y w i t h s u b s t a n t i a l t a x i n c e n t i v e s f o r R&D,  f o l l o w e d by  licensing  of  a l l rights  t o the  technology  or  product t o a company l o c a t e d i n a low t a x c o u n t r y w i t h a l a r g e t a x treaty  network,  adjustment  is a  dispute.  9 9  likely  situation  for a  transfer  pricing  Computer software l i c e n s i n g agreements have  a l s o been i d e n t i f i e d as b e i n g h i g h l y v u l n e r a b l e t o the i m p o s i t i o n of t r a n s f e r p r i c i n g adjustments by the t a x a u t h o r i t i e s o f v a r i o u s countries  due  software.  100  foreign  and  to  problems  Indeed, Canadian  one  of  inherent the  developers  major in  in  valuing  issues  faced  cross-border  computer by  both  licensing  s i t u a t i o n s i s a t t a c k s by the t a x a u t h o r i t i e s on the quantum of the r o y a l t y s e t between r e l a t e d  parties.  A f u r t h e r problem a r i s e s w i t h the U.S.  transfer pricing rules  which a l l o w the IRS t o make p e r i o d i c adjustments o f predetermined p r i c e s of i n t a n g i b l e p r o p e r t y under agreements f o r more than  one  year i n o r d e r ensure t h a t such p r i c e s a r e "commensurate w i t h the income" earned  f o r the use  o f such p r o p e r t y .  Where the  income  2058 (1986)) as r e f e r r e d t o by Kenneth J . Murray, "Research and Development Cost S h a r i n g Arrangements", Report o f Proceedings of the F o r t y - T h i r d Tax Conference. 1991 Conference Report, (Toronto: Canadian Tax Foundation, 1992) a t 46:1 - 46:29, a t 46:3. For a d i s c u s s i o n of t r a n s f e r p r i c i n g i s s u e s s p e c i f i c a l l y r e l a t e d t o r e s e a r c h and development see J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 113 - 115; I n f o r m a t i o n C i r c u l a r 87-2, supra. paragraphs 34 - 39; B.J. A r n o l d and T.E. McDonnell, s u p r a . a t 909 - 911; and Kenneth J . Murray, "Research and Development Cost S h a r i n g Arrangements", ibid.. 9 9  Kenneth G. Murray, "Computer Software: Canadian and C r o s s Border I s s u e s " , Report o f Proceedings o f the F o r t y - F i f t h Tax Conference. 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994), 27:1 a t 27:3. 1 0 0  157 earned  o r c o s t s a v i n g s exceed  20% o f t h e amount e s t i m a t e d a t t h e  time t h e agreement was entered i n t o , t h e agreed upon p r i c e w i l l be adjusted.  101  Canada c o n s i d e r s t h i s approach t o be i n c o n t r a d i c t i o n  of t h e arm's l e n g t h p r i n c i p l e yearly will  retrospective reappraisal  not g e n e r a l l y provide  where  t o the extent t h a t i t i n v o l v e s a  such  a periodic  conseguences:  of p r o f i t s .  a corresponding  adjustment  i s made  1 0 2  Revenue  adjustment  103  with  Canada  i n cases  the following  104  U n i l a t e r a l t r a n s f e r - p r i c i n g adjustments, which i n c r e a s e t h e p r o f i t o f one company and do not reduce t h e p r o f i t o f t h e o t h e r company c o r r e s p o n d i n g l y , may r e s u l t i n double t a x a t i o n . As a t r a n s f e r p r i c i n g adjustment may w e l l be i n excess o f what t r e a t y p a r t n e r s o f t h e U n i t e d S t a t e s r e g a r d as an arm's l e n g t h amount under their transfer pricing rules, even t h e 101  P r e s s Release 93-003, supra.  