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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., University of Calgary (Canada), 1992 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS in THE FACULTY OF GRADUATE STUDIES (Faculty of Law) We accept t h i s thesis as conforming to the required standard. THE UNIVERSITY OF BRITISH COLUMBIA June 1995 ©Cindy L. Rajan, 1995 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of The University of British Columbia Vancouver, Canada DE-6 (2/88) 11 ABSTRACT The thesis i s that to give i n s u f f i c i e n t recognition to inter n a t i o n a l trade agreements i n developing tax p o l i c i e s can r e s u l t i n d i s t o r t i o n s i n international trade. I t i s not suggested that the objective of f a c i l i t a t i n g free trade should be paramount to sovereign in t e r e s t s which underlie tax p o l i c y decisions. However, the proposition i s that i n s e l e c t i n g from among alt e r n a t i v e tax p o l i c i e s , the p o l i c y which should be chosen i s that which achieves national objectives while minimizing d i s t o r t i v e e f f e c t s on international trade. The goals of t h i s study are: 1) to determine whether p a r t i c u l a r tax provisions impede, d i s t o r t , or otherwise have a negative and u n j u s t i f i a b l e e f f e c t on free trade; and 2) to r e f l e c t on the in t e r s e c t i n g r o l e of taxation and in t e r n a t i o n a l trade. Although many tax p o l i c i e s may be viewed as prima f a c i e "discriminatory", such discrimination may be acceptable pursuant to inter n a t i o n a l agreements, or overriding national i n t e r e s t s may p r e v a i l . An attempt i s made to develop a framework for examining the e f f e c t s of taxation on international trade which can be used as a guide for tax p o l i c y makers i n se l e c t i n g p o l i c i e s which meet domestic c r i t e r i a as well as f a c i l i t a t e free trade. The t h e s i s consists of f i v e chapters. The f i r s t chapter sets out the methodology, conceptual framework and t h e o r e t i c a l basis for the study. The next three chapters examine s p e c i f i c tax regimes i n the context of the General Agreement on T a r i f f s and Trade (the "GATT") and underlying p r i n c i p l e s of free trade. The I l l tax regimes are: 1) withholding taxes f o r payments under software l i c e n s i n g arrangements; 2) research and development tax incentives; and 3) cross-border transfer p r i c i n g provisions. Chapter f i v e summarizes the case studies and outlines approaches to f i s c a l harmonization under a free trade regime. The conclusion i s that a GATT tax code may be an appropriate mechanism for achieving harmonization f o r c e r t a i n tax measures. However, i t i s i n f e a s i b l e , at l e a s t i n the short term, to expect a GATT tax code w i l l be placed on the World Trade Organization's agenda. Even i f such a code i s attainable i n the future, u n i l a t e r a l , b i l a t e r a l and other m u l t i - l a t e r a l approaches to eliminating d i s t o r t i v e tax p o l i c i e s may be more appropriate i n some cases. i v TABLE OF CONTENTS Abstract i i Table of Contents i v Acknowledgement v i i i Dedication i x 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 34 PART I: CROSS-BORDER PAYMENTS UNDER SOFTWARE LICENSING ARRANGEMENTS A. The Canadian Approach 36 B. Royalty Provisions i n M u l t i l a t e r a l Treaties 39 C. The Problem of Double Taxation 43 D. Recent Developments 45 PART I I : THE GATT AND WITHHOLDING TAX ON PAYMENTS FOR SOFTWARE A. Introduction 47 B. The P r i n c i p l e of Nondiscrimination and I t s Interpretation 48 i . The P r i n c i p l e 48 i i . Interpretation of A r t i c l e III 50 a. Internal Taxes: Direct, Indirect or Both 51 b. Pol i c y Purpose 55 V c. Extent of E f f e c t on Trade 56 C. Withholding Tax and A r t i c l e 111:2 57 i . Withholding Tax - Direct or Indirect 57 i i . Internal Taxes - Direct and Indirect 60 i i i . Discriminatory Taxation 62 i v . J u s t i f i a b l e Discrimination? 65 CONCLUSION 67 CHAPTER 3: RESEARCH & DEVELOPMENT INTRODUCTION 69 PART I: R&D TAX INCENTIVES 72 A. The Canadian System 72 i . Overview 72 i i . R&D Pool - Deductible Expenditures 76 i i i . ITCs 78 i v . C a p ital Expenditures 82 v. CCPCs - Enhanced ITCs 83 v i . Foreign R&D 83 v i i . Summary 85 B. Recent Developments 86 PART I I : SUBSIDIES AND THE URUGUAY ROUND 87 A. Introduction 87 B. The SCM Agreement 89 i . Overview 89 i i . R&D Subsidies 94 PART I I I : CANADIAN R&D TAX INCENTIVES: DISCRIMINATORY SUBSIDIES? A. Free Trade, Discrimination and R&D Tax Subsidies 98 B. J u s t i f i a b l e Incentives? 107 C. The Need for Revision 115 CONCLUSION 117 v i CHAPTER 4: TRANSFER PRICING INTRODUCTION 120 PART I: THE NATURE OF TRANSFER PRICING 124 A. The Tax Avoidance Perspective 125 B. The Income Measurement Perspective 127 C. Conclusion 128 PART I I : DISCRIMINATION IN THE TRANSFER PRICING REGIME 131 A. To Which Taxpayers do Transfer P r i c i n g Rules Apply? 132 B. What Transactions are Affected? 135 C. How i s the Transfer Price Determined? 13 6 i . Arm's Length P r i n c i p l e 138 i i . Methods for Determining the Arm's Length Price 143 a. Goods and Acquisitions / Dispositions of Intangibles 143 b. Use of Intangibles 147 i i i . Transfer P r i c i n g and Customs Valuation 150 i v . Conclusion 154 D. What are the Eff e c t s of Transfer P r i c i n g Adjustments? 155 E. Compliance and Prevention 161 i . Compliance 161 i i . Prevention 164 i i i . Conclusion 170 PART I I I : JUSTIFICATION FOR DISCRIMINATION & ALTERNATIVES 171 A. Summary of Discrimination i n the Transfer 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 v i i 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 v i i i ACKNOWLEDGMENT I would l i k e to thank my thes i s supervisor, also our Graduate's Dean, Professor Pitman Potter f o r h i s encouragement and guidance from my application for admittance to the LL.M. program through to completion of t h i s t h e s i s . His comments and advice were always i n s i g h t f u l and thought provoking, and have generated many ideas for future research. Special thanks to Professor Robert Paterson, as my thesis* second reader, who reviewed drafts of manuscripts and provided me with guidance and valuable feedback throughout my Master's program. I would also l i k e to acknowledge Professor C l a i r e Young for h e l p f u l comments on the tax aspects of my th e s i s . I also want to acknowledge and express my appreciation to Professor Catherine Brown of the Faculty of Law, University of Calgary, who has been e s p e c i a l l y supportive of my academic and professional pursuits since my LL.B. program at the University of Calgary, contributing time, resources, advice and i n s p i r a t i o n . F i n a l l y , I would l i k e to express my appreciation to the B.C. Law Foundation who provided generous f i n a n c i a l support i n pursuing t h i s degree. In s p i t e of a l l the support I have had i n seeing t h i s thesis through to completion, the sole r e s p o n s i b i l i t y f o r any errors and omissions i s mine alone. To my husand and my parents for t h e i r love and support. 1 CHAPTER 1 INTERNATIONAL TRADE AND TAXATION "The topic, i n my view, i s an important one that has not received s u f f i c i e n t attention. I t makes l i t t l e sense to break down bar r i e r s to i n t e r n a t i o n a l trade and to pursue economic integration, whether i n Europe, North America or the South P a c i f i c , without dealing with the r e l a t e d tax issues." 1 Advances i n international trade should not be impeded by tax p o l i c i e s without sound j u s t i f i c a t i o n ; yet tax p o l i c i e s can and do d i s t o r t i n ternational trade i n c a p i t a l , goods, services and technology. International taxation and i n t e r n a t i o n a l trade are generally treated as independent f i e l d s of study. 2 However, 'g l o b a l i z a t i o n 1 and free trade are the order of the day and the i n t e r r e l a t i o n s h i p between domestic tax p o l i c y and i n t e r n a t i o n a l trade law takes on more importance i n t h i s global marketplace. Governments i n a l l corners of the world seem intent on removing a l l forms of b a r r i e r s to trade and expanding economic unions and free trade zones i n order to remain competitive i n the global marketplace. 3 There can be no doubt that the complexities 1 Brian J. Arnold, "Tax Discrimination Against Aliens, Non-Residents, and Foreign A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the United Kingdom, and the United States", Canadian Tax Paper No. 90, (Toronto: Canadian Tax Foundation, 1991) at xiv. 2 C l e a r l y the subject of international aspects of taxation i s not new. However, u n t i l recently, i t has not been necessary to consider the international ramifications of domestic taxation, beyond s p e c i f i c trade interventions such as customs duties. See Donald J . S. Brean, "International Issues i n Taxation : The Canadian Perspective", Canadian Tax Paper No. 75 (Toronto: CTF, 1984), x i i i and 1. 3 See L. Denis Desautels, "Playing with Blocs", CA Magazine, January/February 1995 (Toronto: CICA, 1995) 38, i n which the Auditor General of Canada 'examines how our small, but dynamic, nation w i l l f i t into the global marketplace.' 2 of global trade can be overwhelming i n view of varying economic, s o c i a l , and p o l i t i c a l conditions; u n i l a t e r a l , b i l a t e r a l and m u l t i l a t e r a l tax regimes add to the confusion. Yet, despite claims to taxation as a national prerogative and complexities involved i n overlapping international trade agreements with tax practices, i t i s e s s e n t i a l to understand the impact tax p r a c t i c e s can have on i n t e r n a t i o n a l trade. The thesis i s that i n t e r n a t i o n a l trade law and p r a c t i c e i s intimately, i f not e x p l i c i t l y , intertwined with taxation; to give i n s u f f i c i e n t consideration to i n t e r n a t i o n a l trade agreements i n developing national tax laws and entering into t r e a t i e s can impair the a b i l i t y to a t t a i n the p o s i t i v e goals of free trade. Therefore t h i s study attempts to develop a framework for understanding the e f f e c t s of taxation on i n t e r n a t i o n a l trade to guide tax p o l i c y makers i n developing sound p o l i c i e s and s e l e c t i n g from among al t e r n a t i v e strategies those tax measures which promote national goals and minimize counter-productive impacts on i n t e r n a t i o n a l trade objectives. 4 This understanding i s also relevant to furthering i n t e r n a t i o n a l f i s c a l harmonization. The object of t h i s study i s the Canadian income tax system i n 4 Donald J.S. Brean, "International Issues i n Taxation", supra at 1: "As countries cast tax nets beyond t h e i r borders, int e r n a t i o n a l f i s c a l overlap i s i n e v i t a b l y created with implications for the e f f i c i e n c y of the world economy, for the effectiveness of domestic tax p o l i c i e s , and for the l e v e l and d i s t r i b u t i o n of gains from in t e r n a t i o n a l economic integration." 3 the broader context of Canada-U.S. trade 5; the perspective has both national and international dimensions. The study focuses on s p e c i f i c tax regimes which may impact on research and development of technology as well as on the flow of i n t e r n a t i o n a l transfers of technology both between arm's length and non-arm's length p a r t i e s . The emphasis on tax 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 6 i s grounded i n the r e a l i t i e s of the twenty-first century marketplace. 'Globalization' was the buzz word of the 80's and early 90's; now the global marketplace i s moving along the •information highway' into the 'information era'. The information era i s here and technology i s the commodity of the future. S i g n i f i c a n t progress was made at the Uruguay Round of the GATT with 5 Although i t may not be reasonable to equate Canada and the United States i n terms of resources, wealth and power, these countries are both considered to be developed countries. Also, Canada has an established trade r e l a t i o n s h i p with the United States which i s s i g n i f i c a n t to the Canadian economy. Trade with Mexico, though a natural extension to t h i s study given NAFTA, has not been addressed as issues r e l a t i n g to trade among developed and developing nations, though important, are beyond the scope of t h i s study. 6 The d e f i n i t i o n adopted for "technology" i s that set out i n CA. Brown, "Tax Aspects of The Transfer of Technology: The Asia-P a c i f i c Rim", Canadian Tax Paper No. 87. (Toronto: Canadian Tax Foundation, 1990) at 5 - 6: "Technology i s , i n the f i n a l analysis, a form of knowledge r e l a t i n g to information with s c i e n t i f i c or commercial value. This knowledge may consist of know-how, concepts, methodologies, formulas, models, designs, prototypes, data bases or products embodying or u t i l i z i n g such knowledge". Brown also r e f e r s to the following common d e f i n i t i o n s for technology (at 6) : "technology as p u b l i c l y or p r i v a t e l y held knowledge, technology as r e l a t i n g to a p a r t i c u l a r stage of i t s development by the transferor, technology as r e l a t i n g to 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 for i t s project development, technology as r e l a t i n g to a p a r t i c u l a r industry, and technology as categories of i n t e l l e c t u a l property r i g h t s protected to various degrees." 4 regard to improved protection of i n t e l l e c t u a l property r i g h t s on a global s c a l e . 7 In part t h i s advancement should stimulate the development of, and trade i n technology through the protection and enforcement of i n t e l l e c t u a l property r i g h t s outside the r i g h t s holders* home j u r i s d i c t i o n . I t seems only l o g i c a l that the domestic and i n t e r n a t i o n a l tax structures should further, rather than impede, t h i s progress. Yet domestic tax p o l i c i e s are a possible impediment to free trade i n technology. 8 The methodology used i n t h i s research i s p r i m a r i l y inductive -an attempt i s made to determine general p r i n c i p l e s about the future of tax p o l i c y formulation i n the context of the global market place by reference to s p e c i f i c case studies. Resource materials include studies on taxation i n the global economy by the Organization for 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 Property Rights ("TRIPs") (Annex IC to the Agreement Establishing the World Trade Organization. Uruguay Round F i n a l Act, Marrakesh, A p r i l 15, 1994) i s the f i r s t trade agreement which provides for comprehensive worldwide protection f o r and enforcement of i n t e l l e c t u a l property r i g h t s . 8 With regard to free trade i n technology, n o n - t a r i f f b a r r i e r s have generally been used to control the conditions under which market access takes place. Non-tariff b a r r i e r s are more subtle 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, Richard W. Ferguson, and Michael F. Oppenheimer, Nontariff Barriers to High-Technology Trade (Boulder: Westview Press, Inc., 1985) at 13. Although domestic tax p o l i c i e s are not a separate category of n o n - t a r i f f b a r r i e r s (such as quantitative r e s t r i c t i o n s , administrative b a r r i e r s to trade, and government procurement), the extent to which tax p o l i c i e s can have subtle and r e s t r i c t i v e e f f e c t s on trade and come with the scope of in t e r n a t i o n a l trade agreements i s explored. 5 International Taxation 9, and the Canadian Tax Foundation ("CTF"), a v a r i e t y of Canadian and American conference materials, and l i t e r a t u r e by accountants, lawyers, government o f f i c i a l s and economists on international law, f i s c a l harmonization, tax p o l i c y , and technology. In addition, the p a r t i c u l a r case studies compel det a i l e d analysis of Canadian Income Tax Act (the "ITA") prov i s i o n s , 1 0 international trade agreements, and scholarly interpretations of these documents. Case law and panel decisions of in t e r n a t i o n a l bodies are also referred to. The purpose of t h i s study i s twofold: The f i r s t goal i s to determine whether the tax provisions under review prima f a c i e 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 discriminatory e f f e c t on the global development or i n t e r n a t i o n a l transfer of technology? Each tax practice w i l l be examined under the General Agreement on T a r i f f s and Trade 1 1 ("GATT") to assess how the 9 This series i s published by the Kluwer Law and Taxation Publishers i n Deventer, Netherlands and i s intended f o r use by those engaged i n the practice of in t e r n a t i o n a l taxation. 1 0 R.S.C. 1952, c. 148 as amended by S.C. 1970-71-72, c.63 and as subsequently amended. 1 1 October 30, 1947, 61 Stat. A3, T.I.A.S. No. 1700, 55 U.N.T.S. 187. The emphasis i s on the GATT, despite the Canada-U.S. context, as a GATT analysis has a more global a p p l i c a t i o n . Reference w i l l be made to the North American Free Trade Agreement ("NAFTA") (Ottawa: Minister of Supply and Services Canada, 1993). NAFTA came into e f f e c t on January 1, 1994 (see North American Free Trade Agreement Implementation Act. S.C. 1993, c. 44). As discussed i n Robert K. Paterson and Martine N. Band, eds., International Trade and Investment Law i n Canada. (2d) (Toronto: Carswell, 1994) at 2-6, the FTA [and NAFTA] "do not replace the GATT as the int e r n a t i o n a l l e g a l foundation of the trading r e l a t i o n s h i p between Canada and the United States. In many respects 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 Parties as to t h e i r l e v e l of compliance with t h e i r GATT obligations i n 6 practice measures up to the p r i n c i p l e s set out therein. This w i l l require an analysis of each of the tax provisions and the relevant A r t i c l e s i n the GATT and the Canada-U.S. Tax Convention. The domestic tax regimes are also compared with the Organization for Economic Cooperation and Development Model Convention (the "OECD Model") when applicable, as well as other foreign 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 the issue under review. The second goal of t h i s study i s much broader and goes beyond the s p e c i f i c examples under consideration. With the conclusion of the Uruguay Round of GATT, and the emphasis on reducing or eliminating a l l b a r r i e r s to trade, i t i s worthwhile to determine the broader e f f e c t of discriminatory tax measures i n the global marketplace. Therefore, with the r e s u l t s from the analysis described above suggestions w i l l be made regarding the in t e r s e c t i n g r o l e of taxation and international trade i n f i s c a l harmonization. PART I: OVERVIEW This introductory chapter provides a conceptual framework for the study. I t b r i e f l y outlines the arguments for and against free trade i n order to es t a b l i s h the basis for proposing tax p o l i c i e s which f a c i l i t a t e free trade. The conceptual framework fo r studying the r e l a t i o n s h i p between taxation and in t e r n a t i o n a l trade i s also outlined. Chapters 2 through 4 contain the analysis of ITA rules i n s p e c i f i c areas of trade. Some also regard c e r t a i n provisions of the FTA [and NAFTA] (such as those concerning trade i n services and dispute settlement) as forerunners of future m u l t i l a t e r a l economic agreements to be developed under GATT auspices." 7 three areas i n p a r a l l e l with in t e r n a t i o n a l tax t r e a t i e s and the GATT. The case studies are: 1) the withholding tax on cross-border payments for licensed software; 2) the s c i e n t i f i c research and development tax incentive system; and 3) the in t e r n a t i o n a l transfer p r i c i n g regime. These chapters are both d e s c r i p t i v e and a n a l y t i c a l ; the s p e c i f i c tax and trade p o l i c i e s under review are presented and the interplay between the p a r t i c u l a r tax p o l i c y and int e r n a t i o n a l trade ramifications i s examined. As mentioned previously, these provisions have been selected i n part because they impact on technology development and technology transfer. The p a r t i c u l a r tax rules under review i n each of the case studies are also of i n t e r e s t as they are controversial and continue to be the subject of ongoing debate. Canada has recently begun to renegotiate withholding tax rates with some treaty partners on payments for licensed software; the OECD, as recently as March 8, 1995, released d r a f t recommendations on transfer p r i c i n g for multinational enterprises as the outcome of a major study i n t h i s area; and the Auditor General of Canada i n h i s 1994 Report has been openly c r i t i c a l of the e x i s t i n g government programs and strategy for stimulating research and development. Furthermore, although only 3 case studies are reviewed, the selected tax provisions require an analysis of a v a r i e t y of GATT A r t i c l e s under the approach taken thereby providing a broader basis for conclusions and recommendations. Also, each case study compels f l e x i b i l i t y i n the analysis. I t i s hoped that t h i s f l e x i b i l i t y within the suggested framework w i l l prove useful as a s t a r t i n g 8 point for future research i n t h i s area. Chapter 2 reviews the matter of arm's length payments for in t e r n a t i o n a l transfers of technology i n the s p e c i f i c context of cross-border software payments. Revenue Canada tr e a t s cross-border payments for software under l i c e n s i n g arrangements as r o y a l t i e s , and, therefore, income from property. This i s contrary to the treatment proposed by the OECD Model which c l a s s i f i e s these payments as business p r o f i t s . Cross-border r o y a l t y payments are subject to withholding tax under subparagraph 212(1)(d)(i) of the ITA. Withholding tax may r e s u l t i n increased pr i c e s for the software to the transferee; or reduce p r o f i t s or cash flows to the foreign transferor. Although Canada has recently concluded two b i l a t e r a l conventions which reduce the withholding rate on these payments to 0%, the underlying characterization problem remains. Therefore, foreign software developers from countries without renegotiated tax t r e a t i e s are p o t e n t i a l l y at a disadvantage v i s a v i s domestic producers of software. The extent to which these disadvantages may be viewed as discriminatory i n i n t e r n a t i o n a l trade terms and a l t e r n a t i v e ways of minimizing or eliminating such discrimination are explored. The focus of Chapter 3 i s on the developmental stages of technology. Accordingly the tax measures under review are the tax incentives for research and development ("R&D") set out i n sections 37, 127 and 127.1 and regulation 2900 of the ITA. Canada's R&D tax incentives are among the most generous i n the world and are viewed as fundamental to encouraging technological development i n Canada. 9 However, there are r e s t r i c t i o n s on the a v a i l a b i l i t y of these incentives which favour research c a r r i e d on within Canada, by Canadian resident taxpayers carrying on business i n Canada. Arguably, these tax incentives discriminate against businesses and research c a r r i e d on outside of Canada 1 2 and may be viewed as countervailable subsidies under the new GATT subsidies agreement. The question of whether these incentives are j u s t i f i a b l e under the subsidies agreement, as well as i n a purely domestic context, w i l l be pursued. The need for revisions to the e x i s t i n g tax incentive system which may be more e f f e c t i v e i n achieving national goals and less vulnerable to international sanctions i s also discussed Chapter 4 examines the pervasive 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 trade among members of a multinational enterprise. When rela t e d companies set up operations i n more than one country, transfer p r i c i n g issues take on even more s i g n i f i c a n c e than domestic transfer p r i c i n g concerns. Canada's tra n s f e r p r i c i n g rules in subsections 69(2) and (3) of the ITA, deal with transactions between taxpayers and non-residents with whom the taxpayer i s not dealing at arm's length. Although there are s i m i l a r provisions for transactions between residents, these are l i m i t e d i n scope. The reason for the difference, of course, i s that t r a n s f e r p r i c i n g with non-residents r e s u l t s i n erosion of the Canadian tax base, whereas transfer p r i c i n g with residents r e s u l t s only i n s h i f t i n g of amounts 1 2 Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents and Foreign A c t i v i t i e s " , supra at 102. 10 between taxpayers. 1 3 In the context of technology, a r r i v i n g at a "reasonable p r i c e " for intangibles i s subjective and open to abuse. Furthermore, the transfer p r i c i n g regime which has evolved places f a r greater burdens and p o t e n t i a l r i s k of double taxation on i n t e r n a t i o n a l non-arm's length transfers than on s i m i l a r domestic transfers. Arguably, these transfer p r i c i n g r u l e s discriminate against multinational enterprises with business transactions beyond Canadian borders. Even though the OECD Model does not p r o h i b i t t h i s type of discrimination, i t i s worthwhile to examine transfer p r i c i n g issues i n connection with i n t e r n a t i o n a l trade i n order to illuminate d i s t o r t i v e e f f e c t s which may a r i s e and suggest improvements to the transfer 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 studies and whether these s p e c i f i c tax p o l i c i e s promote in t e r n a t i o n a l trade. International trade considerations and sovereignty over taxation are not necessarily c o n f l i c t i n g domains, and an acceptable balance should be attainable i f the issues are addressed i n a d i r e c t and coherent manner. The mechanisms and extent to which developments i n domestic taxation, f i s c a l harmonization and i n t e r n a t i o n a l trade should converge are explored. While tax t r e a t i e s provide some assistance i n t h i s regard, they are not a complete solution, and perhaps not even an adequate solut i o n i n addressing tax p o l i c y ramifications i n the global market place. This research w i l l attempt to provide support for the need for t h i s global perspective i n f i s c a l harmonization. I t i s suggested that a 1 3 i b i d . . at 105. 11 GATT-type tax code may be an appropriate approach f o r future in t e r n a t i o n a l f i s c a l harmonization e f f o r t s . Further, i n the interim, domestic tax p o l i c y makers, as well as those engaged i n tax treaty negotiations, should be aware of the impact of t h e i r p o l i c y decisions on international trade, and of the impact international trade agreements may have on tax p o l i c i e s . PART I I : FREE TRADE The s t a r t i n g point for t h i s research i s that "free trade" i s a given; I s h a l l not attempt to enter into the debate about whether or not free trade i s a "good thing" or whether " l i b e r a l trade", "freer trade" or "managed trade" i s a more accurate taxonomy for the a c t u a l i t i e s of international trade. A s t r i c t free trade approach requires no t a r i f f or n o n - t a r i f f b a r r i e r s to trade. However, t h i s discussion i s based on the less pure notion that the goal of "free trade" i s to minimize the amount of interference of governments i n trade flows that cross national borders. 1 4 The global marketplace i s a r e a l i t y which i s r a p i d l y expanding, as a few very recent examples indicate: the new World Trade Organization, successor to the GATT, came into e f f e c t on January 1, 1995; the North American Free Trade Agreement i s on i t s way to becoming the Free Trade Agreement of the Americas; and i n the autumn of 1994 the Canadian Government paved the way for 1 4 John H. Jackson, The World Trading System: Law and Policy of International Economic Relations (Cambridge, Mass., MIT Press, 1989) at 8 uses t h i s d e f i n i t i o n for the notion of " l i b e r a l trade". See the discussion under "Taxation and Free Trade" regarding the necessity for adopting t h i s less stringent d e f i n i t i o n of free trade i n the context of taxation. 12 unprecedented trade with China. This section i s l i m i t e d to providing a b r i e f overview of generally accepted t h e o r e t i c a l basis for free trade and an outline of the main arguments fo r and against free trade. Free trade i s generally based on two premises: 1 5 1. The most e f f i c i e n t use of resources - and hence the maximum combined outputs - of trading nations w i l l be achieved i f trade among them i s freed from a r b i t r a r y interventions by in d i v i d u a l governments. 2. The preservation of sovereign r i g h t s as expressed i n the maintenance of d i f f e r e n t politico-economic systems and sets of p o l i c i e s among nations i s e s s e n t i a l f o r increasing the welfare of the c i t i z e n s of the nations concerned. In t h i s study, the second premise, the national objective i s concerned with the p a r t i c u l a r sovereign r i g h t s to be preserved as embodied i n the Canadian tax p o l i c i e s under review. 1 6 The f i r s t premise, the free trade objective, i s based on the global goal of minimizing governmental interference i n int e r n a t i o n a l trade flows which i s fundamental to the GATT.17 The 1 5 Hirofumi Shibata, F i s c a l Harmonization under Freer Trade: P r i n c i p l e s and Their Applications to a Canada-U.S. Free Trade Area. (University of Toronto Press, 1969) at 4. "In the f i e l d of public finance, t h i s second premise means that a fre e r trade arrangement must not lead to denial of the following two differences: (1) differences that e x i s t among nations i n types and amounts of public goods and services provided by t h e i r governments, and (2) differences that e x i s t among nations i n degrees and patterns of income r e d i s t r i b u t i o n among fellow c i t i z e n s of a sovereign nation..." 1 6 The objectives and c r i t e r i a f or evaluating national tax systems are discussed below. 1 7 Canada has been a strong proponent of the GATT, with the primary i n t e r e s t , pre-Uruguay Round, being to secure access to the U.S. market. With the Uruguay Round of GATT negotiations, Canada directed most of i t s e f f o r t s to achieving better access to markets outside of North America, r e v i t a l i z i n g the o v e r a l l system of 13 "interventions" of concern are tax p o l i c i e s which t r e a t non-residents, multinational enterprises and cross-border a c t i v i t i e s less favourably than residents, domestic enterprises and a c t i v i t i e s within Canadian borders. Whether these interventions can be viewed as " a r b i t r a r y " ("discriminatory" t a x a t i o n ) 1 8 w i l l be determined by reference to standards and p r i n c i p l e s a r t i c u l a t e d i n the GATT and the goal of free trade. The GATT aims to achieve an acceptable balance between the sovereign i n t e r e s t s of i t s Members and the global objective of free trade. Thus, the norm for assessing 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 and generally accepted by the GATT. Government p o l i c i e s which f a i l to achieve t h i s balance can be viewed as an a r b i t r a r y use of sovereign power which f a i l to give due regard to international standards which promote free trade. For example, tax rules which impose withholding taxes on cross-border payments fo 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 the e f f e c t of the tax regime i s contrary to the p r i n c i p l e of non-discrimination as a r t i c u l a t e d i n A r t i c l e III of the GATT ("National Treatment") . Tax p o l i c i e s which seek to promote research and development i n Canada may be viewed as ar b i t r a r y i f the tax incentives create a scheme of subsidization m u l t i l a t e r a l trade regulation, c l a r i f y i n g and strengthening m u l t i l a t e r a l rules respecting 'unfair trade' laws, l i m i t i n g the trade d i s t o r t i n g impacts of no n - t a r i f f measures, and strengthening GATT's dispute settlement rules. See Jock Finlayson, "Canada and International Trade Regulation: The General Agreement on T a r i f f s and Trade" i n R. K. Paterson and M.N. Band, supra, at 1-47 to 1-50. 1 8 The concept of "discriminatory" taxation i s addressed below. 14 for research and development which f a l l s outside of i n t e r n a t i o n a l l y agreed upon parameters for such subsidization as a r t i c u l a t e d i n the 1994 GATT subsidies code. F i n a l l y , a tax regime f o r regulating, monitoring and enforcing in t e r n a t i o n a l transfer p r i c i n g may be viewed as a r b i t r a r y i f that regime not only has undesirable consequences for multinational enterprises, but also f a i l s to achieve the sovereign objective which the p a r t i c u l a r tax regime seeks to a t t a i n . Free trade i s considered to be b e n e f i c i a l to a nation because when each nation s p e c i a l i z e s i n making the products that i t can make most e f f i c i e n t l y and trades for the other products i t needs, 1 9 global welfare i s increased, 2 0 though each i n d i v i d u a l nation's 1 9 In Canada, for example, exports of goods and services are approximately one quarter of Canada's GDP with one h a l f of a l l natural resources and manufactured goods produced i n Canada being exported. Canada depends disproportionately on exports of resource based products (forest products, minerals, metals, o i l and gas) i n which i t has a comparative advantage. Canada's leading imports i n the early 1990's were motor vehicle parts, passenger cars, e l e c t r o n i c computers, telecommunications and r e l a t e d equipment, and apparel and accessories. 77.6% of merchandise exports i n 1992 went to the U.S.; 70.6% of merchandise imports i n 1992 were from the U.S. (Jock Finlayson, supra. at 1-1 to 1-5). 2 0 See John H. Jackson and William J. Davey, Economic Theory and International Economic Poli c y . (St. Paul, Minn.: West Publishing Co., 2d ed., 1986) at 15. This theory of in t e r n a t i o n a l trade has i t s roots i n David Ricardo's 'Law of Comparative Advantage' which states that a country w i l l export products i n which i t has a greater or comparative advantage, and import products i n which i t has a comparative disadvantage. Some economists believe that t h i s theory has ceased to be useful (see for example Robert Kuttner The End of L a i s s e z - f a i r e : National Purpose and the Global Economy After the Cold War (New York: Knoft, 1991); John H. Jackson, The World Trading System: Law and P o l i c y of International Economic Relations, supra. at 14 - 17 for a discussion of challenges to t h i s c l a s s i c theory. Donald J.S. Brean, "International Issues i n Taxation", supra. at 32 - 37 discusses conventional trade theory i n l i g h t of the expansion of foreign 15 welfare w i l l not increase e q u a l l y . 1 I t i s important to emphasize that a l l members of a country w i l l not necessarily be better o f f with free trade; however, preservation of sovereign r i g h t s enables governments to ensure that a l l members could be made better o f f i f the increased national income i s suitably r e d i s t r i b u t e d . 2 2 Based on t h i s theory, the main arguments fo r and against free trade can be summarized as follows: 2 3 For 1. Consumption gains - domestically, the consumer w i l l be able to acquire more goods at lower p r i c e s ; 2. Production gains - importing products which were previously i n e f f i c i e n t l y produced domestically permits a r e a l l o c a t i o n of resources into more productive industries i n which the country has a comparative advantage; investment and concludes (at 38) that the influence of multinational enterprise and foreign ownership on trade 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 substantial, not least i n Canada. These al t e r n a t i v e perspectives are acknowledged but not explored i n t h i s research. 2 1 See John H. Jackson, The World Trading System, i b i d . . at 12 for economic models showing comparative and absolute advantage, and global and national gains with trade between nations. This study focuses on the global benefits to be attained from free trade under the GATT regime. 2 2 Joel B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", International Tax Poli c y Forum, Tax Analysts, Tax Notes International A p r i l 1, 1994, 11 at 12. See also Donald J.S. Brean, "International Issues i n Taxation", supra. at 8 - 9. 2 3 See General Agreement on T a r i f f s and Trade, Studies i n International Trade. Number 5 (Geneva: 1977) as referred to by Armando F. Beteta, International Trade and Legal Modernization: E f f e c t s of Mexico's Membership i n the North American Free Trade Agreement (Faculty of Law, University of B r i t i s h Columbia, 1993) [unpublished]. 16 3. Economies of scale - free trade opens up larger markets, increasing demand for products and enabling lower costs to be r e a l i z e d with expansion of production operations; 4. Competitive domestic industry - free trade r e s u l t s i n more d i r e c t competition between domestic and foreign producers fo r c i n g domestic production to become more e f f i c i e n t i n order to remain competitive. 5. Domestic p r i c e s t a b i l i t y and counter-inflationary pressures - these i n d i r e c t r e s u l t s are achieved as a consequence of pr i c e reduction with increased supply combined with competitive pressures to control input costs. Against 2 4 1. Foreign interference i n domestic markets hinders domestic growth and standards of l i v i n g . 2. Certain industries w i l l pressure t h e i r governments to, i n t e r f e r e with free trade i n order to protect the domestic industry from foreign competition; a common form of protectionism i s the t a r i f f . 3. T a r i f f protection w i l l give domestic producers a larger market share thereby creating jobs for the domestic economy. 4. Interference with free trade i s necessary to protect labour i n developed nations from low paid labour i n developing nations. 2 4 John H. Jackson and William Davey, Economic Theory and International Economic Policy.supra at 17 - 19. Also see Armando F. Beteta, supra, at 23 - 27; the author also discusses c r i t i c i s m s of the procedural aspects of free trade i n addition to the c r i t i q u e s of substantial e f f e c t s free trade set out here. 17 5. T a r i f f s equalize costs between the importing and exporting countries. 6. Certain trade r e s t r i c t i o n s are necessary i n order to achieve national objectives. I t i s suggested that the a b i l i t y to access i n t e r n a t i o n a l markets for goods, services, technology and c a p i t a l i s c r i t i c a l to a nations economic v i a b i l i t y and standard of l i v i n g . R e s t r i c t i o n s on i n t e r n a t i o n a l trade r e s u l t i n less v a r i e t y of products avai l a b l e domestically and, even i f they are available, p r i c e s are l i k e l y to be i n f l a t e d with the r e s u l t that products are not affordable for the average consumer. Attempts to equalize costs or protect i n e f f i c i e n t domestic industries may have some merit i n the short term, but over the long term such p r o t e c t i o n i s t measures w i l l r e s u l t i n non-competitive industries and higher p r i c e s . Even i n the short term, i n t e r f e r i n g with free trade may not be the most appropriate a l t e r n a t i v e for achieving domestic objectives. In addition to the previous arguments against free trade, a case against free trade can be made i n the absence of the following key assumptions about how the economy operates: 2 5 1. If a country has monopoly or monopsony power with regard to a commodity, a t a r i f f or subsidy can enable the country to 2 5 J o e l B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra, at 13. The author also notes that a v a r i e t y of non-economic arguments for trade intervention such as foreign p o l i c y or national security concerns i n addition to domestic p o l i t i c a l reasons. 18 p r o f i t from i t . 2 6 2. I f the domestic economy i s d i s t o r t e d (due to domestic tax p o l i c y , for example), trade intervention could o f f s e t the d i s t o r t i o n thereby increasing national income. 2 7 3. In o l i g o p o l i s t i c markets, i t may be possible to s h i f t some of the p r o f i t s from foreign firms to domestic fi r m s . 2 8 4. Countervailing duties my be s t r a t e g i c a l l y useful as a means of discouraging other countries from using opportunistic trade p o l i c i e s . Except for the d i s t o r t i o n - o f f s e t t i n g argument, to the extent that national income i s increased, i t i s at the expense of the income i n the r e s t of the world; therefore, from a global perspective, these p o l i c i e s are wasteful 2 9. When free trade i s practised by a l l countries, world income w i l l be maximized. Even more important however, i s the r e s u l t that 2 6 A monopoly i s the exclusive r i g h t or power to dominate the t o t a l sales of a product or service; a monopsony i s a market condition where there i s one buyer fo r a p a r t i c u l a r good or service (Blacks Law Dictionary, 5 ed., (St. Paul, Minn. West Publishing Co., 1979)). Slemrod notes that i n the case of monopoly, the country ought to tax exports to drive 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 to drive down the p r i c e . 2 7 Slemrod notes that i t i s generally better to eliminate the d i s t o r t i o n that to counteract i t with trade p o l i c y , because trade intervention introduces new d i s t o r t i o n s even i f i t reduces others. 2 8 An oligopoly exists where a few s e l l e r s s e l l only a standardized product (Black's Law Dictionary, supra). Slemrod notes that i t i s impractical to design a successful p o l i c y of s e l e c t i v e intervention to take advantage of such a s i t u a t i o n . 2 9 Joel B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra. at 14. 19 u n i l a t e r a l adoption of free trade w i l l maximize the adopting country's national income, notwithstanding the trade p o l i c i e s of other countries. 3 0 Based on the current expansion of free trade agreements, i t appears that there i s a continuing Canadian commitment to trade l i b e r a l i z a t i o n . 3 1 A conceptual framework for analyzing taxation measures i n the context of free trade i s set out i n the next section. PART I I I : TAXATION and FREE TRADE As b a r r i e r s to international trade and investment 3 2 f a l l , and 3 0 i b i d . . at 13. Slemrod notes that even i f a trading partner i s subsidizing i t s exports, the importing country i s better o f f not to respond by shielding i t s residents from world p r i c e s ; as to countering a trading partner's t a r i f f s with t a r i f f s of one's own " i t would be j u s t as sensible to drop rocks into our harbours because other nations have rocky coasts" (attributed to Joan Robinson, Essays i n the Theory of Employment (Oxford; Blackwell, 1947) at 192). See also Donald J . S. Brean, "International Issues i n Taxation", supra, at 25: "... economists are continually dismayed that p r i n c i p l e s of free trade are so r e a d i l y v i o l a t e d . They are puzzled by p o l i c i e s that appear to ignore comparative advantage and the international p r i c e structure and that therefore ignore the true costs of economic intervention. T a r i f f s and import quotas ... are merely the least imaginative form of intervention." 3 1 See R.K. Paterson and M.N. Band, supra. at 2-6 regarding Canada's commitment to free trade; Donald J.S. Brean, "International Issues i n Taxation", supra, at 20:"Unilateral free trade 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 free trade i s better s t i l l . " ; Dr. A.A. Knechtle, Basic Problems i n International F i s c a l Law, (Deventer: Kluwer, 1979) at 6; G i l b e r t R. Winham, The Evolution of Trade Agreements (Toronto: University of Toronto Press, 1992) at 9 - 10. Joel B. Slemrod, i b i d . , at 14, summarizes the trade p o l i c y prescriptions for the United States as (i) u n i l a t e r a l free trade 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 device to eliminate trade 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 to lower trade b a r r i e r s . 3 2 References to international trade are generally intended to include trade i n goods, services, i n t e l l e c t u a l property as well as investment. The Uruguay Round agreement on trade-related investment measures ("TRIMs") s i g n i f i e s that "investment i s interchangeable with trade, and, more important, that trade 20 national economies become more integrated, the importance of i n t e r n a t i o n a l taxation for the e f f i c i e n t functioning of i n t e r n a t i o n a l markets becomes a main concern. 3 3 This connection makes i t more important than ever to consider i n t e r n a t i o n a l trade agreements i n making tax p o l i c y decisions: 3 4 The broad lack of i n t e r e s t among general i n t e r n a t i o n a l lawyers i n f i s c a l matters, combined with the diminishing r o l e a t t r i b u t e d to a conceptual 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 led to 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 often 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 increase of a c e r t a i n type of economic a c t i v i t y has drawn attention to a previously undeveloped area of law. Thus, i t so happens that due to such factors as the increase i n d i r e c t investment by c i t i z e n s of one country i n other countries, 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 trade, f i s c a l scholars have been confronted with the problem of taxation of foreign income and nonresident 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 trade 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" (Gilbert R. Winham, supra. at 79) . 3 3 J o e l B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra, at 28; Slemrod's discussion i s r e s t r i c t e d to the e f f i c i e n t functioning of c a p i t a l markets. See also Douglas J. Sherbaniuk, i n Donald J.S. Brean, "International Issues i n Taxation", supra. at i i i : "In the continuing process of trade l i b e r a l i z a t i o n , as c l a s s i c a l trade 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 larger s i g n i f i c a n c e . One set of r e s t r i c t i o n s of increasing 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 4 Rutsel S i l v e s t r e J . Martha, The J u r i s d i c t i o n to Tax i n International Law; Theory and Practice 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 , Series on International Taxation, No. 9 (Deventer, Kluwer Law and Taxation Publishers, 1989) at 11. See also Richard M. Bird, "Some Continuing Issues and an International Perspective" i n Jack Mintz and John Whalley, eds., "The Economic Impacts of Tax Reform", Canadian Tax Paper No. 84 (Toronto: CTF, 1989) at 43 5: "But I do want to emphasize my view that the i n t e r n a t i o n a l dimension of taxation should be the s t a r t i n g point f o r serious tax p o l i c y analysis i n an open economy such as Canada, not something to be o p t i o n a l l y added on at the end." 21 I t has also been noted that: 3 S U n t i l recently, international taxation has been an arcane subspecies among American tax lawyers, and in t e r n a t i o n a l considerations have r a r e l y influenced the thrust of tax reform. Instead, tax rules have been crafted i n consultation with domestic i n t e r e s t ; tax incentives have been i n s t i t u t e d to spur American indivi d u a l s and companies to work toward perceived national goals; and the o v e r a l l l e v e l of tax c o l l e c t i o n s has been determined on the basis of American business conditions. Such a p r o v i n c i a l approach to tax p o l i c y may have been appropriate i n an e a r l i e r era, but the increasing economic integration of the world requires a more global approach to tax p o l i c y . The emphasis i n recent American tax reform debates on competitiveness i s only a precursor to a time i n which i n t e r n a t i o n a l considerations w i l l play a pervasive r o l e i n shaping tax p o l i c i e s . C learly, the r e l a t i o n s h i p between domestic taxation and inter n a t i o n a l transactions cannot be ignored. 3 6 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 global marketplace. 3 7 3 5 Lawrence H. Summers, "Taxation i n a Small World", i n Herbert Stein, ed. , Tax Po l i c y i n the Twenty-First Century (New York: John Wiley & Sons, 1988), 64 - 75 at 64. 3 6 J o e l B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra at 12, seeks to "recast 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 with the theory of int e r n a t i o n a l trade" and notes that "there i s a po t e n t i a l down side to t h i s strategy. I t i s that although the preference toward free trade i s well established among economists, [ i t ] i s not well established elsewhere. On the contrary, the debate over trade p o l i c y continues, with the economist's view sometimes p r e v a i l i n g and sometimes not p r e v a i l i n g . The down side r i s k i s that the ensconced prejudices and misconceptions regarding trade p o l i c y w i l l simply be attached to the issues of int e r n a t i o n a l tax p o l i c y , b l u r r i n g issues rather than sharpening them. But t h i s i s not 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 already happening. To make the linkage e x p l i c i t could, i n my opinion, only be a plus." See also Donald J.S. Brean, "International Issues i n Taxation", supra, at 9. 3 7 See Dr. A.A. Knechtle, supra at 9 - 10 for a discussion of competitive advantages or disadvantages due to f i s c a l measures which may r e s u l t due to the differences i n the structure of national tax systems and i n rates of tax. Dr. Knechtle also hi g h l i g h t s the dangers of multiple taxation of transnational a c t i v i t y on global economic development. Further, Rutsel S i l v e s t r e J. Martha, supra. at 1 states: "One f a c t which, whether 22 One of the objectives of t h i s research i s to develop a framework to a s s i s t tax p o l i c y makers i n determining how s p e c i f i c tax measures should be selected from among a l t e r n a t i v e measures i n order to achieve national objectives and minimize any d i s t o r t i v e impacts on international trade. This emphasis on minimization, rather than elimination, i s necessary f o r the simple reason that i t i s not f e a s i b l e to eliminate the tax system: 3 8 There must be tax revenue, and l o t s of 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 of choice, such as the work-leisure choice, the consumption-saving choice, and the investment-or-not choice, and therefore are the source of i n e f f i c i e n c y . In s e l e c t i n g from among al t e r n a t i v e tax measures i t i s f i r s t necessary to determine the objective(s) of the p a r t i c u l a r tax measure under review. 3 9 Obviously, revenue r a i s i n g i s one of the main objectives of domestic taxation. In an in t e r n a t i o n a l context, the revenue r a i s i n g objective remains i n tac t , but i s complicated by problems which a r i s e i n protecting a nation's share of the tax acknowledged or not, i s of the utmost importance i n the f i e l d of inter n a t i o n a l taxation i s the determinative impact of general in t e r n a t i o n a l law on the outlook of in t e r n a t i o n a l tax pr a c t i c e s . " Also see Donald J.S. Brean, "International Issues i n Taxation", supra, at 1. 3 8 J o e l B. Slemrod "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra at 14. 3 9 The following i s a b r i e f overview of the main objectives of taxation i n general. Each case study w i l l take a closer look at the applicable objective(s) sought to be attained, how successful the tax regime i s att a i n i n g the objective(s) , and look at alte r n a t i v e s to the e x i s t i n g tax regime which may achieve the objective(s) while minimizing undesirable impacts on in t e r n a t i o n a l trade. 23 base i n cross-border transactions. 4 0 For example, withholding taxes and transfer p r i c i n g rules attempt to preserve Canadian tax revenues, but Canadian tax p o l i c i e s may c o n f l i c t with the other nation's tax p o l i c i e s i n these areas, thereby exposing the taxpayer to double taxation. Tax p o l i c i e s are also used as a t o o l to promote economic objectives of growth and e f f i c i e n t a l l o c a t i o n of the economy's resources. 4 1 Tax expenditures, which are equivalent to spending programs, are aimed at achieving such economic, as well as s o c i a l objectives. For example, investment tax c r e d i t s f o r research and development are tax revenues foregone i n order to stimulate research and development which, i n turn, should create wealth, manage r i s k and improve q u a l i t y of l i f e . 4 2 Tax p o l i c i e s must be evaluated to assess whether the objectives are being attained. There are a number of c r i t e r i a used i n evaluating domestic tax p o l i c y which have been summarized as 4 0 Donald J.S. Brean, "International Issues i n Taxation", supra. at 7, also notes that, i n addition to revenue r a i s i n g , taxes are l e v i e d on international trade for protection or i n r e t a l i a t i o n against protection elsewhere. 4 1 For a discussion of economic objectives of taxation r e f e r to D.A. Dodge, "Economic Objectives of Tax Reform" i n Jack Mintz and John Whalley, eds., supra. at 36 - 44. For a general discussion on the use of the tax system to achieve p o l i c y objectives see Satya Poddar, "Taxation and Regulation", i n Richard M. B i r d and Jack M. Mintz, eds., supra. at 71 - 96. 4 2 L. Denis Desautels, Auditor General of Canada, Report of the Auditor General of Canada to the House of Commons. 1994, v o l . 1 (Ottawa: Ministry of Supply and Services, Canada, November 22, 1994) at 1-17. 24 follows: 4 3 1. The tax system should be e f f i c i e n t or neutral. This c r i t e r i o n requires the tax system to apply s i m i l a r (effective) rates of taxation to 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 rests on the presumption that the best a l l o c a t i o n of resources i s achieved by an unfettered market economy. If markets f a i l to achieve the best a l l o c a t i o n of resources, e f f i c i e n t tax p o l i c y may c a l l for c o r r e c t i v e taxes or subsidies. 2. The tax system should be equitable. For example, i t should levy taxes at the same rate on i n d i v i d u a l s or families i n s i m i l a r circumstances (horizontal equity) and apply appropriately higher rates of tax to w e l l - o f f i n d i v i d u a l s or fa m i l i e s than i t applies to the less w e l l - o f f ( v e r t i c a l equity). 3. The tax system should be simple. I t should minimize both the administrative costs faced by the government and the compliance costs incurred by the private sector. In evaluating international tax p o l i c y , s i m i l a r c r i t e r i a are used, but new issues a r i s e . The standard of n e u t r a l i t y i s complicated i n international markets. The goal i s to promote the most e f f i c i e n t a l l o c a t i o n of resources on a global scale. Governments want to encourage inward investment and not encourage outbound investment. Therefore, i t i s necessary to d i s t i n g u i s h between domestic and foreign investment opportunities of domestic investors as well as of foreign investors. Foreign investors should pay the same tax on income earned on an investment i n Country X as a domestic investor would pay on that income earned i n Country X ( c a p i t a l import n e u t r a l i t y ) ; and domestic investors should pay the same tax on income earned on investments whether they invest at 4 3 Richard M. Bird and Jack M. Mintz, "Taxation to 2000 and Beyond", Canadian Tax Paper No. 93 (Toronto: Canadian Tax Foundation, 1992) at 1 - 2. 25 home or abroad ( c a p i t a l export n e u t r a l i t y ) , 4 4 The tax system should also be equitable with regard to in t e r n a t i o n a l transactions. In t h i s context, equity among taxpayers requires that tax i s imposed i n at l e a s t one j u r i s d i c t i o n , but r e l i e f from double taxation must be provided where necessary. 4 5 Tax systems must also grapple with the issue of how to a r r i v e at an equitable d i s t r i b u t i o n of tax revenue on cross-border transactions among the nations involved. F i n a l l y , s i m p l i c i t y remains a v a l i d c r i t e r i a i n taxation of i n t e r n a t i o n a l transactions, yet administration of the tax system i s even more d i f f i c u l t i n t h i s context due to the use of tax havens, the p o t e n t i a l for tax avoidance and d i f f i c u l t i e s i n c o l l e c t i n g accurate and r e l i a b l e information on taxpayer a c t i v i t i e s . 4 4 See Donald J.S. Brean, "Here of There?: The Source and Residence P r i n c i p l e s of International Taxation", i n Richard M. Bird and Jack M. Mintz, supra. 303 at 310. C a p i t a l import n e u t r a l i t y i s concerned with the international a l l o c a t i o n of savings and the a f t e r tax rate of return 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 n e u t r a l i t y i s concerned with the in 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 pre-tax rate of return. 4 5 Double taxation arises i n the i n t e r n a t i o n a l context from the overlapping tax claims of both the source and residence country. See Donald S. Brean, "Here or There? The Source and Residence P r i n c i p l e s of International Taxation", supra. at 309. The author describes 'source' and 'residence' p r i n c i p l e s at 3 07 - 308: The source p r i n c i p l e of taxation of i n t e r n a t i o n a l income assigns the r i g h t to tax to the country that i s the source of the c a p i t a l income... Source taxes... include for most countries the corporate tax and withholding taxes on payments made to foreigners... The residence p r i n c i p l e assigns the r i g h t to tax to the country of residence of the owners of the c a p i t a l that generates the income... Although the corporate tax i n the f i r s t instance i s a source tax, the residence country's corporate tax may be defined on the residence p r i n c i p l e ; that i s , the foreign-source income of a resident corporation i s l i a b l e for (residence) tax. 26 A nation cannot set tax p o l i c y without taking into account the tax systems of other countries, e s p e c i a l l y i t s major trading partners. 4 6 Therefore, any attempt to resolve a taxation issue with int e r n a t i o n a l dimensions should begin with an examination of the tax system of the p a r t i c u l a r country. However, i t i s suggested that 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 , equity and administrative s i m p l i c i t y are not the paramount c r i t e r i a f o r t h i s examination. Although these remain v a l i d c r i t e r i a for evaluating tax p o l i c y , i n recent years there has been a s h i f t i n tax philosophy which recognizes that the future development of tax p o l i c y w i l l depend on many factors including demography, technology and development, ideology and p o l i t i c s , and i n t e r n a t i o n a l i z a t i o n . 4 7 Indeed, e f f o r t s 4 6 Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents and Foreign A c t i v i t i e s " , supra, at 7. Tax t r e a t i e s and model tax conventions are a response to the lack of f i t which arises between national tax systems i n dealing with cross-border transactions. Also, see Donald J.S. Brean, "International Issues i n Taxation", supra at 4 and 17 regarding the p r i n c i p l e of sovereign national tax systems with a network of b i l a t e r a l t r e a t i e s as the primary vehicle f o r achieving i n t e r n a t i o n a l f i s c a l coordination. Tax t r e a t i e s and conventions are necessary as there i s no such thing as an i n t e r n a t i o n a l tax system; rather i n t e r n a t i o n a l taxation r e f e r s to 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 national tax systems. Donald J.S. Brean, "Here or There? The Source and Residence P r i n c i p l e s of International Taxation", supra at 309. 4 7 For a thorough discussion of each of these factors and how they are influencing tax p o l i c y see Richard M. B i r d and Jack M. Mintz, supra, at 3 - 26. Also see Gary Clyde Hufbauer, U.S. Taxation of International Income; Blueprint f o r Reform (Washington, D.C., I n s t i t u t e for International Economics, 1992) at 61 for a discussion of how c a p i t a l n e u t r a l i t y doctrine i s no longer the relevant a n a l y t i c a l approach for i n t e r n a t i o n a l tax p o l i c y issues. J o e l B. Slemrod, i n "Free Trade Taxation and P r o t e c t i o n i s t Taxation", supra, at 12 also moves away from the t r a d i t i o n a l doctrines: "In the hope of maximizing the gains from a fresh perspective, i n what follows I w i l l purposely not r e f e r to the standard catch 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 27 are now under way to "seek new i n s i g h t - indeed a new language for i n t e r n a t i o n a l tax p o l i c y by recasting i t i n p a r a l l e l with the theory of i n t e r n a t i o n a l trade:" 4 8 [A]lthough in t e r n a t i o n a l trade theory has been applied p r i n c i p a l l y to 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 at l e a s t as large an e f f e c t on the flow of goods across countries, the l o c a t i o n of productive a c t i v i t y , and the gains from trade as these trade p o l i c y instruments. Thus i t i s an important object of study i n i t s own r i g h t . 4 9 As indicated previously, the underlying premise of t h i s research i s that tax p o l i c y should f a c i l i t a t e , not hinder, free trade. 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 i n t e r n a t i o n a l taxation context, emphasize the i n t e r e s t s of the p a r t i c u l a r nation. Therefore, the proposal i s to evaluate national tax p o l i c y s t a r t i n g with an i n t e r n a t i o n a l perspective based on a fundamental feature of the i n t e r n a t i o n a l tax structure which i s consistent with global free trade: non-discrimination. 5 0 The p r i n c i p l e of non-discrimination pertains to n e u t r a l i t y export n e u t r a l i t y , c a p i t a l import n e u t r a l i t y and national n e u t r a l i t y . " 4 8 Joel B. Slemrod, i b i d . . at 12. 4 9 i b i d . , at 12. Slemrod i d e n t i f i e s a second reason for studying in 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 with in t e r n a t i o n a l trade theory: there i s a long hi s t o r y of reasoning pertaining to trade - the benefits of free trade, the costs of protectionism -that i s f a i r l y uncontroversial among economists . . . [and] by drawing on t h i s reasoning the murky issues involved i n i n t e r n a t i o n a l taxation can be c l a r i f i e d . 5 0 i b i d . , at 21. Slemrod also i d e n t i f i e s r e l i e f from double taxation as the other fundamental feature of the i n t e r n a t i o n a l tax structure which i s consistent with global free trade. 28 within, as opposed to among, nations: 5 1 A p o l i c y of non-discrimination promises equal treatment of a l l investors within a nation, domestic and foreign a l i k e , and i s a prerequisite 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 national commitment, non-discrimination s e r i o u s l y constrains e f f o r t s to pursue simultaneously objectives with respect to domestic i n d u s t r i a l structure and the domestic/foreign mix of ownership. Canada i n s i s t s on a modified version of non-discrimination. The Canadian approach i s to t r e a t a l l foreign investors i n Canada equally but with no promise to 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 foreign investors d i f f e r e n t l y from Canadian investors. Non-discrimination clauses pertaining to taxation of i n t e r n a t i o n a l transactions are generally provided f o r i n tax t r e a t i e s and commercial t r e a t i e s . 5 2 Discrimination generally has been defined to mean "treating persons unfavourably f o r reasons that are unreasonable, a r b i t r a r y or i r r e l e v a n t . " 5 3 Tax 5 1 Donald J.S. Brean, "International Issues i n Taxation", supra, at 164. 5 2 Kees Van Raad, supra, at 15. For example, A r t i c l e 24:3 of the 1977 OECD Model Convention reads: "Stateless persons who are residents of a Contracting State s h a l l not be subjected i n either Contracting State to any taxation or any requirement connected therewith, which i s other or more burdensome than the taxation and connected requirements to which nationals of the State concerned i n the same circumstances are or may be subjected." Canada has reserved t h e i r p o s i t i o n with respect to 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, regulations and requirements ... should not be applied to imported or domestic products so as to afford protection to domestic production. 5 3 i b i d . . at 11. Also discussed by Kees Van Raad, "Non-discrimination i n International Tax Law", Series on International Taxation. No. 6 (Deventer, the Netherlands, Kluwer Law and Taxation Publishers, 1986) at 7 and 8: the o r i g i n a l meaning of the verb 'to discriminate" i s neutral, r e f e r r i n g to ' d i s t i n c t i o n ' and ' d i f f e r e n t i a t i o n ' ; however, t h i s neutral meaning has been replaced with the notion that the d i f f e r e n t i a l 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 to i t . Kees Van Raad notes that non-discrimination i s the opposite of unfavourable and 29 discrimination has been defined as "the unfavourable treatment of c e r t a i n taxpayers and a c t i v i t i e s for reasons that are unreasonable, a r b i t r a r y , or i r r e l e v a n t . " 5 4 Discrimination i n the context of taxation and international trade r e f e r s p r i m a r i l y to unfavourable treatment of non-residents and foreign a c t i v i t i e s as compared with residents 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 b a s i s . 5 5 To the extent that tax t r e a t i e s 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 'arbitrariness* and 'irrelevance' i n the d e f i n i t i o n of discrimination 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 constitutes discrimination 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 clear (at 9) . 5 4 Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents, and Foreign A c t i v i t i e s " , supra. at 15. Donald J . S. Brean, "International Issues i n Taxation", supra, at 13 states: " . . . t r e a t i e s generally focus on withholding tax rates on i n t e r e s t , dividends, and other earnings on foreign c a p i t a l because such taxes are l e v i e d at the border and are thus, by d e f i n i t i o n , discriminatory." This suggests that the d e f i n i t i o n of tax discrimination includes any taxes 'levied at the border'. 5 5 Brian J. Arnold, "Tax Discrimination Against Aliens, Non-Residents, and Foreign A c t i v i t i e s " , supra. at 11. Arnold also discusses the difference between d i r e c t and i n d i r e c t tax discrimination at 15; Provisions which prima f a c i e discriminate on the basis of a taxpayer's residence are d i r e c t l y discriminatory; i n d i r e c t discrimination does not r e l a t e to residence, but e f f e c t i v e l y r e s u l t s i n less favourable treatment of non-residents. Arnold provides the following examples: Canadian residents are e n t i t l e d to dividend tax c r e d i t s , but non-residents are not (direct discrimination); provisions that deal with Canadian-controlled private corporations and small business corporations which do not discriminate against non-resident taxpayers d i r e c t l y but against c e r t a i n resident taxpayers that are c o n t r o l l e d by non-residents ( i n d i r e c t discrimination). 30 se. 5 6 Where such tax discrimination prima f a c i e e x i s t s , there may well be circumstances when discrimination i s j u s t i f i a b l e , e i t h e r as provided for s p e c i f i c a l l y i n international agreements or as part of the sovereign r i g h t to achieve an i d e a l tax system which meets national o b j e c t i v e s . 5 7 The tax measures under review w i l l be examined to assess whether the p o l i c i e s discriminate against non-resident or foreign a c t i v i t i e s and have a negative e f f e c t on free trade. The s p e c i f i c domestic tax l e g i s l a t i o n w i l l be f i r s t be reviewed. The analysis w i l l move to international trade law as a basis f o r assessing whether discrimination e x i s t s . 5 8 I f discrimination arguably e x i s t s , the • next stage i s to determine whether or not such 5 6 Kees Van Raad, supra f at 9 - 10 r e f e r r i n g generally to Marc Bossuyt, The Pro h i b i t i o n to Discriminate i n International Human Rights Law (Emile Bruylant, Bruxelles, 1976) and W. Kewenig, The Pro h i b i t i o n to Discriminate i n Modern P a c i f i s t International Law (IX Archiv des Volkerechts 137, 1961/1962) [both t i t l e s are tra n s l a t i o n s by Van Raad from the o r i g i n a l t i t l e s i n french and german r e s p e c t i v e l y ] . 5 7 Brian J. Arnold, "Tax Discrimination Against Aliens, Non-Residents, and Foreign A c t i v i t i e s " , supra, at 15 suggests that equity, n e u t r a l i t y , revenue and minimization of administrative and compliance problems are the appropriate c r i t e r i a f or determining whether discriminatory treatment i s j u s t i f i e d . 5 8 Donald J.S. Brean, "International Issues i n Taxation", supra. at 164, suggests that: "To adhere to s t r i c t non-discrimination i s to suppress several degrees of freedom i n domestic economic p o l i c y ... and most countries are reluctant to re l i n q u i s h that sovereign r i g h t . The researchable question involves the extent to which the s t a b i l i t y , n e u t r a l i t y , and equity of i n t e r n a t i o n a l tax arrangements are compromised by s t r a t e g i c discrimination within nations." The current proposed analysis extends t h i s 'researchable question' beyond the borders of inte r n a t i o n a l tax arrangements to consider the impact of tax discrimination on inte r n a t i o n a l trade arrangements. 31 discrimination i s permitted or j u s t i f i a b l e on some b a s i s . 5 9 If 5 9 The analysis proposed here i s s i m i l a r to a Charter analysis which has been used i n Canadian income tax l i t i g a t i o n . For example, under section 15(1) of the Charter, tax provisions that discriminate on the basis of race, national or ethnic o r i g i n , colour, r e l i g i o n , sex, age or mental or physical d i s a b i l i t y can be challenged (see Lennox Industries (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 Realty Inc. et 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); Stromotich v. The Queen. [1988] 1 CTC 252, 88 DTC 6172 (FCTD); The Queen v. Kurisko. [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 to the SCC.) I f an infringement of section 15(1) i s found, the Court then moves to a section 1 analysis (see R±. v. Oakes. [1986] 1 SCR 103, 26 DLR (4th) 200) to see i f the offending provision can be saved. The section 1 analysis i s a four stage t e s t : 1. assess the objectives sought to be achieved by the impugned provision and a determination of whether they are important enough to warrant a Charter breach; 2. the Court must be s a t i s f i e d that there i s a r a t i o n a l connection between the impugned provision and the l e g i s l a t i v e objective; 3. the impugned provision should minimally impair the Charter r i g h t ; and 4. there 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 society and the person whose r i g h t s have been inf r i n g e d . No country's laws p r o h i b i t tax discrimination on the basis of c i t i z e n s h i p , residence, or the geographical source of income. "Nevertheless, many countries have chosen u n i l a t e r a l l y not to discriminate on these bases, or to minimize such discrimination; many have entered into b i l a t e r a l tax t r e a t i e s that p r o h i b i t them from discriminating i n c e r t a i n ways against the nationals or residents of t h e i r treaty partners.'! (Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents and Foreign A c t i v i t i e s " , supra. at 21; see also Dr. A.A. Knechtle, supra at 54-54) . I t i s suggested that where tax discrimination does e x i s t , an analysis s i m i l a r to a Charter analysis w i l l a s s i s t i n assessing whether such discrimination i s j u s t i f i a b l e . As noted by Brian Arnold, i b i d , at 23, "the broad language of the Canadian Charter of Rights 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 applying to the tax treatment of foreigners and non-residents of Canada. However, i t has not been applied i n t h i s way and i t seems very u n l i k e l y that i t w i l l be. The Canadian tax system contains many discriminatory provisions... I t i s v i r t u a l l y unthinkable that Canadian courts would s t r i k e down such provisions, given that they represent c l e a r government p o l i c y and are so 32 inter n a t i o n a l trade law does not provide j u s t i f i c a t i o n f or a p a r t i c u l a r tax measure which appears to be discriminatory, the next question w i l l be whether i t i s j u s t i f i a b l e to maintain the status quo i n l i g h t of an overriding sovereign i n t e r e s t . In order to j u s t i f y tax discrimination on t h i s basis, the tax measure should be r a t i o n a l l y related to the underlying domestic objective and achieve that objective based on appropriate evaluation c r i t e r i a . In addition, the domestic objective must outweigh the broader global objective of f a c i l i t a t i n g free trade. 6 0 F i n a l l y , i n choosing from among a l t e r n a t i v e tax measures, the goal i s not necessarily to choose the absolutely l e a s t i n t r u s i v e means to a t t a i n domestic objectives, but the means should come within a range which r e s t r i c t free trade as l i t t l e as i s reasonably possible. Tax p o l i c y plays a key r o l e i n determining how enterprises adapt t h e i r operations to remain competitive. Though discrimination i s an elusive and ever changing concept, as in t e r n a t i o n a l competition increases, i t i s reasonable to expect that p r o t e c t i o n i s t and discriminatory taxation regimes, w i l l not be tolerated by Canada's trading partners. 6 1 The suggestion i s that widespread." 6 0 As noted by Donald J.S. Brean, "International Issues i n Taxation", supra. at 2, national p o l i c i e s are constrained by p o l i c i e s of other nations (including r e t a l i a t o r y policy) and by economic considerations such as comparative trade advantage and a nations need to import or capacity to export c a p i t a l . 6 1 "Notes for an Address by the Honourable Roy MacLaren, Minister for International Trade, To the 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 the Uruguay Round. Information K i t (Government of Canada, A p r i l , 1994) at 4. The Minister i d e n t i f i e d the following two inescapable conclusions 33 i f nations u n i l a t e r a l l y and consciously eliminate u n j u s t i f i a b l e discriminatory tax practices, impediments to f r e e r trade w i l l be reduced. Yet Canada's income tax system: 6 2 ... contains s p e c i f i c provisions that a f f o r d d i f f e r e n t , and often less favourable, treatment to some taxpayers on the grounds of n a t i o n a l i t y , residence or the geographical location of a c t i v i t i e s . To the extent that such treatment i s unfavourable and the reasons f o r i t appear to be unreasonable, a r b i t r a r y , or i r r e l e v a n t , these provisions can be considered discriminatory. The next three Chapters explore discrimination i n Canada's tax system within the framework set out above. about multilateralism: F i r s t , we must give the p r i n c i p l e s of fairness and mutual advantage new meaning. As our i n t e r e s t s and aspirations increasingly converge, co-operation w i l l be the only way to proceed. Second, we must work harder to leave u n i l a t e r a l i s m and protectionism behind once and f o r a l l . . . 6 2 Brian J . Arnold, "Tax Discrimination Against Aliens, Non-Residents and Foreign A c t i v i t i e s " , supra. at 1. Arnold also notes that up to the time of h i s study (May, 1990) , the Canadian tax system had never been c r i t i c a l l y studied from the perspective of discrimination against a l i e n s , non-residents, and foreign a c t i v i t i e s . 34 CHAPTER 2 CROSS BORDER SOFTWARE PAYMENTS INTRODUCTION This Chapter examines the Canadian tax treatment of cross-border payments for computer software under l i c e n s i n g arrangements 1 i n p a r a l l e l with international trade concepts i n the GATT. Canada has entered into international trade agreements and made amendments to domestic i n t e l l e c t u a l property l e g i s l a t i o n i n order to f a c i l i t a t e the flow of i n t e l l e c t u a l property into Canada from abroad. However, the e f f e c t of Revenue Canada's p o s i t i o n on the tax treatment of payments for computer software across int e r n a t i o n a l borders i s to impede access to foreign technology, not to stimulate i t . Simply put, Canada treats these payments as r o y a l t i e s , and therefore income from property, 2 whereas other i n t e r n a t i o n a l bodies 1 The form of transaction under consideration i s the straightforward delivery to a customer of pre-packaged software contained on a computer disk. The customer could be an i n d i v i d u a l who w i l l use the software on a home computer or a business acquiring sophisticated software f o r use on a l o c a l area network. Payment i s i n exchange for the perpetual r i g h t to use the software. See Melvin S. Adess and Barbara M. Angus, "Knowledge and Technology Transfers to and from the United States: Characterization of Transfers of Computer Software" (July/August 1993) International Bureau of F i s c a l Documentation at 414 - 423 for a discussion on a si m i l a r form of transaction under consideration by the Internal Revenue Service (the "IRS"). 2 This paper assumes that the non-resident does not have a permanent establishment i n Canada and, therefore, i s not subject to Canadian taxation under Part I of the Income Tax Act. In practice, few arrangements for the supply of technology give r i s e to a Canadian business, unless the technology has been developed by the non-resident i n the course of carrying on business i n Canada (see Nathan Boidman and Bruno Ducharme, Taxation i n Canada: Implications for Foreign Investment, (The Netherlands: Kluwer Law and Taxation Publishers, 1985) at 227.) 35 t r e a t them as business p r o f i t s . 3 Royalties are subject to withholding tax i n the cross-border context whereas business p r o f i t s are not. Revenue Canada has recently concluded b i l a t e r a l treaty negotiations with at l e a s t two countries to eliminate withholding tax rates on such payments. However t h i s approach s k i r t s the issue of the underlying royalty c h a r a c t e r i z a t i o n . 4 Although there i s merit to a b i l a t e r a l approach, i t does not a s s i s t countries which either do not have t r e a t i e s with Canada or have not renegotiated e x i s t i n g b i l a t e r a l tax conventions. Therefore, i t i s preferable to take a p r i n c i p l e d approach to resolving the underlying issue rather than merely dealing with the symptoms on a case by case basis. Treaty negotiations, and tax p o l i c i e s i n general, should r e f l e c t , or at l e a s t take into consideration, international developments i n trade and taxation. Thus, the purpose of t h i s Chapter i s two-fold. By examining the p a r t i c u l a r tax p o l i c y presented within the framework of GATT, further support i s advanced for the view that Revenue Canada must change i t s stance on t h i s p o l i c y . In addition, the broader question of what influence i n t e r n a t i o n a l agreements should have on u n i l a t e r a l , b i l a t e r a l and m u l t i l a t e r a l taxation p o l i c i e s i s an 3 See below "Royalty Provisions i n M u l t i l a t e r a l Tax Treaties". 4 This paper does not attempt to deal with the underlying characterization problem other than to suggest that the Canadian approach should be harmonized with the i n t e r n a t i o n a l standard to f a c i l i t a t e 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 characterization of such payments as r o y a l t i e s which are subject to withholding tax when paid to nonresidents. Some of t h i s l i t e r a t u r e i s presented below. 36 underlying theme. Part I sets the stage for the s p e c i f i c taxation issue under consideration with an overview of the Canadian treatment of royalty payments to nonresidents. Next, the characterization of computer software payments i n m u l t i l a t e r a l taxation t r e a t i e s i s presented, followed by a discussion of the po t e n t i a l for double taxation. Part I concludes with a b r i e f update of some recent developments i n Canada's b i l a t e r a l treaty negotiations i n t h i s area. Part II develops the framework for examination of the tax po l i c y under GATT. F i r s t the GATT p r i n c i p l e of national treatment i s outlined and some in t e r p r e t i v e issues pertaining to that p r i n c i p l e are presented. 5 Then, the Canadian software royalty p o l i c y outlined i n Part I i s challenged within t h i s framework to assess how i t accords with t h i s fundamental p r i n c i p l e of international trade. The paper concludes that Revenue Canada should bring i t s po s i t i o n on the characterization of these software payments i n l i n e with the international view, not only to harmonize tax regimes, but as a further impetus to reducing trade b a r r i e r s f o r technology transfer. PART I CROSS-BORDER PAYMENTS UNDER SOFTWARE LICENSING ARRANGEMENTS A. The Canadian approach Software i s often transferred to end users under licence 5 The Canada - U.S. Free Trade Agreement ("FTA") and North American Free Trade Agreement ("NAFTA")incorporate A r t i c l e III of the GATT regarding the p r i n c i p l e of national treatment. 37 agreements which are designed to protect the i n t e r e s t of the software developer by r e s t r i c t i n g the end user's a b i l i t y to copy the software or make changes to the source code. 6 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 ; 7 6 J.A. Chapin-Fortin, "Revenue Canada Hard on Software" (December, 1993), CA Magazine at 30. 7 This int e r p r e t a t i o n i s controversial and has been the source of much debate and discussion. I t i s beyond the scope of t h i s paper to 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 of Revenue Canada's view. See generally, Martin L. O'Brien, "Payments for the Use of Property - Royalty - Know How -Computer Programs", Canadian Current Tax (issue 36; September 7, 1979) 377; T.E. McDonnell, "Withholding Tax - Computerized Data Provided for a Fee - Canada-US Tax Treaty-Rentals or Royalties", 28 Canadian Tax Journal 5 (Toronto: Canadian Tax Foundation, 1980) 607-22, at 615-17; Paul Tamaki, "Withholding Tax on Computer Software Payments to Residents of the United States" (December, 1983), 1 Canadian Computer Law Reporter 23-25; Richard G. Trembly, "Canada-US Cross Border Computer Software Fees", Canadian Current Tax (vol. 1, no. 33) (September, 1986) 163-168; Robert D. Brown, "Tax Aspects of Technology Transfers Between the United States and Canada; A Canadian Viewpoint", 11 Canada United States Law Journal (1986), 227-46; William D. Anderson, "A Potpourri of Elements i n Computing Business Income: Part 2", i n "Current Developments i n Measuring Business Income for Tax Purposes", Corporate Management Tax Conference, 1987 (Toronto: Canadian Tax Foundation, 1987), 6:1-31 at 6:29; Paul Tamaki, "Revenue Canada's New P o s i t i o n on Withholding Tax on Computer Software Royalties", 6 Canadian Computer Law Reporter ( A p r i l 1989), 71-73; Robert D'Aurelio, "International Issues: A Revenue Canada Perspective", 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, "Continuing Cross-Border Software Controversy" (February 11, 1994), 23 Tax Management International Journal 90-94; CA. Brown, "Canadian Income Tax Treatment of Computer Software Payments", 42 Canadian Tax Journal 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 to non-residents" A p r i l 8, 1976: MNR v. Wain-Town Gas O i l Co. Ltd.. 52 DTC 1138 (SCC) ; United Geophysical Co. of Canada v. MNR. 61 DTC 1099 (Ex. Ct.); Vauban Productions v. The Queen. 75 DTC 5371 (FCTD); Societe Nouvelle 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 Ltd.. 80 DTC 6157 (FCA); Grand Toys Ltd. v. MNR. 90 DTC 1059 (TCC) ; The Queen v. Saint John Shipbuilding & Dry Dock Co. Ltd.. 80 DTC 6277 (FCA) ; and Apple Computer Inc. v. Mackintosh Computers Ltd. (1990), 71 DLR (4th) 95 38 a payment for software i s viewed as a payment f o r the use of a secret formula. 8 Under subparagraph 212(1)(d)(i) of Part XIII of the Canadian Income Tax Act 9 (the "ITA") a 25% withholding tax on payments to nonresidents i s deducted at source and calculated on the gross amount of any "rent, royalty or s i m i l a r payment... fo r the use of or for the r i g h t to use i n Canada any property, invention, trade name, patent, trade-mark, design or model, plan, secret formula. 1 0 process or other thing whatever." 1 1 (emphasis added) I t has been suggested that t h i s treatment may be j u s t i f i a b l e i f the foreign software company provides t r a i n i n g , i n s t r u c t i o n or methodology concerning the software code to Canadian resident software developers who use the knowledge for commercial (SCC) a f f ' g (1988), 16 CIPR 15 (FCA), a f f ' g (1986), 28 DLR (4th)178 (FCTD). 8 See CA. Brown, supra, at 601; a f t e r the coming into force of the amendments to the Copyright Act i n 1988 which s p e c i f i c a l l y included computer programs within the d e f i n i t i o n of " l i t e r a r y work", Revenue Canada began to recognize a li m i t e d exemption from withholding tax where a payment i s made to a non-resident only i n respect of the r i g h t to produce or reproduce computer software. See also 212(1)(d)(vi) of the Income Tax Act. 9 R.S.C. 1970 c. 1-5. as amended. 1 0 The Copyright Act. R.S.C 1986, c. C-42, as amended, includes computer programs i n the d e f i n i t i o n of " l i t e r a r y work"; a computer program i s not a "secret formula" under Canadian copyright law. 1 1 Interpretation B u l l e t i n IT-3 03, "Know-How and Similar Payments to Non-Residents", paragraph 10, provides that the 25% withholding tax levi e d under subparagraph 212(1)(d)(i) of the ITA "extends to any payment, including a single or lump-sum payment, made to a non-resident for the r i g h t to use, i n Canada, any property.... Such payment w i l l be subject to tax whether or not i t f a l l s within the category of rent, royalty or s i m i l a r payment". 39 e x p l o i t a t i o n ; but "the end user of a software package gains no more knowledge about the programmer's l o g i c or methodology than a motorist learns about automotive engineering by buying a car." 1 2 Arguably, Revenue Canada's approach does not r e f l e c t the commercial r e a l i t i e s of these l i c e n s i n g agreements or the intent of the p a r t i e s , and therefore i t i s not appropriate to subject these cross-border sales of pre-packaged software to tax. 1 3 Thus, the more generally accepted view i s that such payments should be treated as sale proceeds rather than r o y a l t i e s . 1 4 B. Royalty Provisions i n M u l t i l a t e r a l Tax Treaties There are three main international model taxation agreements: the Organisation for Economic Co-operation and Development ("OECD") Model Tax Convention on Income and on Cap i t a l (the "OECD Model"), the United Nations Model Double Taxation Convention Between Developed and Developing Countries (the "UN Model") and the United 1 2 J.A. Chapin-Fortin, supra. at 32 - 33. 1 3 Nathan Boidman, supra. at 91; J.A. Chapin-Fortin, supra, at 31; and Kenneth J. Murray, CA, "Computer Software: Canadian and Cross-Border Issues", Report of Proceedings of F o r t y - F i f t h Tax Conference. 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994) 27:1 at 27:16. Note that under subparagraph 212(1)(d)(x), payments for software purchased from U.S. vendors by corporations with branches i n other countries are exempt from t h i s withholding tax on the portion of payments sourced to non-Canadian operations. (James Jones, i n "Correspondence", 42 Canadian Tax Journal 5 (Toronto: Canadian Tax Foundation, 1994) at 1444. 1 4 As noted by Kenneth J . Murray, supra. at 27:22 Revenue Canada i s studying the taxation of payments made to non-residents for the r i g h t to use software: "The reason f o r the study was representations that the sale of shrink-wrapped software i s the sale of a product rather than a li c e n c e . " Mr. Murray also notes that other countries t r e a t software payments as sales proceeds rather than licence fees (27:23). 40 States Treasury Model. The focus i n t h i s section i s on the OECD Model; b r i e f reference i s made to the other models. There has been ongoing debate i n the OECD for over a decade on inter n a t i o n a l tax issues regarding the development and transfer of software. 1 5 These debates culminated i n s i g n i f i c a n t amendments to the OECD Model i n 1992, p a r t i c u l a r l y with regard to the tax treatment of software which i s now s p e c i f i c a l l y addressed i n the OECD Model along with revised commentary. The revised OECD Model defines r o y a l t i e s as: ...payments of any kind received as a consideration f o r the use of, or the r i g h t to use, any copyright of l i t e r a r y , a r t i s t i c or s c i e n t i f i c work including cinematograph films, any patent, trade mark, design or Model, plan, secret formula or process. or f o r information concerning i n d u s t r i a l , commercial or s c i e n t i f i c experience. 1 6^ (emphasis added) The guiding p r i n c i p l e s f o r int e r p r e t a t i o n of A r t i c l e 12 of the OECD Model are summarized as follows: 1 7 1 5 See for example OECD, Working Party on Information, Computer, and Communications Policy, Software: An Emerging Industry (Paris: OECD, 1985); "Tax Treatment of Software" i n OECD, Model Tax Convention: Four Related Studies. Issues i n International Taxation no. 4 (Paris: OECD, 1992). 1 6 A r t i c l e 12:2. Note that the words "or for the use, or the ri g h t to use, i n d u s t r i a l , commercial or s c i e n t i f i c equipment" were deleted i n the revised OECD Model so that income from the leasing of such equipment would f a l l within A r t i c l e 7 (Business P r o f i t s ) rather than A r t i c l e 12, thereby escaping withholding taxes on r o y a l t i e s where countries do not adhere to the OECD formulation of A r t i c l e 12. See The Honourable Jan Franke, "The New OECD Model Tax Convention", Report of Proceedings of the Forty-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 47:1 - 47:19 at 47:7. 1 7 See CA. Brown, supra. at 595 -596; see also The Honourable Jan Franke, supra. at 47:16 - 47:17; David G. Broadhurst, Robert J. Dart and David G. Broadhurst (eds.), "Revisions to the OECD Model Convention", 40 Canadian Tax Journal 6 (Toronto: Canadian Tax 41 1. Payments made i n connection with software represent r o y a l t i e s only where there i s a li m i t e d grant of r i g h t s (not amounting to a change i n ownership) f o r the commercial development or ex p l o i t a t i o n of the software. 2. Payments for software (whether "bundled" or not) that i s acquired f o r the personal or business use of the acquiror do not represent r o y a l t i e s . 1 8 3. Payments made f o r the a l i e n a t i o n of a l l r i g h t s attached to software do not represent r o y a l t i e s . 4. Payments made for the purchase of some, but not a l l , of the r i g h t s attaching to software may r e s u l t i n an alie n a t i o n , depending on the precise terms of the relevant contract. In those circumstances, the consideration paid does not represent a royalty. 5. I f payments are made under mixed contracts (such as sales of hardware with b u i l t - i n software, or sales of services with a r i g h t to use software), eit h e r the payments should be apportioned to the component parts, or where some of the parts are a n c i l l a r y to the p r i n c i p a l part, the treatment of the p r i n c i p a l part should p r e v a i l . 6. Where a double taxation agreement provides f o r source taxation i n respect of some, but not a l l , r o y a l t i e s , software payments that have the c h a r a c t e r i s t i c s of r o y a l t i e s w i l l normally be characterized as paid i n respect of copyright. Therefore, a payment i n respect of software w i l l r a r e l y be a royalty payment under the revised OECD Model, even where there i s only a p a r t i a l transfer of r i g h t s . 1 9 An example of payments that Foundation, 1992) 1347 - 1363, at 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 . 1 8 As noted by CA. Brown, supra. at 596: "Further to i t s statement that i n most cases income from the sale of r i g h t s to software should be regarded as business income, personal service income or c a p i t a l gains, the commentary s a y s , • i t i s of no relevance that the software i s protected by copyright or that there may be r e s t r i c t i o n s on the use to which the purchaser can put i t 1 " . 1 9 See footnote 25 and OECD Model, commentary to A r t i c l e 12(14). 42 are r o y a l t i e s i s where the transferor i s the author of the software and the transferor grants p a r t i a l r i g h t s to a t h i r d party to enable that t h i r d party to develop or d i s t r i b u t e that software. 2 0 The ra 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 to encourage and f a c i l i t a t e i n t e r n a t i o n a l trade. 2 1 Even i f a payment i s c l a s s i f i e d as a royalty, only the state of the b e n e f i c i a l owner of the royalty payments has the r i g h t to tax 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 paid to the resident b e n e f i c i a l owner of the other contracting s t a t e . 2 2 In other words, i f a Canadian company makes royalty payments to a U.S. resident company, which i s the b e n e f i c i a l owner, only the United States has the r i g h t to tax those r o y a l t i e s paid under the OECD Model. The UN Model permits the use of a withholding tax where the rate has been agreed to i n a b i l a t e r a l t r e a t y . 2 3 The U.S. Treasury Model follows the OECD Model and allows f o r taxation i n the beneficiary country only. In actual t r e a t i e s signed by the U.S. the U.S. Treasury Model i s generally followed except where i t i s dealing with a country which imposes withholding tax on r o y a l t i e s , 2 4 such as the Canada-U.S. Tax Convention. 2 5 2 0 OECD Model, commentary to A r t i c l e 12(13). 2 1 J.S. P h i l l i p s , "Tax Treaty Networks" Chur, Switzerland: Worldwide Information Inc., 1991 at 389. 2 2 A r t i c l e 12:1 of the OECD Model. 2 3 J.S. P h i l l i p s , supra. at x x i i i and 389. The UN Model permits the use of a withholding tax provided that the rate has been agreed to between the states i n t h e i r b i l a t e r a l treaty. 2 4 i b i d . . at 389. 43 C. The Problem of Double Taxation A number of OECD members, Canada included 2 6, have expressed reservations about the complete exemption of r o y a l t i e s from source country taxation. In addition 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. 2 7 In p a r t i c u l a r , Canada has asserted i t s intention to t r e a t payments for the use of software as r o y a l t i e s which are subject to tax i n Canada. As indicated above, t h i s i s exactly opposite to the OECD recommendation. 2 8 I f both states i n a b i l a t e r a l treaty follow the OECD Model and exempt these payments from tax i n the source country, no double taxation problem w i l l a r i s e ; otherwise, the p o t e n t i a l f o r double taxation e x i s t s . For example, i n the case under review, cross-border payments are characterized by Revenue Canada as r o y a l t i e s subject to non-resident withholding tax with the following e f f e c t s : The Canadian customer generally must bear the cost of the 2 5 Canada-US Tax Convention, 1980 as amended. 2 6 A u s t r a l i a , Austria, France, Greece, I t a l y , Japan, New Zealand, Portugal, Spain and Turkey have also expressed varied reservations about A r t i c l e 12 of the OECD Model. 2 7 For example, A u s t r a l i a reserves the r i g h t to tax r o y a l t i e s that, under Australian law have a source i n A u s t r a l i a (see Commentary to OECD Model, A r t i c l e 12, paragraph 31) but Australian Taxation Ruling 93/12 issued on May 13, 1993 respecting the development and marketing of computer software determined that payments fo r a straightforward or simple use of computer software are not r o y a l t i e s (see Nathan Boidman, supra. at 93 per Andrew, "World Tax Scene - A u s t r a l i a - Computer Software Ruling," 1993/9 Intertax 448 (Sept. 1993)). CA. Brown, supra, at 596 - 597. 44 withholding tax; 2 9 a foreign tax c r e d i t may not be avai l a b l e to the s e l l e r i n the source country because of income-sourcing rules i n that country or the lack of current taxable income. 3 0 To i l l u s t r a t e , 3 1 a U.S. source sale a r i s e s when a U.S. software manufacturer exports software to Canada with t i t l e passing south of the border. Under these circumstances the U.S. manufacturer i s not e l i g i b l e for foreign tax c r e d i t on Canadian withholding tax. 3 2 I t i s u n l i k e l y that the U.S. manufacturer i s prepared to bear these costs and w i l l , therefore, increase the p r i c e to the Canadian end-user. 3 3 2 9 See also Kenneth J . Murray, supra. at 27:17: "In many cases, foreign vendors w i l l i n s i s t that the Canadian customer bear the burden of the withholding tax." Note also that the withholding tax i s based on gross revenue and can r e s u l t i n a very high e f f e c t i v e rate of tax on the net return to the l i c e n s o r a f t e r expenses have been taken into account. 3 0 J.A. Chapin-Fortin, supra, at 30. 3 1 J.A. Chapin-Fortin, supra, at 32. 3 2 In the United States, the foreign tax c r e d i t i s not designed to provide r e l i e f from double taxation caused by overlapping residence or overlapping source claims; i t only provides r e l i e f from a c o n f l i c t of U.S. residence j u r i s d i c t i o n with foreign source j u r i s d i c t i o n . See Michael J . Mclntyre, The International Income Tax Rules of the United States. (Mass.; Butterworth, 1989) at 4-5. 3 3 Obviously t h i s problem does not a r i s e when the treaty withholding rate i s n i l . However, other foreign j u r i s d i c t i o n s with s i m i l a r sourcing rules do not have t h i s treaty benefit. There are also ways to structure business operations to avoid the withholding tax issue e n t i r e l y . For example, large foreign software vendors may choose to set up Canadian subsidiaries to s e l l t h e i r products i n Canada. This i s done under d i s t r i b u t i o n agreements which can be designed to q u a l i f y for exemption from the Part XIII Canadian withholding tax. This option may not be f e a s i b l e f o r smaller vendors. Therefore, smaller foreign companies may choose to enter into d i s t r i b u t i o n arrangements with Canadian resident software d i s t r i b u t o r s which are structured to meet the Part XIII exemption. Subparagraph 212(1)(d)(vi) of the ITA provides and exemption from the withholding requirement for a "royalty or s i m i l a r payment on or 45 Even i n circumstances when a foreign tax c r e d i t may be claimed, the complexities and differences i n the foreign tax c r e d i t systems w i l l often not r e s u l t i n f u l l i ntegration; a f u l l and immediate c r e d i t for foreign taxes withheld may not be forthcoming. 