B.J. A r n o l d and T.E. McDonnell, supra. a t 908. Canada's view i s i n l i n e w i t h t h e OECD. P e r i o d i c adjustments are also c o n s i d e r e d t o be tantamount t o d i s r e g a r d i n g t h e c o n t r a c t u a l arrangement e n t e r e d i n t o by t h e p a r t i e s , though o t h e r s argue t h a t arm's l e n g t h p a r t i e s would not o r d i n a r i l y t r a n s f e r v a l u a b l e i n t a n g i b l e s o r would p r o v i d e f o r a v a r i a b l e r o y a l t y . 1 0 2  P r e s s Release No. 93-003, supra, "Backgrounder". Where t h i s happens, taxpayers may seek r e l i e f through competent a u t h o r i t y procedures (see A r t i c l e XXVI and t h e Canada-U.S. Tax Convention and I n f o r m a t i o n C i r c u l a r 71-17R3, "Requests f o r Competent A u t h o r i t y C o n s i d e r a t i o n - Double T a x a t i o n I s s u e s " ) ; The Canadian r u l e s suggest t h a t p e r i o d i c adjustments n o t contemplated i n a user c o n t r a c t p r o b a b l y a r e not c o n s i s t e n t w i t h t h e arm's l e n g t h t e s t and a f u n c t i o n a l a n a l y s i s t h a t depends upon knowledge o f a c o u n t e r p a r t y ' s p r o f i t s may be i n c o n s i s t e n t w i t h t h e p r i c i n g behaviour o f u n r e l a t e d p a r t i e s ( J i l l C. Pagan and J . S c o t t W i l k i e , s u p r a a t 116) . See a l s o B.J. A r n o l d and T.E. McDonnell, supra. a t 915. Mexico i s a l s o o f t h e view t h a t r e t r o s p e c t i v e adjustments on payments made between a s s o c i a t e d e n t e r p r i s e s f o r t h e use o f i n t a n g i b l e s i n order t o make them "commensurate w i t h income" should not be a p p l i e d (see E m i l i o Romano, supra. a t 6 - 7 ) . 1 0 3  f  Kenneth J . Murray, "Computer Software: Border I s s u e s " , supra. a t 27:31 - 27:32. 1 0 4  Canadian and Cross  158 " c o r r e s p o n d i n g adjustment" p r o v i s i o n s i n t a x t r e a t i e s may not f u l l y remove t h e r i s k o f double t a x a t i o n . Therefore, result  in  an upward t r a n s f e r p r i c e adjustment by t h e IRS w i l l  double  taxation  unless  Revenue  Canada  grants  a  compensating adjustment. The Canada-U.S. Tax Convention p r o v i d e s a measure o f p r o t e c t i o n a g a i n s t double t a x a t i o n by p r o v i d i n g t h a t t h e other  t r e a t y partner  agrees  with  s h a l l make a compensating adjustment  the t r a n s f e r  There i s no guarantee t h a t  pricing  adjustment  that  such adjustments w i l l  was  i f i t  made.  105  be made and i n  cases where l a r g e compensating adjustments a r e r e q u e s t e d , t h e r e i s l i k e l y t o be s u b s t a n t i a l r e s i s t a n c e due t o t h e c o r r e s p o n d i n g l o s s of t a x r e v e n u e .  106  Where t h e s e t r e a t y p r o v i s i o n s a r e not s u f f i c i e n t t o r e s o l v e a dispute  between  competent  interested  authority  parties,  consideration  t h e taxpayer  under  may  t h e mutual  request  agreement  Canada-U.S. Tax Convention, A r t i c l e IX:3. J i l l C. Pagan and J . S c o t t W i l k i e , supra. a t 29; and 39: Tax t r e a t i e s can impact on t r a n s f e r p r i c i n g i n t h e f o l l o w i n g ways: F i r s t , they can d e f i n e a p a r t i c u l a r b a s i s f o r a l l o c a t i o n o f income and through t h e t r e a t y network f a c i l i t a t e agreement on an i n t e r n a t i o n a l s t a n d a r d . Second, they can i d e n t i f y t h e t r a n s a c t i o n s t o which t h e b a s i s w i l l apply. T h i r d , they can p r o v i d e f o r r e s o l u t i o n o f d i s p u t e s . F i n a l l y , they can p r o v i d e a method f o r mutual a s s i s t a n c e between t h e t a x authorities involved. 105  i b i d . . a t 170. The authors a l s o d i s c u s s t h e importance o f c o n s