3 4 Further any tax c r e d i t obtained s t i l l puts the non-resident at a cash flow cost disadvantage. Therefore, the p o t e n t i a l f o r double taxation i s s i g n i f i c a n t . D. Recent Developments This problem has not been overlooked on the i n t e r n a t i o n a l scene. In the United States, a c o a l i t i o n of 19 software developers devised a two step process to solve the problem of Canadian withholding tax on d i r e c t sales to Canadian end users: 3 5 1. The c o a l i t i o n would convince the [Internal Revenue in respect of a copyright i n respect of the production or reproduction of any l i t e r a r y . . . work". However, i f the production s i t e i s not i n Canada, the withholding tax w i l l apply with the same re s u l t s as above. Also, 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 to Canadian customers would avoid the Part XIII withholding tax but may subject the non-resident to Part I tax on i t s sales i n Canada, depending on the circumstances. A complete analysis of the various al 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. at 27:28 - 27:31. 3 4 See R.D. Brown, "Perspective on the Taxation of Technology Transfers Between Canada and the United States", Discussion Paper prepared f o r Bureau of Po l i c y Coordination f Department of Consumer and Corporate A f f a i r s : Price Waterhouse, Toronto, 1987 wherein the author suggests that t h i s i s p a r t i c u l a r l y true f o r new high technology companies which have substantial immediate write-offs for research and development, and access to domestic tax 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 to claim foreign tax c r e d i t s . 3 5 Nathan Boidman, supra. at 92. Note that c e r t a i n members of the industry, such as IBM and Xerox, were opposed to t h i s i n i t i a t i v e purportedly on the basis that i t could undermine protection of proprietary r i g h t s to t h e i r software. See also Kenneth J . Murray, supra. at 27:34 - 27:35. 46 Service] to issue a generic r u l i n g taking the p o s i t i o n that such cross-border l i c e n s i n g or sale of prepackaged software should be treated under US domestic law as a sale of property and not the l i c e n s i n g of property. Such a generic r u l i n g would therefore t r e a t any foreign d i s t r i b u t o r of prepackaged software (in the United States) as being i n receipt of proceeds of sale and not r o y a l t i e s . 2. Armed with such an IRS r u l i n g , an approach would be made to Revenue Canada to have the Canadian government adopt a s i m i l a r p o s i t i o n . Although the IRS has not yet issued the r u l i n g , the problem i s under review and two rul i n g s are expected to be issued at the end of 1994.36 The ultimate r u l i n g s w i l l be moot as the August 31, 1994 Protocol to the Canada-U.S. treaty reduces the withholding rate on payments for the use of software to 0% from the current rate of 10%. Changes have also been made to the Canada-Netherlands Income Tax Convention which s p e c i f i c a l l y exempts payments made for the use of computer software from withholding tax. 3 7 The problem i s that despite these recent trea t y developments, Revenue Canada s t i l l maintains the r i g h t to tax these cross-border payments. The 1993 Canadian federal budget stated the government's intention to exempt cross-border software payments fo r withholding tax i n i t s upcoming treaty negotiations, but f a i l e d to address the underlying issue of whether the software payments should be 3 6 Nathan Boidman, i b i d . . at 94. 3 7 March 4, 1993 Protocol to the Canada-Netherlands Income Tax Convention. A r t i c l e 12(3)(a) extended the exemption from host country taxation of r o y a l t i e s to "payments for the use of, or the r i g h t to use, computer software." This broadened the previous exemption for r o y a l t i e s on software licences which granted the ri g h t to reproduce. 47 c l a s s i f i e d as r o y a l t i e s i n the f i r s t instance: Revenue Canada shows no i n c l i n a t i o n to waver i n i t s inte 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, that Canadian firms may not be able to "keep pace with innovative developments abroad," the government pledged i n the 1993 federal budget to "negotiate, on a b i l a t e r a l basis, exemptions from withholding taxes f o r payments made for the use of computer software."... The United States - Canada's major trading partner, e s p e c i a l l y i n computer software - doesn't need a renegotiated treaty to conclude that nonresident withholding tax should not be le v i e d on software payments. The commitment to eliminate the withholding tax on these payments as part of upcoming treaty negotiations can be likened to t r e a t i n g the symptoms of a disease rather than the disease i t s e l f . 3 8 Therefore, software exporting countries which do not have t r e a t i e s or which have not renegotiated treaty provisions with Canada on t h i s matter are arguably at a competitive disadvantage, and may well be at a disadvantage f o r quite some time. Given Revenue Canada's reluctance to modify i t s p o s i t i o n on the cross-border software l i c e n s i n g debate, perhaps a consideration of t h i s p o l i c y i n l i g h t of other international agreements may have some persuasive impact. PART II THE GATT AND WITHHOLDING TAX ON PAYMENTS FOR SOFTWARE A. Introduction In t h i s Part, the question under consideration i s whether Revenue Canada's p o s i t i o n on the taxation of software has an e f f e c t on the international flow of computer software; s p e c i f i c a l l y whether the e f f e c t discriminates against imported software i n J.A. Chapin-Fortin, supra, at 33. 48 favour of domestically produced software. The question i s posed i n the context of the p r i n c i p l e of nondiscrimination i n the GATT. B. The P r i n c i p l e of Nondiscrimination and i t s Interpretation i . The P r i n c i p l e The underlying GATT p r i n c i p l e of nondiscrimination i s embodied i n A r t i c l e s I and I I I . The p r i n c i p l e i s p o t e n t i a l l y far-reaching and has the a b i l i t y to 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 contains the Most-Favoured-Nation (MFN) clause. The MFN o b l i g a t i o n i s a nondiscrimination clause which applies to goods from d i f f e r e n t exporting countries; any benefit extended by one member to another must be immediately extended to a l l other members.39 A r t i c l e III contains the national treatment o b l i g a t i o n which i s also a nondiscrimination clause but with a d i f f e r e n t emphasis. National treatment applies as between domestically produced goods and imported goods 4 0 and "generally [is] designed to r e i n f o r c e the basic p o l i c y of trade l i b e r a l i z a t i o n - minimizing governmental interference and d i s t o r t i o n of transactions which cross borders." 4 1 The clause i s i n part designed to prevent the importing country from undermining the elimination of t a r i f f import b a r r i e r s v i s a 3 9 There are a number of exceptions to the MFN clause. For example, the NAFTA v i o l a t e s the MFN obligation, put i s permitted under A r t i c l e 24 of GATT. 4 0 The concept of national treatment i s also fundamental to the NAFTA, and i t s predecessor Canada/U.S. Free Trade Agreement. 4 1 John H. Jackson and William J . Davey, Legal Problems of International Economic Relations (St. Paul, Minn.: West Publishing Co.,2d ed., 1986) at 483. 49 v i s i n t e r n a l governmental mechanisms. 2 A r t i c l e 111:1 states that i n t e r n a l taxes and laws "should not be applied to imported or domestic products so as to aff o r d protection to domestic production." I t has been suggested that because of t h i s language, i t can be strongly argued that even though a tax may appear to be nondiscriminatory on i t s face, i f i t has an e f f e c t of affording protection, and t h i s e f f e c t i s not es s e n t i a l to the v a l i d regulatory purpose suggested i n A r t i c l e XX, then the tax i s inconsistent with GATT o b l i g a t i o n s . 4 3 A r t i c l e 111:2 focuses on i n t e r n a l taxes and charges: 2. The products of the t e r r i t o r y of any contracting party imported into the t e r r i t o r y of any other contracting party s h a l l not be subject, d i r e c t l y or i n d i r e c t l y , to i n t e r n a l taxes or other i n t e r n a l charges of any kind i n excess of those applied, d i r e c t l y or i n d i r e c t l y , to l i k e domestic products. Moreover, no contracting party s h a l l otherwise apply i n t e r n a l taxes or other i n t e r n a l charges to imported or domestic products i n a manner contrary to the p r i n c i p l e s set 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 discriminatory taxes on l i k e products; i t does not p r o h i b i t tax on imports where 4 2 National treatment only applies to trade i n products but the obli g a t i o n to void discriminatory i n t e r n a l taxes applies to a l l products, not just scheduled ones. See also John H. Jackson, World Trade and the Law of 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 Michie Company, 1969) at 280. 4 3 John H. Jackson.World Trade and the Law of GATT. i b i d . . at 193 and John H. Jackson, "National Treatment and Non-Tariff Bar r i e r s " , Michigan Journal of International Law. Vo. 10, No.l 207, at 213. 4 4 As noted by K.W. Dam, The GATT Law and International Economic Organization, (Chicago: The University of Chicago Press, 1970) at 118, paragraph 1 does not set out " p r i n c i p l e s " but only states that i n t e r n a l taxes should not be applied "so as to afford protection to domestic production." (emphasis added) 50 there i s a d i f f e r e n t i n t e r n a l tax on l i k e domestic products which imposes an equal or greater burden. 4 5 Further, the i n t e r p r e t i v e note to paragraph 2 states that: A tax conforming to the requirements of the f i r s t sentence of paragraph 2 would be considered to be inconsistent with the provisions of the second sentence only i n cases where competition was involved between, on the one hand, the taxed product and, on the other hand, a d i r e c t l y competitive or substitutable product which was not s i m i l a r l y taxed. 4 6 Therefore, i f a tax measure i s inconsistent with the f i r s t sentence of paragraph 2, i t i s not necessary to consider the second sentence. However, even i f a tax measure complies with the f i r s t sentence, i t can contravene the second sentence. The second sentence deals with other i n t e r n a l taxes where l i k e products are not involved but the tax discriminates between d i r e c t l y competitive or substitutable domestic products i n f a c t , not i n form. 4 7 i i . Interpretation of A r t i c l e III The approach for examining conformity with A r t i c l e 111:2 i s to f i r s t determine whether the imported and domestic products are " l i k e " ( f i r s t sentence) or " d i r e c t l y competitive or substitutable" (second sentence) 4 8; then, whether the taxation i s discriminatory 4 5 i b i d . , at 117. Note that A r t i c l e I I , paragraph 2(a) permits "a charge equivalent to an i n t e r n a l tax imposed consistently with the provisions of paragraph 2 of A r t i c l e I I I . . . " on imported products. 4 6 Interpretive Note, Ad. A r t i c l e I I I . 4 7 K.W. Dam, supra, at 118. 4 8 This paper does not address the i n t e r p r e t i v e issues regarding the meaning of " l i k e " or " d i r e c t l y competitive or substitutable" products which are assessed on a case by case basis 51 ( f i r s t sentence) or p r o t e c t i v e 4 9 (second sentence) . 5 0 In addition, there are a number of fundamental i n t e r p r e t a t i v e issues which must be addressed. a. Internal Taxes: Direct, Indirect 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 and other taxes, 5 1 usually c a l l e d i n t e r n a l taxes. 5 2 A t a r i f f i s a tax using the following c r i t e r i a : the product's end uses i n a given market; consumers' tastes and habits, which change from country to country; and the product's properties, nature and q u a l i t y (see "Border Tax Adjustments", BISD 18S/97 at 101-102, paragraph 18 and "Japan - Customs Duties, Taxes and L a b e l l i n g Practices 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 that 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 context of under review. 4 9 A r t i c l e 111:2 has the object and purpose of promoting non-discriminatory competition among imported and l i k e domestic products; i t was designed with the intention that i n t e r n a l taxes on goods should not be used as a means of protection (Pierre Pescatore, William Davey and Andreas F. Lowenfeld, Handbook of GATT Dispute Settlement (U.S.A.: Transnational J u r i s Publications, Inc., 1991) at 28 - 29). See also A r t i c l e 111:1 and footnote 51. 5 0 "Japan - Customs Duties, Taxes and L a b e l l i n g Practices on Imported Wines and A l c o h o l i c Beverages", BISD 34S/83, 85 at paragraph 5.5. 5 1 The common d i s t i n c t i o n i n a GATT analysis 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 to trade. 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 relevant as the GATT philosophy regarding n o n t a r i f f and t a r i f f b a r r i e r s i s quite d i f f e r e n t ; a contracting party i s not required to reduce t a r i f f s i n the absence of a s p e c i a l agreement whereas the general p r i n c i p l e with respect to 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. at 19) . The GATT makes no general provision for negotiations on the reduction 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 preferred method to r e s t r a i n trade for a v a r i e t y of reasons. In addition to being easier to administer, a t a r i f f i s highly 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 options). See also John H. Jackson and William J. Davey, supra, at 366 for a discussion of why i n t e r n a t i o n a l trade p o l i c y generally favoured t a r i f f s over a l l other types of import r e s t r a i n t s . 52 or duty lev i e d on imports and payable by the importer to the government of the importing country. 5 3 Internal taxes or other i n t e r n a l charges imposed at the time or point of importation, 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 subject to the provisions of A r t i c l e I I I . 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 III applies to d i r e c t as well as to i n d i r e c t taxes. The difference between these categories can be described as follows: The theory i s that a d i r e c t tax i s a tax which i s r e a l l y paid by the person on whom i t i s l e g a l l y imposed. I t i s assessed according to the personal ' a b i l i t y to pay' and i s r e l a t e d to facts which are regarded as being an objective and l a s t i n g expression of the tax paying capacity (eg. residence, landed property). The tax burden i s d i s t r i b u t e d according to the economic capacity of the taxpayers which manifests 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 other hand, i s a tax which i s imposed on one person, but paid p a r t l y or wholly by another; eg. i t i s lev i e d on the trade and s h i f t e d on to the consumers. Indirect taxes are aimed at assessing the a b i l i t y to pay taxes i n d i r e c t l y and r e l a t e d to the momentary tax paying capacity. The tax burden i s d i s t r i b u t e d among the consumers i n accordance with t h e i r expenditure. 5 5 5 2 K.W. Dam, i b i d . . at 115. 5 3 See John H. Jackson and William J . Davey, supra. at 364 for a discussion of the three types of t a r i f f s : ad valorem, s p e c i f i c and mixed. 5 4 Interpretive 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 to taxes lev i e d on both imported and l i k e domestic products, but gives no guidance where l i k e domestic products are not involved. Note that the national treatment o b l i g a t i o n i n A r t i c l e III i s divided into those r e l a t i n g to taxation and those r e l a t i n g to various other regulations. 5 5 Arnold A. Knechtle, Basic Problems i n International F i s c a l Law. (The Netherlands: A.A. Knechtle, 1979) at 210 (n.40). See also Black's Law Dictionary (St. Paul Minn., West Publishing Co. 1979) for the d e f i n i t i o n of "tax" (direct taxes are assessed on the 53 The c l a s s i f i c a t i o n into d i r e c t and i n d i r e c t taxes i s c o n t r o v e r s i a l ; 5 6 i t i s not always cle a r whether a tax belongs to one or the other category. 5 7 The issue of whether a tax i s passed through to the eventual consumer i s p a r t i c u l a r l y problematic. 5 8 The terms " d i r e c t l y " and " i n d i r e c t l y " arguably do not r e f e r to " d i r e c t " and " i n d i r e c t " taxes, 5 9 though i t i s possible to argue property, person, business or income of those who pay them; i n d i r e c t taxes are lev i e d on commodities before they reach the consumer and are paid by those upon whom they ultimately f a l l as part 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 generally r e f e r to the t e s t set 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. Direct taxes t y p i c a l l y include personal and corporate income taxes; i n d i r e c t taxes include the excise and sales taxes. 5 6 I t i s worth noting that the mere de s c r i p t i o n or categorization of a tax under the domestic law i s not determinative of whether the tax i s subject to the requirements of A r t i c l e I I I . See "European Economic Community; Regulation on Imports of Parts and Components", BISD S37/132, 193 (May 16, 1990) paragraph 5.7 which a r r i v e s at t h i s conclusion i n regard to the "description or categorization of a 'charge'" and of "the 'product subject to a charge•". The author submits that the same treatment would be accorded to descriptions of taxes under the i n t e r n a l law. 5 7 A. A. Knechtle, supra. at 30. The c l a s s i f i c a t i o n into d i r e c t and i n d i r e c t a rises often i n Canadian c o n s t i t u t i o n a l law. For a thorough analysis see G.V. LaForest, "The A l l o c a t i o n of Taxing Power Under the Canadian Constitution",2d., 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 Direct Taxation". 5 8 See John H. Jackson, The World Trading System; Law and P o l i c y of International Economic Relations. (Cambridge, Mass.: The MIT Press, 1989) at 196 - 197 for a discussion of the d i f f i c u l t y of accurately measuring the incidence of a tax. The issue also arises head on i n the context of border tax adjustments where value-added-taxes have been considered by the GATT to be i n d i r e c t taxes which are e l i g i b l e for border-tax-adjustment. See John H. Jackson, The World Trading System, supra. at 194 - 195. 5 9 K.W. Dam, supra. at 124. As the author notes, a tax which applies d i r e c t l y to products i s , i n f a c t , an i n d i r e c t tax, whereas a tax which applies i n d i r e c t l y to products i s a d i r e c t tax. 54 that the " d i r e c t l y or i n d i r e c t l y " language i s broad enough to cover the discriminatory e f f e c t s of d i r e c t taxes. 6 0 The common int e r p r e t a t i o n i s that the reference to "products" i n A r t i c l e III implies that i t i s only i n d i r e c t taxes which are within the scope of A r t i c l e I I I . 6 1 Also, the predecessor to A r t i c l e I II d i d not appear to apply to d i r e c t taxes. 6 2 I f d i r e c t taxes are excluded from A r t i c l e I I I , the following consequences a r i s e : ... a domestic income [direct] tax may not be o f f s e t by any [indirect] tax on imported products, [and] an income [direct] tax levi e d on importers or foreign s e l l e r s need not o f f s e t any domestic tax. 6 3 Further, consider the following discussion on whether ce r t a i n income tax p r i v i l e g e s are covered by A r t i c l e I I I : For instance, suppose Xonia grants an immediate income 6 0 P i e r r e Pescatore, William Davey and Andreas F. Lowenfeld, supra, at 29. Although the authors suggest that t h i s argument could be made, they go on to say that the framers of GATT probably did not have t h i s i n t e r p r e t a t i o n i n mind as they generally distinguished between i n d i r e c t , product-related taxes and other, d i r e c t taxes. 6 1 K.W. Dam, supra. at 124. Indirect taxes are generally considered to be borne by the consumer, as compared with d i r e c t taxes (such as income taxes) which are absorbed by the s e l l e r . An int e r p r e t a t i o n that i n d i r e c t taxes are the taxes covered by A r t i c l e III i s consistent with these economic assumptions. 6 2 i b i d . . at 124 - 125. The author r e f e r s to the A n a l y t i c a l Index, at 19, regarding a statement i n the reports on the Havana Conference which indicates that the p a r t i c u l a r a r t i c l e i n the Havana Charter d i d not apply to income taxes. 6 3 i b i d . . at 125. The l a t t e r point i s important because [direct] taxes on the l o c a l income of foreign s e l l e r s are common and are frequently li m i t e d only by the requirement that the foreign s e l l e r have a "permanent establishment" i n the taxing country. In addition, such [direct] taxes are often calculated on a d i f f e r e n t basis from taxes on l o c a l enterprises. 55 tax deduction equal to the p r i c e of a c e r t a i n machine for each such machine purchased from a domestic firm, but no such deduction for machines imported. I f the deduction or exemption were from a tax on the machine [ i n d i r e c t tax], 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 to a tax on the firm [d i r e c t tax], 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 of such a p r i v i l e g e , even when i t concerns income taxes on a firm, i s often decisive. But i t can be argued from the language of A r t i c l e I I I , paragraph 2, that such exemption i s not from a tax "on the product". Can i t be argued that i t amounts i n e f f e c t to an " i n d i r e c t " tax or charge? Or i s t h i s one of the major loopholes of GATT? Certainly practices of many countries would be affected by any attempt to close t h i s loophole. 6 4 The net e f f e c t of excluding d i r e c t taxes from A r t i c l e III can be summarized i n the following chart: Tax on Imports Domestic Tax A r t i c l e III Applies? d i r e c t d i r e c t no d i r e c t i n d i r e c t no i n d i r e c t d i r e c t yes i n d i r e c t i n d i r e c t yes Although i t appears that A r t i c l e III may have been o r i g i n a l l y intended to apply only to i n d i r e c t taxes, 6 5 t h i s i n t e r p r e t a t i o n i s not clear and would r e s u l t i n a large loophole, which i s d i f f i c u l t to j u s t i f y . This issue i s further complicated 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 tax as d i r e c t or i n d i r e c t , b. Po l i c y Purpose GATT panels have considered whether the p o l i c y purpose of an i n t e r n a l tax or charge i s relevant i n i n t e r p r e t i n g the text of A r t i c l e s I, I I , III and the Note to A r t i c l e I I I . I t has been expressed that the relevant f a c t i s not the p o l i c y purpose attributed to the charge or tax, but whether the charge i s due on importation, at the time or point of importation or whether i t i s 6 4 John H. Jackson, World Trade and the Law of GATT, supra. at 285. 6 5 For a discussion on whether A r t i c l e 111:2 applies to i n d i r e c t taxes only, see generally K.W. Dam, supra, at 124-125. c o l l e c t e d i n t e r n a l l y : 6 6 the tax adjustment rules of the General Agreement di s t i n g u i s h between taxes on products and taxes not d i r e c t l y l e v i e d on products; they do not d i s t i n g u i s h between taxes with 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 States - Taxes on Petroleum and Certain Imported Substances" the GATT panel determined that A r t i c l e 111:2 applies whether or not adverse trade e f f e c t s occur. The f i r s t sentence of A r t i c l e III "obliges contracting p a r t i e s to e s t a b l i s h c e r t a i n competitive conditions for imported products i n r e l a t i o n to domestic products. Unlike some other provisions i n the General Agreement, i t does not r e f e r to trade e f f e c t s . " 6 7 Therefore: 6 8 A change i n the competitive r e l a t i o n s h i p contrary to [ A r t i c l e 111:2] must consequently be regarded ipso facto as a n u l l i f i c a t i o n or impairment of benefits accruing under the General Agreement. A demonstration that a measure inconsistent with 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 therefore. . . not be a s u f f i c i e n t demonstration that the benefits accruing under that provision had not been n u l l i f i e d or impaired... With regard to A r t i c l e 111:2, second sentence, small tax differences can also influence the competitive r e l a t i o n s h i p , but the existence of protective taxation must be established on a case 6 6 BISD 34S/136 at 161; see also "Belgian Family Allowances" BISD IS/59 at 60; 25S/49, 67 and "E.E.C. Regulation on Imports of Parts and Components", 37S/132 at 192, 193. 6 7 BISD 34S/136 i b i d , at paragraph 5.1.9. See also " B r a z i l i a n Internal Taxes", BISD Vol. 11/185 and John H. Jackson, World Trade and the Law of Gatt. supra at 193 and John H. Jackson, "National Treatment and Non-Tariff Barriers", Michigan Journal of International Law. Vol 10, No. 1, 207 at 213. 6 8 i b i d 57 by case basis and there may be a minimum l e v e l below which a tax ceases to have the protective e f f e c t prohibited by A r t i c l e 111:2, second sentence. 6 9 C. Withholding Tax and A r t i c l e 111:2 Before embarking on an analysis of whether the taxation i s discriminatory or protective under A r t i c l e 111:2, the fundamental in t e r p r e t a t i v e issue of the category of tax i s examined. 7 0 i . Withholding Tax - Direct or Indirect? For domestically produced software, income tax i s imposed on royalty revenue through the corporate tax system. These revenues form part of the net income c a l c u l a t i o n and corporate income tax i s paid on the net income; t h i s i s a d i r e c t tax. The enforcement process i s quite d i f f e r e n t f o r foreign royalty payments. The withholding tax mechanism i s arguably more akin to a sales tax on a product than to a tax on income which i s imposed on a firm. The amount to be withheld i s based on the gross revenue generated from a single payment for a p a r t i c u l a r product, without any deduction for expenses. 7 1 6 9 "Japan - Customs Duties, Taxes and L a b e l l i n g Practices on Imported Wines and A l c o h o l i c Beverages", BISD 34S/83, 85 at paragraph 5.11. 7 0 As noted previously the f i r s t issue i s whether the domestic and foreign products are " l i k e " or " d i r e c t l y competitive or substitutable"; i t i s assumed that 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 also not pursued since they are not relevant to t h i s analysis as discussed i n the previous section. 7 1 See R i . v. Caledonian C o l l i e r i e s , [1928] A.C. 358, which distinguished between an income tax and a gross revenue tax. The Alberta Mine Owners Tax Act provided that every mine owner should be subject to a tax of 2% of gross revenue received by him during the year. The Privy Council held that t h i s was an i n d i r e c t tax as 58 The i n t e r p r e t a t i o n of a tax as d i r e c t or i n d i r e c t comes up frequently i n the Canadian context of the a l l o c a t i o n of taxing power between the federal and p r o v i n c i a l governments. 7 2 In C.P.R. v. A.G. Saskatchewan. [1952] 2 S.C.R. 231, Rand J . adopted the following t e s t for determining whether a tax i s i n d i r e c t (at 252): If the tax i s rela t e d or re l a t a b l e , d i r e c t l y or i n d i r e c t l y to a unit of the commodity or i t s p r i c e , imposed when the commodity i s i n the course of being manufactured or marketed, then the tax tends to c l i n g as a burden to the unit or the transaction presented to the market. A l t e r n a t i v e l y , the general tendencies of a tax and the common understanding as to those tendencies can be examined i n assessing whether a tax i s d i r e c t or i n d i r e c t . 7 3 The amount of withholding i s d i r e c t l y r e l a t e d to the pr i c e of the software; i t i s based on the gross revenue or the p r i c e of the software. 7 4 The tax must be withheld when the payment i s made -when the software i s marketed i n Canada. Therefore, the tax tends to c l i n g as a burden to the unit or the transaction presented to there was a general tendency to pass the tax along. Also r e f e r to Re Wallace Realty Co. Ltd. (1930), 3 D.L.R. 417 (SCC). 7 2 A large body of Canadian case law ex 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 relevant to a GATT challenge, the general p r i n c i p l e s a r t i c u l a t e d are of some guidance. For a comprehensive review of the Canadian law i n t h i s area, see G.V. LaForest, "The A l l o c a t i o n of Taxing Power Under the Canadian Constitution",2d. Canadian Tax Paper No. 65. (Toronto: Canadian Tax Foundation, 1981). 7 3 See Simpsons-Sears Ltd. v. P r o v i n c i a l Secretary of New Brunswick (1978), 82 D.L.R. (3d) 321 (S.C.C.); Brewers 1 and Maltsters' Association v. A.G. Ontario. [1897] A.C. 231. 7 4 See The Corporation of the D i s t r i c t of Maple Ridge v. A.G. Canada. [1993] 4 S.C.R. 371 (S.C.C.). 59 the market and, as such, has the c h a r a c t e r i s t i c s of an i n d i r e c t tax. Further, i t i s suggested that the foreign taxpayer w i l l tend to pass the amount of tax on to the customer, j u s t as customs duties tend to enter into the p r i c e of a product. 7 5 The amount of the tax i s r e a d i l y i d e n t i f i a b l e and the p r i c e can e a s i l y be adjusted f o r the tax. I t i s reasonable to conclude that such an adjustment would be made and the general tendency would be to pass the tax along. Any such tax s h i f t would not e n t a i l a c i r c u i t o u s process as would be required to pass corporate income taxes on i n the p r i c e of goods produced and sold domestically. On the other hand, there are a number of arguments which support the view that such a tax i s d i r e c t . F i r s t , i t i s more l i k e l y than not that i t i s the foreign software developer who i s intended to bear the incidence of the tax, not the Canadian 7 5 Kenneth J. Murray, supra. at 27:17 notes that i n many cases, foreign vendors w i l l i n s i s t that the Canadian customer bear the burden of the withholding tax. He also r e f e r s to Revenue Canada guidelines on how the withholding i s to be calculated " i n t h i s s i t u a t i o n " ; the s p e c i f i c Round Table question i n which t h i s c a l c u l a t i o n was set out referred to gross-up clauses i n loan agreements where the in t e r e s t payment i s subject to withholding (see Revenue Canada Round Table, 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) Question 31 at 58:16. The grossed-up t o t a l of withholding tax i s calculated by applying the following formula: Required Payment = [tax rate/100 - tax rate] * payment. An example i s also provided: f o r a payment of $1,000 at a withholding rate of 15% the required payment of withholding tax i s : [15/100-15] * 1,000 = $176.47 60 consumer.76 However, i f the person who ultimately pays the tax, the end user, i s not the one who i s intended to bear the burden, the tax i s i n d i r e c t . 7 7 Second, i f the tax can e a s i l y be passed on, i t may not be passed 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 buried i n the p r i c e of the goods, even an economic tendency to pass on a tax may not be s u f f i c i e n t to make the tax i n d i r e c t . 7 8 i i . Internal Taxes - Direct and Indirect? I t 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 that i n t e r n a l taxes are li m i t e d to i n d i r e c t taxes. When the GATT was drafted, the focus of attention was on the reduction of t a r i f f b a r r i e r s to trade; arguably not much thought was given to the p o t e n t i a l impact of c l a s s i f y i n g a p a r t i c u l a r tax as d i r e c t or i n d i r e c t . Therefore, there i s some room fo r f l e x i b i l i t y i n 7 6 Subsection 212(1) i n Part XIII of the ITA states: "Every non-resident person s h a l l pay an income tax of...". Subsection 215(1) requires a person to withhold when the person "pays or c r e d i t s or i s deemed to have paid or credited an amount on which an income tax i s payable under [Part XIII]", however, the payer i s e n t i t l e d to recover the amount from the non-resident (see Kenneth Murray, supra, at 27:26) . Therefore, i t appears that i t i s the non-resident who i s intended to bear the burden of the tax, not the Canadian consumer. 7 7 See Reference Re Quebec Sales Tax (23 June 1994) , S.C.C. no. 23690, (S.C.C). 7 8 In the Canadian context see Bank of Toronto v. Lambe (1887) , 12 A.C. 575; Brewers' and Maltsters' Association v. Attorney General of Ontario. [1897] A.C. 231; Cairns Construction Ltd. 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 Act. [1976] 2 S.C.R. 373 at 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. - Alberta. [1954] 3 D.L.R. 121; A.G. - Newfoundland v. Avalon Telephone Co. (1962), 33 D.L.R. (2d) 402; Simpson-Sears Ltd. v. P r o v i n c i a l Secretary of New Brunswick (1978), 82 D.L.R. (3d) 321 (S.C.C). 61 i n t e r p r e t i n g the language, despite the p r e v a i l i n g view that the provision i s intended to apply only to i n d i r e c t taxes. Should the language be given as broad an in t e r p r e t a t i o n as i s reasonably j u s t i f i e d ? 7 9 Should the meaning which i s l e a s t trade r e s t r i c t i v e be adopted? As previously discussed, the " d i r e c t l y or i n d i r e c t l y " language i n A r t i c l e III may be broad enough to include d i r e c t taxes. 8 0 I t would have been easy enough to use the words " i n d i r e c t taxes" i n the place of " i n t e r n a l taxes" i n A r t i c l e III i f i t was intended to exclude d i r e c t taxes from t h i s provision. Furthermore, even i f A r t i c l e I II was o r i g i n a l l y intended to apply only to i n d i r e c t taxes, i n t e r p r e t i n g the language i n the global market of today requires a broader, more f l e x i b l e approach which recognizes the advances made i n the reduction of trade b a r r i e r s . Twenty-five years ago i t was noted that some of the GATT provisions were outdated: [S]ome of the provisions of GATT have become outdated because, as t a r i f f s have declined, other modes of protection of domestic industry have become r e l a t i v e l y more important, and these have sometimes "slipped through" the i n t r i c a c i e s of the complex GATT language. One example i s the border tax adjustment. Others include c e r t a i n subsidies, the import deposit scheme, and the "l o y a l t y rebate." 8 1 7 9 See American Farm Bureau Assn. v. Canadian Import Tribunal. [1990] 2 S.C.R. 1324 (SCC) for comments regarding a " l i b e r a l " i n t e r p r e t a t i o n of the GATT i n the context of the Special Import Measures Act. R.S.C. 1985, c.S-15, as amended. 8 0 See Pierre Pescatore, William Davey and Andreas F. Lowenfeld, supra. at 29. 8 1 John H. Jackson, World Trade and the Law of GATT. supra. at 769 - 770. 62 The view that the GATT provisions were viewed as outdated i n 1969 i s even more pronounced going into the 22nd century. Another example which could be added to the foregoing l i s t i s an inte r p r e t a t i o n of in t e r n a l taxes being l i m i t e d to i n d i r e c t taxes -a major loophole i n the GATT with p o t e n t i a l l y f a r reaching impact on tax p o l i c i e s . Tax p o l i c i e s should not be an impediment to international trade 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 flow of i n t e l l e c t u a l property have been made. Yet t h i s could be the r e s u l t i f d i r e c t taxes s l i p through the GATT cracks because they do not conform to c e r t a i n language drafted hal f a century ago. F i n a l l y , on January 1, 1995 the new World Trade Organization (the "WTO") took over the reigns from the GATT to pursue further advances i n international trade. 8 2 Perhaps under the auspices of the WTO a broader interpretation of the meaning of " i n t e r n a l taxes" i s f e a s i b l e . i i i . Discriminatory Taxation If the tax i n issue i s c l a s s i f i e d as an i n d i r e c t tax, or i f i t 8 2 The WTO incorporates the new 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 ("TRIPs") which establishes standards of protection for i n t e l l e c t u a l property r i g h t s ; i t i s the most comprehensive int e r n a t i o n a l agreement i n t h i s area to date. (Agreement on Trade-Related Aspects of I n t e l l e c t u a l Property Rights, including Trade i n Counterfeit Goods, Annex IC to the F i n a l Act Embodying the Results of the Uruguay Round of M u l t i l a t e r a l Trade Negotiations, GATT document MTN/FA (UR-93-0246) (1993)). The TRIPs also provides for enforcement of these standards under national law and contains provisions for accessing the WTO's dispute procedures. See Jock A. Finlayson, "Canada and International Trade Regulation: The General Agreement on T a r i f f s and Trade", i n Robert K. Paterson and Martine M. Band, International Trade and Investment Law i n Canada. 2d., (Toronto: Carswell, 1994) at 1-56 - 1-57. 63 i s c l a s s i f i e d as a d i r e c t tax and A r t i c l e I II i s interpreted to address d i r e c t taxes, i t must be determined whether the taxation i s discriminatory. 8 3 In " I t a l i a n Discrimination Against Imported A g r i c u l t u r a l Machinery" 8 4 the GATT panel considered the standard i n A r t i c l e 111:4 that imported products be subject to "treatment no less favourable" than that accorded domestic products i n applying i n t e r n a l law. The panel was of the view that t h i s standard requires e f f e c t i v e eguality of opportunities. This focus on e f f e c t i n the context of the p r i n c i p l e of national treatment should apply equally to i n t e r n a l taxes as to other i n t e r n a l law. Thus, i t i s necessary to e s t a b l i s h whether the e f f e c t s of the tax are discriminatory. C l a s s i f y i n g a payment for a software licence as a royal t y i s the same f o r domestic and foreign l i c e n s i n g arrangements. Prima f a c i e , the tax treatment may not appear to be discriminatory simply because there i s a d i f f e r e n t enforcement procedure i n place for c o l l e c t i n g the taxes. However, i t i s not the enforcement mechanism of the withholding for the tax on the royal t y revenue which i s discriminatory; i t i s the e f f e c t of such withholding. In addition, although the withholding tax applies only to 8 3 Under the assumption that l i k e products are involved, i t i s only necessary to determine whether the tax i s discriminatory under the f i r s t sentence. The second sentence applies i f the products are d i r e c t l y competitive or substitutable. For further discussion on the t h i s point, see Part B. above "The P r i n c i p l e of Nondiscrimination and i t s Interpretation". 8 4 BISD. 7S / 60. 6 4 imports, "a tax applying to imports only i s not unlawful [within A r t i c l e 111:2] i f another, but d i f f e r e n t , i n t e r n a l tax imposes an equal or greater burden on l i k e domestic products." 8 5 Therefore, i t i s necessary to es t a b l i s h that the e f f e c t of withholding i s that a greater tax burden i s placed on imported software i n comparison with the income tax on domestic software. In the domestic sphere, software r o y a l t i e s form part of the net income c a l c u l a t i o n for income tax purposes; the tax payment i s based on net income and no withholding i s required. In the cross-border transfer of software, withholding tax i s calculated on the gross amount paid. Thus, the withholding tax can represent a very high rate of tax on the net return to the software vendor a f t e r expenses are taken into account; the tax withheld on behalf of the non-resident could well exceed what would be charged i f the income was taxable as income i n Canada 8 6 and have the e f f e c t of being discriminatory. Further, as discussed i n Part I, withholding tax on royalty payments may r e s u l t i n double taxation when non-residents have l i t t l e or no opportunity to use the foreign tax c r e d i t , or s i m i l a r mechanism, to o f f s e t Canadian withholding taxes. 8 7 Such double taxation subjects the imported software to taxes i n excess of those applied to domestic software, contrary to A r t i c l e 111:2. 8 5 K.W. Dam, supra. at 117. 8 6 J.S. P h i l l i p s , supra, at x x i i i - xxiv. 8 7 As discussed i n Part I, even when a foreign tax c r e d i t may be claimed, there i s often not f u l l i ntegration and, at a minimum, a cash-flow disadvantage e x i s t s . 65 Also: ...by v i r t u e of double taxation the tra n s f e r of technology ceases to be of i n t e r e s t i f the required minimum income cannot be achieved . . . the s i t u a t i o n det e r i o r a t i n g due to taxation of the gross amount of some income, eg. ... r o y a l t i e s . Thus the taxpayer w i l l act according to tax rather than economic c r i t e r i a , and as a r e s u l t i n i t i a t i v e w i l l be restrained and e f f i c i e n t enterprises w i l l f i n d i t harder to operate. 8 8 In other words, the foreign producer may f i n d i t i s not economically viable to transfer technology to Canada or may decide to pursue more tax advantageous business structures to e f f e c t such transactions: The underlying assumption of the General Agreement -indeed, the argument for free trade i n general - i s that l o c a l laws and regulations should not make the loc a t i o n of industry a factor i n trade. To say that part of the foreign industry must be moved to the [domestic country] for the foreign product to have the same competitive p o s i t i o n as the domestic product i s to concede that the 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 trading patterns and serves to "afford protection to domestic production. 1 , 8 9 In summary, a strong argument can be made that the e f f e c t of the withholding tax mechanism i s to discriminate against foreign software i n favour of domestic software; t h i s i s contrary to the p r i n c i p l e of national treatment i n A r t i c l e I I I . i v . J u s t i f i a b l e Discrimination An i n t e r n a l tax which i s discriminatory may s t i l l come within a GATT exception and not be prohibited. These exceptions are b r i e f l y canvassed i n t h i s section. I t i s worth bearing i n mind that 8 8 Manuel Pires, International J u r i d i c a l Double Taxation of Income. Series on International Taxation, No.11 (The Netherlands; Kluwer Law and Taxation Publishers, 1989) at 76. K.W. Dam, supra. at 130. 66 these exceptions can be a form of hidden protectionism. F i r s t , discriminatory taxes which were i n e f f e c t on October 30, 1947 may be continued, but not increased. 9 0 In the p a r t i c u l a r case under review, the provisions of the Income Tax Act which were i n force i n 1947 d i d not include the "secret formula or process" language r e l i e d upon by Revenue Canada to treaty payments for software licences as r o y a l t i e s . 9 1 Second, i t i s cle a r that the p r i n c i p l e of national treatment must also be balanced with national p o l i c y goals. This overriding r i g h t of sovereignty to promote domestic p o l i c y goals i s acknowledged i n A r t i c l e s XX (General Exceptions) and XXI (Security Exceptions). These A r t i c l e s recognize that there are various governmental measures which are based on legitimate p o l i c i e s not necessarily designed for purposes of r e s t r a i n i n g imports. Legitimate p o l i c y goals, including those mentioned A r t i c l e XX prevent a measure from being inconsistent with GATT obligations. I t i s u n l i k e l y that either of these A r t i c l e s applies to the tax under review, unless a national security 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 transaction. From a domestic perspective, i t appears that Revenue Canada's objective i n imposing t h i s withholding tax i s to maintain control over such cross-border payments i n order to preserve the Canadian tax base. Certainly the withholding tax mechanism i s r a t i o n a l l y 9 0 i b i d . . at 119. 9 1 See The Income War Tax Act, c.97 R.S.C. 1927 ss. 24 and 25; The Income Tax Act.c. 52 S.C. 1948, s. 96(e) and The Income Tax Act, c. 148 R.S.C. 1952, s. 106(6). 67 r e l a t e d to achieving t h i s objective, and i s e f f e c t i v e i n achieving i t . However, t h i s case study suggests that t h i s domestic objective does not outweigh the broader domestic and in t e r n a t i o n a l objectives of f a c i l i t a t i n g free trade i n technology. With the recent Canadian treaty re-negotiations reducing the withholding tax rate to n i l i n for these payments, and given the generally accepted in t e r n a t i o n a l p o s i t i o n on t h i s matter, i t i s suggested that there i s l i t t l e j u s t i f i c a t i o n for Revenue Canada to continue to maintain t h i s p o l i c y . The alternatives are to: 1) maintain the status quo and continue pursuing treaty re-negotiations on a case by case basis; or 2) to t r e a t these payments as business p r o f i t s , not income from property. I t i s suggested that 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 to 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-discrimination i n the GATT. CONCLUSION In t h i s case study, withholding tax puts the foreign software producer at a disadvantage v i s a v i s domestic software producers who are not subject to the withholding tax; t h i s i s contrary to the national treatment p r i n c i p l e i n GATT. I t also r e s u l t s i n foreign technology being less accessible to the Canadian consumer. The Canadian purchaser of software may be penalized with increased prices for, or reduced access to, foreign software. This i s contrary to the objective of Canadian government to f a c i l i t a t e the free flow of technology. 68 While Revenue Canada has made some progress i n the area of cross border software payments with the U.S. and the Netherlands through renegotiated tax t r e a t i e s , perhaps i t i s time to accept the int e r n a t i o n a l norm and stop t r e a t i n g these payments as r o y a l t i e s . B i l a t e r a l treaty negotiations c e r t a i n l y go some way to ameliorating the underlying problem but are not a cure a l l . Revenue Canada should bring i t s p o s i t i o n on the characterization of these software payments i n l i n e with the inte r n a t i o n a l view, not only to harmonize tax regimes, but as a further impetus to reducing trade b a r r i e r s for technology transfer. 69 CHAPTER 3 RESEARCH AND DEVELOPMENT The global economy i s increasingly driven by knowledge-based industries. According to the Secretariat f or Science and Technology Review, i n constant-dollar terms, global production by high-technology industries more than doubled between 1980 and 1990. This compares with a 23 percent increase i n other 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 the leap from a resource-based economy to one based on meeting consumer needs for services and products. I t i s an i n t e g r a l part of any nation's global competitiveness. 1 INTRODUCTION Research and development ("R&D" or s c i e n t i f i c research and experimental development, "SR&ED") can be viewed as a commodity, a stock of accumulated knowledge derived from R&D expenditures that depreciates as new products and processes replace old ones. 2 R&D conducted i n one sector can have productivity enhancing e f f e c t s on the performing sector as well as other sectors, and can contribute i n d i r e c t l y to productivity growth i n the external economy through i t s i n t e r a c t i o n with other inputs and through the in t e r a c t i o n of supply and demand.3 The importance of commercial, high-technology i n i t i a t i v e s to 1 L. Denis Desautels, Auditor General of Canada, Report of the Auditor General of Canada to the House of Commons, 1994 v o l . 1 (Ottawa: Ministry of Supply and Services, Canada, November 22, 1994) at 1-17 (the "1994 AG's Report"). See also Michael Wilson, Minister of Finance, Canada, Department of Finance, Budget Papers, Budget Speech, May 23, 1985, at 7; and Research. Development and Economic Growth (Canada: Ministry of State, Science and Technology, 1985) at 1, regarding the Canadian government's p r i o r i t y i n encouraging research and development. 2 Pierre Mohnen, The Relationship Between R&D and Productivity Growth i n Canada and Other Major I n d u s t r i a l i z e d Countries (Ottawa: Ministry of Supply and Services, Canada, 1992) at 3. 3 i b i d . . at 3. 70 the in t e r n a t i o n a l competitiveness, economic health and growth i n prod u c t i v i t y of a nation has long been recognized. 4 In Canada, continual changes to the ITA r e f l e c t the government's desire and commitment to stimulate research and development a c t i v i t i e s i n Canada.5 Indeed, Canada's tax incentives for R&D are generally seen as among the most generous i n the world 6 and Revenue Canada 4 George K l e i n f e l d and David Kaye, "Red Light, Green Light? The 1994 Agreement on Subsidies and Countervailing Measures, Research and Development Assistance, and U.S. P o l i c y " , (December 1994) Journal of World Trade. Vol. 28, No. 6, 43 at 55; Mark A.A. Warner and Alan 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 Multinationals Exempted?", Canadian Business Law Journal. v o l . 23 (1994) at 395 - 431; James Hutchison, "Canadian Tax Incentives for S c i e n t i f i c 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 at 26:1; and Tom C. Routley, "Research and Development Tax Incentive Pol i c y : A C a l l to Action", Report of Proceedings of the Thirty-Eighth Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 24:1 - 24:16 at 24:2. 5 A l Katiya, "Proposed Changes to the SR & ED Program Under the Income Tax Act", (1994) 42 Canadian Tax Journal 2, 309 - 326 at 326. The o v e r a l l impact of the 1992 changes to the R&D system was expected to enrich the program by about $230 m i l l i o n over a f i v e year period (W. Steven Clark, Gerry Goodchild, Bob Hamilton, and B i l l Toms, "Canada's R&D Tax Incentives: Recent Developments", Report of Proceedings of the Forty-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 32:1 -32:29, at 32:2) . 6 See W.S. Clark, e t . a l . , supra. at 32:1; Roy Shu l t i s , "Revenue Canada's Administration of R&D Tax Incentives: Overview of Current Administrative Practices", Report of Proceedings of the Forty-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 33:1 - 33: 11, at 33:2. Kenneth J. Murray, "Recent Developments i n Research and Development Tax Incentives", Report of Proceedings of the Forty-Second Tax Conference. 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991) 9:1 - 9:22, at 9:1; Jacek Warda, International Competitiveness of Canadian R&D Tax Incentives: An Update. Conference Board of Canada Report no. 55-90 (Ottawa: The Conference Board of Canada, 1990) at v i ; and Donald G. McFetridge and Jacek P. Warda, "Canadian R&D Incentives: Their Adequacy and Impact", Canadian Tax Paper No. 70 (Toronto: Canadian Tax Foundation, 1983) 71 continues to amend administrative practices i n order to f a c i l i t a t e access to these incentives. 7 The r a t i o n a l for providing tax support f o r R&D i s based generally on the " s p i l l o v e r " of R&D benefits into the external economy and the i n a b i l i t y of the performers of R&D to recover t h e i r investment. 8 Based on the tendency for p r i v a t e industry to under fund long-term, high r i s k R&D, government involvement and assistance i n i n i t i a t i n g private innovation i n R&D has been seen as at 75. 7 See Roy S h u l t i s , supra for an overview of Revenue Canada's r e s p o n s i b i l i t i e s , administrative practices, communication and pu 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. 8 W.S. Clark, e t . a l . , supra. at 32:3. Mohnen, supra. at 3 discusses s p i l l o v e r e f f e c t s : " F i r s t , e x t e r n a l i t i e s may occur because a downstream user derives d i r e c t benefit from the R&D without having to pay the f u l l value of the input - as when a bank purchases personal computers that enable i t to streamline operations. In t h i s example, the benefits to the bank measured against the cost of the computers are worth s u b s t a n t i a l l y more to the bank than the p r i c e paid f o r them. Also, 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 service because of competition, monitoring costs and, frequently, l i m i t e d or incomplete information on the part of the developer with respect to the r e a l value of the enhanced product to the end user. The second type of s p i l l o v e r r e l a t e s to the i n s p i r a t i o n a research project, t e c h n i c a l discovery or innovation i n one sector can stimulate i n another sector. New ideas often t r i g g e r new avenues of research and render established methods uneconomical or i n e f f i c i e n t . For example, the development of synthetic f i b r e technology by the chemical industry found wide app l i c a t i o n i n the t e x t i l e industry. Research undertaken by NASA focusing on space exploration, cleared the way f o r many innovations and new developments i n the automobile and computer ind 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 private and s o c i a l rates of return, i . e . , those that are appropriated by the developer or performer and those that cannot be appropriated. In the l a t t e r case, society at large enjoys a maximum rate of return at apparent minimum cost." Mohnen also concludes, at 43, that the s p i l l o v e r e f f e c t s can be substantial generating s o c i a l rates of return 50 to 100 percent i n excess of the private rates of return. 72 e s s e n t i a l to a t t a i n i n g a s o c i a l l y optimum l e v e l of R&D.9 To t h i s end, the Canadian governments commits approximately $1 b i l l i o n 1 0 i n tax incentives for R&D per year, representing over 10 percent of the annual federal revenues from corporation income tax, f o r three basic purposes: 1 1 ...creating wealth, managing r i s k and improving q u a l i t y of l i f e , and advancing knowledge through basic research. Wealth creation involves, for example, the development of new technologies to increase the competitiveness of the Canadian economy. Managing r i s k and improving q u a l i t y of l i f e includes research to support regulation i n environmental health areas... Advancement of knowledge involves basic s c i e n t i f i c research. PART I RESEARCH AND DEVELOPMENT TAX INCENTIVES A. The Canadian System i . Overview The relevant tax rules pertaining to research and development are contained i n ITA section 37, 127 and 127.1 and regulation 9 J. Hutchison, supra, at 26:1; W.S. Clark, e t . a l . , supra. at 32:3; T. Routley, supra. at 24:2; and Canada, Department of Finance, Budget Papers, Research and Development P o l i c i e s : A Paper for Consultation, A p r i l 1983, 11. 1 0 Joanne A. Hausch, "Maximizing R&D Credits and Refunds" i n "Corporate Tax Planning i n a Changing Business Environment", Corporate Management Tax Conference. 1994 (Toronto: Canadian Tax Foundation, 1994) 14:1 - 14:24, at 14:1 f o r 1993. An annual investment of $1 b i l l i o n i n tax incentives for science and technology i s also reported i n the 1994 AG's Report, supra. vol.1, at 1-17, i n addition to $6 b i l l i o n i n other program support for R&D. 1 1 1994 AG's Report, supra. v o l . 1, at 1-17. 73 2900.12 Subsection 37(2) contains s p e c i a l provisions f o r current research and development expenditures incurred outside of Canada. Information C i r c u l a r 86-4R3,13 sets out Revenue Canada's views on research and development and discusses the following three e s s e n t i a l c r i t e r i a f o r R&D, a l l of which must be met i n order for a project to be e l i g i b l e f o r the R&D tax benefits: s c i e n t i f i c or technological uncertainty, s c i e n t i f i c or technological advancement, and s c i e n t i f i c and technical content. 1 4 For example, with respect 1 2 Only federal R&D incentives are considered here, although a number of provinces, including Ontario, Nova Scotia, and Quebec, have incentives for R&D. ( See W.S. Clark, e t . a l . , supra at 32:13 -32:15 f o r an summary of the federal R&D tax c r e d i t s , d i s t r i b u t i o n of federal c r e d i t s by rate and province, and an overview of the p r o v i n c i a l incentives.) This Chapter i s based on amendments to the ITA up to B i l l C-9, An Act To Amend the Income Tax Act, which received royal assent on May 12, 1994 (now S.C. 1994, c.8). This B i l l implemented measures contained i n the December 2, 1992 economic statement and the A p r i l 26, 1993 federal budget. B i l l C-27, An Act To Amend the Income Tax Act, the Income Tax Application Rules, the Canada Pension Plan, the Canada Business Corporations Act, the Excise Tax Act, the Unemployment Act, and Certain Related Acts, received royal assent on June 15, 1994. This B i l l (now SC 1994, c.21) includes one measure from the February 22, 1994 federal budget pertaining to new R&D f i l i n g deadlines which are not addressed here. 1 3 " 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 release provided two industry s p e c i f i c papers which are not included i n IC 86-4R3: Appendix B.'l Application Paper - Computer Software and Appendix B.2 Application Paper - Food and Beverage. Per J . Hausch, supra at 14:7, fn 30, the computer software a p p l i c a t i o n paper i s being revised and w i l l be reissued separately as a supplement. Also r e f e r to Western Plywood Co. Ltd. v. MNR. 51 DTC 392 (TAB); International Nickel Co. of Canada Ltd. [No.21 v. MNR. 71 DTC 5332 (FCTD); and Sass Manufacturing Limited v. MNR. 88 DTC 1363 (TCC) which deal with the d e f i n i t i o n of s c i e n t i f i c research f o r tax purposes. For an overview of the f i r s t IC 86-4, see T. Routley, supra. at 24:8 - 24:11. 1 4 For further discussion of these c r i t e r i a , see J . Hausch, supra, at 14:8; Information C i r c u l a r IC 86-4R3, supra. Part 6 " C r i t e r i a for Identifying E l i g i b l e A c t i v i t i e s i n Computer Science 74 to computer software: 1 3 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 only i f there i s an i d e n t i f i e d technological uncertainty and the project attempts to resolve that problem. Uncertainty i n software or systems development may be due to an operating environment that places s p e c i a l and unusual demands on the system. For example, technological challenges may a r i s e when response times are c r i t i c a l and transaction volumes are high. The development of new or improved t o o l s or processes to solve t h i s technological 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 indicate uncertainty. System uncertainty may occur where new technologies are combined or where known technologies are combined i n a new way. Where a change i n one area a f f e c t s performance i n other areas, system uncertainty may e x i s t . If the solutions to these problems add to the knowledge of computer technology within the context of the business environment of the taxpayer, a technological advancement i s achieved and the project may be SR&ED. The s c i e n t i f i c and technological content i s generally achieved i f the project i s undertaken by q u a l i f i e d personnel using a systematic approach such as SDLC (system development l i f e cycle) . As with any project, t h i s systematic approach must be supported by documentation of the plan and of the design, b u i l d , t e s t , evaluate and modify cycle. In addition, c e r t a i n basic t e s t s must be met f o r a taxpayer to be e n t i t l e d to claim benefits under the ITA: 1 6 and Associated Technologies"; and Geoffrey G. Briant, "Advising the Technology C l i e n t : The May 23, 1985 Amendments and Information C i r c u l a r 86-4", Report of Proceedings of the Thirty-Eighth Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 23:1 - 23:30, at 23:24 - 23:27. 1 5 J . Hausch, supra. at 14:9. 1 6 Postamble to subparagraph 3 7 ( 1 ) ( a ) ( i i ) ; J . Hausch, supra. at 14:2; Deborah Duncan, "A Review of Recent Administrative Positions", 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) 47:1 - 47:22 at 47:3 - 47:4. 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; 1 7 - the SR&ED must be re l a t e d to a business 1 8 of the 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 1 9 , (other than par t i e s performing R&D on behalf of the taxpayer), the taxpayer must have the contractual r i g h t to e x p l o i t the r e s u l t s ; 2 0 - the taxpayer must claim the benefits by f i l i n g a prescribed form. 2 1 F i n a l l y , as a preliminary consideration, research and development a c t i v i t i e s must come within the meaning of the term " s c i e n t i f i c research and experimental development" as defined i n regulation 2900(1): systematic inves t i g a t i o n or search c a r r i e d out i n a f i e l d of 1 7 Subsection 37(1). See subsection 37(2) f o r the tax treatment of current expenditures incurred on R&D c a r r i e d on outside Canada. 1 8 Subparagraph 37(1) (a) (i) , clause 37(1) (a) ( i i i ) (A) , paragraph 37(8) (b) , and paragraph 37(8) (c) . Interpretation 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 Katiya, supra, at 325: "To meet t h i s t e s t the taxpayer must show that the R&D, i f successful, 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 to a business that i s c a r r i e d on the taxpayer." 1 9 Subparagraph 3 7 ( 1 ) ( a ) ( i i ) . See D. Duncan, supra. at 47:4 -47:8 f o r a discussion of Revenue Canada's p o s i t i o n regarding payments to "approved" e n t i t i e s . J. Hausch, supra. at 14:2, FN 6: "The words "on behalf of" imply d i r e c t supervision and control of the work. I t i s often d i f f i c u l t to evaluate whether a payment i s e l i g i b l e under subparagraph 37(1)(a)(i) or 3 7 ( 1 ) ( a ) ( i i ) . " 2 0 Subparagraph 3 7 ( 1 ) ( a ) ( i i ) ; Claude Desy, ed., Access to Canadian Income Tax (Markham, Ont.: Butterworths) (looseleaf), paragraph C20-1060; Interpretation B u l l e t i n IT-151R4, supra. paragraph 12; and Revenue Canada Round Table, 1993 Conference Report, supra, Question 2, at 58:2 - 58:3. 2 1 Form T661(E) (rev. 93), "Claim for S c i e n t i f i c Research and Experimental Development Expenditures Carried on i n Canada"; Interpretation B u l l e t i n IT-151R4, supra, paragraph 6; J . Hutchison, supra. at 26:16 - 26:17. 76 science or technology by means of experiment or analysis, that i s to say, (a) basic research, namely, work undertaken f o r the advancement of s c i e n t i f i c knowledge without a s p e c i f i c p r a c t i c a l application i n view, (b) applied research, namely, work undertaken f o r the advancement of s c i e n t i f i c knowledge with 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 achieving technological advancement for the purposes of creating new, or improving e x i s t i n g , materials, devices, products or processes, including incremental improvements thereto, or (d) work with respect to engineering, design, operations research, mathematical analysis, computer programming, data c o l l e c t i o n , t e s t i n g and psychological research where that work i s commensurate with the needs, and d i r e c t l y i n support of the work described i n paragraph (a), (b) or (c), but does not include work with respect to (e) market research or sales promotion, (f) q u a l i t y control or routine t e s t i n g of materials, devices, products or processes, (g) research i n the s o c i a l sciences or the humanities, (h) prospecting, exploring or d r i l l i n g f o r , or producing, minerals, petroleum or natural gas, (i) the commercial production 2 2 of a new or improved material, device or product or the commercial use of a new or improved process, (j) s t y l e changes, or (k) routine data c o l l e c t i o n . i i . The R&D Pool - Deductible Expenditures 2 2 Regarding expenditures related to commercial production see Karen Wensley, "SR & ED: An Update", Report of Proceedings of the Forty-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 31:1 - 31:16, at 31:7 - 31:9; and Les Cultures Laflamme (1984) Inc. v. MNR 93 DTC 603 (TCC). 77 Section 37 and regulation 2900 describe what constitutes q u a l i f y i n g R&D for Canadian income tax purposes and provide various rules f o r the computation of R&D expenditures: 2 3 [T]hese provisions d e t a i l the tax treatment of current and c a p i t a l expenditures as well as the apportionment of expenditures between e l i g i b l e and non- 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 , to ensure that a taxpayer's Canadian SR&ED expenditure pool i s increased only to the extent of an amount incurred from SR&ED a c t i v i t i e s , clause 37 ( 7 ) ( c ) ( i i ) ( A ) [now clause 37(8 ) ( a ) ( i i ) ( A ) ] requires that the expense ( c a p i t a l or current) s u b s t a n t i a l l y r e l a t e to the prosecution of SR&ED or the provision of premises, f a c i l i t i e s , or equipment f o r the prosecution of SR&ED. Thus, where a taxpayer can demonstrate that an expenditure was incurred, s u b s t a n t i a l l y (generally interpreted to be 90 percent or more) fo r the prosecution of SR&ED or the provision of SR&ED f a c i l i t i e s f o r the prosecution of SR&ED, the entir e amount of the expenditure may be added to the SR&ED expenditure pool. Where a c a p i t a l expenditure does not meet the substantial t e s t , none of the costs r e l a t e d to i t q u a l i f i e s as SR&ED. A current expenditure may, however, be added to the SR&ED pool by v i r t u e of clause 37(7)(c)(ii)(B) [now subclause 37 (8) ( a ) ( i i ) (B)(II)], 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 to the prosecution of SR&ED f a c i l i t i e s pursuant to regulations 2900(2) and (3). The following expenditures are " d i r e c t l y a t t r i b u t a b l e " to the prosecution of R&D:24 (a) the cost of materials consumed i n such prosecution; (b) where an employee d i r e c t l y undertakes, supervises or supports such prosecution, the portion of the amount incurred for salary or wages of the employee that can reasonably be considered to be i n respect of such prosecution; and (c) other expenditures, or those portions of other expenditures, that are d i r e c t l y r e l a t e d to such prosecution 2 3 A l Katiya, supra, at 310. 2 4 Regulation 2900(2) which applies f o r the purposes f o r clause 37(8) (a) (i) (B) and subclause 37 (8) (a) ( i i ) (B) (II) [note typographical error i n the regulation r e f e r s to subclause 37 (8) (a) ( i i ) (A) (II) which does not e x i s t i n the ITA]. See Karen Wensley, supra, at 31:5 - 31:6 regarding expenditures d i r e c t l y a t t r i b u t a b l e to SR&ED; and Imapro Corporation v. The Queen. 92 DTC 6487 (FCTD). 78 and that would not have been incurred i f such prosecution had not occurred. The following expenditures are d i r e c t l y a t t r i b u t a b l e to the provision of R&D f a c i l i t i e s , premises or equipment: 2 5 (a) the cost of maintenance and upkeep of such premises, f a c i l i t i e s or equipment; and (b) other expenditures, or those portions thereof, that are d i r e c t l y related to that provision and that would not have been incurred i f those premises or f a c i l i t i e s or that equipment had not existed. The taxpayer i s permitted to claim an immediate deduction of up to 100% of the amount of both current and c a p i t a l expenditures 2 6 added to i t s R&D pool i n computing i t s income the taxation year. The deduction may be applied against income from any source with any unused portion remaining i n the pool to be c a r r i e d forward indef i n i t e l y . 2 7 i i i . Investment Tax Credits The ITA contains generous investment tax c r e d i t ("ITC") provisions for q u a l i f i e d R&D expenditures 2 8 other than prescribed expenditures 2 9 at rates ranging from 20% to 30%. 3 0 Unused 2 5 Regulation 2900(3) applies f o r the purposes of subclause 37 ( 8 ) ( a ) ( i i ) ( B ) ( I I ) [note typographical error i n the regulation re f e r s to subclause 37 ( 8 ) ( a ) ( i i ) ( A ) ( I I ) which does not e x i s t i n the ITA] . 2 6 See paragraph 37(1)(a) for current expenditures; 37(1)(b) for c a p i t a l expenditures. 2 7 See subsection 37(1); and Interpretation B u l l e t i n IT-151R4, supra, paragraphs 15 - 25 regarding current expenditures and paragraphs 2 6 - 3 0 regarding c a p i t a l expenditures. The deduction i s subject to o v e r a l l l i m i t a t i o n s i n subsection 37(1). 2 8 Subsection 127(9) defines " q u a l i f i e d expenditure". 2 9 Regulation 2902. 7? investment tax c r e d i t s can be c a r r i e d back three years or forward for ten years. 3 1 Beginning a f t e r 1993, ITC claims may be used to f u l l y o f f s e t federal income taxes otherwise payable. 3 2 I t i s also possible to obtain a refund of taxes paid or deemed to have been paid for purposes of the refund, i n c e r t a i n circumstances. 3 3 For taxation years ending a f t e r December 2, 1992, the provisions regarding overhead costs that can be a l l o c a t e d to R&D projects for ITC ca l c u l a t i o n s were s i m p l i f i e d . Before December 2, 1992 only incremental overhead, costs that would not have been incurred i f the R&D had not been c a r r i e d on, could be claimed. Now, the system provides f o r a notional overhead amount c a l l e d the "prescribed proxy amount".34 3 0 Subsection 127(9) defines " s p e c i f i e d percentage". Subject to t r a n s i t i o n a l rules, the February 22, 1994 federal budget proposed to amend the rates i n A t l a n t i c Canada from 3 0% to 2 0% for expenditures incurred a f t e r 1994. 3 1 Subsection 127(9), d e f i n i t i o n of "investment tax c r e d i t " . Note that q u a l i f i e d expenditures before A p r i l 20, 1983 only had a f i v e year carry forward period. 3 2 Subsection 127(5). Previously claims f o r non-refundable ITCs were l i m i t e d to 75 percent of federal taxes otherwise payable for a taxation year plus 3 percent of taxable income subject to the small business deduction (the "annual investment tax c r e d i t l i m i t " ) . 3 3 Subsection 127.1(1). See "CCPCs - Enhanced ITCs" below. 3 4 Subsection 127(9) , d e f i n i t i o n of " q u a l i f i e d expenditure" and Regulations 2900(4) to (10) set out how to determine the salary base, 65% of which i s the "prescribed proxy amount" (subject to an o v e r a l l cap set out i n regulation 2900(6)). The proxy e l e c t i o n i s optional, but must be f i l e d within new f i l i n g deadlines set out i n subsection 37(10) on form T661. For further discussion of the proxy e l e c t i o n , see J . Hausch, supra. at 14:15 - 14:16; A l Katiya, supra, at 317 - 322; K. Wensley, supra. at 31:12 - 31:14; and W.S. Clark, e t . a l . , supra. at 32:19 -32:23. 80 The proxy amount i s a q u a l i f y i n g expenditure only f o r ITC purposes, i t i s not added to the R&D pool. 3 5 I f the proxy e l e c t i o n i s made, the costs which may be treated as R&D costs f o r the subsection 37(1) pool do not include administrative s a l a r i e s , t r a v e l , o f f i c e expenses and f a c i l i t i e s maintenance, which are replaced by the proxy amount. A " q u a l i f i e d expenditure" i s defined i n subsection 127(9) of the ITA and includes both current and c a p i t a l expenditures on R&D ca r r i e d on i n Canada. However, an expenditure which i s deductible under subsection 37(1) may not necessarily be a q u a l i f i e d expenditure f o r the ITC. 3 6 Q u a l i f i e d expenditures which are added to the subsection 37(1) pool and which are included i n the ITC claim c a l c u l a t i o n are: 3 7 - the cost of purchasing or leasing property that i s a l l or su b s t a n t i a l l y a l l 3 8 used for R&D a c t i v i t i e s (other than general purpose o f f i c e eguipment and f u r n i t u r e ) ; 3 5 Actual overhead w i l l either been deducted i n the current year as an ordinary business expense or may be c a p i t a l i z e d and e l i g i b l e for c a p i t a l cost allowance. 3 6 See Interpretation 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 not include prescribed expenditures i n Regulation 2902. 3 7 Clause 37(8) (a) ( i i ) (B) . 3 8 "Substantially a l l " i s generally considered to mean at least 90 percent. See Interpretation B u l l e t i n IT-151R4, supra. paragraphs 8, 14, 29; Douglas Wood v. MNR. 87 DTC 312; and Kenneth J. Murray, "Complying With the R&D Rules", i n "Income Tax Enforcement, Compliance, and Administration", Corporate Management Tax Conference 1988. (Toronto: Canadian Tax Foundation, 1988) 6:1 - 6:17, at 6:2 - 6:4 f o r a discussion of the " 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 the Department and by the courts. 81 - expenditures i n respect of R&D d i r e c t l y undertaken on behalf of the taxpayer (eg. payments to contractors, subcontractors, approved research association and u n i v e r s i t i e s ) ; - c a p i t a l expenditures for R&D equipment (other than general purpose o f f i c e equipment and f u r n i t u r e ) ; - s a l a r i e s and wages of employees d i r e c t l y engaged i n R&D a c t i v i t i e s ; 3 9 - cost of materials consumed i n R&D; - 1/2 of the cost of leasing property that i s p r i m a r i l y 4 0 used i n R&D a c t i v i t i e s . ITC claims are based on the above R&D expenditures plus the prescribed proxy amount. ITCs may also be earned on "shared-use equipment" 4 1 at one-half the taxpayer's rate f o r R&D expenditures. E l i g i b l e corporations that incur large R&D expenditures early on i n a project can maximize the re l a t e d tax benefits by claiming 3 9 Salaries do not have to be paid to be e l i g i b l e f o r ITCs as q u a l i f y i n g expenditures (Al Katiya, supra, at 326; Interpretation B u l l e t i n IT-151R4, supra, paragraph 17 and Revenue Canada Round Table, 1993 Conference Report, supra. Question 4 at 58:4 - 58:5.) 40 iip rim a riiy» means more than 50 percent, but less than 90 percent. 4 1 Shared-use equipment i s new equipment purchased a f t e r December 2, 1992 that i s used more than 50 percent but l e s s than 90 percent of i t s operating 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 to non-qualifying a c t i v i t i e s . See J. Hausch, supra, at 14:17; A l Katiya, supra, at 314 - 316; K. Wensley, supra. at 31:14 - 31:16; subsection 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 "refundable investment tax c r e d i t " ) , and subsection 127(11.2). Such ITCs cannot be claimed on buildings and p i l o t plants and equipment that w i l l be used i n commercial production a f t e r the s t a r t up phase (regulation 2900(11)). 82 ITCs during that period and deferring the deduction from the R&D pool to l a t e r years. 4 2 i v . C apital Expenditures As mentioned previously, expenditures f o r c a p i t a l assets 4 3 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 may be immediately deducted from income. P r i o r to December 2, 1992, a l l or s u b s t a n t i a l l y a l l meant that 90 percent of the useful l i f e of the asset must be used for R&D or that 90 percent of the cost of the asset was consumed i n . or a t t r i b u t a b l e to the time during which the property was used for R&D a c t i v i t i e s . After t h i s date, t h i s requirement w i l l be met i f i t was intended that the assets would be used f o r R&D 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 operating time i n i t s expected useful l i f e , or a l l or s u b s t a n t i a l l y a l l consumed R&D a c t i v i t i e s i n 4 2 Kenneth J . Murray, "Recent Developments i n R&D Tax Incentives", supra, at 9:20: "This can be accomplished by deferring only the amount of R&D expenditures required to reduce taxable income to a l e v e l j u st below the $200,000 [annual business l i m i t ] l i m i t a t i o n for federal tax purposes. The tax on t h i s income can be o f f s e t by federal ITCs... The benefits of t h i s strategy are generated by two factors. The f i r s t i s that the company has greater access to the low rate of federal tax. The second i s that i t may be possible to use the additional deductions deferred to subsequent years to keep at least one a d d i t i o n a l year 1s taxable income below $200,000. For q u a l i f y i n g corporations, t h i s w i l l increase the subsequent year's ITC rate by 15 percent (from 20 to 35 percent on the f i r s t $2 m i l l i o n of R&D expenditures) and allow the ITCs on the expenditures to be refunded i f they are not used to o f f s e t taxes payable." Note that there have been recent amendments to the a v a i l a b i l i t y of the enhanced rate f o r q u a l i f y i n g corporations (Canadian-controlled private corporations) which are discussed below under "Recent Developments". 4 3 Other than land and buildings or leasehold i n t e r e s t i n buildings (subparagraph 37(8)(d)(i); note the exception for "prescribed special-purpose b u i l d i n g " as defined i n regulation 2903. 83 Canada. v. CCPCs - Enhanced ITCs Certain Canadian-controlled private corporations (CCPCs) are e l i g i b l e for an enhanced ITC rate of 35 percent, subject to c e r t a i n l i m i t s . 4 5 The ITC can be used to o f f s e t a l l federal taxes f o r the year with any excess 100 percent refundable for current expenditures, 4 0 percent refundable for c a p i t a l expenditures. 4 6 The amount refunded reduces the balance of the R&D p o o l . 4 7 Therefore, CCPCs have a var i e t y of tax planning opportunities requiring a ca r e f u l mix of claims for investment tax c r e d i t s , section 37 deductions, loss carrybacks or carryforwards and c a p i t a l cost allowance. 4 8 v i . Foreign R&D Research and development which i s c a r r i e d on outside of Canada 4 4 Subclause 37 (8) (a) ( i i ) (B)(III); A l Katiya, supra. at 316 -317; and W.S. Clark, e t . a l . , supra, at 32:23 - 32:27. 4 5 Subsections 127(10.1) and (10.2) .'Interpretation B u l l e t i n IT-151R4, paragraphs 61 and 64 - 67; J. Hausch, supra. at 14:18 -14:19; and A l Katiya, supra, at 324 - 325. 4 6 Paragraph 127(11.1)(e) and subsection 127.1(2) ( d e f i n i t i o n of "refundable investment tax c r e d i t " ) . The CCPC i s subject to a taxable income t e s t to determine e l i g i b i l i t y f o r the enhanced rate. In addition, the 35 percent rate only applies up to the CCPCs annual expenditure l i m i t (subsection 127(10.2)); for R&D expenditures i n excess of t h i s expenditure l i m i t , the ITC rate i s reduced to 20 percent. For an overview of these l i m i t s and an example of how to calculate the expenditure l i m i t , refundable and non-refundable ITC, see J. Hausch, supra, at 14:19 - 14:20. 4 7 This reduction of the R&D pool e f f e c t i v e l y includes the ITC refund i n income i n subsequent years by reducing the balance of deductible expenditures. 4 8 For an example see Kenneth J . Murray, "Complying With the R&D Rules", supra. at 6:16 - 6:17. 84 does not benefit from many of the R&D tax incentives. The costs of such R&D a c t i v i t i e s are not included i n the R&D pool under subsection 37(1), and are not q u a l i f i e d expenditures f o r ITCs. There are sp e c i a l rules for current expenditures f o r foreign R&D set out i n subsection 37 (2). 4 9 Current expenditures f o r foreign R&D are deductible only i n the year incurred and cannot be ca r r i e d forward. 5 0 The nature and loc a t i o n of the a c t i v i t i e s w i l l i ndicate where R&D i s ca r r i e d on f o r the purposes of subsections 37 (1) or 37 (2) . 5 1 According to Revenue Canada, the only foreign expenditures that are included i n subsection 37(1) are: 5 2 - the cost of c a p i t a l equipment imported to Canada f o r SR&ED; _ the cost of materials imported to Canada f o r SR&ED; - the wage, t r a v e l , t r a i n i n g , and conference costs for employees receiving SR&ED t r a i n i n g outside Canada; and - the wage and t r a v e l costs f o r employees investigating foreign technology that r e l a t e s to an SR&ED project i n Canada. 5 3 4 9 There are no sp e c i a l rules for c a p i t a l expenditures i n these circumstances; they are not deductible under section 37 (Interpretation B u l l e t i n IT-151R4, supra f paragraph 38). 5 0 See generally Interpretation B u l l e t i n IT-151R4, supra, paragraphs 38 - 40 and J. Hausch, supra at 14:20 - 14:21. 5 1 Interpretation B u l l e t i n IT-151R4, supra. paragraph 38. 5 2 J. Hausch, supra. at 14:21. 5 3 Wage and t r a v e l costs of Canadian employees sojourning outside of Canada during 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 only under subsection 37(2) (Revenue Canada Round Table, 1993 Conference Report, supra, Question 1, 58:1 - 58:2; the Department has also taken the p o s i t i o n that t r a v e l , including salary or wages and rel a t e d benefits, of a Canadian employee undertaking foreign t r a v e l r e l a t i n g to R&D c a r r i e d on outside of Canada q u a l i f i e s under 85 There have been recent ITA changes which a f f e c t foreign t e s t i n g and data c o l l e c t i o n . Testing and data c o l l e c t i o n i s now included i n the d e f i n i t i o n of SR&ED i n regulation 2900(1)(d). Previously, these costs were included i n subsection 37(1) i f they were fo r support a c t i v i t i e s for a Canadian R&D project. Now that t e s t i n g and data c o l l e c t i o n are included i n the d e f i n i t i o n of SR&ED i n regulation 2900, the costs of foreign t e s t i n g and data c o l l e c t i o n must be included i n subsection 37(2) even i f necessary to a Canadian R&D project. Therefore, the impact of t h i s change has been to include the costs of foreign t e s t i n g and data c o l l e c t i o n i n subsection 37(2), even i f they are necessary to a Canadian R&D pro j e c t . 5 4 v i i . Summary Qualifying R&D expenditures c a r r i e d on i n Canada are pooled and may be deducted as claimed ( i e . may be i n d e f i n i t e l y c a r r i e d forward) including expenditures for ce r t a i n c a p i t a l assets which may be immediately deducted from income for tax purposes. Certain R&D expenditures, including an amount for overhead, may also be e l i g i b l e f o r an ITC to reduce taxes otherwise payable. ITCs claimed and refunded reduce the R&D pool avai l a b l e f o r deduction i n a taxation year. 5 5 CCPCs are e l i g i b l e f or an enhanced ITC rate of subsection 37(2).) Also see Kenneth J. Murray, "Complying with the R&D Rules", supra, at 6:11 - 6:12. 5 4 J. Hausch, supra, at 14:20. 5 5 Other government assistance received or receivable i n respect of R&D expenditures must also be applied against the balance i n the pool or included i n income under paragraph 12(1)(x). 8 6 3 5%, subject to c e r t a i n l i m i t s . A 100 percent refund of the enhanced ITC i s avai l a b l e for current R&D expenditures; 40 percent for c e r t a i n c a p i t a l expenditures. The refund mechanism provides a s i g n i f i c a n t advantage to CCPCs as a source of cash and as an ad d i t i o n a l tax planning t o o l Only current expenditures for R&D c a r r i e d on outside of Canada are deductible from income and only i n the year incurred. B. Recent Developments The February 22, 1994 federal budget contained a number of proposals r e l a t i n g to R&D. 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 proposed on enhanced incentives f o r CCPCs f o r taxation years commencing a f t e r 1995. By l i n k i n g the small business deduction to taxable c a p i t a l f o r an associated group of companies, access to R&D refunds w i l l be l i m i t e d for larger CCPCs.56 The February 27, 1995 federal budget also proposed a number of amendments to the R&D 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 rules for R&D expenditures for information technology (including the use of software, hardware and communication technology to c o l l e c t , process, store and disseminate information) are to be reviewed. Based on the outcome of t h i s review, i t i s proposed that such expenditures incurred by f i n a n c i a l i n s t i t u t i o n s and s e c u r i t i e s dealers for information technology R&D w i l l not q u a l i f y as R&D for 5 6 This consequence arises due to the flow through of small business deduction annual business l i m i t c a l c u l a t i o n s to the determination of the ITC rate. See J . Hausch, supra. at 14:22 -14:23 f o r a description of t h i s proposed amendment and other proposed amendments i n the February 22, 1994 federal budget which may impact on R&D a c t i v i t i e s . 87 tax purposes. This proposal arose out of concern that most of Canada's largest banks were claiming the benefits of these R&D incentives for software development that may have been performed even without the incenti v e s . 5 7 PART II SUBSIDIES AND THE URUGUAY ROUND A. Introduction Subsidization r e f e r s to the practices of governments whereby f i n a n c i a l assistance or other incentives are provided to producers and/or exporters. 5 8 Although subsidization i s a n o n - t a r i f f trade b a r r i e r of increasing si g n i f i c a n c e , there i s s t i l l a lack of inter n a t i o n a l consensus regarding the nature of subsidies. 5 9 There are two sub-categories of subsidy: the "export" subsidy which i s granted only on goods destined f o r export; and "domestic" or "production" subsidies which are granted f o r the manufacture or production of goods regardless of t h e i r ultimate d e s t i n a t i o n . 6 0 Subsidies for research and development might be viewed as domestic 5 7 Stikeman's Canadian Federal Budget, February 27, 1995. Canada Tax Service (Toronto: Carswell, 1995) at 1-16 to 1-17. Also r e f e r to T. Corcoran, "R&D Tax Credit a Fiasco Waiting to Happen", The Globe & Mail (16 December 1994). 5 8 Robert K. Paterson and Martine M.N. Band, et. a l . , International Trade and Investment Law i n Canada (2d), (Toronto: Carswell, 1994) at 8-5. 5 9 i b i d . . at 8-5. For a discussion of the d e f i n i t i o n of subsidy under Canadian law, re f e r to R. Paterson and M. Band, at 8-55 f f . and American Farm Bureau Association v. Canadian Import Tribunal. [1990] 2 S.C.R. 1324. 6 0 i b i d . . at 8-5. 88 subsidies or export subsidies, depending on the circumstances. 6 1 The 1979 Subsidies Code 6 2 d i d not attempt to define "subsidies", but sought to regulate subsidies depending on how negatively they impacted on trade. 6 3 The 1979 Subsidies Code recognized that many domestic subsidies were "widely used as important instruments f o r the promotion of s o c i a l and economic p o l i c y o b jectives" 6 4 and permitted subsidies "used by governments to promote important objectives of national p o l i c y " . 6 5 The Code outlined s i x desirable p o l i c y goals including subsidies "to encourage research and development programmes, e s p e c i a l l y i n the f i e l d of high-technology i n d u s t r i e s " . 6 6 The 1994 Agreement on Subsidies and Countervailing Measures 6 1 i b i d . . at 8-5; the authors suggest that domestic subsidies "might include research and development grants to i n d u s t r i e s . " The argument that R&D tax incentives might be viewed as export subsidies i s developed below. 6 2 Agreement on Interpretation and Application of A r t i c l e s VI, XVI and XXIII. Anti-Subsidies Code. GATT (1980), BISD, 26th Supp., at 56 (the "1979 Subsidies Code"). 6 3 See 1979 Subsidies Code, A r t i c l e 8. The three e f f e c t s which could a t t r a c t compensatory measures under the 1979 Subsidies Code were: 1. injury to the domestic industry of another GATT Member; 2. n u l l i f i c a t i o n or impairment of GATT benefits; or 3. serious prejudice to the in t e r e s t s of another Member. Also see R. Paterson and M. Band, supra. at 8-6 to 8-8 f o r an overview of the 1979 Subsidies Code; Gary C. Hufbauer and Joanna Shelton Erb, Subsidies i n International Trade. (Cambridge, MA: MIT Press, 1984), Chapter 2; and John J. Barcelo, "Subsidies, Countervailing Duties and Anti-dumping After the Tokyo Round" (1980), 13 Cornell Int. L.J. 257. 1979 Subsidies Code, A r t i c l e 11. 1979 Subsidies Code, Preamble. 1979 Subsidies Code, A r t i c l e 11(1)(d). 89 (the "SCM Agreement 1 1) 6 7 attempts to r e f i n e , c l a r i f y and enforce the previously vague d i s t i n c t i o n s between subsidies that d i s t o r t trade and those that do not. 6 8 These refinements may have implications for Canadian R&D tax incentives and high-technology p o l i c y . This Part provides an overview of the SCM Agreement with an emphasis on i t s R&D provisions. B. The SCM Agreement i . Overview The new SCM Agreement,69 unlike i t s predecessor, defines and categorizes subsidies and establishes a binding dispute resolution procedure for each category of subsidy. A "subsidy" i s defined according to two t e s t s : 7 0 1. a 6 7 F i n a l Act Embodying the Results of the Uruguay Round of M u l t i l a t e r a l Trade Negotiations. Agreement on Subsidies and Countervailing Measures, 15 A p r i l 1994 i n The Results of the Uruguay Round of M u l t i l a t e r a l Trade Negotiations: The Legal Texts (Geneva: GATT Secretariat, June 1994) at 264. 6 8 George K l e i n f e l d and David Kaye, supra. at 43. 6 9 See Terence P. Stewart, ed., The GATT Uruguay Round: A Negotiating History (1986 - 1992) v o l . 1 (Cambridge, MA.: Kluwer Law and Taxation Publishers, 1993) at 809 - 958 for a review of the GATT negotiating h i s t o r y on subsidies and countervailing measures. See R. Paterson and M. Band, supra, at 8-9 to 8-10 for an overview of dumping and subsidy negotiations i n the FTA and NAFTA. 7 0 SCM Agreement, A r t i c l e 1.1 deems a subsidy to e x i s t i f : (a)(1) there i s a f i n a n c i a l contribution by a government or any public body within the t e r r i t o r y of a Member... i . e . where: (i) a government practice involves a d i r e c t transfer of funds (eg. grants, loans and equity i n f u s i o n ) , p o t e n t i a l d i r e c t transfers of funds or l i a b i l i t i e s , (eg. loan guarantees) ; 90 government must either contribute f i n a n c i a l l y , d i r e c t l y from the government or through another public body or mechanism, or provide income or p r i c e support; and 2. the contribution or support must confer a benefit upon the r e c i p i e n t . Further, i n order for a subsidy to be subject to d i s c i p l i n a r y action i t must meet a s p e c i f i c i t y t e s t ; i t must be l i m i t e d to ce r t a i n industries or companies. 7 1 I f the granting authority e x p l i c i t l y l i m i t s access to a subsidy to c e r t a i n enterprises, i t i s s p e c i f i c . 7 2 I f a subsidy i s granted on the basis of objective c r i t e r i a or conditions, 7 3 which are c l e a r l y s p e l l e d out and s t r i c t l y adhered to, and there i s no reason to believe that the ( i i ) government revenue that i s otherwise due i s foregone or not co l l e c t e d , (eg. f i s c a l incentives such as tax credits) [except where l i k e products destined for domestic production are s i m i l a r l y exempt from duties or taxes; SCM Agreement; footnote 1]; ( i i i ) a government provides goods or services other than general inf r a s t r u c t u r e , or purchases of goods; (iv) a government makes payments to a funding mechanism, or entrusts or d i r e c t s a private body to carry out one or more of the type of functions i l l u s t r a t e d i n (i) to ( i i i ) above, which would normally be vested i n the government and the practice, i n no r e a l sense, d i f f e r s from practices normally followed by governments; or (a) (2) there i s any form of income or p r i c e support i n the sense of A r t i c l e XVI of the GATT 1994; and (b) a benefit i s thereby conferred. 7 1 SCM Agreement, A r t i c l e 1.2. Also see A r t i c l e 2 f o r a de t a i l e d t e s t for determining s p e c i f i c i t y . 7 2 SCM Agreement, A r t i c l e 2(a). 7 3 SCM Agreement, 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 must be automatic. 91 subsidy i s i n f a c t s p e c i f i c , i t i s not subject to d i s c i p l i n e . However, notwithstanding any appearance of n o n - s p e c i f i c i t y , other factors may be considered such as: use of the subsidy program by a lim i t e d number of c e r t a i n enterprises, predominant use of the subsidy program by c e r t a i n enterprises, disproportionately large amounts to c e r t a i n enterprises, or the d i s c r e t i o n exercised by the granting authority i n providing the subsidy. 7 4 The SCM Agreement i d e n t i f i e s three l e v e l s of subsidy: prohibited ("red l i g h t " ) , , actionable ("yellow l i g h t " ) and permissable ("green l i g h t " ) . This i s referred to as the " t r a f f i c l i g h t " approach to subsidies. 7 5 Each category gives r i s e to d i f f e r e n t dispute resolution procedures and permissable countervailing measures. 7 6 7 SCM Agreement, A r t i c l e 2(c). Also see Gary Horlick and Peggy Clarke, "The 1994 WTO Subsidies Agreement", Annual International Trade Update. Georgetown University Law Center, (June 1994) . 7 5 See George K l e i n f e l d and David Kaye, supra. at 44. The authors note that the SCM does not e x p l i c i t l y r e f e r to 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 since the Tokyo Round (refer also to T. Stewart, supra. at 830 and 855.) 7 6 See SCM Agreement, A r t i c l e s 4 and 7. Also see George K l e i n f e l d and David Kaye, supra. at 46, and footnotes 20 - 22, for a summary of these provisions; In the case of prohibited or actionable subsidies, a Member i n i t i a t e s the process of WTO dispute re s o l u t i o n by requesting consultations with the alleg e d l y offending government. (In the case of actionable subsidies, a complaining Member must also show evidence of the negative e f f e c t s caused by the subsidy; A r t i c l e 7.2). I f the part i e s do not reach a "mutually acceptable so l u t i o n " with a c e r t a i n period (30 days f o r prohibited subsidies, and 60 days f o r actionable subsidies; A r t i c l e s 4.4 and 7.4), either may r e f e r the matter to the Dispute Settlement Body (DSB) for res o l u t i o n by a panel under WTO r u l e s . I f a panel i s convened, i t w i l l review the facts and submit a report f i r s t to the par t i e s and then to the DSB for adoption. I f the panel finds the existence of a prohibited subsidy, " i t s h a l l recommend that the 92 The red. l i g h t p r o h i b i t s "subsidies contingent, i n law or i n fact, whether s o l e l y or as one of several other conditions, upon export performance including those i l l u s t r a t e d i n Annex I" and "subsidies contingent, whether s o l e l y or as one of several other conditions, upon the use of domestic over imported goods". 7 7 Annex I to the SCM Agreement sets out an i l l u s t r a t i v e l i s t of export subsidies including: (e) The f u l l or p a r t i a l exemption, 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 to exports, of d i r e c t taxes 7 8 or s o c i a l welfare charges paid or payable by i n d u s t r i a l or commercial enterprises. And (f) The allowance of sp e c i a l deductions d i r e c t l y r e l a t e d to exports or export performance, over and above those granted i n respect to production f o r domestic consumption, i n the c a l c u l a t i o n of the base on which d i r e c t taxes are charged. The yellow l i g h t cautions governments against granting subsidizing Member withdraw the subsidy without delay" ( A r t i c l e 4.7) ; i n cases involving actionable subsidies, a f i n d i n g by the panel of adverse e f f e c t s would obligate the offending Member to "remove the adverse e f f e c t s " or "withdraw the subsidy" ( A r t i c l e 7.8) . Either party to a panel determination may choose to appeal i t to an Appellate Body, whose report the DSB may accept or r e j e c t . Subseguent to these procedures, i f a Member does not follow the DSB recommendations, the DSB " s h a l l grant authorization to the complaining Member to take appropriate countermeasures" ( A r t i c l e s 4.10 and 7.9. Note that as an a l t e r n a t i v e to m u l t i l a t e r a l enforcement of subsidies d i s c i p l i n e s , Members also have the option of imposing countervailing duties on imports benefiting from prohibited or actionable subsidies under domestic law i f the requirements of Part V ( A r t i c l e s 10 - 23) are met (footnote 35). 7 7 SCM Agreement, A r t i c l e 3. 7 8 SCM Agreement, footnote 58 defines " d i r e c t taxes" for the purpose of the Agreement as "taxes on wages, p r o f i t s , i n t e r e s t s , rents, r o y a l t i e s , and a l l other forms of income, and taxes on the ownership of r e a l property". Also "remission" of taxes includes "the refund or rebate of taxes." 93 subsidies which cause "adverse e f f e c t s " to the i n t e r e s t s of other Members.79 "Adverse e f f e c t s " are defined i n A r t i c l e 5.1 as: "(a) injury to the domestic industry of another Member; (b) n u l l i f i c a t i o n or impairment of benefits accruing d i r e c t l y or i n d i r e c t l y to other Members under GATT 1994...; and (c) serious prejudice 8 0 to the inte r e s t s of another Member." Serious prejudice w i l l a r i s e only i n ce r t a i n l i m i t e d circumstances. For example, serious prejudice i s deemed to ex i s t i n the case of subsidies to cover operating losses sustained by an industry. 8 1 However, serious prejudice would not be found i f the Member demonstrates that the subsidy i n question has not resulted i n any of the e f f e c t s enumerated i n paragraph 3 of A r t i c l e 6, including import- or export-distorting e f f e c t s , or when the e f f e c t of the subsidy i s to increase the world market share of the subsidizing country i n a p a r t i c u l a r subsidized primary product or commodity.82 F i n a l l y , A r t i c l e 8, the green l i g h t , s t i p u l a t e s that subsidies which are not s p e c i f i c , or are s p e c i f i c but are within one of the following classes of subsidies, are not actionable under c e r t a i n 7 9 SCM Agreement, A r t i c l e 5. 8 0 "Serious prejudice" i s defined i n SCM Agreement A r t i c l e 6 and includes threat of serious prejudice (SCM Agreement, footnote 13) . 8 1 SCM Agreement, A r t i c l e 6.1(b). 8 2 R. Paterson and M. Band, supra, at 8-9, fn. 28; and SCM Agreement, A r t i c l e 6.3. Also r e f e r to SCM Agreement A r t i c l e 6.7 for other exceptions to the serious prejudice provisions. 94 conditions: 8 3 assistance f o r research a c t i v i t i e s 8 4 conducted by firms or by higher education or research establishments on a contract basis, assistance to disadvantaged regions within the domestic t e r r i t o r y of the subsidizing government's t e r r i t o r y pursuant to a general framework of regional development; and assistance to promote adaptation of e x i s t i n g f a c i l i t i e s to new environmental requirements. However, these subsidy programs are subject to n o t i f i c a t i o n requirements. 8 5 i i . R&D Subsidies As mentioned above, the 1979 Subsidies Code supported government financing of R&D programs 8 6. However, governments were cautioned to "weigh, as f a r as p r a c t i c a b l e . . . possible adverse e f f e c t s on trade" 8 7 and Members were permitted to countervail foreign R&D subsidies that harmed t h e i r domestic i n d u s t r i e s . 8 8 The SCM Agreement reduces the threat of countervailing action for green l i g h t subsidies. Fundamental research of a non-8 3 SCM Agreement, A r t i c l e 8.1. Products containing less than a one percent ad valorem subsidy are also not countervailable under A r t i c l e 11.9. 8 4 See "R&D Subsidies" below for further discussion. 8 5 SCM Agreement, A r t i c l e 8.3. 86 1 9 7 9 subsidies Code, A r t i c l e 11(3). 8 7 1979 Subsidies Code, A r t i c l e 11(2). 8 8 Imports benefiting from industry or product s p e c i f i c R&D subsidies were not exempted from countervailing duties. See George K l e i n f e l d and David Kaye, supra, at 46 - 47. The authors also r e f e r to the following U.S. cases involving foreign R&D subsidies: Optic Liquid Level Sensing Systems from Canada. 44 Fed. Reg. 1728 (1979); Certain Steel Products from Belgium, 47 Fed. Reg. 39304 (1982); Agrexco v. United States, 604 F. Supp. 1328 (1985). 95 commercial and non-industrial nature conducted by educational and research establishments f a l l s outside the SCM Agreement as long as such research i s targeted toward the "enlargement of general s c i e n t i f i c and technical knowledge not linked to i n d u s t r i a l and commercial objectives." 8 9 Assistance for research a c t i v i t i e s conducted by firms or by educational or research establishments on a contract basis with firms i s also permitted 9 0 for up to 75 percent of c e r t a i n costs of " i n d u s t r i a l research" 9 1 or 50 percent of c e r t a i n costs of "pre-competitive development a c t i v i t y " . 9 2 Therefore, any subsidy beyond the pre-competitive development stage becomes actionable requiring a demonstration of adverse e f f e c t s . Only f i v e categories of R&D costs q u a l i f y f o r green l i g h t 8 9 SCM Agreement, footnote 26. George K l e i n f e l d and David Kaye, supra, at 47 footnote 32 also r e f e r to Certain Steel Products From Belgium. Appendix 2, 47 Fed. Reg. 39316 et seq. (1982). 9 0 SCM Agreement A r t i c l e 8.2(a). Where a project contains both i n d u s t r i a l research and pre-competitive development a c t i v i t y , the allowable l e v e l of non-actionable assistance s h a l l not exceed the simple average (62.5 percent) of the two categories, calculated on the basis of a l l e l i g i b l e costs (SCM Agreement, A r t i c l e 8, footnote 30) . 9 1 " I n d u s t r i a l research" i s planned search or c r i t i c a l i n v e s t i g a t i o n aimed at discovering new knowledge with the objective that such knowledge may help i n the development of new or improved products, processes or services (SCM Agreement, footnote 28). 9 2 "Pre-competitive development a c t i v i t y " transforms i n d u s t r i a l research into a "plan, blueprint or design f o r new, modified or improved products, processes or services" including the f i r s t non-commercial prototype. Note that routine 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 considered to go beyond the terms of the green l i g h t . (SCM Agreement, footnote 29). 96 treatment: 9 3 1. personnel, including researchers, technicians and support s t a f f employed exclusively i n research a c t i v i t y ; 2. instruments, equipment, land and buildings used exclusively and permanently for the research a c t i v i t y ; 9 4 3. consultancy and equivalent services used exclu s i v e l y for the project, including bought i n research, t e c h n i c a l knowledge and patents; 4. overhead costs incurred d i r e c t l y as a r e s u l t of the research a c t i v i t y ; and 5. the cost of materials, supplies and other operating expenses incurred d i r e c t l y as a r e s u l t of the research a c t i v i t y . I f a subsidy i s not actionable under A r t i c l e 8, i t i s s t i l l open to challenge under other provisions i n the SCM Agreement which apply equally to a l l subsidies, including R&D subsidies. In such cases, an A r t i c l e 8 green l i g h t subsidy could be converted into a red l i g h t v i o l a t i o n . 9 5 A r t i c l e 3, f o r example, regarding subsidies contingent on export performance or on the use of domestic over imported goods applies equally to government assistance for R&D.96 Further, A r t i c l e 9.1 provides for a challenge of a program which i s 9 3 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. at 48. The allowable l e v e l s of non-actionable assistance i s established by reference to the t o t a l e l i g i b l e costs incurred over the duration of the p a r t i c u l a r project. 9 4 Except when "disposed of on a commercial basis". 9 5 George K l e i n f e l d and David Kaye, supra. at 49. 9 6 i b i d . , at 49. 97 consistent with A r t i c l e 8 9 7 i f the subsidy causes "serious adverse e f f e c t s to the domestic industry [of another Member] such as to cause damage which would be d i f f i c u l t to r e p a i r " . 9 8 There are a few other provisions i n the SCM Agreement pertaining to R&D subsidies which are of i n t e r e s t . A r t i c l e 25 encourages Members to provide n o t i f i c a t i o n of any subsidy granted or maintained; n o t i f i c a t i o n i s not mandatory. 9 9 I f a government wants to question another Member's R&D subsidy a review by the WTO Secretariat may be requested, followed by a request f o r binding a r b i t r a t i o n . 1 0 0 F i n a l l y , the SCM Agreement requires the WTO Committee on Subsidies and Countervailing Measures to review the A r t i c l e 8 R&D subsidy rules, including the d e f i n i t i o n s of the categories, within 18 months of the Agreement entering into f o r c e . 1 0 1 9 7 The dispute resolution procedures are modified i n these circumstances as set out i n SCM Agreement A r t i c l e s 9.1 - 9.4. 9 8 "Serious adverse e f f e c t s " i s not defined i n the SCM Agreement. See above for A r t i c l e 5 d e f i n i t i o n of "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 of "serious prejudice". George K l e i n f e l d and David Kaye, supra. at 50, note that the U.S. government p o s i t i o n i s that the serious adverse e f f e c t s standard i s higher than the normal serious prejudice or injury standard. 9 9 SCM Agreement, A r t i c l e 25.2 and footnote 35. A r t i c l e 25.3 states that n o t i f i c a t i o n s must specify the form of a subsidy, i t s amount, p o l i c y objective, duration and impact on trade. N o t i f i c a t i o n for 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 to permit other Members to determine whether the project s a t i s f i e s the conditions of A r t i c l e 8 ( A r t i c l e 8.3). 1 0 0 SCM Agreement, A r t i c l e 8.4 and 8.5. 1 0 1 SCM Agreement, footnote 25. Note that U.S. Trade Representative, Mickey Kantor, has stated that the Clinton Administration intend to use the review "to ensure the provision has not been abused." (Hearing of the House Subcommittee on 98 PART III CANADIAN R&D TAX INCENTIVES: DISCRIMINATORY SUBSIDIES? In t h i s Part an assessment i s made as to whether Canada's R&D tax incentives are discriminatory based on whether such incentives would be subject to d i s c i p l i n e under the SCM Agreement. Possible j u s t i f i c a t i o n s for any such discrimination are explored, as well as factors to consider i n r e v i s i n g Canadian R&D tax incentives. A. Free Trade, Discrimination and R&D Tax Incentives As discussed previously, free trade i s based on two premises: the free trade objective and preservation of national i n t e r e s t s . 1 0 2 A l l subsidies are a n t i t h e t i c a l to free trade causing t r a d e - d i s t o r t i n g e f f e c t s on a global l e v e l . 1 0 3 Yet, as indicated above, subsidization has not been subject to outright GATT pro h i b i t i o n , i n recognition of overriding sovereign o b j e c t i v e s : 1 0 4 Rather, the GATT objective has been to manage and reduce current l e v e l s of subsidization i n world trade and to est a b l i s h minimum standards for the r e t a l i a t o r y countervailing Commerce, Consumer Protection 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, at 47, footnote 31) . 1 0 2 See Chapter 1. 1 0 3 R. Paterson and M. Band, supra at 8-5 and 8-63. The authors note that "the question of whether or not the use of subsidies to foster domestic prosperity i s economically advisable i n the long term remains open. By contrast, arguments have also been made that there may well be net gains to a domestic economy from foreign subsidies and net losses from the imposition of countervailing duties." 1 0 4 i b i d . , at 8-5. Also r e f e r to Kenneth Dam, The GATT Law and International Economic Organization (London: University of Chicago Press, 1970), Chapter 7, for a general discussion on subsidies. 99 duty measures that subsidies often provoke. No attempt has been made to give a precise d e f i n i t i o n of what a subsidy i s i n vacuo. Rather, the issue of subsidization i s viewed as a f a c t u a l or contextual one, the focus being upon i t s ultimate e f f e c t on the international market. Adhering to the concept that some domestic subsidies are legitimate t o o l s of domestic economic planning and development, they are, f o r c e r t a i n purposes, treated somewhat more f l e x i b l y under GATT than are export subsidies. Notwithstanding a f l e x i b l e GATT attitude, Canada must also be aware of U.S. opinion on the SCM Agreement as the United States remains the only nation which uses countervailing duty laws to any s i g n i f i c a n t extent. 1 0 5 Despite the Clinton Administration's support for expansion of green l i g h t provisions for R&D s u b s i d i e s , 1 0 6 the U.S. Administration intends to maintain an aggressive approach to R&D subsidies. For example, the Administration has determined t h a t : 1 0 7 ...subsidies which exceed the green l i g h t parameters... w i l l be countervailable i n f u l l , not j u s t with respect to the amount of assistance which exceeds the green l i g h t l e v e l s . Further U.S. trade negotiators i n s i s t that the R&D provisions of the SCM Agreement: 1 0 8 1 0 5 R. Paterson and M. Band, supra. at 8-63. 1 0 6 See George K l e i n f e l d and David Kaye, supra. at 50 - 56. 1 0 7 i b i d . . at 53: "In other words, i f a government provides i n d u s t r i a l research assistance beyond the 75 percent cap, or pre-competitive development assistance beyond the 50 percent cap, or i f a portion of the funding involves unauthorized expenditures under A r t i c l e 8, the United States w i l l , under domestic law, countervail the f u l l measure of government assistance to the project." The authors note however, that under these circumstances, 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 actionable subsidy for which countermeasures, i f authorized, have to be "commensurate with the degree and nature or the adverse e f f e c t s determined to e x i s t . " i b i d . . at 54. 100 . . . protect the type of technology programmes the United States currently has, while excluding the type of development and production assistance which other countries t y p i c a l l y grant. I f foreign abuses of the green l i g h t provisions w i l l not be tolerated by the United States, t h i s l i k e l y means Canada's R&D programs w i l l be subject to c a r e f u l monitoring by the United States. 1 0 9 Indeed, the Canadian government has recognized that along with the greater certainty provided by the SCM Agreement for promoting government objectives i n R&D, comes the r i s k that l e v e l s of assistance i n excess of the a r t i c u l a t e d thresholds w i l l expose the e n t i r e subsidy to countervailing a c t i o n . 1 1 0 There are c e r t a i n features of the Canadian tax system related to R&D which may be vulnerable to attack as contrary to the free trade i d e a l underlying the SCM Agreement. In p a r t i c u l a r , the enhanced ITC f o r CCPCs w i l l now be assessed for such discrimination within the framework set out i n the SCM agreement. A r t i c l e 1.1 of the SCM Agreement deems a subsidy to e x i s t i f "government revenue that i s otherwise due i s forgone or not c o l l e c t e d " . 1 1 1 The s p e c i f i c example given i s f i s c a l incentives such as tax c r e d i t s ; ITCs f o r R&D conducted by CCPCs can be used to 1 0 9 See Mark A.A. Warner and Alan M. Rugman, supra, at 405 -412 regarding the U.S. National Competitiveness Act. 1993 and U.S. technology which, i n part, provides for a mechanism to monitor foreign technology c a p a b i l i t i e s r e l a t i v e to the U.S. and to i d e n t i f y and respond to "competitive opportunities and challenges" (at 406) . 1 1 0 "New Rules and I n s t i t u t i o n s " , Canada and the Uruguay Round (Ottawa: Government of Canada, A p r i l , 1994) at 7 - 8. 1 1 1 SCM Agreement, A r t i c l e 1.1(a)(1)(H). 101 o f f s e t a l l federal taxes for the current year with any excess 100 percent refundable for current expenditures, 40 percent refundable for c a p i t a l expenditures. A r t i c l e 1.1 also requires that a benefit i s conferred. Clearly, CCPCs benefit from being able to deduct ITCs from taxes payable from a l l sources, from the p o t e n t i a l f o r cash flow from refunds, and from the f l e x i b i l i t y provided within the system to tax plan with the ITCs i n combination with section 37 deductions, loss carrybacks or carryforwards and c a p i t a l cost allowance. Therefore, the subsidy deeming provisions set out i n A r t i c l e 1.1 appear to apply to ITCs for CCPCs. 1 1 2 However, A r t i c l e 1.2 of the SCM Agreement also requires that such subsidies be " s p e c i f i c " i n accordance with the provisions of A r t i c l e 2, before the subsidy i s subject to the provisions r e l a t i n g to prohibited subsidies, actionable subsidies or countervailing measures. In turn, A r t i c l e 2 states that a subsidy must be s p e c i f i c to an enterprise or industry or group of enterprises or industries within the j u r i s d i c t i o n of the granting authority. In p a r t i c u l a r : 1 1 3 Where the granting authority, or the l e g i s l a t i o n pursuant to which the granting authority operates, e x p l i c i t l y l i m i t s access to a subsidy to c e r t a i n enterprises, such subsidy s h a l l be s p e c i f i c . The enhanced rate f o r ITCs i s expressly l i m i t e d to c e r t a i n 1 1 2 Note that the same conclusion can be reached regarding ITCs for non-CCPCs, even though the refundable aspect i s not present i n that case. 1 1 3 SCM Agreement, A r t i c l e 2.1 (a). 102 enterprises, those enterprises being e l i g i b l e CCPCs. 1 1 4 Also, any subsidy which f a l l s within the provisions of A r t i c l e 3, i s deemed to be s p e c i f i c . 1 1 5 A r t i c l e 3 are the red l i g h t s u b s i d i e s ; 1 1 6 those subsidies which are prohibited under the SCM Agreement and subject to the most stringent remedial provisions. A r t i c l e 3 p r o h i b i t s subsidies which are contingent i n law or i n f a c t , whether s o l e l y or as one of several other conditions, upon export performance. A r t i c l e 3 also p r o h i b i t s subsidies contingent, whether s o l e l y or as one of several other conditions, upon the use of domestic goods over imported 1 1 4 Note that A r t i c l e 2.1(b) of the SCM Agreement, states that "Where the granting authority, or the l e g i s l a t i o n pursuant to which the granting authority operates, establishes objective c r i t e r i a or conditions 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 , provided that the e l i g i b i l i t y i s automatic and that such c r i t e r i a and conditions are s t r i c t l y adhered to. The c r i t e r i a or conditions must be c l e a r l y s pelled out i n law, regulation, or other o f f i c i a l document, so as to 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 governing the e l i g i b i l i t y for the enhanced ITCs may be said to meet these requirements, footnote 2 of the SCM Agreement goes on to state: "Objective c r i t e r i a or conditions, as used herein, mean c r i t e r i a or conditions which are neutral, which do not favour c e r t a i n enterprises over others, and which are economic i n nature and h o r i z o n t a l i n application, such as number of employees or s i z e of the enterprise." Therefore, the c r i t e r i a f o r CCPCs q u a l i f y i n g for enhanced ITCS are not "objective" according to the SCM Agreement as c e r t a i n enterprises, CCPCs, are favoured. 1 1 5 This A r t i c l e should be considered f o r other R&D tax incentives which are arguably not enterprise or industry s p e c i f i c . In such cases, the provisions of A r t i c l e 3 must be examined c l o s e l y to see whether or not the subsidy would be deemed to be s p e c i f i c under A r t i c l e 2.3. 1 1 6 A r t i c l e 8 green l i g h t subsidies f o r R&D w i l l be addressed below. Note that 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 absolute and A r t i c l e 8 does not provide f o r a waiver, either 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 constraints. (See George K l e i n f e l d and David Kaye, supra, at 59). 103 goods. With respect to subsidies contingent on export performance, an i l l u s t r a t i v e l i s t i s provided i n Annex I to the SCM Agreement. Annex I includes the f u l l or p a r t i a l exemption, 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 to exports, of d i r e c t taxes paid or payable. 1 1 7 Arguably, the provisions r e l a t e d to R&D tax incentives generally are re l a t e d to exports, as one of the stated purposes of providing such incentives i s to create wealth by developing new technologies to increase the competitiveness of the Canadian economy. To the extent that such competitive a c t i v i t y i s directed to global markets f o r the R&D technology, these incentives may be viewed as being re l a t e d to exports. A l t e r n a t i v e l y , with respect to the domestic content 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 assistance which i s l i m i t e d to CCPCs, or contingent on R&D being conducted i n Canadian based f a c i l i t i e s or otherwise favouring Canadian inputs, may be subject to an SCM challenge. Even though c e r t a i n foreign-source inputs are permitted, 1 1 8 a dispute r e s o l u t i o n panel could construe 1 1 7 SCM Agreement, Annex I, paragraph (e) . Direct taxes i s defined to include taxes on a l l forms of income. Note that paragraph (f) of Annex I, pertains to s p e c i a l deductions d i r e c t l y r e l a t e d to exports or export performance over and above those granted for domestic production, i n c a l c u l a t i n g the tax base on which d i r e c t taxes are charged. This provision may be applicable with regard to the immediate write o f f of c a p i t a l expenditures for Canadian R&D, i f i t can be argued that these deductions are d i r e c t l y r e l a t e d to stimulating export performance i n high technology industries, for example. 1 1 8 As discussed above, there are r e s t r i c t i o n s on the foreign expenditures 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 section 37 pool and f o r the ITC claim. Deductions f o r foreign R&D are also severely r e s t r i c t e d under subsection 37(2). 104 b a r r i e r s to p a r t i c i p a t i o n by foreign-owned companies, along with national objectives of job creation and preservation and enhancing Canadian competitiveness i n the p a r t i c u l a r industry, as manifestations of an i m p l i c i t domestic content requirement. 1 1 9 Therefore, i t i s arguable that Canadian R&D tax incentives f o r CCPCs are discriminatory and come within the prohibited subsidy provisions of the SCM Agreement. As a further 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 to override the provisions of A r t i c l e 8, i t i s worthwhile to consider whether the c e r t a i n R&D tax incentives come within the green l i g h t provisions r e l a t e d to R&D. A r t i c l e 8 non-actionable subsidies are those subsidies 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 conditions provided f o r i n A r t i c l e 8. With respect to research a c t i v i t i e s , the assistance must not cover more than 75 percent of the costs of i n d u s t r i a l research or 50 percent of the costs of pre-competitive research. The various Canadian R&D tax incentives may well exceed these l i m i t s , alone or i n combination, depending on the circumstances. Further, i t may be that the types of research which q u a l i f y under the Canadian R&D tax 1 1 9 See George K l e i n f e l d and David Kaye, supra. at 59 f o r such an argument pertaining to the United States R&D i n i t i a t i v e s f o r the Partnership f o r a New Generation of Vehicles (PNGV). The PNGV i s a partnership between the government and the "big three" (General Motors, Ford and Chrysler) U.S. auto-makers to develop technologies that improve f u e l e f f i c i e n c y and emissions control and " to help ensure the U.S. jobs are not threatened" and that "pursuit of such goals w i l l t r a nslate into a demand fo r U.S. products, not foreign products" (at 57 - 58) . Also see Mark A.A. Warner and Alan M. Rugman, supra, for an analysis of recent 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 other i n t e r n a t i o n a l instruments. 105 rules are broader than those under the SCM Agreement. For example, a project must meet three c r i t e r i a ( s c i e n t i f i c or technological uncertainty, s c i e n t i f i c or technological advancement, and s c i e n t i f i c or technical content) to be e l i g i b l e f o r R&D tax incentives, but these c r i t e r i a have been applied broadly, as i n the case of Canadian banks accessing the tax incentives f o r c e r t a i n software development. 1 2 0 On the other hand, i t may be that the d e f i n i t i o n s i n the SCM Agreement w i l l be construed more narrowly, thereby r e s t r i c t i n g the R&D green l i g h t subsidy provisions to research a c t i v i t i e s which are aimed at "new knowledge". F i n a l l y , with respect to A r t i c l e 8, assistance i s li m i t e d exclusively to enumerated costs which are much more r e s t r i c t e d than costs enumerated i n the ITA. For example, A r t i c l e 8 requires that costs of personnel, instruments, equipments, land and buildings, and consultancy be used exclusively for research a c t i v i t y . On the other hand, the ITA provisions generally require that q u a l i f i e d 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 a c t i v i t i e s . The proxy provisions for overhead may be contrary to the SCM 1 2 0 In 1994 several Canadian banks f i l e d taxpayer requested adjustments for R&D expenditures made back to 1986 i n the f i e l d of computer software (1994 AG's Report, supra, v o l . 6 at 32-15). The fa c t that these claims were not f i l e d u n t i l eight years a f t e r the expenditures were incurred suggests that such R&D was performed, and would be performed, i n spite of any tax incentives. The February 27, 1995 budget proposes a close examination of the R&D system with regard to these applications for 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 , Martin Says", Ottawa (CP), December 15, 1994.) Also r e f e r to Linda McQuaig, Behind Closed Doors (Markham, Penguin Books, 1987) Chapter 9, for a discussion of the s c i e n t i f i c research tax c r e d i t "quick f l i p s " of the mid-1980's fo r another example of abuse of previous the tax provisions for research and development. 106 Agreement requirement that a d d i t i o n a l overhead costs must be incurred d i r e c t l y as a r e s u l t of the research a c t i v i t y . Also, the a b i l i t y to deduct expenditures f o r c a p i t a l assets intended to be used i n R&D a c t i v i t i e s may go beyond the e l i g i b l e cost parameters set out i n A r t i c l e 8 of the SCM Agreement. I t should be noted that even i f such incentives do meet the green l i g h t provisions and are not prohibited subsidies, reviews of these incentives can s t i l l be requested under the SCM Agreement. 1 2 1 Also, i f neither A r t i c l e 8 nor A r t i c l e 3 applies, the yellow l i g h t actionable subsidies provisions may be used to launch a complaint i n cases where another Member i s able to esta b l i s h that the use of any subsidy has injured the domestic industry of that Member, caused serious prejudice to the interests of that Member, or otherwise n u l l i f i e d or impaired benefits accruing to that Member under the GATT. In conclusion, there are reasonable grounds fo r a n t i c i p a t i n g that the United States, i n p a r t i c u l a r , w i l l be monitoring Canadian R&D programs, including tax incentives, to ensure compliance with the SCM Agreement. The above assessment, though cursory, indicates that there are reasonable arguments to be made that such subsidies may be prohibited under the SCM Agreement. In other words, the R&D tax incentives may be viewed as discriminating against non-residents and foreign a c t i v i t i e s and contrary to the free trade objective. The next section considers whether tax incentives for R&D are j u s t i f i a b l e notwithstanding any such discrimination. 1 2 1 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 that WTO Members may be deterred from challenging other Members' R&D subsidy programs f o r a number of reasons. F i r s t , an "uneasy truce" could p r e v a i l while each Member pursues t h e i r own exclusionary R&D i n i t i a t i v e s . 1 2 2 I t i s not uncommon for such tax incentives to be r e s t r i c t e d to 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 countries r e l y on the income tax system as an e f f i c i e n t and equitable means of d e l i v e r i n g R&D support. 1 2 4 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 countries R&D may be seen to outweigh the negative e f f e c t s of any such subsidy f o r e s t a l l i n g the i n i t i a t i o n of dispute r e s o l u t i o n mechanisms. 1 2 5 Third, R&D tax incentive programs may quite simply come within the bounds of the SCM Agreement. F i n a l l y , i t may be that even i f tax 1 2 2 George K l e i n f e l d and David Kaye, supra. at 60. 1 2 3 Brian J. Arnold, "Tax Discrimination Against Ali e n s , Non-Residents, and Foreign A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the United Kingdom, and the United States", Canadian Tax Paper No. 90 (Toronto: Canadian Tax Foundation, 1991) at 102. 1 2 4 W.S.Clark, e t . a l . , supra. at 32:5. 1 2 5 see Laura D'Andrea Tyson, Remarks before the Economic Strategy I n s t i t u t e . Federal News Service, 9 March 1994, as quoted i n George K l e i n f e l d and David Kaye, supra. at 56: "On the issue of whether or not our p o s i t i o n i n the GATT, the Uruguay Round, on R&D subsidies would touch o f f a subsidy competition, I think... t h i s i s one area where economic theory would suggest that the s p i l l o v e r benefits from R&D subsidies - both the global s p i l l o v e r benefits and the l o c a l s p i l l o v e r benefits - are measured to be very high -You don't want international rules to discourage subsidies which would a c t u a l l y generate benefits, not just 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 to t r y and fig u r e out where that l i n e would be. No one exactly knows where i t w i l l be, but... we took a sensible p o s i t i o n i n those negotiations to draw the l i n e to allow governments to support these programmes, but to set some l i m i t s on how they could support." 108 incentives for research and development can be viewed as being discriminatory and contrary to the free trade i d e a l , these incentives may be j u s t i f i a b l e based on overriding domestic objectives. I t i s submitted that i n the case of R&D, the stated national objectives must be of primary concern due 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 to the s o c i a l and economic aims of Canada. However, even within t h i s purely domestic context there are arguments to be made that the e x i s t i n g R&D tax incentives cannot be j u s t i f i e d as either being r a t i o n a l l y connected with, or capable of achieving, these stated national objectives. In evaluating tax incentives for research and development, i t i s important to emphasize that these incentives are e s s e n t i a l l y public spending programs delivered through the tax system by way of foregone tax revenues: 1 2 6 I t i s generally accepted that, as i n d i r e c t government spending programs, such provisions must be evaluated on the basis of budgetary rather than tax p o l i c y c r i t e r i a . I t makes no sense to assess tax expenditure provisions on the basis of tax p o l i c y c r i t e r i a such as equity, n e u t r a l i t y , or revenue. Tax expenditures are inherently and i n t e n t i o n a l l y inequitable and non-neutral; they are designed to benefit c e r t a i n taxpayers or a c t i v i t i e s i n preference to others. Further, they are intended not to r a i s e revenue, but rather to spend i t i n the form of forgone tax. *** Although tax expenditures that discriminate against a l i e n s , non-residents or foreign a c t i v i t i e s cannot be j u s t i f i e d on the basis of tax p o l i c y c r i t e r i a , they are nevertheless tax provisions i n the sense that they form part of the tax l e g i s l a t i o n . As a r e s u l t , they are covered by the non-discrimination 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, 1 2 6 Brian J . Arnold, "Tax Discrimination Against A l i e n s , Non-Residents, and Foreign A c t i v i t i e s " , supra. at 128 - 129. 109 however, tax expenditures are i n substance i n d i r e c t spending programs, i t i s inappropriate to assess them on t h i s basis; as stated above, they must be judged by reference to budgetary c r i t e r i a . Accordingly, a tax expenditure that discriminates against a l i e n s , non-residents, or foreign a c t i v i t i e s may be j u s t i f i e d i f an equivalent d i r e c t p u blic spending program that discriminates i n the same way can be j u s t i f i e d . For example, d i r e c t public spending to encourage s c i e n t i f i c research i n Canada would be seen by most people as desirable public p o l i c y . The r e s t r i c t i o n of the program to research i n Canada would be viewed as an e s s e n t i a l feature of the program for several reasons, including the cost of funding research outside Canada and the benefits of the spending program for Canadian u n i v e r s i t i e s and other research i n s t i t u t i o n s and for Canadian research 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 evaluating and j u s t i f y i n g tax incentives i s whether these "expenditures" are achieving the stated objectives of wealth creation, managing r i s k and improving q u a l i t y of l i f e , and advancing knowledge through basic research. Despite the recognized need for R&D, the effectiveness of tax incentives i n stimulating R&D i s not conclusive. 1 2 7 Studies have been done which measure the impact of tax incentives on the "user cost" of R&D c a p i t a l and combining t h i s measurement with an estimate of the s e n s i t i v i t y of R&D c a p i t a l investment to changes i n i t s user c o s t . 1 2 8 These studies are used to support the statement that Canada has one of the most generous tax incentive structures for 1 2 7 See the 1994 AG's Report, supra. v o l . 6 at 32-16 to 32-17 regarding the lack of information a v a i l a b l e i n the Department of Finance and Revenue Canada to be able to monitor and evaluate tax incentives on a systematic basis. 1 2 8 W.S. Clark, e t . a l . , supra. at 32:8 - 32:10 f o r an overview for a number of these studies. Also see D. McFetridge and J . Warda, supra; J . Warda, supra; and P. Mohnen, supra. 110 R&D i n the world. 1 2 9 However, generosity of tax incentives does not necessarily r e s u l t i n the s o c i a l l y optimal l e v e l of R&D being attained, which i s the goal which provides the economic r a t i o n a l e f o r such tax incentives i n the f i r s t place. I t i s d i f f i c u l t to e s t a b l i s h the effectiveness of tax-based incentives f o r R&D and whether these tax expenditures are a c t u a l l y creating t e c h n o l o g i c a l l y innovative products or whether the incentives have any influence on business d e c i s i o n s . 1 3 0 I t i s also d i f f i c u l t to estimate the impact of changes i n the user cost from tax incentives on the investment 1 2 9 W.S. Clark, e t . a l . , supra. summarize Warda's "B-index" studies at 32:17. The "B-index" i s an a n a l y t i c t o o l used to rank the r e l a t i v e attractiveness of a country's R&D tax system. I t accounts for the influence of R&D tax c r e d i t s on the after-tax cost of undertaking R&D as well as the influence of income tax rates i n determining both the value of q u a l i f y i n g R&D deductions and the after-tax value of the returns from R&D. Other things being equal, the lower the B-index, the greater the amount of R&D a firm w i l l undertake. Canada has the lowest B-index of developed countries. See D. McFetridge and J . Warda, supra. f o r the i n i t i a l study which examined the favourableness of the Canadian tax system toward R&D; and the follow-up study by J . Warda, supra, which concludes, at 18 "that r e l a t i v e to other countries examined, Canada's tax treatment of R&D remains the most favourable because i t o f f e r s the taxpayer a v a r i e t y of benefits at both the federal and p r o v i n c i a l l e v e l s . " Note that Warda's study i s l i m i t e d to the B-index analysis and does not address the adequacy of R&D tax treatment i n Canada. 1 3 0 J.R. Roberts and William Leiss, "Technological and Accounting Innovation: Can They Mesh?", Report of Proceedings of the Thirty-Eighth Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 25:1 - 25:8 at 25:2. Also see Richard M. Bird, "Tax Incentives for Investment: The State of the Art", Canadian Tax Paper No. 64 (Toronto: Canadian Tax Foundation, 1980) f o r a general study on investment tax incentives, the usefulness of incentives e x i s t i n g at the date of the study and suggestions f o r useful research i n the area of incentives. I l l behaviour of R&D performers and on broader s p i l l o v e r e f f e c t s . 1 3 1 One recent study has even concluded that there i s strong evidence that higher rates of return are obtained on privately-funded R&D than on p u b l i c l y funded R&D.132 A further j u s t i f i c a t i o n f o r Canada's generous R&D tax incentives i s that the after-tax cost of performing R&D i n Canada of f e r s s i g n i f i c a n t competitive advantages to Canadian R&D performers. These advantages, i t i s suggested, may be exploited by Canadian companies to "carve a niche" f o r themselves i n performing R&D for foreign based corporations, and multinational enterprises ("MNEs") should consider having R&D operations c e n t r a l i z e d i n Canada to take advantage of these competitive advantages. 1 3 3 1 3 1 W.S. Clark, e t . a l . , supra. at 32:8. The authors r e f e r to a number of studies and, i n p a r t i c u l a r J e f f r e y Berstein, "The E f f e c t of Direct and Indirect Tax Incentives on Canadian I n d u s t r i a l R&D Expenditures" (September, 1986), 12 Canadian Public P o l i c y 438-48. As summarized at 32:10, using 1984 parameters, Berstein "estimates that a 1 percent r i s e i n the (effective) R&D tax c r e d i t rate reduces the user cost of R&D c a p i t a l by 0.07 percent. Combining t h i s r e s u l t with h i s empirical findings indicates that a 1 percent increase i n the (effective) R&D tax c r e d i t rates stimulates the demand for R&D c a p i t a l by about 0.01 percent, or over $1,045 m i l l i o n i n the short run, based on an estimated R&D c a p i t a l stock figure i n 1984 of $10 b i l l i o n . When the induced output supply e f f e c t i s taken into account, the stimulus i s as high as $2.2 m i l l i o n , depending on the assumed s e n s i t i v i t y of output demand to pri c e changes. In r e l a t i o n to budgetary cost, the R&D tax c r e d i t rate i s found to create $.80 of add i t i o n a l R&D expenditures per d o l l a r of forgone (federal and provincial) tax revenues. When output expansion e f f e c t s are taken into account, the a d d i t i o n a l R&D expenditures are found to increase by more than the d o l l a r cost to government." 1 3 2 P. Mohnen, supra, at 44. 1 3 3 See Kenneth J . Murray, "Recent Developments i n R&D Tax Incentives", supra, at 9:21 for a c a l c u l a t i o n of after-tax cost to a large US company of performing R&D i n house or contracted out to another large US R&D performer versus the a f t e r tax cost to 112 However, given differences i n national tax systems, and the int e r a c t i o n of those systems, i t may be d i f f i c u l t to use such tax expenditures to induce foreign firms to move t h e i r R&D a c t i v i t i e s to Canada. 1 3 4 Also, i f a MNE c a r r i e s out R&D a c t i v i t i e s i n a low-tax j u r i s d i c t i o n , the e f f e c t i v e after-tax cost of that R&D i s greater than i t i f were done i n a high tax country due to the r e l a t i v e l y higher value of the tax incentives i n the high tax country. Therefore, a l l other things being equal, the global tax-minimizing strategy of an MNE would require R&D to be performed i n the high-tax country and the technology to be transferred to another d i v i s i o n of the MNE i n a low tax country at a minimal transfer p r i c e . 1 3 5 Consider the fol l o w i n g : 1 3 6 In regard to Canada's p o s i t i o n as host to many foreign-owned su b s i d i a r i e s , the charge i s frequently made that these sub s i d i a r i e s do not do the amount of R and D i n Canada that could be expected of them given t h e i r s i z e and i n d u s t r i a l character. Since Canada i s the "low-tax country" from the vantage point of most sub s i d i a r i e s here, t h i s a l l o c a t i o n of R and D a c t i v i t y appears to be consistent with the global tax-minimizing strategy outlined above. However, i t i s an empirical question whether domestic taxation or the inte r n a t i o n a l structure of taxation influence, either p o s i t i v e l y or negatively, the current state of Canada's aggregate R and D e f f o r t . That state, to 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 the f a c t that R and D expenditure i n Canada as a percentage of GNP accounts for approximately half what i t i s i n other i n d u s t r i a l i z e d countries. The private i n d u s t r i a l sector undertakes about 40 percent of the t o t a l amount of R and D. Canadian R&D performers. 1 3 4 D. McFetridge and J . Warda, supra. at 91 - 92. 1 3 5 See Chapter 4 fo r a discussion of tran s f e r p r i c i n g . 1 3 6 Donald J.S. Brean, "International Issues i n Taxation: The Canadian Perspective", Canadian Tax Paper No. 75 (Toronto: Canadian Tax Foundation, 1984), 132 - 133. 113 Another consideration i n seeking to j u s t i f y R&D tax incentives i s that, despite Canada o f f e r i n g some of the most generous domestic tax p o l i c i e s regarding R&D expenditures, the r e l a t i v e l y poor investment i n research and development by Canadian private industry may be explained primarily by the small Canadian market: 1 3 7 Canadian industry i s at a comparative disadvantage i n R and D. The expected benefits from innovation are small due to the si z e of the Canadian market and likewise the cost of R and D, si m i l a r to any overhead, i s high on a u n i t basis because i t must be spread over a smaller income base. I t i s questionable whether Canadian tax incentives, despite various forms and increasing generosity, are able to o f f s e t s u b s t a n t i a l l y these fundamental cost considerations. The i n t e r n a t i o n a l structure of taxation encourages the growth of foreign investment i n Canada. Multinational firms i n Canada are generally research-intensive. Although t h i s brings technology to Canada, i t does not bring as much of the process for developing 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 usually means they do i t at home. While t h i s i s p rimarily explained by the economics of R and D, an additional consideration i s the f a c t that incentives f o r R and D i n the home country do not apply to research done abroad. Of course, research done i n Canada i s rewarded by Canadian tax wri t e - o f f s . One can conclude that R and D c a r r i e d out by foreign subsidiaries i n Canada either must be done here because of p a r t i c u l a r l o c a l conditions or i s done here e s s e n t i a l l y to c a p i t a l i z e on tax incentives that exceed incentives at home. In the f i r s t case, incentives become g i f t s . In the second, the g i f t s are the incentive. In either case, Canada pays to have R and D c a r r i e d out here when i t could receive the technological benefits at no extra f i s c a l cost. F i n a l l y , i t has been suggested that the p o s s i b i l i t y e xists that i n a l l countries R&D a c t i v i t i e s that are s o c i a l l y b e n e f i c i a l are not undertaken because they are not p r i v a t e l y b e n e f i c i a l - a 1 3 7 i b i d . , at 135 - 136. Also see 1994 AG's Report, supra. v o l . 6 at 9-12 regarding Canada's poor performance i n science and technology. 114 problem that cannot be solved by Canada alone: 1 3 8 Indeed, as already indicated, i t i s not necessarily i n Canada's i n t e r e s t to provide for s u b s t a n t i a l l y more generous tax treatment of R&D than do other i n d u s t r i a l countries. 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 others, one may appeal to the taxpayers of a small country to provide a high l e v e l of support for 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 to sustain. Research and development are important to Canada's economic growth rate, yet stimulating R&D depends on more than the provision of tax i n c e n t i v e s : 1 3 9 Tax incentives f o r R and D ventures are one useful p o l i c y t o o l . However, alone they w i l l tend to be r e l a t i v e l y 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 turn the a b i l i t y of Canadian firms to 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. at 91. 1 3 9 Fred Lazar, The New Protectionism: Non-Tariff B a r r i e r s and Their E f f e c t s on Canada (Toronto: James Lorimer & Company i n association with the Canadian I n s t i t u t e for Economic Policy, 1981), at 71. 1 4 0 Lazar, i b i d . f suggests, at 71 - 73, that "government could enhance i t s R and D tax incentives by undertaking programs aimed at r a t i o n a l i z i n g Canadian firms and increasing t h e i r domestic markets to enable them to grow large enough to 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 strategy should be a package or programs that enhances the procurement and supply p o t e n t i a l f o r Canadian firms i n the domestic economy." Lazar suggests a number of options to t h i s end including: the federal government could d i r e c t a l l i t s purchasing, wherever possible and reasonable, towards Canadian-controlled firms and foreign c o n t r o l l e d firms that comply with a code of good corporate behaviour; the federal government could i n s i s t that i t s crown corporations pursue the same procurement p o l i c y ; the federal government could use i t s regulatory agencies to t r y to increase the share of the domestic market available to Canadian-controlled firms of foreign firms meeting the code of good corporate behaviour; the federal government could explore the f e a s i b i l i t y of restructuring the corporate tax system to encourage companies to increase t h e i r use of Canadian firms as suppliers of c a p i t a l goods and parts; and any firm receiving government loans, grants or other forms of assistance should be required by contract to give p r e f e r e n t i a l access to Canadian suppliers. Lazar i s also of the view, at 79, 115 Factors such as h i s t o r i c a l and corporate development, s o c i a l structures, c u l t u r a l factors, 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 aimed at promoting exports, investment, entrepreneurship and private enterprise, as well as developing human c a p i t a l through science, education and manpower p o l i c i e s a l l impact on the l e v e l of R&D.141 Therefore, i t i s worthwhile to explore a l t e r n a t i v e s to the e x i s t i n g R&D tax programs. C. The Need For Revision In 1994, the National Advisory Board on Science and Technology recommended that the government of Canada manage i t s investment i n science and technology as a d i s t i n c t s t r a t e g i c asset. I t appeared to the Board that budget decisions of the federal government have " r e f l e c t e d h i s t o r i c a l incrementalism rather than s t r a t e g i c management of a national asset." I t also appeared to the Board that "the government lacks the c a p a b i l i t y to a l l o c a t e science and technology resources i n a way that r e f l e c t s broad government ob j e c t i v e s . 1 1 1 4 2 On June 28, 1994, the Minister of Industry and the Secretary of State for Science, Research and Development, launched a major review of federal science and technology a c t i v i t i e s . This study i s expected to provide a c r i t i c a l basis for that: "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 could lead to r e t a l i a t i o n by the United States." In my opinion, though some of these suggestions may have had some merit i n 1981, they are not f e a s i b l e today given the nature of the global market place, the expansion of free trade and developments i n NAFTA and GATT since 1981. 1 4 1 i b i d . . at 59. 1 4 2 1994 AG's Report, supra, v o l . 1, at 1-18. 116 Canada's future R&D strategy. 1 4 3 Thus, i t appears that the e x i s t i n g R&D tax incentive program i s f a r from immutable. I f the current tax incentive program i s not meeting the stated objectives, and i f there i s a p o s s i b i l i t y that Canadian R&D tax i n i t i a t i v e s may be subject to d i s c i p l i n a r y action under the SCM Agreement, the system i s i n need of r e v i s i o n . Given that Canada has only modest resources to invest i n science and technology compared with other developed nations, i t i s es s e n t i a l that resources be invested i n areas of greatest need and po t e n t i a l payback. 1 4 4 Yet the current R&D tax incentives are not well focused. 1 4 5 For example, i t has been shown that higher rates of return are obtained from basic research than from applied research or development, 1 4 6 from company financed R&D over p u b l i c l y funded R&D147 and from R&D geared to new processes as 1 4 3 i b i d . . v o l . 6 at 9-12. This Report i s expected to be complete i n 1995, but was not avail a b l e at the time of writing. 1 4 4 i b i d . , v o l . 6, 9-16. The Report suggests the need to boost cooperation between federal and p r o v i n c i a l governments, industry and u n i v e r s i t i e s . A central o f f i c e to monitor technology projects throughout the government i s also recommended. 1 4 5 i b i d . . v o l . 6, at 9-16 to 9-17. 1 4 6 P. Mohnen, supra. at 44, concludes that basic research i s l i k e l y to have the highest s o c i a l rates of return and be less privately-appropriable. 1 4 7 i b i d . . at 44; Mohnen concludes that despite the strong evidence of a higher rate of return on privately-funded R&D, useful public support i n basic research i s important f o r " t o t a l factor productivity growth", and that the knowledge contribution from government agencies and research labs 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 . 117 opposed to new products. 1 4 8 Further, although the s p i l l o v e r e f f e c t s of R&D are substantial, i t may be more e f f e c t i v e to target R&D support at c e r t a i n key sectors of the economy where these s o c i a l rates of return are the highest. 1 4 9 Another factor that has been determined to be extremely important i n achieving high rates of return on R&D support, i s the s c i e n t i f i c knowledge base: 1 5 0 In t h i s respect, the location of research labs near c e r t a i n types of academic research centers, the funding of academic research and, where possible, the l o c a t i o n a l concentration of academic f a c i l i t i e s i n order to induce priva t e research might be wise decisions... Po l i c y decisions for stimulating R&D should take these factors into consideration as well as international agreements such as the SCM Agreement to ensure that revised tax incentives are more e f f e c t i v e at achieving national objectives while minimizing the exposure of such programs to international sanctions. 1 5 1 CONCLUSION To succeed i n the global marketplace businesses must have either a s t r a t e g i c i n t e r e s t i n the R&D e f f o r t s of others which can 1 4 8 i b i d . . at 43. 1 4 9 i b i d . , at 43. Mohnen's study concluded that these key sectors include 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. 1 5 0 i b i d . . at 44. 1 5 1 See Mark A.A. Warner and Alan M. Rugman, supra who suggest that Canada should "pursue an appropriate 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 p o l i c i e s " notwithstanding recent U.S. i n i t i a t i v e s which may v i o l a t e fundamental p r i n c i p l e s i n the GATT (at 428). 118 be incorporated into t h e i r own operations, 1 5 2 or indigenous R&D leading to new product development or technological advancements which enable more e f f i c i e n t production. 1 5 3 Tax support for indigenous R&D i s believed to a s s i s t technological development i n a number of ways: 1 5 4 1. d i r e c t benefits to the R&D performer of increased knowledge leading to reduced unit production costs and the development of new products and processes f o r sale or a p p l i c a t i o n ; 2. benefits of spinoff technological applications; 3. pushing firms to technological f r o n t i e r s allowing them to imitate guickly; and 4. s p i l l o v e r benefits conferred upon those conducting the R&D. Despite Canada's generous tax incentives f o r R&D, Canadian industry has performed poorly over the past 20 years r e l a t i v e to other i n d u s t r i a l nations. 1 5 5 I f Canada's R&D tax p o l i c i e s are open to attack under the SCM Agreement, subj ect to abuse by taxpayers, and not achieving the stated objectives, i t i s timely that Canada's o v e r a l l strategy for R&D i s being reviewed. I t may be that Canada's R&D tax incentives are not the most e f f e c t i v e 1 5 2 Government p o l i c i e s which enhance market access and f a c i l i t a t e flow of c a p i t a l influence the adoption and d i f f u s i o n of new technology. W.S. Clark, et. a l . , supra. at 32:3. 1 5 3 i b i d . . at 32:2. 1 5 4 i b i d . . at 32:3 - 32:4. 1 5 5 Judith Maxwell, Chair of the Economic Council of Canada (closed i n June 1992) i n foreword to P. Mohnen, supra. at v i i ; and 1994 AG's Report, supra. v o l . 16 at 9-12. 119 means of stimulating research and development i n Canada. The Canadian government does not have the luxury of being able to af f o r d to support a l l R&D; Canada has modest resources to invest i n R&D compared with other i n d u s t r i a l i z e d countries so must ensure they are spending e f f e c t i v e l y . Given the importance of R&D to Canada's economic and s o c i a l agenda, these national objectives must be given p r i o r i t y over the free trade objective, but the l a t t e r should not be disregarded. The SCM Agreement establishes parameters regarding what i t s signatories consider to be acceptable subsidization, f o r R&D, and promotes general p r i n c i p l e s of free trade. To the extent that these parameters and p r i n c i p l e s are adaptable to a revised Canadian agenda for R&D, the SCM Agreement may provide useful guidelines i n r e v i s i n g Canadian tax incentives for R&D while l i m i t i n g exposure of these incentives to in t e r n a t i o n a l sanction. 120 CHAPTER 4 TRANSFER PRICING Transfer p r i c i n g i s one of the most controversial tax issues of the 1990s. During the l a s t decade, national b a r r i e r s to the free flow of international trade and investment have been su b s t a n t i a l l y eased and i n many cases removed altogether. The gl o b a l i z a t i o n of the economy has provided multinational enterprises with increased opportunities to minimize tax 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 e n t i t i e s . National governments have become increasingly concerned about protecting t h e i r domestic tax bases from t h i s type of tax avoidance. Moreover, both governments and multinational enterprises must confront the problem of a l l o c a t i n g tax revenues among countries on an equitable basis. 1 INTRODUCTION Many transactions take place between members of multinational 1 Brian J . Arnold and Thomas E. McDonnell, "Report on the In v i t a t i o n a l Conference on Transfer P r i c i n g : The A l l o c a t i o n of income and Expenses Among Countries" (1993), v o l . 41, No. 5 Canadian Tax Journal 899-922, at 901. The OECD has been working for several years on transfer p r i c i n g rules and has published a number of reports which are referred to throughout t h i s Chapter: OECD, Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (Paris: OECD, 1979), (the "1979 Report"); OECD, Transfer P r i c i n g and Multinational Enterprises: Three Taxation Issues. Report of the OECD Committee on F i s c a l A f f a i r s (Paris: OECD, 1984) (the "1984 Report"); OECD, Tax Aspects of Transfer P r i c i n g Within Multinational Enterprises: The United States Proposed Regulations. Report of the Committee on F i s c a l A f f a i r s on the Proposed Regulations Under Section 482 IRC (Paris: OECD, 1993) (the "1993 Report"); OECD, Intercompany Transfer P r i c i n g Regulations Under US Section 482 Temporary and Proposed Regulations (Paris: OECD, 1993). A r e v i s i o n of the 1979 and 1984 reports i s expected to be completed by mid-1995; a discussion d r a f t on Part I ("Principles and Methods"), OECD Transfer P r i c i n g Guidelines for Multinational Enterprises and Tax Administrations (Paris: OECD, 1994) (the "1994 Draft, Part I") was released on July 8, 1994 and reproduced i n "Tax Poli c y Forum", Tax Notes International, July 18, 1994, 155 - 187; a discussion d r a f t on Part II ("Applications"), (the "1994 Draft, Part II") was released on March 8, 1995 and reproduced i n "Tax Analysts", Tax Notes International. March 16, 1995 (on Lexis: 95 TNI 51-1). 121 enterprises ("MNEs"),2 including sale of goods, l i c e n s i n g of intangibles and the provision of ser v i c e s . 3 I t has been estimated that major MNEs w i l l have, at any one time, i n excess of 200 transactions between e n t i t i e s which may be s e n s i t i v e to transfer p r i c i n g i n a number of countries. 4 The term "transfer p r i c i n g " i s 2 1979 Report, supra. at 11, footnote 2. The OECD has not found i t necessary to define p r e c i s e l y the expression "multinational enterprise" i n reference to tr a n s f e r p r i c i n g guidelines, but re f e r to the OECD Guidelines f o r Multinational Enterprises, paragraph 8: A precise l e g a l d e f i n i t i o n of multinational enterprises i s not required for the purposes of the guidelines. These usually comprise companies or other e n t i t i e s whose ownership i s private, State or mixed, established i n d i f f e r e n t countries and so linked that one or more of them may be able to exercise a s i g n i f i c a n t influence over the a c t i v i t i e s of others and, i n p a r t i c u l a r , to share knowledge and resources with the others. The degree of autonomy of each e n t i t y i n r e l a t i o n to the others varies widely from one multinational enterprise to another, depending on the nature of the l i n k s between such e n t i t i e s and the f i e l d s of a c t i v i t y concerned. Also see J i l l C. Pagan and J. Scott Wilkie, Transfer P r i c i n g Strategy i n a Global Economy (The Netherlands: IBFD Publications, 1993), at 22 - 26 for an overview of the es s e n t i a l s of a MNE. 3 Rarely w i l l there be transactions between e n t i t i e s of a multinational enterprise which involve the sale or purchase of fin i s h e d goods without any support services, or at l e a s t without i m p l i c i t transfers of i n t e l l e c t u a l property and other intangibles developed within a MNE. Examples include the sharing of costs for the development of technology, or know-how, and how intra-group p r i c i n g of the fi n i s h e d products or services r e f l e c t s t h i s ; and the establishment of the pri c e for access to technology, or know-how, or product d i s t r i b u t i o n , or production r i g h t s , as, f o r example, r e f l e c t e d i n the basis of a royalty rate charged f o r a licence. ( J i l l C. Pagan and J. Scott Wilkie, supra. at 99). 4 J i l l C. Pagan and J. Scott Wilkie, supra, at 102. Also see Donald J.S. Brean, "Here or There: The Source and Residence P r i n c i p l e s of International Taxation", i n "Taxation to 2000 and Beyond", Canadian Tax Paper No. 93 (Toronto: Canadian Tax Foundation, 1992) 303 at 321 which estimates more than 70% of Canada-US b i l a t e r a l trade i s non-arm's length i n t r a - f i r m trade (Brean c i t e s Alan M. Rugman, Multinationals and Canada-United 122 generally used to describe the measurement and reporting of corporate p r o f i t s f or tax purposes a r i s i n g from transactions between members of a MNE.5 An acceptable t r a n s f e r p r i c e i s one that r e s u l t s i n income to the transaction p a r t i c i p a n t s which i s reasonably commensurate with t h e i r productive c a p a c i t i e s as members of, and with t h e i r actual contributions to, the economic u n i t . 6 I t i s generally accepted that tax factors may a f f e c t the price s charged for transfers between members of a MNE.7 Indeed, shrewd s e l e c t i o n of a transfer p r i c e may enable a MNE to increase o v e r a l l a f t e r tax earnings by s h i f t i n g p r o f i t s to low tax j u r i s d i c t i o n s . This a b i l i t y to manipulate t r a n s f e r p r i c e s may t h e o r e t i c a l l y put MNEs at a comparative advantage over domestic firms. 8 However, the Canadian and int 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 States Free Trade (Columbia, SC: University of South Carolina Press, 1990) chapter 3) . See also the 1993 Report, supra. at 1, which states that MNEs "have come to play a dominant r o l e i n the inte r n a t i o n a l trade arena, accounting f o r more that 50 per cent of inte r n a t i o n a l transactions. 1 1 For s t a t i s t i c s on the importance of transfer p r i c i n g to Canada see Roger Y.W. Tang, Transfer P r i c i n g i n the 1990s: Tax and Management Perspectives. (Connecticut: Quorum Books, 1993) at 33 - 37. 5 J i l l C. Pagan and J. Scott Wilkie, supra. at 99 - 100. 6 i b i d . . at 229. 7 1979 Report, supra. at 7. Tax factors may also a f f e c t the nature of the payments. 8 G.F. Mathewson and G.D. Quirin, F i s c a l Transfer P r i c i n g i n Multinational Enterprises (Toronto: University of Toronto Press, 1979) at 1. The authors conclude, however (Chapter 9) that there i s an o f f s e t t i n g nature to taxes and t a r i f f s ( i f t r a n s f e r s prices are manipulated so as to r e s u l t i n high p r o f i t s i n a low tax j u r i s d i c t i o n , the t a r i f f at the border w i l l be high which o f f s e t s the low income tax). This s e l f - p o l i c i n g mechanism disappears as t a r i f f b a r r i e r s are eliminated. See also 1994 Draft, Part I, supra. at 171 regarding o f f s e t t i n g incentives i n s e t t i n g values for 123 regimes attempt to remove any incentive MNEs may have to manipulate transfer prices for tax purposes. Indeed, i n economic terms, transfer p r i c i n g has the p o t e n t i a l to be as great, or greater, a trade b a r r i e r than customs duties 9 and may reduce global welfare. 1 0 Further, the ITA rules r e l a t i n g to tr a n s f e r p r i c i n g , d i s t i n g u i s h between residents and non-residents, and appear on customs and income tax purposes. 9 Norman C. Loveland, Canadian Issues i n Transfer P r i c i n g under the North American Free Trade Agreement, paper presented at the International F i s c a l Association, 1994 Annual Congress, Toronto, Canada, August, 1994 at 5. 1 0 Robert Z. A l i b e r , "Transfer P r i c i n g : A Taxonomy of Impacts on Economic Welfare", i n A. Rugman and L. Eden, eds., Multinationals and Transfer P r i c i n g (London: Croom Holm, 1985), 82 - 97, at 96: " I f corporate tax rates are i d e n t i c a l across countries, no incentive e x i s t s to manage tran s f e r p r i c i n g to s h i f t income among tax j u r i s d i c t i o n s ; after-tax rates of return are i d e n t i c a l . I f tax rates are raised or lowered i n one country, a wedge i s driven between before-tax rates of return i n the several countries, and c a p i t a l flows towards the country with the lower tax rates. The consequence of t h i s s h i f t adjustment i s that economic welfare declines on both a global basis and i n the higher tax country. The impact of transfer p r i c i n g by the multinational firm to s h i f t income from the high tax j u r i s d i c t i o n to the low tax j u r i s d i c t i o n i s to undo p a r t i a l l y or reverse the welfare-reducing impact of the increase i n the tax rate, so l e s s production i s diverted from t h i s j u r i s d i c t i o n . Transfer p r i c i n g also reduces the reserves of the tax c o l l e c t o r i n the high-tax j u r i s d i c t i o n while increasing economic welfare. The d i s t r i b u t i o n of the gains r e a l i z e d from the tax savings a t t r i b u t a b l e to t r a n s f e r p r i c i n g depends on the competitiveness of goods markets and of factor markets; i f taxes are s h i f t e d forward, the gains 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 . This r e s u l t appears pervasive across the various measures that segment national markets. Measures that segment national markets f o r goods or factors r a i s e economic welfare i n the country adopting these measures but at the expense of global welfare. Transfer p r i c i n g tends to lessen the global welfare-reducing impact of these measures, and thus undercuts the e f f o r t s of the state to exercise i t s monopoly power. Cr i t i c i s m s of transfer p r i c i n g as a welfare-decreasing a c t i v i t y are exercises i n misplaced concreteness." 124 t h e i r face to discriminate against non-residents. 1 1 This Chapter reviews and evaluates the Canadian ITA rules, and relevant international provisions, pertaining to transfer p r i c i n g to determine the p o t e n t i a l l y discriminatory consequences of the current transfer p r i c i n g regime on the a l l o c a t i o n of resources and economic a c t i v i t y of MNEs.12 PART I THE NATURE OF TRANSFER PRICING Transfer p r i c i n g i s an important issue f o r tax au t h o r i t i e s and MNEs a l i k e . Tax authorities face p o t e n t i a l erosion of t h e i r tax base, loss of tax revenues and incur time and expense administering and investigating compliance with transfer p r i c i n g provisions. MNEs are confronted with uncertainty i n se l e c t i n g and applying transfer p r i c i n g methods (despite tax authority e f f o r t s to delineate how and when to apply acceptable methods), high compliance costs and r i s k of penalties, i n t e r e s t and double taxation. 1 3 Despite the importance of transfer p r i c i n g , the current 1 1 Brian J. Arnold, "Tax Discrimination Against Aliens, Non-Residents, and Foreign A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the United Kingdom, and the United States", Canadian Tax Paper No. 90, (Toronto: Canadian Tax Foundation, 1991) at 12. 1 2 Unlike the previous two Chapters, t h i s Chapter does not engage i n a det a i l e d analysis of any p a r t i c u l a r GATT provision. Rather the sovereignty / free-trade dichotomy i s explored generally through examination of a vari e t y of transfer p r i c i n g issues which may a f f e c t MNEs thereby s h i f t i n g the balance i n favour of protectionism over free trade. 1 3 See L. Franko, M. Patton, J . Wheeler and C. T r i p l e t t , "The International Tax Showdown", The International Tax Journal, Vol.20, No. 3, Summer 1994, 1 for an informative, open forum debate on transfer p r i c i n g issues, p a r t i c u l a r l y the U.S. regulations and the impetus behind those regulations. 125 transfer p r i c i n g regime lacks a coherent d e f i n i t i o n of the very nature of transfer p r i c i n g : 1 4 A consequence of t h i s i s that firms (MNEs), even outside the context of deliberate p r i c i n g manipulation, f i n d i t d i f f i c u l t to detect a s u f f i c i e n t l y coherent underlying regulatory theme to allow them to assess the f i s c a l aspects of t h e i r organizations 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 transfer p r i c i n g rule, or at l e a s t the recognition among national tax 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 transfer p r i c i n g regulations... would reduce the a b i l i t y of national j u r i s d i c t i o n s to disguise the use of the tax system to achieve other p o l i t i c a l and economic objectives. Therefore, i t i s important at the outset to consider the nature of transfer p r i c i n g before evaluating the e x i s t i n g regime's impact on MNEs.15 A. The Tax Avoidance Perspective Transfer p r i c i n g has i t s roots i n anti-avoidance, yet as a system used to p r i c e transfers between r e l a t e d e n t i t i e s i t i s e s s e n t i a l l y a neutral concept. 1 6 In the i n t e r n a t i o n a l context transfer p r i c i n g i s often used i n a negative way to allude to a p r i c i n g decision by a MNE which s h i f t s income from one member of 1 4 J i l l C. Pagan and J . Scott Wilkie, supra at 238. 1 5 I t i s generally agreed that the broad purpose of transfer p r i c i n g rules i s to ensure that 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 reasonable. Although there i s agreement about t h i s general purpose, there i s no general agreement about whether these rules should be regarded as a n t i -avoidance rules or as basic income measurement r u l e s . See B. J . Arnold and T. E. McDonnell, supra, at 904. 1 6 Despite i t s anti-avoidance roots, t r a n s f e r p r i c i n g does not include a motive t e s t ; i t i s an objective t e s t of whether the p r i c i n g of a transaction r e f l e c t s arm's length dealings. J i l l C. Pagan and J . Scott Wilkie, supra. at 52. 126 the group to another to take advantage of d i f f e r e n t tax regimes. 1 7 Although the o v e r a l l pre-tax p r o f i t a b i l i t y of the MNE i s not affected, the s h i f t i n g of p r o f i t s between e n t i t i e s i n d i f f e r e n t countries r e s u l t s i n the tax base of one country shrinking to the benefit of the other. 1 8 Thus, transfer p r i c i n g i s often viewed as way to avoid or minimize taxation, thereby maximizing p r o f i t s of the MNE as a whole. In order to maintain the i n t e g r i t y of the tax base, Canada seeks to prevent t h i s type of tax avoidance by requ i r i n g an arm's length p r i c e f o r transfers of goods, services and intangibles between members of a MNE.19 An anti-avoidance focus w i l l i n e v i t a b l y r e s u l t i n adjustments which w i l l increase taxable p r o f i t and, 1 7 i b i d . . at 15. See also Donald J.S. Brean, "International Issues i n Taxation: The Canadian Perspective", Canadian Tax Paper No. 75 (Toronto: Canadian Tax Foundation, 1984) at 108 - 110 for a discussion of incentives for transfer p r i c i n g manipulations beyond minimizing the o v e r a l l income tax l i a b i l i t y of a MNE. 1 8 J i l l C. Pagan and J. Scott Wilkie, supra. at 17. The authors note that by the mid-1970's, increased communication and technological advances meant that developed nations (generally high tax countries) had a problem preserving t h e i r tax base. This recognition led to the development of tran s f e r p r i c i n g expertise and other means to attack the use of tax havens (such as the Canadian "foreign accrual property r u l e s " ) . However, general transfer p r i c i n g guidelines, as set out i n the 1979 Report, are equally applicable to transactions between e n t i t i e s i n developed countries or e n t i t i e s i n developed and developing countries (1979 Report, supra, at 10) . 1 9 Section 69 of the ITA i s discussed below. Such a n t i -avoidance tax l e g i s l a t i o n i s common throughout the world and has been the topic of 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 years due to changes i n the U.S. tran s f e r p r i c i n g regulations. See J i l l C. Pagan and J . Scott Wilkie, supra at 17 -22 for an overview of the hi s t o r y of transfer p r i c i n g . Also see the 1979 Report, supra; 1984 Report, supra; and the 1993 Report, supra. 127 therefore, domestic tax revenues. I r o n i c a l l y , such an approach on a global scale may r e s u l t i n double taxation and reduce global a f t e r tax p r o f i t s of the MNE.20 B. The Income Measurement Perspective Transfer p r i c i n g by MNEs may be used not only to minimize taxes but also to improve the e f f i c i e n c y of worldwide operations. 2 1 To suggest that MNEs make transfer p r i c i n g decisions p r i m a r i l y to minimize tax l i a b i l i t y i s not substantiated. Accounting, marketing, business p o l i c y , international business, economics and finance, performance evaluation and l e g a l considerations also impact on transfer p r i c i n g decisions. 2 2 For example, tax considerations are un l i k e l y to be paramount where MNEs are subject to c o n f l i c t i n g pressures from various government departments, 2 3 where d i f f e r e n t members of the MNE are subject to scrutiny by minority 2 0 J i l l C. Pagan and J. Scott Wilkie, supra. at 32. 2 1 Ramy E l i t z u r and Jack Mintz, Transfer P r i c i n g Rules and Corporate Tax Competition. (Toronto: Department of Economics and In s t i t u t e for P o l i c y Analysis, 1994) at 4. 2 2 Roger Y.W. Tang, supra. at 12 and 104. Also see Lorraine Eden, "Free Trade, Tax Reform, and Transfer P r i c i n g " , (1991) 39 Canadian Tax Journal 1, 90 at 92 and 111; J i l l C. Pagan and J . Scott Wilkie, supra at 227 - 228; Jean-Thomas Bernard and Robert J. Weiner, "Multinationals, Transfer Prices, and Taxes" i n Assaf Raz i n and J o e l Slemrod, eds., Taxation i n the Global Economy (Chicago: University of Chicago Press, 1990) 12 3 - 154 f o r a systematic empirical analysis of transfer prices i n the petroleum industry which indicates that the r e l a t i o n between tra n s f e r p r i c e / arm's length p r i c e d i f f e r e n t i a l s and corporate tax rates i s weak; Donald J.S. Brean "Financial Dimensions of Transfer P r i c i n g " i n A. Rugman and L. Eden, eds., supra. 149 - 169, at 149; and G.F. Mathewson and G.D. Quirin, supra, at 4. 2 3 1979 Report, supra. at 8. For example, customs au t h o r i t i e s or exchange control o f f i c e s i n the home and host countries. 128 shareholders, or where members of the MNE have considerable autonomy and managers are evaluated on t h e i r performance. 2 4 An a l t e r n a t i v e , and more balanced, view considers transfer p r i c i n g merely as part of the operational p r i c i n g structure of a MNE which i s governed by commercial considerations, not by the desire to avoid taxation: 2 5 Today transfer 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. I t applies to v i r t u a l l y a l l i n t e r n a t i o n a l transactions within a MNE world group and, because of technological advancements and s p l i t functions, a MNE has more int e r n a t i o n a l transactions than ever before. Tax avoidance, i f present, i s at the margins, not at the centre. C. Conclusion The nature of transfer p r i c i n g i s a contentious issue, yet i t i s a fundamental determination which impacts issues about regulation. Presumably i f transfer p r i c i n g r u l e s are considered to be anti-avoidance rules, they should only be applied i n abusive 2 4 See Wagdy M. Abdallah, International Transfer P r i c i n g P o l i c i e s : Decision Making Guidelines f o r Multinational Companies (Connecticut: Greenwood Press Inc., 1989) at 8 - 12; and Sylvain R. F. Plasschaert, Transfer P r i c i n g and Multinational Corporations: An Overview of Concepts. Mechanisms and Regulations (Great B r i t a i n : ECSIM, 1979) at 12 - 13. 2 5 J i l l C. Pagan and J . Scott Wilkie, supra at 15 - 16. Also see the 1979 Report, supra. at 9: " I t i s important to bear i n mind, moreover, that the need to adjust the actual p r i c e to an arm's length price, i n order to a r r i v e at a proper l e v e l of taxable p r o f i t s , a r ises i r r e s p e c t i v e of any contractual o b l i g a t i o n undertaken by the p a r t i e s to pay a p a r t i c u l a r p r i c e or of any intention of the p a r t i e s to minimise tax. Hence, the consideration of transfer p r i c i n g problems should not be confused with the consideration of problems of tax fraud or tax avoidance, even though transfer p r i c i n g p o l i c i e s may be used f o r such purposes." 129 cases. 2 6 I f transfer p r i c i n g rules are basic income measurement rules, they would apply i n every case where there are transactions between associated enterprises. 2 7 Yet, as the next Part of t h i s Chapter w i l l attempt to demonstrate, the present system, rooted i n anti-avoidance, i s not l i m i t e d to abusive cases: 2 8 The need to address the problem of a l l o c a t i o n of income of a MNE f o r taxation purposes cannot be ignored. The global economy i s developing apace and the problem of transfer p r i c i n g moving towards taking a disproportionate amount of time and e f f o r t of both taxpayer and tax gatherer. . . In general, there i s recognition that the problem e x i s t s , but because i t i s so complex and there i s no easy solution, discussion tends to descend into analysis of the d e t a i l of methodology and lose sight of the r e a l issue... Taxation i n t h i s area i s an a r t , and no amount of complex methodology can turn i t into an exact science. In my opinion, i t i s preferable to view the nature of transfer p r i c i n g as 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 resources, value and p r o f i t within a MNE, rather than p r i m a r i l y as a vehicle for tax avoidance. However, t h i s does not mean that an even more complex and d e t a i l e d set of r u l e s and compliance procedures i s necessary. Rather, by understanding the nature of 2 6 B. J . Arnold and T. E. McDonnell, supra at 904 and at 919: "The need for i n t e r n a t i o n a l cooperation may be somewhat less important i f t r a n s f e r - p r i c i n g rules are considered to be a n t i -avoidance rules that apply only i n abusive s i t u a t i o n s . In either case, however, such cooperation i s much more important today than i t was when the OECD l a s t considered t r a n s f e r - p r i c i n g r u l e s . " Further, i t has been suggested that perhaps a l e s s d e t a i l e d set of rules would be required i f transfer p r i c i n g rules are viewed as anti-avoidance rules (at 919). Whether t h i s i s the true i s debatable i n l i g h t of U.S. transfer p r i c i n g developments (see footnote 83, i n f r a . for 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 7 i b i d . . at 904. J i l l C. Pagan and J . Scott Wilkie, supra. at 16. 130 transfer p r i c i n g i n t h i s way, a more c l e a r l y defendable transfer p r i c i n g regime could be developed to enable MNEs to conduct t h e i r business i n the global economy while: 2 9 - reducing " f i s c a l nationalism" with respect to the analysis of transfer prices and the formulation of tax p o l i c y i n t h i s area; - having the capacity to generate a l e v e l of i n t e r n a t i o n a l tax harmonization by diminishing f i s c a l nationalism; - recognizing the economic nature of MNEs, and i n c i d e n t a l l y reducing the value of engaging i n p r i c i n g manipulation directed to "tax avoidance"; - recognizing and preserving national tax bases according to the economic c h a r a c t e r i s t i c s of national economies; - l i m i t i n g the intervention of tax regulations i n business de c i s i o n s / 3 0 and - addressing the movement of income and p r o f i t s through MNEs without giving undue concern to national tax systems and without requiring the adoption of contentious formulary methods of income a l l o c a t i o n to replace e x i s t i n g transfer p r i c i n g methods.31 The following discussion of discrimination i n the transfer p r i c i n g regime i s based on the nature of tr a n s f e r p r i c i n g as concerned with the international a l l o c a t i o n of resources, rather than with tax avoidance. To the extent that the tr a n s f e r p r i c i n g regime seeks to preserve national tax bases, transactions among members of MNEs are open to p r o t e c t i o n i s t and discriminatory 2 9 i b i d . , at 236 - 237 for a more complete d e s c r i p t i o n of these possible outcomes. 3 0 i b i d . . The authors suggest that t h i s benefit may be limi t e d to developed economies. 3 1 i b i d . . The authors suggest that the substantial r e l o c a t i o n by MNEs of economic a c t i v i t y i n response to tax considerations would, presumably, remain of concern to governments, but not on transfer p r i c i n g grounds. 131 measures which would have no p a r a l l e l for s i m i l a r domestic transactions. Part II reviews key p r i n c i p l e s , methods and procedural aspects of the e x i s t i n g transfer p r i c i n g system with a view to 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 negative impact on global trading by MNEs. Part III considers whether any such discrimination i n the e x i s t i n g transfer p r i c i n g system i s j u s t i f i a b l e i n l i g h t of the overriding objective of protecting the domestic tax base and considers alternatives which may more equitably balance the i n t e r e s t s of tax authorities and MNEs thereby f a c i l i t a t i n g global trade. PART II DISCRIMINATION IN THE TRANSFER PRICING REGIME The thesis i s that the e x i s t i n g transfer 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 orientation; they are aimed at maintaining national f i s c a l sovereignty without s u f f i c i e n t recognition of the impact the system has on MNEs. A p o t e n t i a l outcome of t h i s emphasis i s to decrease the e f f i c i e n c y and effectiveness of MNE operations 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 global operations which otherwise benefit from free trade. In t h i s Part, the following guestions are used to evaluate Canada's transfer p r i c i n g l e g i s l a t i o n , and how i t operates within the international transfer p r i c i n g regime, to assess whether the l e g i s l a t i o n discriminates against MNEs: A. To which taxpayers do transfer p r i c i n g provisions apply? B. What transactions are "affected? 132 C. How i s the transfer p r i c e determined? D. What are the consequences of tran s f e r p r i c e adjustments? E. What compliance measures are required to enforce the provisions? What other steps, such as advance p r i c i n g agreements, are suggested to avoid a p p l i c a t i o n of the provisions? A. To which taxpayers do transfer p r i c i n g provisions apply? The transfer p r i c i n g rules for transactions between residents and non-residents are set out i n section 69 of the ITA: 3 2 (2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm's length as pri c e , r e n t a l , royalty or other payment fo r or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in t h i s subsection referred to as "the reasonable amount") that would have been reasonable i n the circumstances i f the non-resident person and the taxpayer had been dealing at arm's length, the reasonable amount s h a l l , for the purpose of computing the taxpayer's income under t h i s Part, be deemed to have been the amount that was paid or i s payable therefor. (3) Where a non-resident person has neither paid nor agreed to pay to a taxpayer with whom the person was not dealing at arm's length as pri c e , r e n t a l , royalty or other payment for or for the use or reproduction of any property or as consideration for the carriage of goods or passengers or for other services, an amount equal to or greater than the amount that would have been a reasonable amount i n the circumstances i f the non-resident person and the taxpayer had been dealing at arm's length, that reasonable amount s h a l l , f or the purposes of computing the taxpayer's income under t h i s Part, be deemed to have been received or receivable by the taxpayer therefor, (emphasis added) Subsection 69(2) means, i n e f f e c t , that the amount that the 3 2 Other ITA provisions which may be applicable i n a p a r t i c u l a r case, but which are not addressed here, include section 67 (which disallows unreasonable expenses), subsection 245(1) (the general anti-avoidance provision which deals with undue or a r t i f i c i a l reductions of income), subsection 15(1) (shareholder appropriations) and Part XIII (tax on income from Canada of a non-resident) . 133 Canadian taxpayer has paid or agreed to pay to the non-resident may not, f o r tax purposes, exceed a reasonable arm's length p r i c e ; subsection 69(3) means that the amount (including a n i l amount) a non-arm's length, non-resident has paid or agreed to pay to a Canadian taxpayer may not, f o r tax purposes, be l e s s than a reasonable arm's length p r i c e . 3 3 These provisions apply on a transaction by transaction b a s i s . 3 4 The ITA transfer p r i c i n g provisions require c e r t a i n transactions to occur at a reasonable p r i c e i n circumstances where a resident and non-resident are not dealing at "arm's length". 3 5 The arm's length t e s t contains both f a c t u a l and substantive components and embraces natural persons 3 6 and corporations 3 7. 3 3 Information C i r c u l a r 87-2, "International Transfer P r i c i n g and other International Transactions", February 27, 1987, paragraph 6. 3 4 i b i d . . paragraph 56. This approach i s necessary as the ITA applies to each transaction between the various r e l a t e d p a r t i e s and not to any general measure of p r o f i t a b i l i t y . 3 5 i b i d . . Note that p r i o r to May 9, 1985, t h i s p r o v i s i o n only applied i f the taxpayer was carrying on business i n Canada. "Arm's length" i s defined i n section 251 of the ITA; also see Interpretation B u l l e t i n IT-419, "Meaning of Arm's Length" (July 10, 1978) . 3 6 "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 deal at arm's length. 3 7 Relationships between in d i v i d u a l s and corporations, or among corporations depend on "control" to determine whether the p a r t i e s deal at arm's length (see subsections 251(1) to (5)). "Control" i s a f a c t u a l determination not defined i n the ITA, but by case law, and generally means ownership of more than 50% of the shares of a corporation having f u l l voting r i g h t s . See Nathan Boidman, "Canadian Perspectives on Intercompany Transfer P r i c i n g " , Tax Management. Special Report, Vol. 2, No. 1, Report No. 5, May 12, 1993 (Washington, D.C.: BNA, 1993) at 6, footnote 14. 134 Parties not dealing at arm's length include, f o r example, transactions between a parent and subsidiary or between any two corporations controlled by the same person or group of persons. 3 8 These rules 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 to, the rules with respect to non-arm's length transactions between resident taxpayers set out i n subsection 69(1). 3 9 Although the tests f or assessing whether an arm's length r e l a t i o n s h i p e x i s t s do not d i f f e r e n t i a t e between foreign and domestic persons, the a p p l i c a t i o n of the t r a n s f e r p r i c i n g rules i s r e s t r i c t e d to transactions between a resident taxpayer and a non-3 8 Facts must be c a r e f u l l y analyzed to assess 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 or transactions with loosely associated p a r t i e s would be at arm's length. To the extent that d i f f e r e n t countries impose varying standards i n assessing when transfer p r i c i n g provisions come into play, uncertainty e x i s t s for the MNE and the opportunities or p i t f a l l s w i l l depend upon the facts and circumstances of each case (see J i l l C. Pagan and J. Scott Wilkie, supra. at 44). 3 9 Subsection 69(1): Except as expressly otherwise provided i n t h i s Act, (a) where a taxpayer has acquired anything from a person with whom the taxpayer was not dealing at arm's length at an amount i n excess of the f a i r market value thereof at the time the taxpayer so acquired i t , the taxpayer s h a l l be deemed to have acquired i t at that f a i r market value: (b) Where a taxpayer has disposed of anything (i) to a person with whom the taxpayer was not dealing at arm's length f o r no proceeds of for proceeds less than the f a i r market value thereof at the time the taxpayer so disposed of i t , or ( i i ) to any person by way of g i f t i n t e r vivos. the taxpayer s h a l l be deemed to have received proceeds of di s p o s i t i o n therefor equal to that f a i r market value; and (c) where a taxpayer has acquired property by way of g i f t , bequest or inheritance, the taxpayer s h a l l be deemed to have acquired the property at i t s f a i r market value at the time the taxpayer so acquired i t . 135 resident person. 4 0 The tax regime f o r p r i c i n g transactions between residents and non-residents d i f f e r s from that among residents, and i s prima f a c i e discriminatory. 4 1 The nature and extent of such discrimination i s explored i n the following sections. B. What transactions should be affected? Subsections 69(2) and 69(3) are much broader than subsection 69(1) i n the range of transactions that are a f f e c t e d : 4 2 Some transactions between residents - d i s p o s i t i o n s and acquis i t i o n s of property - are subject to s i m i l a r r u l e s . Many si m i l a r transactions between residents at less or more than an arm's length p r i c e are not adjusted to an arm's length amount, although t n eY_ may r e s u l t i n other disadvantageous tax consequences. The reason for the difference, of course, i s that transfer p r i c i n g with non-residents r e s u l t s i n erosion of the Canadian tax base, whereas transfer p r i c i n g with residents r e s u l t s only i n the s h i f t i n g of amounts between taxpayers, (emphasis added) Further, the transfer p r i c i n g rules apply to transfers of services, tangible and intangible property, when: a) a taxpayer has paid or agrees to pay to an non-resident, non-arm's length person, an amount greater than a reasonable amount; and b) a non-resident, non-arm's length person has neither paid or agreed to pay a 4 0 Subsections 69(2) and (3) override section 69(1) i n the case of transactions between Canadian taxpayers and non-residents (Information C i r c u l a r 87-2, supra. paragraph 6). 4 1 Brian J . Arnold, "Tax Discrimination Against A l i e n s , Non-Residents and Foreign A c t i v i t i e s " , supra. at 12. 4 2 i b i d . . at 105. 4 3 i b i d . . at 105, footnote 214: "For example, i f a corporation performs services for a shareholder for le s s than f a i r market value, the benefit conferred must be included i n the shareholder'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 included i n subsections 69(2) and 69(3). 136 reasonable amount to a taxpayer. 4 4 In these circumstances, the taxpayer's taxable income i s presumably less than i t would otherwise be, had the transaction occurred with an arm's length person. Therefore, the provisions are drafted i n such a way that the only transactions which are affected are those where transfer p r i c i n g adjustments lead to an increase i n p r o f i t f o r the taxpayer, with a corresponding increase i n the domestic tax base. I t i s submitted that r e s t r i c t i n g the app l i c a t i o n of the tr a n s f e r p r i c i n g rules i n t h i s way discriminates against MNEs v i s a v i s s i m i l a r domestic transactions: 4 5 Two independent business e n t i t i e s with a long h i s t o r y of doing business together may f i n d some arrangements or business dealings f a r more p r o f i t a b l e to one than to the other. However, over the years they average out... However, transfer p r i c i n g l e g i s l a t i o n ... does not t e c h n i c a l l y accept averaging out over the years, so MNEs are p o t e n t i a l l y at a disadvantage. Prices may be adjusted for those transactions where i n t r a -group prices may be said not to meet the arm's length c r i t e r i a and r e s u l t i n a decrease i n income or increase i n expenditure; no regard would be given to s i m i l a r transactions i n previous years where p r i c i n g may have resulted i n greater p r o f i t than appropriate i f a s t r i c t arm's length p r i c e were to be substituted. Therefore, by including a broader range of transactions and applying only to transactions which increase the domestic tax base, the cross-border transfer p r i c i n g r u l e s can be viewed as discriminatory. C. How i s the transfer p r i c e determined? The transfer p r i c i n g rules provide that "the reasonable 4 4 The question of what a "reasonable amount" i s w i l l be addressed below. 45 J i l l C. Pagan and J . Scott Wilkie, supra. at 51, 137 amount", the amount that would have been reasonable i n the circumstances, s h a l l be deemed to have been the amount that was paid or payable. 4 6 This reasonable amount i s rooted i n the arm's length p r i n c i p l e . 4 7 The presumption i s that a reasonable arm's length p r i c e would be a f a i r market value 4 8 and the most persuasive evidence of t h i s amount i s from the market to which the tra n s f e r i s This section provides an overview of the arm's length 4 6 Subsections 69(2) and 69(3); Information C i r c u l a r 87-2, supra. paragraphs 5 - 7 . 4 7 The arm's length p r i n c i p l e i s discussed below. See generally i b i d . . paragraph 9; 1979 Report, supra; 1984 Report, supra: 1993 Report, supra; A r t i c l e 9(1) of the OECD Model; and "Tax Treaties between Developed and Developing Countries" (United Nations, 1978) at 62. 4 8 Revenue Canada uses the same theories and p r i n c i p l e s of transfer p r i c i n g to determine f a i r market value under section 69(1) for domestic non-arm's length transactions (Information C i r c u l a r 87-2, supra. paragraph 5). However, the language of subsections 69(2) and 69(3) "of both a reasonableness standard and a circumstantial context suggests a basis f o r accepting intra-group p r i c i n g that may depart from " f a i r market value" as interpreted conventionally for arm's length transactions, but nevertheless may be appropriate taking into account the nature and c h a r a c t e r i s t i c s of a multi-national enterprise, provided that there i s no evidence of a tax avoidance motivation." (J. Scott Wilkie, "Transfer P r i c i n g : R ealizing Corporate Goals" , Tax Aspects of Canada-United States Business Transactions (Mississauga: Insight Press, 1991) Tab 5 at 12) . 4 9 The arm's length p r i c e i s determined from the perspective of the transferor's destination market which may or may not be equal to " f a i r market value", the standard which i s imposed i n a purely domestic non-arm's length transaction. Information C i r c u l a r 87-2, supra. paragraph 7 gives the example of a supplier attempting to increase market share, so the supplier might temporarily e s t a b l i s h an arm's length p r i c e that was below f a i r market value. See also J. Hofert Limited v. MNR, 62 DTC 50 (TAB) ; Indalex Limited v. The Queen. 86 DTC 6039 (FCTD), 88 DTC 6053 (FCA); and The Queen v. Irving O i l Limited. 91 DTC 5106 (FCA); and J i l l C. Pagan and J . Scott Wilkie, supra. at 233. 138 p r i n c i p l e and the generally accepted methods fo r a r r i v i n g at the arm's length transfer p r i c e . Problems with the arm's length p r i n c i p l e as well as d i f f i c u l t i e s i n applying the prescribed methods are discussed i n the context of discrimination against MNEs. i . Arm's length p r i n c i p l e When independent e n t i t i e s conduct business with each other, market forces generally determine the conditions of t h e i r commercial and f i n a n c i a l r e l a t i o n s . MNEs can d i s t o r t these market forces i n a number of ways, including s h i f t i n g p r o f i t s from one j u r i s d i c t i o n to another i n order to reduce the o v e r a l l tax burden. The arm's length p r i n c i p l e t r i e s to eliminate t h i s e f f e c t by t r e a t i n g each member of a MNE as a separate e n t i t y . 5 0 On January 7, 1994 the Department of Finance issued a Press Release 5 1 to c l a r i f y the Canadian rules and guidelines for determining transfer prices between members of an i n t e r n a t i o n a l corporate group. Canada requires transfer prices to conform to the "arm's length p r i n c i p l e " that prices for transactions between members of a MNE52 be equivalent to those which would be set by two 5 0 See Diane Hay, Frances Horner, and J e f f r e y Owens, "Past and Present Work i n the OECD on Transfer P r i c i n g and Selected Issues", Tax Notes International, Tax Advisors Forum, July 25, 1994 249 at 253. Also see Donald J.S. Brean "International Issues i n Taxation", supra, at 112. 5 1 Press Release 93-003, "Transfer P r i c i n g Rules and Guidelines C l a r i f i e d " . 5 2 Transactions between members of a MNE are also referred to as the "controlled transaction". For a discussion on whether of not the arm's length p r i n c i p l e necessitates the existence of a transaction i n order to apply see B.J. Arnold and T.E. McDonnell, 139 unrelated companies engaged i n the same or s i m i l a r transactions under the same or s i m i l a r conditions i n the open market. The arm's length p r i n c i p l e has been incorporated i n a l l Canadian tax 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.53 There are a number of reasons why the arm's length p r i n c i p l e has been o f f i c i a l l y recommended.54 Market forces of supply and demand are considered to be the best way to a l l o c a t e resources and reward e f f o r t . Also, the arm's length p r i n c i p l e provides broadly equal treatment for MNE groups and independent enterprises thereby avoiding the creation of tax advantages by concentrating economic power i n large MNE groups. F i n a l l y , the arm's length p r i n c i p l e has been applied with success i n p r a c t i c e . There are a number of problems with the arm' s length p r i n c i p l e . 5 5 MNEs may engage i n transactions which independent enterprises would not engage i n making i t d i f f i c u l t to apply the supra. 905. 5 3 See the 1979 Report, supra; the 1984 Report, supra; the 1993 Report, supra; and the 1994 Draft Part I, supra, which favour the arm's length method and r e j e c t a global method of apportionment (discussed below). I t has been suggested that the tension 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 recognized that there are a v a r i e t y of methods fo r resolving transfer p r i c i n g issues. (B.J. Arnold and T.E. McDonnell, supra. at 920). There i s substantial concern about the use of predetermined formulas to a l l o c a t e income among members of a MNE and i t i s unclear whether the arm's length p r i n c i p l e permits the use of p r o f i t based methods i n addition to the transaction based methods which are discussed i n section i i ) below. For a discussion see B.J. Arnold and T.E. McDonnell, supra. at 905-906. 5 4 See Diane Hay, et. a l . , supra. at 253 and 1994 Draft, Part I, supra. 5 5 See generally J i l l C. Pagan and J . Scott Wilkie, supra, at 28 and Norman C. Loveland, supra. at 2. 140 arm's length p r i n c i p l e where comparable transactions do not e x i s t i n the market place. I t i s u n l i k e l y that a t r u l y comparable uncontrolled transaction w i l l be a v a i l a b l e f o r such comparison, 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 I t i s also u n l i k e l y that there i s going to be a s i n g l e arm's length p r i c e ; rather there w i l l be a commercially f e a s i b l e range of p r i c e s . 5 7 The arm's length p r i n c i p l e i s also inherently flawed i n that i t adopts the separate e n t i t y approach which may not account f o r economies of scale or the i n t e r - r e l a t i o n of diverse a c t i v i t i e s by MNEs.58 When comparable transactions do e x i s t , a s i g n i f i c a n t amount of data i s required i n order to compare these transactions to a c t i v i t i e s of the MNE. This data may be inaccessible, incomplete and d i f f i c u l t to i n t e r p r e t when the MNE i s establishing transfer prices, but Revenue Canada w i l l compare the information a f t e r the f a c t when relevant data i s 5 6 B.J. Arnold and T.E. McDonnell, supra, at 900; Emilio Romano, Taxation and the North American Free Trade Area, paper presented at the International F i s c a l Association, 1994 Annual Congress, Toronto, Canada, August, 1994, at 4; 1979 Report, supra. at 13 and 46; and 1994 Draft, Part I I , supra. at paragraph 1. 5 7 I f i t i s recognized that the arm's length p r i n c i p l e contemplates an acceptable range of prices, rather than a single " r i g h t " p r i c e , i t may be necessary to develop "safe harbour" rules for p r i c e s f a l l i n g within the acceptable range. See B.J. Arnold and T.E. McDonnell, i b i d , at 915 and at 915 - 916 regarding safe harbour rules generally; 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 safe harbours. 5 8 For example, the arm's length p r i n c i p l e i s d i f f i c u l t to apply i n a l l o c a t i n g costs for research 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 benefit of one or more other members of the MNE (see the 1979 Report, supra. at 45 - 71). 141 easier to obtain and i d e n t i f y . 5 9 F i n a l l y , to the extent that Revenue Canada uses industry-wide standards to assess an arm's length p r i c e , i t i s u n l i k e l y that these standards w i l l r e f l e c t the p a r t i c u l a r circumstances of the MNE and the transaction under review. 6 0 An a l t e r n a t i v e to the arm's length approach i s formulary apportionment. 6 1 Formulary apportionment r e f e r s to global or d i r e c t methods of p r o f i t a l l o c a t i o n , or f i x i n g t r a n s f e r p r i c e s by reference to a predetermined formula based on factors such as sales, p a y r o l l and assets. 6 2 Advocates of t h i s approach claim that 5 9 Emilio Romano, supra, at 4. See also Amp of Canada. Ltd. v. The Queen. 87 DTC 5157 (FCTD); and Crestbrook Forest Industries Limited v. The Queen. 91 DTC 5521 (FCA) regarding taxpayers seeking disclosure of documents used by Revenue Canada. 6 0 There may be sound business reasons f o r e s t a b l i s h i n g a transfer p r i c e which i s at odds with the "industry standard", such as to gain entry into a market. The "reasonable i n the circumstances" language of subsections 69(2) and (3) provides some measure of protection f o r the MNE i n t h i s regard. 6 1 See B.J. Arnold and T.E. McDonnell, supra. at 904 - 908. This method i s also referred to as the unitary approach because i t treats members of a MNE as a member of a single, u n i f i e d business rather than as a separate e n t i t y under the arm's length approach. The 1994 Draft, Part I, supra. cautions (at 185 - 186) that global formulary apportionment methods (which use a formula that i s predetermined for a l l taxpayers to a l l o c a t e p r o f i t s ) should not be confused with p r o f i t methods (which compare, on a case by case basis, the p r o f i t s of one or more associated enterprises with the p r o f i t experience that comparable independent enterprises would have sought to achieve i n comparable circumstances). These global methods are also distinguished from cases of selected a p p l i c a t i o n of a formula developed by both tax a u t h o r i t i e s i n cooperation with a MNE a f t e r c a r e f u l analysis of the p a r t i c u l a r f a c t s and circumstances (for example, under mutual agreement procedures or advance p r i c i n g agreements). 6 2 See J i l l C. Pagan and J . Scott Wilkie, supra. at 32 regarding 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 length transfer p r i c i n g system (in which a functional analysis of 142 i t would provide greater administrative convenience, reduced compliance costs and certainty for taxpayers. Advocates also believe that t h i s approach i s more i n l i n e with economic r e a l i t y of the highly integrated r e l a t i o n s h i p s among members of MNEs.63 The OECD has rejected t h i s approach as producing a r b i t r a r y r e s u l t s and being incompatible with A r t i c l e s 7 and 9 of the OECD Model which broadly accepts the arm's length b a s i s . 6 4 However, the most s i g n i f i c a n t problem with global formulary apportionment i s said to be the p o t e n t i a l f o r double taxation due to lack of i n t e r n a t i o n a l consensus and coordination on the predetermined formulae and composition of the tax u n i t . 6 5 Other perceived problems with global methods include compliance costs and data requirements, lack of uniform accounting standards and lack of the actual operations and s i m i l a r types of transactions has a r o l e to play) as compared with a global formulary apportionment method (in which a functional analysis i s supplanted by, f o r example, a formula applied to adjusted figures from the national and global accounts.) 6 3 1994 Draft, Part I, supra, at 186. 6 4 The 1979 Report, supra. at 14, reports that the r e s u l t i s a r b i t r a r y because these methods disregard market circumstances, 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 to lead to 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 to economic facts (see the 1979 Report at 14 f o r examples). However, t h i s r e s u l t i s also possible under the arm's length standard, p a r t i c u l a r l y with regard to intangibles where comparable arm's length transactions are u n l i k e l y to e x i s t . 6 5 1994 Draft, Part I, supra. at 186 - 187. Similar problems of double taxation also e x i s t under the arm's length p r i n c i p l e , however, regarding d i f f e r i n g standards and lack of consistency i n a p p l i c a t i o n of methods. If compensating adjustments are not forthcoming, double taxation w i l l r e s u l t . These concerns are discussed below. 143 f l e x i b i l i t y i n applying pre-determined formulae. Overall, s t r i c t a p p l i c a t i o n of either standard i s l i k e l y to be unreasonably c o s t l y and burdensome for MNEs, requi r i n g an undue amount of time and e f f o r t to support an a r b i t r a r y transfer p r i c e which may s t i l l be subject to adjustment. I t i s suggested that the following methods for determining an arm's length p r i c e exacerbate these problems. In an attempt to make transfer p r i c i n g less a r b i t r a r y by imposing s p e c i f i c transfer p r i c i n g methods, a less a r b i t r a r y r e s u l t i s not necessarily the outcome, i i . Methods for Determining an Arm's Length Price a. Transfer of Goods; Acquisitions or Dispositions of Intangibles There are three generally accepted methods for determining an arm's length p r i c e for.the transfer of goods, and the a c q u i s i t i o n or d i s p o s i t i o n of int a n g i b l e s : 6 6 the comparable uncontrolled price, resale p r i c e and cost-plus methods. 6 7 6 6 Information C i r c u l a r 87-2, supra, paragraph 13. Methods for establ i s h i n g an arm's length p r i c e f o r the use of intangibles (the "arm's length royalty rate") are discussed below and at paragraphs 40 through 47 of Information C i r c u l a r 87-2. 6 7 The following discussion i s a b r i e f overview of the methods. For a more complete description, r e f e r to: Information C i r c u l a r 87-2, i b i d . ; J i l l C. Pagan and J. Scott Wilkie, supra. at 104 - 110; J. Scott Wilkie, "Transfer P r i c i n g : Realizing Corporate Goals", supra; Diane Hay, et. a l . , supra; Nathan Boidman, "Canadian Perspectives on Intercompany Transfer P r i c i n g " , supra; David G. Broadhurst, "Developing a Poli c y for Intercompany P r i c i n g " (1989) 37 Canadian Tax Journal 1, 128 - 140; Nathan Boidman, "Revenue Canada's Transfer P r i c i n g C i r c u l a r : Selected Commentary" (1988) 3 6 Canadian Tax Journal 2, 405 - 427; Robert F. Lindsay, "Cross-Border Transfer P r i c i n g : General P r i n c i p l e s " , Report of Proceedings of the Thirty-Eighth 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 Draft, Part I, supra. For Canadian case law relevant to transfer p r i c i n g see Irving O i l Limited v. The Queen. 88 DTC 6138 (FCTD), a f f ' d 91 DTC 144 The primary method to e s t a b l i s h an arm's length p r i c e i s to a r r i v e at an exact comparable uncontrolled 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 length party f o r the same item, i n the same quantity, under the same conditions and i n the same market; or i i . the p r i c e set by two t h i r d p a r t i e s f o r the same item, i n the same quantity, under the same conditions and i n the same market. In cases where differences i n circumstances between a con t r o l l e d and uncontrolled transaction do not a f f e c t p r i c e , or are minor or can be reasonably quantified, i t i s appropriate to use an inexact comparable uncontrolled p r i c e . 6 9 Where exact or inexact comparable uncontrolled p r i c e s are not available, Revenue Canada w i l l generally accept e i t h e r of the "resale minus" or "cost plus" transactional methods. 7 0 The resale 5106 (FCA) (leave to appeal to SCC denied Sept. 1991); Consolidated Bathurst Limited v. The Queen. 85 DTC 5120 (FCTD); Stubart Investments Limited v. The Queen. 84 DTC 6305 (SCC); Indalex Limited v. The Queen. 83 DTC 89 (TRB); Spur O i l Ltd. v. The Queen. 81 DTC 5168 (FCA); Dominion Bridge Co. Ltd. v. The Queen. 75 DTC 5150 (FCTD), a f f ' d 77 DTC 5367 (FCA); J . Hofert Ltd. V . MNR. 62 DTC 50 (TAB); and Central Canada Forest Products Ltd. v. MNR. 52 DTC 539 (TAB). A number of these cases are discussed by Robert A. Friesen i n "Contemporary Issues i n Cross-Border Transactions", Report of Proceedings of the Thirty-Eighth Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 22:1 -22:7; and see Memorandum, Rulings Directorate, "Subsidiary Doing Business i n Canada - Transfer P r i c i n g " (December 1, 1992). 6 8 Press Release No. 93-003, supra. "Backgrounder". 6 9 Information C i r c u l a r 87-2, supra. paragraph 14. Factors which may be used i n assessing comparability include product d e f i n i t i o n , guantity, 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, trade l e v e l s , and other terms of trade. 7 0 For United States examples where courts 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), Hospital Corporation of America 145 minus method i s used where no acceptable comparable e x i s t s and the taxpayer adds l i t t l e value to a product. This approach begins with an arm's length sales p r i c e and deducts an appropriate 7 1 mark-up to cover the taxpayers costs and earn a p r o f i t . By comparison, the cost plus method begins with the cost of the product and adds on an appropriate mark-up. Where neither the uncontrolled p r i c e methods nor the transactional methods can be applied, group p r o f i t s should be allocated based on a proper remuneration of functions performed by d i f f e r e n t e n t i t i e s within the corporate group. 7 2 Possible other methods include some form of p r o f i t s p l i t analysis, or global methods based on a va r i e t y of factors important to a p r i c i n g decision, or y i e l d or rate of return a n a l y s i s . 7 3 I t has been suggested that whether or not a comparable e x i s t s , tax a u t h o r i t i e s and courts w i l l be concerned about some notion 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 (Cl.ct. 1979) , United States Steel v. Comm'r. TC Memo 1977-140 rev'd, 617 F.2d 942 (2d C i r . 1980), PPG Industries Inc. v. Comm'r. 55 TC 928 (1970). Also see J.Hofert Ltd. v. MNR. 62 DTC 50 (TAB) for a Canadian case on p r o f i t s p l i t s . For examples where the CUP method was applied see Indalex Ltd. 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 Cir.) a f f ' g 92 TC 525, i n the United States. 7 1 See Information C i r c u l a r 87-2, supra. paragraphs 15 and 17 for comments on the word "appropriate" i n t h i s context. 7 2 Press Release 93-003, supra, and Information C i r c u l a r 87-2, i b i d . 7 3 J i l l C. Pagan and J . Scott Wilkie, supra, at 38. The authors note that these other methods are more d i r e c t l y r e l a t e d to a facts and circumstances review of affected taxpayers, but, as discussed above, are generally denounced by tax a u t h o r i t i e s and the OECD. 146 p r o f i t s p l i t : 7 4 Not only do the recent US court cases suggest at l e a s t an underlying s e n s i t i v i t y , i f not objective, i n t h i s regard, but there are a number of instances 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 that the issue of p r o f i t s p l i t i s always present. For example, at an International F i s c a l Association 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 , expressing h i s remarks as personal views, commented that the standard four t e s t s are perhaps not a productive a n a l y t i c a l premise and observed that there may be a tendency to favour some sort of p r o f i t s p l i t on the basis of "common sense". He suggested, i n t h i s connection, that the conventional methodologies may f a i l to give adequate recognition to elements of integrated operation and that, notwithstanding reservations about a p r o f i t s p l i t approach, the inadequacies of other methods are d r i v i n g the analysis i n t h i s d i r e c t i o n . Despite the general 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 into account by Revenue Canada i n evaluating transfer p r i c e s : 7 5 The most frequently used i s the group p r o f i t a l l o c a t i o n method. Although denigrated i n t e r n a t i o n a l l y (by the OECD) , i n p r a c t i c e the p r o f i t s p l i t approach i s applied guite frequently... as a l a s t resort. Gross p r o f i t s r e a l i z e d from the non-arm's length sales to the customer are aggregated and divided amount the r e l a t e d p a r t i e s . This 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 proportion of Canadian sales to group sales or Canadian costs to group costs. I t i s extremely important that 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 material f a c t s and circumstances of the case. In addition, i t i s advisable to have objective evidence such as . .. industry p r o f i t s t a t i s t i c s to support the proprietary a l l o c a t i o n . I t appears that Revenue Canada acknowledges that transfer p r i c i n g analysis i s fundamentally f a c t u a l and the ultimate purpose of the transfer p r i c i n g analysis i s to evaluate p r i c e s i n l i g h t of actual economic circumstances with the r e s u l t being a f a i r and 7 4 i b i d . . at 94. 7 5 Revenue Canada auditing guidelines as quoted i n J i l l C. Pagan and J . Scott Wilkie,' i b i d . . at 109 - 110. 147 reasonable a t t r i b u t i o n of group p r o f i t among members. The presumption i s that a s p e c i f i c , thoughtfully and thoroughly considered and documented commercial transfer p r i c i n g strategy i s a basis and rationale for intercompany p r i c i n g rather than a retrospective explanation or pl a u s i b l e j u s t i f i c a t i o n to meet Revenue Canada ' s purposes. 7 6 b. Use of Intangibles Transfer p r i c i n g problems r e l a t i n g to transactions involving use of intangibles are es p e c i a l l y problematic due to the unigue nature of most in t a n g i b l e s . 7 7 Comparable transactions are often not available, yet the intangible may be very valuable and p r o f i t a b l e so the conseguences of p r i c i n g are s i g n i f i c a n t . 7 8 I t has been suggested that any attempt to value intangibles by reference to the 7 6 i b i d . , at 230 - 231. The authors r e f e r to the Revenue Canada view that p r i c i n g statements "should be based on a thorough functional analysis of the a c t i v i t i e s and contribution of each group member and should c l a r i f y and quantify the various factors which were considered i n establishing the tran s f e r prices, eg. technical assistance, access to technology, reward for economic r i s k , financing assistance, etc." (Information C i r c u l a r 87-2, supra, paragraph 15). 7 7 Kenneth J. Murray, supra. at 27:31 - 27:32; see also the 1979 Report, supra. 1993 Report, supra, and Information C i r c u l a r 87-2, i b i d . , paragraphs 40 - 47. 7 8 B.J. Arnold and T.E. McDonnell, supra, at 908. The use of comparables i s considered to be the preferred method, but there i s disagreement about whether comparables should be viewed broadly or narrowly. In addition, i t i s d i f f i c u l t f or one taxpayer to know the p r o f i t p o t e n t i a l of another taxpayer's intangible property, the p r o f i t p o t e n t i a l of intangibles may be a t t r i b u t a b l e to many organizational factors that are d i f f i c u l t to segregate, and i f the royalty established for intangible property i s too low, should the royalty be adjusted or should a tax be imposed on an imputed gain on the o r i g i n a l transfer of the intangible. Revenue Canada requires the use of an arm's length comparable roya l t y where available (Information C i r c u l a r 87-2, i b i d . . paragraph 46). 148 arm's length p r i n c i p l e i s u n l i k e l y to be workable. 7 9 In many cases there i s no objective economic solut i o n to the intra-corporate transfer p r i c i n g problem f o r intangibles and the a l l o c a t i o n of p r o f i t s within a MNE must be seen as a r b i t r a r y . 8 0 In the absence of comparable transactions, Revenue Canada expects comparisons with royalty rates i n the same industry or a si m i l a r industry involving r e l a t i v e l y s i m i l a r products, s i m i l a r market conditions and s i m i l a r l i c e n s i n g arrangements. 8 1 In practice, the transfer p r i c i n g method applied w i l l l i k e l y be some form of p r o f i t s p l i t . 8 2 The United States transfer p r i c i n g regulations s p e c i f i c a l l y allow for the use of a p r o f i t s p l i t method: the comparable p r o f i t method ("CPM"),83 Unlike the resale minus and cost plus methods, 7 9 B.J. Arnold and T.E. McDonnell, i b i d . . at 906. The treatment of intangibles under formulary apportionment also came under scrutiny: "One p o s s i b i l i t y i s to t r e a t intangibles as an a t t r i b u t e of the enti r e enterprise; therefore, the income from and expenses associated with intangibles would be allocated on the basis of the other factors. Another p o s s i b i l i t y i s to take the costs of developing intangibles into account as assets. Such an approach may be j u s t i f i a b l e because the country that allows deductions for the costs of research and development has a legitimate claim to tax the p r o f i t s of the enterprise a t t r i b u t a b l e to e x p l o i t i n g the intangibles." 8 0 Donald J.S. Brean, "International Issues i n Taxation", supra. at 111. 8 1 Information C i r c u l a r 87-2, supra. paragraph 45. The taxpayer should also be prepared to demonstrate the reasonableness of intercompany r o y a l t i e s (paragraph 47). 8 2 B.J. Arnold and T.E. McDonnell, supra. at 908.; J i l l C. Pagan and J. Scott Wilkie, supra. at 101 - 102. 8 3 A review of the US transfer p r i c i n g regulations i s beyond the scope of t h i s paper. Refer to Dora K. Cheng, "Transfer P r i c i n g : U.S Regulations and OECD Discussion Draft Compared", Tax 149 the CPM allo c a t e s income among group members on the basis of comparable p r o f i t s rather than comparable p r i c e s . Use of the CPM i s Notes International. January 16, 1995, at 199 - 202; Elizabeth King and Scott D. Newman, "Taxonomy of P r i c i n g Problems Involving Intangibles and Their Treatment Under the Old and New s.482 Regulations", Tax Notes International. December 12, 1994, at 1851 -1860; W. Gordon Williamson, "Transfer P r i c i n g Update", Taxation of Outbound Investments (Toronto: Insight Publications, 1994), Tab 5; 1993 Report, supra; David R. T i l l i n g h a s t , "The Great American Transfer P r i c i n g Saga, Act II , Scene I I I : The 1993 Regulations and the L e g i s l a t i v e Outlook, with Some Comments on Advance P r i c i n g Agreements and Audits" i n "Tax Planning f o r Canada-US and International Transactions", Corporate Management Tax Conference 1993 (Toronto: Canadian Tax Foundation, 1994) 7:1 - 7:15); Peter G l i c k l i c h and Seth B. Goldstein, "Changes i n US Transfer-Pricing Regulations Increase Compliance Burdens f o r Multinationals and up the Anti i n Transfer-Pricing Disputes" (1993), 41 Canadian Tax Journal 2, 382; B.J. Arnold and T.E.McDonnell, supra; David R. Black, " S p l i t t i n g P r o f i t s : Finding the Right Transfer P r i c i n g Methodology" (1993), 41 Canadian Tax Journal 1, 140; P h i l i p D. Morrison, "US Transfer-Pricing P o l i c y : Prospects for Continuing Controversy", Report of Proceedings of the Fourty-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 46:1; Jean Potvin, "Transfer P r i c i n g and the Proposed Regulatory Amendments to Section 482 of the Internal Revenue Code", Report of Proceedings of the Fourtv-Fourth Tax Conference. 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993) 5:58 - 5:64; Charles S. T r i p l e t t , "Intercompany P r i c i n g " , Report of Proceedings of the Forty-Second Tax Conference. 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991) 39:5 - 39:22; Charles S. T r i p l e t t , "The Po l i c y Rationale f o r the Proposals on Transfer P r i c i n g and an IRS Perspective on the Administration of the Measures", Report of Proceedings of the Fo r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 41:1; J.A. Calderwood, "Impact of the IRS Section 482 White Paper: A Perspective from Revenue Canada, Taxation", Report of Proceedings of the F o r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 42:1; Robert J. Patrick, J r . , " P r i c i n g f o r Intangibles: A US Pra c t i t i o n e r ' s Perspective", Report of Proceedings of the Fo r t i e t h Tax Conf erence. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 43:1; Nathan Boidman, "The American Super Royalty Rule: A Canadian Perspective", Report of Proceedings of the Fo r t i e t h Tax Conference. 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 44:1; and Percy Woodard, J r . , "Transfer P r i c i n g Rules: Section 482 of the Internal Revenue Code", Report of Proceedings of the Thirty-Eighth Tax Conference. 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987) 21:1. 150 not acceptable for Canadian tax purposes as i t may not generate a transfer p r i c e which i s i n accordance with the arm's length p r i n c i p l e . 8 4 Further, the CPM does not account for the re l a t i o n s h i p s between members of an i n t e r n a t i o n a l group and the functions c a r r i e d on by the members. F i n a l l y , double taxation i s a p o s s i b i l i t y with the CPM method, i f i t i s applied by a l l countries, as the t o t a l of the a l l o c a t i o n s to the various countries could e a s i l y exceed the t o t a l income of the group. 8 5 Unfortunately, Revenue Canada's p o s i t i o n on the CPM may, i n i t s e l f , lead to double taxation where the IRS reassess a U.S. a f f i l i a t e company using the CPM rules, and Revenue Canada does not provide a corresponding adjustment. 8 6 i i i . Transfer P r i c i n g and Customs Valuation There i s a lack of coordination between customs valuation and transfer p r i c i n g on the international scene which has been 8 4 Press Release No. 93-003, supra. This would occur where there are factors which make p r o f i t performance comparisons defective including: varying cost e f f i c i e n c i e s such as differences i n age of plant and equipment; differences i n the q u a l i t y of management; differences i n the cost 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, while others may borrow heavily; and the degree of business experience since mature companies w i l l generally have d i f f e r e n t r e s u l t s than start-up companies. 8 5 i b i d . . This over taxation could a r i s e because each country would compare r e s u l t s with independent firms operating i n i t s j u r i s d i c t i o n . 8 6 See section D.) "Consequences of Transfer Price Adjustments" below. 151 i d e n t i f i e d , 8 7 but not remedied. 8 8 For example, the use of uncontrolled comparables for customs valuation purposes i s much more r e s t r i c t e d than for transfer p r i c i n g purposes. This may r e s u l t i n an arm's length comparable used to set transfer prices for income tax purposes while another method i s used for customs valuation purposes. Also, time l i m i t s f o r reappraising value for customs purposes are l i k e l y to expire long before an income tax audit even begins. I f Revenue Canada reduces the tran s f e r p r i c e to the Canadian buyer, a corresponding reduction i n customs value may 8 7 1 9 9 4 Draft, Part I, supra. at 171 - 172; Lorraine Eden, "Free Trade, Tax Reform, and Transfer P r i c i n g " , supra. at 100 -101; Robert F. Lindsay, supra. at 20:14; Donald J.S. Brean, "International Issues i n Taxation", supra. at 105 - 106; G. F. Mathewson and G.D. Quirin, supra. at 15 - 16; and Emilio Romano, supra. at 4 - 5: "The alt e r n a t i v e mechanisms that each system provides for the determination of the relevant p r i c e i n transactions between related parties are d i f f e r e n t i n many respects. Some differences are due to the very nature of the taxable base. An example of t h i s s i t u a t i o n i s the exclusion of the value of any " a s s i s t " provided from the country of importation from the customs value of an imported good. Some other differences could be harmonized, making the customs rules f o r i d e n t i c a l or si m i l a r goods, and the resale and reconstructed value c r i t e r i a , as close as possible to t h e i r corresponding tax methods. The integration of income tax p r i c i n g adjustments with duties and sales taxes i s common i n Mexico where d i r e c t and i n d i r e c t taxes, as well as customs duties, are administered by the same a u t h o r i t i e s . . . The savings and increased e f f i c i e n c y obtained from such structure are complemented by the a b i l i t y to make complimentary adjustments on i n d i r e c t taxes and duties payable by a taxpayer as a consequence of income tax adjustments." 8 8 B.J.Arnold and T.E.McDonnell, supra. at 906, report that the following questions were raised at the I n v i t a t i o n a l Conference on Transfer P r i c i n g for future research during a discussion concerning the GATT rules for determining the value of goods f o r custom purposes: 1. Are there aspects of the GATT rules that could be us e f u l l y adopted for income tax purposes? 2. Should the income tax and GATT rules be coordinated i n some way; and 3. More generally, can trade considerations a s s i s t the development of workable transfer p r i c i n g rules, (emphasis added). 152 not be forthcoming from customs o f f i c i a l s and the MNE could be subject to excess taxation. 8 9 Revenue Canada's p o s i t i o n on t h i s issue i s as follows: 9 0 As a r e s u l t of the integration of both Customs and Taxation into one department coupled with the i n i t i a t i o n of the advance p r i c i n g concept, we have received a number of i n q u i r i e s as to whether or not the department would recognize and accept one "valuation" or "price" for both customs and taxation purposes. There are benefits to be gained by our major importing c l i e n t s (and s i m i l a r l y for those importers i n other countries) from the implementation of such an approach. However. there are many points to consider (for example, domestic l e g i s l a t i v e requirements and international commitments and t r e a t i e s such as the general agreement on t a r i f f s and trade). Because the implications of being able to secure a "one f i g u r e " approach that would s a t i s f y a l l areas are f a r reaching, I do not believe that we w i l l be able to a r r i v e at a "quick and simple answer" to t h i s p a r t i c u l a r issue, (emphasis added) I t i s of i n t e r e s t to note the Agreement on Implementation of A r t i c l e VII (Valuation for Customs Purposes) of the GATT.91 The preamble recognizes the need f o r "a f a i r , uniform and neutral system for the valuation of goods f o r customs purposes that precludes the use of a r b i t r a r y or f i c t i t i o u s values" and which i s "based on simple and equitable c r i t e r i a consistent with commercial practices and valuation procedures". A r t i c l e 7:2(g) s p e c i f i c a l l y 8 9 Robert F. Lindsay, supra. at 20:15. The Canadian Customs Act. R.S.C. 1985 (2nd Supp) , c l , does not currently permit downward adjustments of valuation for customs purposes a f t e r importation where there have been transfer p r i c e adjustments (Norman C. Loveland, supra. at 6 and paragraph 48(5) (c) of the Customs Act). 9 0 Denis Lefebvre, "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 at 6:8. 9 1 BISD (26 Supp.) 116. 153 disallows customs values based on " a r b i t r a r y or f i c t i t i o u s values". 9 2 The fac t that the buyer and s e l l e r are r e l a t e d i s not considered, i n i t s e l f , to be grounds f o r regarding the transaction value to be unacceptable: 9 3 In such case the circumstances surrounding the sale s h a l l be examined and the transaction value s h a l l be accepted provided the r e l a t i o n s h i p d i d not influence the p r i c e . I f . . . the customs administration has grounds f o r considering that the re l a t i o n s h i p influenced the pr i c e , i t s h a l l communicate i t s grounds to the importer and he s h a l l be given a reasonable opportunity to respond. The importer only has to demonstrate that the value " c l o s e l y 9 2 GATT, A n a l y t i c a l Index: Guide to GATT Law and Practice. 6th ed., (1994) at 240. The Agreement on Implementation of A r t i c l e VII of the GATT was signed on A p r i l 12, 1979 and entered into force on January 1, 1981. The text of the Agreement and the Protocol appear at 26S/116. The Agreement sets out f i v e acceptable valuation methods, ranked i n a h i e r a r c h i c a l order: "The primary basis for customs value under the Agreement i s "transaction value" as defined i n A r t i c l e 1: 'the p r i c e a c t u a l l y paid or payable f o r the goods when sold for export to the country of importation', subject to ce r t a i n s p e c i f i e d adjustments (eg. the cost of packaging, and r o y a l t i e s r e l a t e d to the goods being valued that the buyer must pay as a condition of s a l e ) . When the customs values cannot be determined under the provisions of A r t i c l e 1, there should normally be a process of consultation between the customs administration and the importer with a view to a r r i v i n g at a basis of value under A r t i c l e 2 (transaction value of i d e n t i c a l goods) or A r t i c l e 3 (transaction value of s i m i l a r goods). When the customs value cannot be determined on t h i s basis, resort may be made to deductive value ( A r t i c l e 5) or computed value ( A r t i c l e 6), at the choice of the importer. A r t i c l e 7 provides a f a l l - b a c k method: using reasonable means consistent with the p r i n c i p l e s and general provisions of t h i s Agreement and of A r t i c l e VII of the [GATT] and on the basis of data available i n the country of importation." There are a number of other s p e c i f i c a l l y disallowed bases for customs valuation including: (a) the s e l l i n g p r i c e i n the country of importation of goods produced i n such country; (b) a system which provides for the acceptance f o r customs purposes of the higher of two al t e r n a t i v e values; (c) the p r i c e of goods on the domestic market of the country of exportation; and (d) the cost of production other than computed values which have been determined for i d e n t i c a l or s i m i l a r goods i n accordance with the provisions of A r t i c l e 6. 9 3 A r t i c l e 1:2 of the Agreement on Implementation deals with rel a t e d p a r t i e s . 154 approximates" to any one of four enumerated methods, 9 4 and the methods, or " t e s t s " are to be used at the i n i t i a t i v e of the importer and only for purposes of comparison; s u b s t i t u t i v e values may not be established under these provisions. To the extent that i n the future there i s harmonization of valuations for customs and income tax purposes, current prescribed transfer 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 values being substituted for commercial transfer prices may have to be eliminated, revised, or, at a minimum, applied more f l e x i b l y at the option of the MNE, and i n a more r e s t r i c t e d manner for transfer p r i c i n g adjustments at the hands of tax a u t h o r i t i e s , i v . Conclusion The generally accepted methods for determining "the reasonable amount" or arm's length price, do not adequately deal with the economic c h a r a c t e r i s t i c s of a MNE. MNEs e x i s t to avoid the economic r e s t r i c t i o n s of independent dealing, 9 5 yet f o r income tax purposes are e f f e c t i v e l y penalized by Revenue Canada which ignores t h i s economic r e a l i t y and imposes an a r t i f i c i a l , and i n most cases, a r b i t r a r y arm's length p r i c e . I t i s highly u n l i k e l y that unconnected p a r t i e s carry out transactions under exactly the same circumstances as controlled transactions. I f they did, the whole economic r a t i o n a l e f o r a MNE 9 4 The four methods are b a s i c a l l y the exact comparable, inexact comparable, resale minus and cost plus methods. 9 5 J i l l C. Pagan and J . Scott Wilkie, supra, at 227. 155 would be i n doubt. 9 6 Where comparable transactions do e x i s t , a great deal of time and expense i s required to make adjustments to inexact comparables i n order to a r r i v e at an acceptable p r i c e -despite the commercial r e a l i t i e s of the arrangement. MNEs may become preoccupied with 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 using a transfer p r i c i n g methodology that i s commercially i n e f f e c t i v e . 9 7 F i n a l l y , lack of harmonization of acceptable methods by countries may lead to double taxation, lack of consistent a p p l i c a t i o n of acceptable methods may lead to double taxation, and lack of coordination with customs valuations may lead to excess taxation. Overall, the transfer p r i c i n g methods are arguably a r b i t r a r y and uncertain (despite t h e i r systematic approach), require an unreasonable amount of time and e f f o r t to produce and substantiate (by MNEs and taxation a u t h o r i t i e s ) , may be redundant or i r r e l e v a n t fo r customs valuations (depending on how p a r t i c u l a r government auth o r i t i e s apply valuation standards), and can leave a MNE open to possible double taxation. D. What are the e f f e c t s of transfer p r i c i n g adjustments? Because of problems inherent i n valuing intangible property, intangibles are p a r t i c u l a r l y vulnerable to tr a n s f e r p r i c i n g adjustments. 9 8 Research and development ("R&D") a c t i v i t i e s 9 6 i b i d . . at 27. 9 7 i b i d . . at 28. 9 8 The s e n s i t i v i t y to po t e n t i a l tax leakage due to underlying technology transferred abroad i s seen i n the US super-royalty provisions of the 1986 Tax Reform Act (Pub.L. no. 99-514, 100 Stat. 156 conducted i n a high tax country with substantial tax incentives for R&D, followed by l i c e n s i n g of a l l r i g h t s to the technology or product to a company located i n a low tax country with a large tax treaty network, i s a l i k e l y s i t u a t i o n f o r a t r a n s f e r p r i c i n g adjustment dispute. 9 9 Computer software l i c e n s i n g agreements have also been i d e n t i f i e d as being highly vulnerable to the imposition of transfer p r i c i n g adjustments by the tax a u t h o r i t i e s of various countries due to problems inherent i n valuing computer software. 1 0 0 Indeed, one of the major issues faced by both foreign and Canadian developers i n cross-border l i c e n s i n g s i t u a t i o n s i s attacks by the tax a u t h o r i t i e s on the quantum of the royalty set between related p a r t i e s . A further problem arises with the U.S. tr a n s f e r p r i c i n g rules which allow the IRS to make periodic adjustments of predetermined pri c e s of intangible property under agreements f o r more than one year i n order ensure that such prices are "commensurate with the income" earned for the use of such property. Where the income 2058 (1986)) as referred to by Kenneth J . Murray, "Research and Development Cost Sharing Arrangements", Report of Proceedings of the Forty-Third Tax Conference. 1991 Conference Report, (Toronto: Canadian Tax Foundation, 1992) at 46:1 - 46:29, at 46:3. 9 9 For a discussion of transfer p r i c i n g issues s p e c i f i c a l l y r e l a t e d to research and development see J i l l C. Pagan and J . Scott Wilkie, supra. at 113 - 115; Information C i r c u l a r 87-2, supra. paragraphs 34 - 39; B.J. Arnold and T.E. McDonnell, supra. at 909 - 911; and Kenneth J. Murray, "Research and Development Cost Sharing Arrangements", i b i d . . 1 0 0 Kenneth G. Murray, "Computer Software: Canadian and Cross-Border Issues", 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), 27:1 at 27:3. 157 earned or cost savings exceed 20% of the amount estimated at the time the agreement was entered into, the agreed upon p r i c e w i l l be adjusted. 1 0 1 Canada considers t h i s approach to be i n contradiction of the arm's length p r i n c i p l e to the extent that i t involves a yearly retrospective reappraisal of p r o f i t s . 1 0 2 Revenue Canada w i l l not generally provide a corresponding adjustment i n cases where such a periodic adjustment i s made103 with the following conseguences: 1 0 4 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 increase the p r o f i t of one company and do not reduce the p r o f i t of the other company correspondingly, may r e s u l t i n double taxation. As a transfer p r i c i n g adjustment may well be i n excess of what treaty partners of the United States regard as an arm's length amount under t h e i r transfer p r i c i n g r u l e s , even the 1 0 1 Press Release 93-003, supra. 1 0 2 B.J. Arnold and T.E. McDonnell, supra. at 908. Canada's view i s i n l i n e with the OECD. Periodic adjustments are also considered to be tantamount to disregarding the contractual arrangement entered into by the part i e s , though others argue that arm's length parties would not o r d i n a r i l y t r a n s f e r valuable intangibles or would provide for a variable royalty. 1 0 3 Press Release No. 93-003, supra, "Backgrounder". Where t h i s happens, taxpayers may seek r e l i e f through competent authority procedures (see A r t i c l e XXVI and the Canada-U.S. Tax Convention and Information C i r c u l a r 71-17R3, "Requests f o r Competent Authority Consideration - Double Taxation Issues"); The Canadian rules suggest that periodic adjustments not contemplated i n a user contract probably are not consistent with the arm's length t e s t and a functional analysis that depends upon knowledge of a counter-party's p r o f i t s may be inconsistent with the p r i c i n g behaviour of unrelated p a r t i e s ( J i l l C. Pagan and J . Scott Wilkie, supra f at 116) . See also B.J. Arnold and T.E. McDonnell, supra. at 915. Mexico i s also of the view that retrospective adjustments on payments made between associated enterprises f o r the use of intangibles i n order to make them "commensurate with income" should not be applied (see Emilio Romano, supra. at 6 - 7). 1 0 4 Kenneth J . Murray, "Computer Software: Canadian and Cross Border Issues", supra. at 27:31 - 27:32. 158 "corresponding adjustment" provisions i n tax t r e a t i e s may not f u l l y remove the r i s k of double taxation. Therefore, an upward transfer p r i c e adjustment by the IRS w i l l r e s u l t i n double taxation unless Revenue Canada grants a compensating adjustment. The Canada-U.S. Tax Convention provides a measure of protection against double taxation by providing that the other treaty partner s h a l l make a compensating adjustment i f i t agrees with the transfer p r i c i n g adjustment that was made.105 There i s no guarantee that such adjustments w i l l be made and i n cases where large compensating adjustments are requested, there i s l i k e l y to be substantial resistance due to the corresponding loss of tax revenue. 1 0 6 Where these treaty provisions are not s u f f i c i e n t to resolve a dispute between interested p a r t i e s , the taxpayer may request competent authority consideration under the mutual agreement 1 0 5 Canada-U.S. Tax Convention, A r t i c l e IX:3. J i l l C. Pagan and J. Scott Wilkie, supra. at 29; and 39: Tax t r e a t i e s can impact on transfer p r i c i n g i n the following ways: F i r s t , they can define a p a r t i c u l a r basis for a l l o c a t i o n of income and through the treaty network f a c i l i t a t e agreement on an in t e r n a t i o n a l standard. Second, they can i d e n t i f y the transactions to which the basis w i l l apply. Third, they can provide f o r resolution of disputes. F i n a l l y , they can provide a method for mutual assistance between the tax aut h o r i t i e s involved. 1 0 6 i b i d . . at 170. The authors also discuss the importance of considering well i n advance whether a compensating adjustment w i l l l i k e l y be required when involved i n a transfer p r i c i n g dispute (at 181 - 182). For example, i t may be important to avoid having the arm's length p r i c e issue determined by the courts as such determination may severely r e s t r i c t the f l e x i b i l i t y of the tax authority i n that country when seeking compensating adjustments from the foreign tax authority. Limitation periods must also be borne i n mind, however, as i t may be necessary to commence c e r t a i n actions i n order to keep open access to a l l dispute resolution avenues. 159 a r t i c l e . 1 0 7 The mutual agreement procedure requires the competent au t h o r i t i e s , which have broad, discretionary powers, 1 0 8 to consider the case and resolve i t i n a manner that w i l l avoid double ta x a t i o n . 1 0 9 However, the countries are only required to endeavour to reach agreement, i t i s not mandatory that they do so. Even i f an agreement i s reached, i t can take many years to conclude. 1 1 0 F i n a l l y , the taxpayer i s not d i r e c t l y involved i n the discussions between the competent a u t h o r i t i e s , which usually deal with more than one case at a time. Therefore there i s concern that issues a f f e c t i n g one taxpayer may be bargained away i n order to s e t t l e the issues a f f e c t i n g other taxpayers. 1 1 1 Although the competent authority provisions have generally worked well i n the Canada/U.S. context, concerns have arisen over delays i n reaching decisions and i t i s believed that under NAFTA, the number of transactions between members of a MNE w i l l l i k e l y be 1 0 7 Information C i r c u l a r 87-2, supra. paragraph 52. Also see Information C i r c u l a r 71-17R3, supra, f o r a more d e t a i l e d discussion of the procedures and a c c e p t a b i l i t y of requests f o r competent authority consideration. 1 0 8 Emilio Romano, supra. at 8. 1 0 9 See also A r t i c l e XXV of the OECD Model. A r t i c l e 2103 of the NAFTA establishes the p r i o r i t y of b i l a t e r a l tax conventions i n income tax matters generally. For a European perspective on the EEC A r b i t r a t i o n Convention for elimination of double taxation a r i s i n g from transfer p r i c i n g adjustments, see P i l a r Moina Gomez-Arnau, "Spanish Rules on Transfer P r i c i n g " , (Winter, 1995) 21 The International Tax Journal 1, 15 - 30. 1 1 0 J i l l C. Pagan and J . Scott Wilkie, supra. at 183. See also pages 214-218. 1 1 1 B.J. Arnold and T.E. McDonnell, supra, at 916. 160 of such a magnitude as to require changes to the e x i s t i n g 112 regime.' ,<£ Additional concerns a r i s e under the "Exchange of Information" a r t i c l e s between contracting p a r t i e s . 1 1 3 The tax a u t h o r i t i e s have access to c o n f i d e n t i a l information which could be of i n t e r e s t to a taxpayer's commercial r i v a l s . Yet, i n most cases the taxpayer has no r i g h t to be advised i n advance of an exchange of that information and i s open to the r i s k that the tax a u t h o r i t i e s w i l l d i s c l o s e commercially s e n s i t i v e information. 1 1 4 Furthermore, when Revenue Canada bases i t s assessment of arm's length p r i c e s on information obtained from t h i r d p a r t i e s , i t i s u n l i k e l y that the taxpayer w i l l have access to that c o n f i d e n t i a l information u n t i l l e g a l proceedings have commenced.115 In conclusion, transfer p r i c i n g adjustments lead to a very r e a l r i s k of double taxation which the e x i s t i n g dispute settlement 1 1 2 See Norman C. Loveland, supra. at 5 - 6; and J i l l C. Pagan and J. Scott Wilkie, supra. at 26 regarding tax a u t h o r i t i e s generally devoting more time and resources to dealing with transfer p r i c i n g i n q u i r i e s . 1 1 3 A r t i c l e XXVII of the Canada-U.S. Tax Convention. 1 1 4 J i l l C. Pagan and F. Scott Wilkie, supra. at 19; Germany i s one of the few countries which provides that the taxpayer has a r i g h t to be advised i n advance of an exchange of such information. The authors review i n t e r n a t i o n a l pressures and developments regarding exchange of information (at 20). 1 1 5 Revenue Canada w i l l seek written permission from the t h i r d p a r t i e s to d i s c l o s e the information to the taxpayer involved, but i f permission i s not granted, disclosure i s prohibited under section 241(1) of the ITA u n t i l l e g a l proceedings wave commenced (Information C i r c u l a r 87-2, supra, paragraph 48). Also see Amp of Canada. Ltd. v. Her Majesty the Queen, 87 DTC 5157 (FCTD) and Crestbrook Forest Industries Limited v. Her Majesty the Queen. 91 DTC 5521 (FCTD), 92 DTC 6187 (FCA). 161 procedures may not a l l e v i a t e . Further, MNEs have to contend with r i s k of d i s c l o s i n g t h e i r own c o n f i d e n t i a l information to support t h e i r transfer p r i c e while having r e s t r i c t e d access to c o n f i d e n t i a l information i n the tax authority's hands. E. Compliance and Prevention This section b r i e f l y reviews the main compliance requirements and preventative measures that a r i s e i n a cross-border transfer p r i c i n g s i t u a t i o n , i . Compliance There are two aspects to compliance: a) the reporting requirements placed on the taxpayer and corresponding a b i l i t y of the taxpayer to be able to obtain the necessary reporting information; and b) penalties for non-compliance or under-reporting of income. 1 1 6 Form T106, "Corporate Information Return of Non-arm's Length Transactions with Non-resident Persons", requires c e r t a i n basic information be f i l e d for reporting non-arm's length a c t i v i t i e s between Canadian corporation taxpayers and non-resident persons. 1 1 7 The form i s required whenever a Canadian corporate 1 1 6 J i l l C. Pagan and J. Scott Wilkie, supra at 67. See 1994 Draft, Part I I , supra, at paragraphs 124 - 144 regarding examination practices, burden of proof and penalties. See B.J.Arnold and T.E. McDonnell, supra. at 914 and William J. Strain, "The Long Arm of the United States Law", Report of Proceedings of the Forty-Third Tax Conference. 1991 Conference Report (Toronto: Canadian Tax Foundation, 1992) at 8:35, regarding the US rules requiring contemporaneous documentation and penalties for non-compliance. 1 1 7 The form i s required to be f i l e d pursuant to section 233.1 of the ITA. See B.J.Arnold and T.E. McDonnell, i b i d . . at 913-914 for a discussion on information requirements for tr a n s f e r p r i c i n g 162 taxpayer has any non-arm's length transactions with a non-resident person. 1 1 8 The form must be f i l e d within s i x months from the end of each taxation year, separate from the corporation income tax return. A separate T106 must be f i l e d f o r each non-resident person with which the reporting corporation engaged i n non-arm's length transaction during i t s taxation year. Although the form i s not p a r t i c u l a r l y onerous, i t does impose a burden which i s not required i n a s i m i l a r domestic s i t u a t i o n , 1 1 9 and which gives Revenue Canada a useful t o o l i n i d e n t i f y i n g p o t e n t i a l audit areas. There are penalties for f a i l u r e to f i l e the T106 form. 1 2 0 In addition to the penalties f o r f a i l u r e to f i l e an information return, 1 2 1 every corporation that f a i l s to f i l e , and does not comply with a demand to f i l e within 90 days a f t e r the demand was served, i s l i a b l e f o r a penalty of $1,000 fo r each month or part of cases. 1 1 8 Including transactions for which there was a non-monetary or n i l consideration. 1 1 9 Companies are also encouraged to contemporaneously document the basis for s e l e c t i n g a transfer p r i c i n g method and the steps taken i n e s t a b l i s h i n g a p r i c e . (Press Release 93-003, supra. "Backgrounder"). See also B.J. Arnold and T.E. McDonnell, supra, at 914 for a discussion of various "unreasonable" and "unproductive" reporting requirements including contemporaneous documentation and p r e - f i l i n g of additional transfer p r i c i n g information at the audit l e v e l ; and 1994 Draft, Part I I , supra. Chapter VIII regarding problems with and guidelines for documentation requirements. 1 2 0 Subsection 162(10). 1 2 1 Under subsection 162(7), a taxpayer i s l i a b l e f o r a penalty equal to the greater of $100 or $25 m u l t i p l i e d by the number of days (not exceeding 100), during which the f a i l u r e continues, for f a i l u r e to f i l e an information return. The penalty applies i n respect of each f a i l u r e , so i f multiple forms are required, the penalty applies to each form which was not f i l e d . 163 a month, not exceeding 24 months, during which the f a i l u r e continues. This penalty has no a p p l i c a t i o n other than i n the cross-border context. Penalties may also be e x i g i b l e r e l a t i n g to u n d e r - f i l i n g of taxable income. 1 2 2 Although such penalties also apply i n a purely domestic context, the MNE i s at a disadvantage due to a p p l i c a t i o n of the arm's length standard. Since the "reasonable amount" i s a matter of opinion, i t i s questionable whether a taxpayer should be l i a b l e for penalties i f an increase i n taxable income i s the r e s u l t of an adjustment even though the o r i g i n a l p r i c e could reasonably be argued to be at arm's length. The a p p l i c a t i o n of t r a n s f e r p r i c i n g penalties may produce an incentive to overstate income i n the j u r i s d i c t i o n levying the penalty causing d i s t o r t i o n s i n what may otherwise be an appropriate transfer p r i c e . 1 2 3 These concerns do not a r i s e i n the domestic context. Interest charges may apply to any a d d i t i o n a l taxes l e v i e d as the r e s u l t of a transfer p r i c i n g adjustment. This i s problematic i n that the taxpayer has not necessarily had the use of the money for the period that i n t e r e s t i s being charged; rather another tax authority has had use of the money. Even assuming a corresponding 1 2 2 Subsection 163(2) applies to f a l s e statements or omissions. See also J i l l C. Pagan and J. Scott Wilkie, supra. at 71. 1 2 3 See Norman C. Loveland, supra, at 4; U.S. t r a n s f e r p r i c i n g penalties which create an incentive to overstate U.S. income and understate Canadian income (also 1994 Draft, Part I I , supra, at paragraph 141). See Carlton M. Smith, "New US Transfer P r i c i n g Penalty Regulations Require Contemporaneous Documentation of P r i c i n g Decisions" (1994), 42 Canadian Tax Journal 4, 1136, for further information on US penalty regulations. 164 adjustment w i l l eventually be agreed upon, a MNE may be penalized by a lack of symmetry i n in t e r e s t provisions between the two tax auth o r i t i e s concerned. 1 2 4 i i . Prevention Revenue Canada has set out the following guidelines to avoid transfer p r i c i n g problems with the Department: 1 2 5 10. To the extent possible, taxpayers are encourage to design t h e i r intercompany p r i c i n g so that, f o r example, a product i s transferred at a reasonable arm's length p r i c e f o r the product i t s e l f , and i f there are also benefits or services being transferred, as i s common i n the operations of a multinational group, each i s i d e n t i f i e d as a separate t r a n s f e r and i s subject to a separate evaluation and intercompany charge. A separate i d e n t i f i c a t i o n and valuation of the various products and services w i l l not only f a c i l i t a t e the audit of international transactions but w i l l also, where an income tax treaty or convention i s i n force, a s s i s t the treaty partners i n t h e i r negotiations to avoid double taxation. 11. I f the above approach i s not p r a c t i c a l or proves u n r e a l i s t i c i n terms of the manner i n which the p a r t i c u l a r industry conducts i t s business, then the taxpayer should be prepared to provide. i n a comprehensive statement of intercompany p r i c i n g p o l i c y , the basis on which transfer prices are established worldwide. Such a statement should be based on a thorough functional analysis of the a c t i v i t i e s and contributions of each group member, and should c l a r i f y and quantify the various factors which were considered i n establishing the transfer prices, e.g. techn i c a l assistance, access to technology, reward for economic r i s k , financing, etc. (emphasis added) Section 15(53)9.5(1) of the Revenue Canada Operations Manual also indicates the importance of a p r i c i n g plan and the burden on 1 2 4 See J i l l C. Pagan and J. Scott Wilkie, supra. at 72 - 73. The authors note that the basis f o r charging i n t e r e s t i n the f i r s t place i s that the taxpayer has had the use of the money for the extra period and i t i s not unreasonable to expect the tax authority to be compensated i n the form of i n t e r e s t . 1 2 5 Information C i r c u l a r 87-2, supra. 165 the tax authority to also provide d e t a i l e d documentation: 1 2 6 The taxpayer i s usually considered expert i n h i s own business. He need only e s t a b l i s h a prima f a c i e case that the intercompany p r i c i n g arrangements are reasonable and the onus then f a l l s on the Minister to prove otherwise. Therefore, any adjustments of intercompany prices must be very well documents, researched and supported by evidence, (emphasis added) Therefore, the key to prevention appears to be i n well supported, extensive documentation of tr a n s f e r p r i c i n g methods which i s resource intensive and expensive, e s p e c i a l l y f o r large MNEs,127 and for taxation a u t h o r i t i e s . Another way to prevent transfer p r i c i n g disputes i s through the advance p r i c i n g agreement ("APA"). An APA i s an advance binding agreement between a company and the government of Canada 1 2 8 on the a c c e p t a b i l i t y of the p r i c i n g methodology to be used by the company.129 The purpose of t h i s type of advance r u l i n g has been described as an opportunity f o r the taxpayer to convince the tax authority that i t s commercial p r i c i n g p o l i c y i s s e n s i t i v e to f a i r income a l l o c a t i o n among the countries concerned and i s not a 1 2 6 As reproduced i n J i l l C. Pagan and J . Scott Wilkie, supra. at 84 - 85. 1 2 7 i b i d . . at 18. 1 2 8 And perhaps between the governments of one or more other countries. 1 2 9 Press Release 93-003, supra. "Backgrounder"; and Draft Information C i r c u l a r . "International Transfer P r i c i n g : Advance P r i c i n g Agreements (APA) Procedures and Guidelines", May 21, 1993 ("Draft Information C i r c u l a r " ) ; see 1994 Draft, Part I I , supra. paragraphs 2 34 - 276 regarding APAs, t h e i r advantages and disadvantages and the o v e r a l l conclusion that i t i s too early to make a f i n a l recommendation on whether the use of APAs should be expanded (at paragraph 272). 166 candidate for an adjustment under the 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 . 1 3 0 APAs are also r e s t r i c t e d to future s p e c i f i e d non-arm's length transactions f o r a s p e c i f i e d period of time. Revenue Canada announced the APA program on July 29, 1993 1 3 1 and began consulting on d r a f t g u i d e l i n e s . 1 3 2 Key differences 1 3 0 J i l l C. Pagan and J . Scott Wilkie, supra. at 206. The purpose i s not to s t r i k e a "deal" on p r i c i n g p o l i c y . Draft Information C i r c u l a r , supra. states the purpose of APAs: "to promoted voluntary compliance, uniformity and self-assessment by providing taxpayers with s p e c i f i c guidelines on how transfer p r i c i n g methods are to be determined and applied." 1 3 1 Revenue Canada, Customs, Excise and Taxation, Press Release 93-21. "Revenue Canada I n i t i a t e s Advance P r i c i n g Agreement Service", July 29, 1993. See also Carole Gouin-Toussaint, "Revenue Canada: Exposure Draft Procedures and Guidelines f o r Advance P r i c i n g Agreements", i n "Tax Planning f o r Canada-US and International Transactions", Corporate Management Tax Conference. 1993 (Toronto, Canadian Tax Foundation, 1994) at 6:1 - 6:8. The United States APA service was announced by the IRS i n 1991 (Revenue Procedure 91-22). For a discussion of the U.S. APA process see P h i l i p J . Bergquist, "Experience with Advance P r i c i n g Agreements", in "Tax Planning for Canada-US and International Transactions", Corporate Management Tax Conference. 1993 (Toronto, Canadian Tax Foundation, 1994) at 5:1 - 5:29. For a thorough review of the United States APA process, including Revenue Canada's response and recommendations for change, see Janice A. McCart, "Advance P r i c i n g Agreements: The Answer to I n t e r a f f i l i a t e P r i c i n g Disputes?", Report of Proceedings of the Forty-Third Tax Conference. 1990 Conference Report, (Toronto, Canadian Tax Foundation, 1992) 40:1 -40:38; also see W. Gordon Williamson, supra. at 57 - 66; Carlton M. Smith, "United States Adopts Procedures f o r Reaching Advance Agreement Concerning Appropriate Intercompany Transfer Prices", (1991) 39 Canadian Tax Journal 6, 1622 - 1633. For an overview of the process i n the U.S., Canada, A u s t r a l i a , Japan, France, Germany, I t a l y , The Netherlands and the United Kingdom, see Nathan Boidman, "The Role of Advance Rulings i n International Transfer P r i c i n g " , (1991) 39 Canadian Tax Journal 6, 1563 - 1575. 1 3 2 See Denis Lefebvre, supra. at 6:7 - 6:8. See also J i l l C. Pagan and J . Scott Wilkie, supra. at 198 - 205 f o r general procedures on obtaining and administering APAs; and Kathleen Matthews, "U.S. and Canadian O f f i c i a l s Discuss APAs i n the Global Trading Context", Tax Notes International. May 23, 1994, 1362 f o r general comments on APAs. I t i s of i n t e r e s t to note that, with reference to Chapter 4, the issue of characterization of software 167 between the APA procedure and the normal tra n s f e r p r i c i n g audit include: 1 3 3 ... the abandonment of adversarial attitudes, a r e l i a n c e on the veracity of material submitted, and the need to consider future events and projections as well as h i s t o r i c a l data. Our experience during the p i l o t project cases was one of consultation and cooperation among a l l p a r t i e s , including taxpayers, national and d i s t r i c t tax representatives, l e g a l counsel, and the competent a u t h o r i t i e s . According to Revenue Canada, the Department i s committed to the APA concept and has received favourable feedback and a high l e v e l of i n t e r e s t from c l i e n t s ; the Department antici p a t e s that the l e v e l of requests f o r b i l a t e r a l and m u l t i l a t e r a l APA's " w i l l surpass our i n i t i a l expectations". 1 3 4 There are a number of possible advantages i n using the APA procedure. APAs can p o t e n t i a l l y l i m i t c o s t l y and time consuming transfer p r i c i n g disputes, double taxation, and penalties, when MNEs address these p r i c i n g p o l i c y issues i n advance of the transactions. Even i f a transfer p r i c i n g dispute does not a r i s e , as either a sale or licence has been presented as an issue i n an APA to the Internal Revenue Service (Kathleen Matthews, i b i d . . at 1363). 1 3 3 Denis Lefebvre, i b i d , at 6:8. For a d e s c r i p t i o n of the APA process i n Canada, r e f e r to Draft Information C i r c u l a r , supra. 1 3 4 Denis Lefebvre, i b i d . . at 6:8. There were o r i g i n a l l y two p i l o t cases and by l a t e 1993 Revenue Canada was a c t i v e l y pursuing 7 cases covering a wide range of industries from computer d i s t r i b u t i o n to f i n a n c i a l i n s t i t u t i o n s . As of August, 1994 there were 16 Canadian APAs i n process, 15 involving the United States (see John Turro, "U.S. Tax O f f i c i a l s B r i e f ABA Tax Section's International Committees", Tax Notes International. May 23, 1994 at 1366 and Norman C. Loveland, supra. at 7). As of August, 1994, Mexico had received 8 u n i l a t e r a l APA requests, several of which are anticipated to become b i l a t e r a l when f i n a l i z e d (Emilio Romano, supra. at 6). 168 any audit by Revenue Canada would l i k e l y be s i m p l i f i e d . Further, a measure of cert a i n t y i s achieved regarding the MNEs transfer p r i c i n g method, which should f a c i l i t a t e business planning. However, there are several problems with APAs. 1 3 5 APAs are not always p r a c t i c a l f o r transactions with a short-term commercial l i f e , or for companies which do not have the time or resources to compile and negotiate and APA. Disclosure of information that would not normally be disclosed could be problematic i n cases of controversial or aggressive p r i c i n g structures i n the transaction under review, previous transactions 1 3 6, or transactions with an 1 3 5 See Norman c. Loveland, i b i d . . at 7; J i l l C. Pagan and J. Scott Wilkie, supra. at 205 - 206 for the following suggestions as to when an app l i c a t i o n for an APA may not be i n the taxpayers best i n t e r e s t s : 1. a taxpayer has an exceptionally strong case that the p r i c i n g p o l i c y meets the arm's length c r i t e r i a ( i n which case i t i s un l i k e l y to be c o s t - e f f e c t i v e to use the APA procedure); 2 a low or no-tax country i s involved (as the home tax authority may not be e a s i l y s a t i s f i e d ) ; 3. the transactions and p r i c i n g structure are extremely complex and of short to medium term duration; 4. the tax authority has i n s u f f i c i e n t resources to process the ap p l i c a t i o n within a reasonable period of time; 5. the taxpayer i s pursuing a tax aggressive p r i c i n g p o l i c y ; and 6. the transaction i s one of a cer t a i n kind which i s currently being l i t i g a t e d i n another case. On the other hand, an APA may be appropriate i n the following cases: 1. a taxpayer has a good, but not indisputable, case that i t s p r i c i n g p o l i c y should be acceptable; 2. the transactions involve two countries which take an aggressive stance on transfer p r i c i n g and competent authority proceedings could be expected to be insti g a t e d ; 3. the transactions are extremely integrated and incapable of easy a l l o c a t i o n on a country-source basis of p r o f i t apportionment; 4. the transactions have a long-term l i f e ; and 5. certainty of taxation implications i s of p a r t i c u l a r importance. 1 3 6 Carole Gouin, Director General , International Tax Programs Directorate, i n an address to the ABA Tax Section, conceded that the concern f o r most corporations considering entering into an APA regarding the opening of books for p r i o r years was v a l i d . She noted that Canadian auditors responsible for a company's f i l e are part of the APA team and "won't close t h e i r eyes" and issue a blank check governing p r i o r years (as reported i n John Turro, "U.S. Tax O f f i c i a l s B r i e f ABA", supra. at 1367). Also, several l e v e l s of 169 otherwise high degree of c o n f i d e n t i a l i t y . As Revenue Canada can only process a l i m i t e d number of APAs i n a given time period, there i s no guarantee an APA w i l l be reached even i f the MNE has a transaction which i s a suitable candidate f o r an APA. I f APA negotiations do proceed but are abandoned or unsuccessful, the taxpayer w i l l have expended substantial resources 1 3 7 and p o t e n t i a l l y compromised i t s p o s i t i o n i n any l i t i g a t i o n that may r e s u l t 1 3 8 . Further, i f the APA i s accepted, onerous annual reports must be f i l e d , yet the taxpayer i s s t i l l open to being audited, and Revenue Canada may cancel an APA at any time and disclosure may ensue ( i e . Revenue Canada, foreign tax a u t h o r i t i e s , and foreign tax a u t h o r i t i e s to foreign tax payers, t h e i r treaty partners and the p u b l i c ) , as well as disclosure to Revenue Canada of issues that may never have arisen i n the course of a normal audit and to foreign tax a u t h o r i t i e s of issues that may never have arisen i n the course of a normal foreign audit (see Janice A. McCart, supra. 40:29). 1 3 7 The taxpayer w i l l have to spend considerable i n t e r n a l resources i n order to compile the information required f o r an APA. Further Revenue Canada w i l l levy a user charge fo r each APA request or renewal and the taxpayer i s required to absorb the cost of independent experts. See Draft Information C i r c u l a r , supra. See also Nathan Boidman, "The Role of Advance Rulings i n International Transfer P r i c i n g " , supra. at 1564; and "Foreign Income, s.482 -Special Problems", v. 116 Tax Management Inc.. Dec. 16, 1991 (Washington D.C.: BNA, 1991), at 64 - 116, which discusses the United States APA process and s u b s t a n t i a l l y s i m i l a r problems to those outlined here, but i n the U.S. context. 1 3 8 The taxpayer i s required to provide a d e t a i l e d explanation and analysis of each proposed transfer p r i c i n g method including extensive and d e t a i l e d information about the applicant (history, organizational structure, nature and scope of operations, transaction flows, relevant f i n a n c i a l and tax data). In addition, information used to e s t a b l i s h the transfer p r i c i n g methodology has to be submitted including functional analyses, p r o f i t a b i l i t y measurements, economic studies, general industry trends, and a v a i l a b l e information on competitors and comparable or s i m i l a r businesses (Draft Information C i r c u l a r , i b i d . ) . 170 r e t r o a c t i v e l y under c e r t a i n conditions. 1 3 9 I t i s also worthwhile to consider the ramifications of the p o s s i b i l i t y that Revenue Canada's view w i l l have s i g n i f i c a n t influence i n commercial p r i c i n g decisions; APAs may recognize or ignore the existence and legitimacy of transfer p r i c i n g rules i n reaching a p a r t i c u l a r p r i c i n g agreement. Clearly, APAs should not be viewed as a substitute for developing a sound transfer p r i c i n g system. 1 4 0 i i i . Conclusion Advance p r i c i n g agreements, compliance measures (recommended and required) , penalties, and i n t e r e s t add up to a system which encourages MNEs to address p o t e n t i a l transfer p r i c i n g transactions well i n advance of, or contemporaneous with, the time the transactions are undertaken. Although t h i s regime may have b e n e f i c i a l e f f e c t s from an i n t e r n a l accounting and corporate management perspective, such compliance and prevention measures require an extensive amount of complex documentation. Experts may 1 3 9 Draft Information C i r c u l a r , i b i d . Annual reports must describe actual operations for the year and demonstrate the extent of compliance with the terms and conditions of the APA. Audits w i l l not reevaluate the transfer p r i c i n g method i t s e l f , but focus on est a b l i s h i n g i f taxpayers have complied with the terms and conditions of the APA, and the r e l i a b i l i t y and accuracy of the representations i n the APA and annual reports. They w i l l also t e s t the accuracy and consistency of how the transfer p r i c i n g method i s applied along with the supporting data, and the continuing relevance and soundness of c r i t i c a l assumptions. An APA can be cancelled i f , for example, there i s fraud or misrepresentation i n providing information during the APA process, or i f the taxpayer f a i l s to comply with the terms and conditions of the APA. 1 4 0 See J i l l C. Pagan and J. Scott Wilkie, supra. at 185 - 187. The authors also set out examples of actual APAs at 187 - 193. The 1994 Draft, Part II, supra. sets out a number of additional p o t e n t i a l problems with APAs at paragraphs 258 - 270, including problems from the tax authority's perspective. 171 be required to a s s i s t i n preparing t h i s information, and i t can be problematic obtaining the necessary comparable data. Time and resources that could otherwise be spent on business operations are incurred by MNEs to s a t i s f y the tax a u t h o r i t i e s even when the MNE has not been motivated by tax avoidance considerations. 1 4 1 GATT A r t i c l e VIII, "Fees and Formalities Connected With Importation and Exportation", recognizes the need fo r minimizing the incidence and complexity of import and export f o r m a l i t i e s and for decreasing and simplifying import and export documentation requirements. Although t h i s A r t i c l e may be viewed as applying only to customs f o r m a l i t i e s , i t does recognize that documents and documentation can pose a p o t e n t i a l b a r r i e r to trade. I t i s suggested that the transfer p r i c i n g documentation requirements outlined above may well be a s i g n i f i c a n t b a r r i e r to i n t r a - f i r m trade i n many cases. PART III JUSTIFICATION FOR DISCRIMINATION AND ALTERNATIVES A. Summary of Discrimination of the Transfer P r i c i n g Regime The very nature of transfer p r i c i n g , rooted as i t i s i n a n t i -avoidance, has developed i n such a way as to bias the e x i s t i n g regime against MNEs and i n favour of the tax a u t h o r i t i e s . The following i s a b r i e f summary of such discrimination as i d e n t i f i e d 1 4 1 1994 Draft, Part I, supra, at 157: "In the case of MNEs, the need to comply with laws and administrative requirements that may d i f f e r from country to country creates a d d i t i o n a l problems. The d i f f e r i n g requirements may lead to a greater burden on an MNE, and r e s u l t i n higher costs of compliance, than for a s i m i l a r enterprise operating s o l e l y within i n single j u r i s d i c t i o n . " 172 above: 1. The ITA rules prima f a c i e discriminate against MNEs by applying d i f f e r e n t l y to nonresident-resident transactions than to resident-resident transactions. 2. International transfer p r i c i n g r u l e s apply to a wider range of transactions than s i m i l a r domestic r u l e s . 3. The ITA rules are drafted i n such a way that the only transactions p o t e n t i a l l y affected are those where tr a n s f e r p r i c i n g adjustments lead to an increase i n the domestic tax base. 4. The arm's length p r i n c i p l e , which underlies the transfer p r i c i n g regime, ignores the very essence of MNEs by t r e a t i n g each member as an independent e n t i t y . 5. Use of the prescribed transactional methods (comparable uncontrolled p r i c e / royalty, resale minus, and cost plus) are often not applicable or achievable, and can produce a r b i t r a r y r e s u l t s . 1 4 2 This i s p a r t i c u l a r l y problematic f o r intangibles. 6. Lack of coordination between transfer p r i c e s and customs valuations can r e s u l t i n d i f f e r e n t valuations f o r d i f f e r e n t purposes which i s i l l o g i c a l and unfair as i t can r e s u l t i n duplication of work, a r b i t r a r y values, excess taxation, and uncertainty for the taxpayer. 7. The compensating adjustment procedures do not go f a r enough i n preventing double taxation which can create an impediment 1 4 2 Donald J.S. Brean, "Financial Dimensions of Transfer P r i c i n g " , i n A. Rugman and L. Eden, eds., supra. at 149. 173 to cross-border transactions. 1 4 3 8. Compliance requirements, advance p r i c i n g agreements, penalties and i n t e r e s t impose tremendous burdens on time, information systems, experts, and compliance costs on both the taxpayer and tax authority. B. J u s t i f i a b l e Discrimination? Even i f transfer p r i c i n g rules discriminate against non-residents, any such discrimination may be j u s t i f i a b l e i f the transfer p r i c i n g rules are r a t i o n a l l y connected to a national objective and that national objective outweighs the global objective of free trade. I t i s submitted that although the transfer p r i c i n g rules are c l e a r l y connected with the national objective of maintaining the domestic tax base, there i s some doubt as to whether t h i s goal can be said to outweigh the objective of f a c i l i t a t i n g free trade, p a r t i c u l a r l y when Canada continues to expand i t s international free trade commitments. I t i s worthwhile to r e c a l l from Chapter 1 the two premises on which free trade i s based: 1. the most e f f i c i e n t use of resources w i l l be achieved i f trade i s free of a r b i t r a r y interventions by in d i v i d u a l governments (the free trade o b j e c t i v e ) ; and 2. the preservation of sovereign r i g h t s i s e s s e n t i a l f o r increasing the welfare of the c i t i z e n s of the nations concerned (the national 1994 Draft, Part I, supra. at 157. 174 o b j e c t i v e ) 1 4 4 . In t h i s case, MNEs seek to a l l o c a t e resources e f f i c i e n t l y , and set transfer prices accordingly, without a r b i t r a r y intervention by l e g i s l a t i o n including transfer p r i c i n g l e g i s l a t i o n . On the other hand, the main objective of the tran s f e r p r i c i n g regime i s to secure the domestic tax base by ensuring that MNEs are not able to manipulate transfer prices i n order to s h i f t taxable p r o f i t s out of Canada. In face of Canada's mounting national debt, the importance of maintaining Canada's tax base i s self-evident. However, the objectives of maintaining domestic tax bases and of promoting free trade do not necessarily c o n f l i c t . Presumably businesses which t h r i v e under a free trade regime w i l l have increased p r o f i t s which w i l l increase the tax base. MNEs which operate p r o f i t a b l y i n Canada, create jobs and stimulate the domestic economy, thereby creating a d d i t i o n a l tax revenues from a number of sources i n addition to tax revenues from the MNE i t s e l f . Transfer p r i c i n g l e g i s l a t i o n may have the unintended e f f e c t of ultimately reducing the tax base i f MNEs p u l l operations out of, or do not es t a b l i s h operations i n , Canada. Furthermore, i f the costs of administering and enforcing transfer p r i c i n g l e g i s l a t i o n outweigh the tax revenues preserved, the l e g i s l a t i o n does not promote either objective. Consider the following: 1 4 5 1 4 4 The sovereign r i g h t under review i s the legitimate r i g h t of the government of Canada to tax the p r o f i t s of a taxpayer based upon income and expense that can reasonably be considered to a r i s e within Canada. See the 1994 Draft, Part I, supra. at 157. 1 4 5 J i l l C. Pagan and J. Scott Wilkie, supra. at 31. 175 If one powerful country i n the world economy decides to go i t alone and investigate every cross-border transaction of MNEs within i t s tax j u r i s d i c t i o n , then a l l the other countries would be forced to apply t h e i r transfer p r i c i n g provision with equal force; f a i l u r e to do so would r e s u l t i n a loss of t h e i r f a i r share of taxation on a l l cross-border transactions involving that country. However, r e c i p r o c i t y [stepping up the appl i c a t i o n of transfer p r i c i n g when an e n t i t y i n the aggressor country i s involved] cannot be a large-scale or long-term international solution. I t would mean discrimination against a l l MNEs with operations i n the country which applied the aggressive stance. Not only i s discrimination i n d i r e c t contravention of the tenet that a taxation system must be operated even-handedly, but i t could also be against the national i n t e r e s t of those countries which encourage foreign investment. ... i n the f i n a l analysis a highly aggressive approach i s un l i k e l y to be i n any country's i n t e r e s t . Compliance costs could well exceed the marginal tax revenue and there could be a consequential e f f e c t i n l i m i t i n g benefit from the global economy. MNEs i n general might be i n c l i n e d to concentrate investment i n countries without an aggressive enforcement p o l i c y and MNEs based i n the aggressor country would be at a competitive disadvantage i n world markets because of harsher tax treatment, (emphasis added) I t has also been suggested that preservation of the tax base through transfer p r i c i n g l e g i s l a t i o n (the national objective) may not be economically e f f i c i e n t (the free trade o b j e c t i v e ) : 1 4 6 The MNE i t s e l f regards in t e r n a t i o n a l tax rate d i f f e r e n t i a l s and exchange controls imposed by nation states as exogenous market imperfections to which transfer p r i c i n g i s a legitimate i n t e r n a l response. On the other hand, nation states view the power to manipulate transfer prices as a method of evading l e g a l obligations, thus eroding national sovereignty. I t i s clear that most of the contributors to t h i s volume would 1 4 6 A. Rugman and L. Eden, eds., supra. at 9 - 10 also note, however, that some authors are of the opinion that without int e r n a t i o n a l harmonization of government tax, commercial and regulatory p o l i c i e s , regulation of transfer p r i c i n g i s necessary on e f f i c i e n c y grounds. The various studies presented, demonstrate that unregulated transfer prices may be eithe r more or less e f f i c i e n t than regulated ones. Even though a c l e a r e f f i c i e n c y r a t i o n a l e does not ex i s t , some contributors view tra n s f e r p r i c i n g regulation to be necessary on d i s t r i b u t i o n a l grounds. 176 agree that, i n the presence of natural market imperfections but i n the absence of government induced market imperfections, t r a n s f e r p r i c i n g i s e f f i c i e n t , and therefore regulation, on e f f i c i e n c y grounds, i s unnecessary. Therefore, i t i s reasonable to conclude that the p r o t e c t i o n i s t national objective does not, and should not, outweigh the free trade objective. C. Alternatives Even i f the transfer p r i c i n g rules are r a t i o n a l l y connected to the national objective, and i f the need to preserve the tax base does outweigh that of f a c i l i t a t i n g free trade f o r MNEs, there are alte r n a t i v e s to enable Canada to achieve the national objective, while a l l e v i a t i n g some of the discriminatory aspects of the transfer p r i c i n g regime and f a c i l i t a t i n g MNE operations i n the global economy. The focus i n t h i s section i s on the general nature of transfer p r i c i n g and on points 4 through 8 summarized above. The following b r i e f comments apply to points 1 through 3. F i r s t , although the ITA provisions prima f a c i e discriminate against MNEs, the provisions are not i n v i o l a t i o n of A r t i c l e 24:5 of the OECD Model ("Nondiscrimination") since that provision i s subject to s p e c i f i c exceptions for transactions between related p a r t i e s . 1 4 7 The existence of a provision which d i f f e r e n t i a t e s 1 4 7 Canada has reserved i t s p o s i t i o n on A r t i c l e 24 i n any event, (see OECD Model, A r t i c l e 24 Commentary, paragraph 61) . There i s s i m i l a r l y no breach of A r t i c l e XXV:7 of the Canada-US Tax Convention. The Canada-U.S. Tax Convention i s the only Canadian tax treaty that contains a provision comparable to OECD a r t i c l e 24(5); o r d i n a r i l y t r e a t i e s expressly recognize t r a n s f e r p r i c i n g by related pa r t i e s as an exception to the non-discrimination a r t i c l e (B.J. Arnold, "Tax Discrimination Against Aliens, Non-residents, and 177 between residents and non-residents i s not necessarily overly p r o t e c t i o n i s t ; i t i s the app l i c a t i o n of the provision which can be problematic. On the second point, the fac t that the int e r n a t i o n a l transfer p r i c i n g rules apply to a wider range of transactions than s i m i l a r domestic provisions can also be j u s t i f i e d to the extent that domestic transactions are taxed under other provisions i n the ITA. F i n a l l y , i s the fa c t that the only transactions which are p o t e n t i a l l y affected are those where transfer p r i c i n g adjustments increase the domestic tax base. This discrimination can be j u s t i f i e d i n that there i s l i t t l e r e a l r i s k of MNEs being penalized by adjustments which increase p r o f i t s i n Canada, without obtaining adjustments i n i t i a t e d by the Canadian tax au t h o r i t i e s to reduce p r o f i t s i n Canada. This i s l i k e l y to be the case due to the inte r e s t s of other j u r i s d i c t i o n s i n maintaining t h e i r tax bases, and seeking transfer p r i c i n g adjustments which would decrease p r o f i t s i n Canada, i f a compensating adjustment was permitted. 1 4 8 On the other hand there are several suggestions f o r other aspects of the transfer p r i c i n g regime which may benefit both MNEs and tax au t h o r i t i e s . Fundamentally there i s need to reach i n t e r n a t i o n a l agreement on the r o l e of transfer p r i c i n g i n the global economy. Tax Foreign A c t i v i t i e s " , supra at 75 and 105). Also, to the extent that MNEs are exposed to transfer p r i c e discrimination, perhaps i t i s reasonable to expect that t h i s i s part of the normal cost of doing business i n the global market place. 1 4 8 The problem which remains, however, i s when these compensating adjustments are not forthcoming. The compensating adjustment mechanism i s discussed below. 178 avoidance i s not always at the centre of MNE p r i c i n g p o l i c i e s and transfer p r i c i n g must lose i t s tax avoidance t a i n t i t i f i s to mature successfully and r e l a t e to a global economy.149 This s h i f t to a global focus from a national focus i s key to developing a transfer p r i c i n g framework which r e f l e c t s global commercial r e a l i t i e s . 1 5 0 A broader meaning of arm's length could a l l e v i a t e some of the d i f f i c u l t i e s within the e x i s t i n g regime by providing f o r maximum f l e x i b i l i t y . 1 5 1 Already acceptance of an arm's length range, rather than a s p e c i f i c arm's length p r i c e , has been recommended by the OECD i n the 1994 Draft. Also, a wider range of methodologies, such as p r o f i t s p l i t methods, could be viewed as acceptable within 1 4 9 J i l l C. Pagan and J . Scott Wilkie, supra. at 38 - 39 r e f e r r i n g to the 1984 Report, supra. which cautions against focusing on tax avoidance i n transfer p r i c i n g ; and 1994 Draft, Part I, supra. at 161. 1 5 0 J i l l C. Pagan and J. Scott Wilkie, i b i d . . at 27; a national perspective uses methodology f o r es t a b l i s h i n g i n d i v i d u a l transaction p r o f i t whereas a global perspective focuses on consolidated r e s u l t s . This i s p a r t i c u l a r l y pertinent where c e r t a i n functions of an MNE are so globalized or c e n t r a l i z e d that there i s no acceptable method of a l l o c a t i n g revenues and expenses on a national basis yet the national tax system forces a l l o c a t i o n of national p r o f i t on a basis which does not follow economic r e a l i t y . The authors note that although there are s t i l l taxpayers who may be tr y i n g to obtain a tax advantage by p r i c i n g s t r a t e g i e s , i t can be argued that a firm stand against those taxpayers may encourage MNEs to be more responsible i n t h i s area. 1 5 1 i b i d . . at 30. For example, the United Kingdom and the Netherlands take an extremely businesslike approach to arm's length and transfer p r i c i n g . Transfer p r i c i n g reviews proceed by analyzing the transaction and accepting what on reasonable evidence appears to be a f a i r p r i c e . An agreement i s struck and compliance costs are kept within reason. On the other hand, the United States approach has been to c o l l e c t maximum tax regardless of compliance cost and apply the arm's length c r i t e r i a on the basis of s t r i c t and complex methodology. 179 a broader conception of arm's length. This would be a step i n overcoming problems associated with using methodologies which ignore the r e a l i t i e s of the integrated global economy:152 Integrated i n t e r n a t i o n a l operations have an economic r a t i o n a l e viewed i n t o t a l i t y ; by t h e i r very nature they are incapable of r a t i o n a l d i v i s i o n into the non-interdependent transactions that conventional transfer p r i c i n g methodologies r e l y on. ... No matter how much objective or s c i e n t i f i c r u l e formulation i s imposed by national tax systems, the key i s functional analysis on an i n d i v i d u a l f a c t s and circumstances basis... The difference i s that, where integrated operations are concerned the three conventional methods [comparable uncontrolled p r i c e , resale p r i c e and cost-plus] are not an end in themselves, but merely a point of departure exemplary or in d i c a t i v e of possibly useful guidelines. The 1994 Draft recognizes the use of p r o f i t methods i n cases where data i s not adequate to apply transaction-based methods r e l i a b l y . 1 5 3 I f the objective of transfer p r i c i n g i s to al l o c a t e income of a MNE between competing nations, a functional analysis of each member's contribution i n terms of reward fo r r i s k and economic contribution should be recognized by tax a u t h o r i t i e s . 1 5 4 When p r o f i t s p l i t methods are based on facts and circumstances, t h i s functional analysis can be argued to be within the wider d e f i n i t i o n of arm's length 1 5 5 and r e f l e c t the integrated nature of MNEs. The compensating adjustment and dispute r e s o l u t i o n process 1 5 2 i b i d . . at 101-102. The authors discuss t h i s issue further at pages 99 - 102. 153 1 9 9 4 Draft, Part I, supra. at 179 - 185. The p r o f i t s p l i t and comparable p r o f i t method are discussed, but are s t i l l generally discouraged and there are "substantial concerns" with the comparable p r o f i t method i n p a r t i c u l a r . 1 5 4 J i l l C. Pagan and J . Scott Wilkie, supra, at 41. 1 5 5 1994 Draft, Part I, supra, at 180. 180 could also benefit from revisions to eliminate the p o s s i b i l i t y for double taxation. Competent aut h o r i t i e s should be required to reach agreement within a s p e c i f i e d time frame. In the event that agreement i s not reached, binding a r b i t r a t i o n may provide a more workable, and eguitable, a l t e r n a t i v e to the present trea t y system for disputes: 1 5 6 As t a r i f f s are being eliminated and foreign investment r e s t r i c t i o n s are being l i f t e d throughout the world, addi t i o n a l harmonization i s becoming more and more important. In t h i s context, binding dispute mechanisms w i l l have to be introduced. International cooperation i n tax matters i s i n i t s i n i t i a l stages and w i l l have to adapt i t s e l f to a highly integrated world economy. E f f o r t s should also be made to harmonize customs valuations and transfer prices, review the need fo r penalties on transfer p r i c i n g except i n abusive cases, and ensure that i n t e r e s t i s deductible on payment of tax assessments i n t r a n s f e r p r i c i n g cases. 1 5 7 1 5 6 Emilio Romano, supra. 8; Mexico approves of a r b i t r a t i o n as a means to avoid double taxation. Also see B.J. Arnold and T.E. McDonnell, supra, at 916 - 919; Janice McCart, supra at 40:32 -40:38; J i l l C. Pagan and J . Scott Wilkie, supra, at Chapter 7; and Carl S. Shoup, "International A r b i t r a t i o n of Transfer P r i c i n g Disputes Under Income Taxation", i n A. Rugman and L. Eden, eds., supra, at 291 - 309. 1994 Draft, Part I I , supra. at paragraphs 277 - 281 recommends that i t i s "appropriate to analyze again and i n more d e t a i l whether the introduction of a tax a r b i t r a t i o n procedure would be an appropriate addition to i n t e r n a t i o n a l tax r e l a t i o n s . " Also r e f e r to the European Economic Community A r b i t r a t i o n Convention which came into force January 1, 1995 (discussed i n Chapter 5). 1 5 7 See also Norman C. Loveland, supra. at 5 - 6 for suggestions raised i n the context of NAFTA. Loveland also recommends t r i l a t e r a l arrangements between NAFTA p a r t i e s to provide r e l i e f from double taxation by competent a u t h o r i t i e s on transfer p r i c e assessments based on f i n a l p r o f i t r e a l i z e d on multiple transactions i n v e r t i c a l l y integrated corporate production l i n e s . 181 These modifications to the transfer p r i c i n g regime should also r e s u l t i n reduced burdens on time, information systems, experts, and compliance costs for both the MNEs and tax a u t h o r i t i e s through a more f l e x i b l e system which r e f l e c t s commercial r e a l i t y . CONCLUSION International harmonization w i l l be the key to resolving transfer p r i c i n g i s s u e s . 1 5 8 The Canadian Finance Minister has i d e n t i f i e d the need to address in 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 1 5 8 In addition to the problems i d e n t i f i e d , which require i n t e r n a t i o n a l harmonization, are the following concerns: B.J. Arnold and T.E. McDonnell, supra. at 916, discuss the importance of harmonization regarding safe harbours, which are relevant with the acceptance of an arm's length range; J i l l C. Pagan and J. Scott Wilkie, supra, at 44 and 45 discuss the lack of consistency between countries as to the attitude of the tax authority toward transfer p r i c i n g provisions; two countries may have i d e n t i c a l transfer p r i c i n g l e g i s l a t i o n , yet apply the law guite d i f f e r e n t l y . I t i s fundamental to a successful competent authority s o l u t i o n that apparent differences be c a r e f u l l y analyzed and not be permitted, e f f e c t i v e l y , to impose a measure of transfer p r i c i n g hegemony by exp l o i t i n g formal or non-substantive differences; Emilio Romano, supra, at 5: "Harmonization should also be oriented to the foreign tax c r e d i t provisions i n each country as they have a serious impact on the transfer p r i c i n g p o l i c i e s of multinational companies. An increasing number of such companies are i n an excess foreign tax cr e d i t p o s i t i o n as a r e s u l t of recent changes i n t h e i r domestic l e g i s l a t i o n . In some cases t h i s i s due to a reduction on [sic] the income tax rate i n t h e i r country of residence, but i n other cases i t i s because of changes i n the rules that a t t r i b u t e the country of source to p a r t i c u l a r items of income, the a l l o c a t i o n of expenses to foreign v i s - a - v i s l o c a l income, as well as other provisions that r a i s e additional tax revenues by reducing the amount of foreign taxes that can be credited, but increase the r i s k of double taxation. In t h i s [sic] circumstances, the a l l o c a t i o n of p r o f i t s between j u r i s d i c t i o n s with s i m i l a r rates f o r multinational companies facing an excess foreign tax c r e d i t p o s i t i o n i s no longer a tax neutral decision. There i s a cle a r incentive to transfer p r o f i t s to the country of residence of the group i n order not to face a [sic] double taxation." 182 issues on a m u l t i - l a t e r a l b a s i s : 1 5 9 We must work together with our major trading partners to develop common approaches to tran s f e r p r i c i n g problems i n order to minimize c o n f l i c t s between tax administrations and provide greater ce r t a i n t y for taxpayers. For these reasons, Canada supports the work that the OECD has done to develop a consistent set of guidelines and we w i l l continue to work with the United States and other OECD countries to examine where further c l a r i f i c a t i o n i s needed. The 1994 Draft has made some changes since the 1979 Report and 1984 Report to r e f l e c t the increased g l o b a l i z a t i o n of national economies. Such amendments and ongoing discussion about transfer p r i c i n g recognize the need to continue to think about transfer p r i c i n g r u l e s and how they should evolve i n l i g h t of the following o b j e c t i v e s : 1 6 0 - income of MNEs must be allocated f a i r l y between competing nations - the basis of a l l o c a t i o n must be accepted i n t e r n a t i o n a l l y - the need to recognize a range of acceptable p r i c e s i n analysis and methodology used to a r r i v e at arm's length p r i c e - a balance must be achieved between ce r t a i n t y and f l e x i b i l i t y - the system must be cost e f f e c t i v e to administer and c o l l e c t - the system must be f a i r . The goal of evaluating and r e v i s i n g the tran s f e r p r i c i n g regime should ultimately be to achieve an appropriate balance between the free trade objective and the sovereign r i g h t to 159 p r e s s Release No. 93-003, supra. Also see the 1979 Report, supra. 1984 Report, supra; 1993 Report, supra; 1994 Draft, Part I, supra. at 158; and B.J. Arnold and T.E. McDonnell, supra at 901. 1 6 0 J i l l C. Pagan and J. Scott Wilkie, supra. at 34 - 35. Also see W. Abdallah, supra. at 10, f o r 5 c r i t e r i a f o r an e f f e c t i v e transfer p r i c i n g system. 183 taxation which accurately r e f l e c t s how MNEs operate i n the global economy. 184 CHAPTER 5 CONCLUSIONS & RECOMMENDATIONS INTRODUCTION Two goals for t h i s study were declared the outset: 1) to determine whether the tax provisions under review prima f a c i e 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 discriminatory e f f e c t on free trade; and 2) to r e f l e c t on the i n t e r s e c t i n g r o l e of taxation and international trade i n advancing global f i s c a l harmonization. The tax provisions selected were chosen with the underlying theme of f a c i l i t a t i n g the inte r n a t i o n a l development of, and trade i n , technology. However, i t i s hoped that the a n a l y t i c a l framework and recommendations proposed here w i l l be useful for a broader range of tax p o l i c y analysis. This Chapter summarizes the conclusions reached i n each of the case studies followed by a discussion of the need f o r f i s c a l harmonization and suggestions for approaches to harmonization as we move into the twenty-first century. PART I: SUMMARY AND CONCLUSIONS A. Case Study Summaries In Chapter 2, Revenue Canada's p o l i c y of t r e a t i n g cross-border payments for software under l i c e n s i n g arrangements as r o y a l t i e s was examined. The r e s u l t of t h i s characterization under the ITA i s that such payments are subject to withholding tax. Under the OECD Model these payments are treated as business p r o f i t s , and are not subject to withholding tax. Although Canada has recently renegotiated b i l a t e r a l tax t r e a t i e s with the United States and the 185 Netherlands reducing t h i s withholding rate to zero percent, the underlying characterization issue remains. The question of whether t h i s Canadian tax p o l i c y can be viewed as discriminatory was examined with reference to A r t i c l e III of the GATT which contains the national treatment provisions. National treatment applies as between domestic goods and imported goods and i s designed to reinforce the basic p o l i c y of minimizing governmental interference i n cross-border transactions. As A r t i c l e III applies to " i n t e r n a l " taxes, the meaning of " i n t e r n a l " taxes was considered along with the guestion of whether withholding taxes are " i n t e r n a l " taxes. Arguments were advanced suggesting that i t i s possible for withholding taxes to come within the scope of A r t i c l e I I I . The e f f e c t of the withholding tax on the transactions under review was determined to be discriminatory i n that i t imposed a greater tax burden on imported software i n comparison with domestic software. This burden i s due to: 1) the higher e f f e c t i v e rate of tax which arises from c a l c u l a t i n g the withholding on gross amount of payments; 2) the p o t e n t i a l for double taxation; or 3) at a minimum, a cash flow disadvantage. The conclusion reached i s that there i s no j u s t i f i a b l e basis for Revenue Canada's p o l i c y i n t h i s area. I t i s u n l i k e l y that the GATT exceptions would apply to allow f o r t h i s discrimination. Further, the national objective of maintaining control over cross-border payments i n order to preserve the tax base does not outweigh the objective of f a c i l i t a t i n g i n t e r n a t i o n a l trade i n technology. 186 Given that Revenue Canada has begun to eliminate withholding taxes on a case-by-base basis, a more p r i n c i p l e d approach would be to reform the underlying characterization to come i n l i n e with the int e r n a t i o n a l norm. This would require minimal revenue s a c r i f i c e , e s p e c i a l l y i f withholding rates are going down to n i l i n any event, while s i g n i f y i n g Canada's commitment to cross-border trade i n technology, as well as to f i s c a l harmonization e f f o r t s . Chapter 3 examines the Canadian tax incentives f o r research and development ("R&D"). Research and development are c r i t i c a l to Canada's int e r n a t i o n a l competitiveness, economic health and productivity. To t h i s end, Canada has implemented a program of tax incentives which are among the most generous i n the world. Yet, i n 1991 Canada ranked fourteenth among the 24 OECD countries i n R&D spending as a percentage of gross domestic product; i t s e f f o r t i n research and development was lower than that of a l l G-7 countries except I t a l y . 1 These s t a t i s t i c s suggest that the present annual commitment of $1 b i l l i o n i n tax expenditures on R&D i s not e f f e c t i v e i n meeting the objective of stimulating R&D. In addition to domestic concerns about the effectiveness and d i r e c t i o n of Canada's R&D tax incentives, there i s a r i s k that these tax incentives may be subject to i n t e r n a t i o n a l sanctions under the new subsidies code, the SCM Agreement, concluded i n the Uruguay Round of GATT. Chapter 3 reviewed the key points of the 1 L. Denis Desautels, Auditor General of Canada, Report of the Auditor General of Canada to the House of Commons. 1994. v o l . 6 (Ottawa: Ministry of Supply and Services, Canada, November 22, 1994) at 9-9 (the "1994 AG's Report). 187 ITA tax provisions f o r research and development as well as the relevant SCM Agreement provisions. In p a r t i c u l a r , investment tax c r e d i t s ("ITCs") available to c e r t a i n Canadian corporations were examined under the SCM Agreement to see i f these ITCs are countervailable subsidies. The tentative conclusion was that these tax incentives may be viewed as countervailable subsidies ( i e . discriminatory) i n c e r t a i n circumstances. As the United States seems to be maintaining an aggressive stance with regard to subsidies i n whatever form, i t i s reasonable to expect that Canadian R&D subsidies w i l l not escape the attention of American watchdogs. If Canadian R&D tax incentives are not e f f e c t i v e at achieving the stated domestic objectives and, i f these incentives are open to possible countervailing duties under the terms of i n t e r n a t i o n a l agreements, there i s a c l e a r need fo r r e v i s i o n s of the current program of tax expenditures f o r R&D. On June 28 1994, the Minister of Industry and the Secretary of State for Science, Research and Development launched a major review of federal science and technology a c t i v i t i e s i n order t o : 2 help determine how federal spending i n science and technology can best be applied to creating economic growth and jobs within the context of sustainable development, enhancing the q u a l i t y of l i f e and advancing knowledge. The Auditor General strongly supported t h i s i n i t i a t i v e i n h i s 1994 Report. He also emphasized that Canada has l i m i t e d resources which must be spent i n a cost e f f e c t i v e way focusing on those 2 1994 AG's Report, supra, v o l . 6, at 9-12. 188 sectors of the economy that are most promising i n terms of p o t e n t i a l value added and that w i l l y i e l d the maximum return. I t i s suggested that i n devising a R&D strategy, i n t e r n a t i o n a l agreements should be considered as both a possible guideline for future r e v i s i o n s to the R&D tax incentives and to l i m i t exposure to in t e r n a t i o n a l sanctions f o r Canadian R&D tax i n i t i a t i v e s . However, in t h i s case, the domestic objectives for promoting R&D are considered to be paramount to the free trade objective. F i n a l l y , Chapter 4 reviewed the current i n t e r n a t i o n a l transfer p r i c i n g regime. Transfer p r i c i n g f o r transactions between members of multinational enterprises ("MNEs") has been an ongoing source of in t e r n a t i o n a l controversy. To the extent that the t r a n s f e r p r i c i n g regime seeks to preserve the domestic tax base, transactions among members of MNEs are open to p r o t e c t i o n i s t and discriminatory measures which have no p a r a l l e l f o r s i m i l a r domestic transactions and f a i l to recognize the economic nature of MNEs. The a b i l i t y of MNEs to manipulate transfer p r i c e s i n order to achieve b e n e f i c i a l tax r e s u l t s has given r i s e to a t r a n s f e r p r i c i n g regime which i s rooted i n anti-avoidance. The very nature of transfer p r i c i n g as being rooted i n anti-avoidance i s a contentious issue. A more preferable view i s that t r a n s f e r p r i c i n g 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 resources, value and p r o f i t within a MNE, rather than p r i m a r i l y as a v e h i c l e for tax avoidance. Unlike the previous two Chapters, t h i s case study did not undertake an analysis of the tax regime pursuant to a s p e c i f i c GATT 189 provision. Rather key p r i n c i p l e s , methods and procedural aspects of the e x i s t i n g transfer p r i c i n g system were studied with a view to i d e n t i f y i n g unreasonable or a r b i t r a r y standards and procedures which could have a negative impact on global trading by MNEs. A number of conclusions were reached which were characterized as discrimination i n the e x i s t i n g system against MNEs: 1. The ITA rules prima f a c i e discriminate against MNEs by applying d i f f e r e n t l y to nonresident-resident transactions than to resident-resident transactions. 2. International transfer p r i c i n g r u l e s apply to a wider range of transactions than s i m i l a r domestic r u l e s . 3. The ITA rules are drafted i n such a way that the only transactions p o t e n t i a l l y affected are those where tra n s f e r p r i c i n g adjustments lead to an increase i n the domestic tax base. 4. The arm's length p r i n c i p l e , which underlies the transfer p r i c i n g regime, ignores the very essence of MNEs by t r e a t i n g each member as a independent e n t i t y . 5. Use of the prescribed transactional methods (comparable uncontrolled p r i c e / royalty, resale minus, and cost plus) are often not applicable or achievable, and can produce a r b i t r a r y r e s u l t s . This i s p a r t i c u l a r l y problematic f o r intangibles. 6. Lack of coordination between tra n s f e r p r i c e s and customs valuations can r e s u l t i n d i f f e r e n t valuations f o r d i f f e r e n t purposes which i s i l l o g i c a l and unfai r as i t can r e s u l t i n dupli c a t i o n of work, a r b i t r a r y values, excess taxation, and uncertainty f o r the taxpayer. 190 7. The compensating adjustment procedures do not go f a r enough i n preventing double taxation which can create an impediment to cross-border transactions. 8. Compliance requirements, advance p r i c i n g agreements, penalties and in t e r e s t impose tremendous burdens on time, information systems, experts, and compliance costs on both the taxpayer and tax authority. The conclusion reached was that the foregoing aspects of the transfer p r i c i n g regime could not be j u s t i f i e d i n l i g h t of the national objective of maintaining the domestic tax base. Even though the transfer p r i c i n g rules are r a t i o n a l l y r e l a t e d to t h i s objective, a l t e r n a t i v e approaches to transfer p r i c i n g are avail a b l e which would enable Canada to achieve t h i s objective while a l l e v i a t i n g some of the discriminatory aspects of the transfer p r i c i n g regime. These recommendations were advanced, with the o v e r a l l conclusion being that the ultimate key to resolving transfer p r i c i n g issues i s international harmonization of transfer p r i c i n g r u l e s . B. Conclusions What t h i s research has attempted to do i s to evaluate s p e c i f i c aspects of the Canadian income tax system i n terms of in t e r n a t i o n a l p r i n c i p l e s and norms set out i n the GATT. Tax p o l i c i e s which are prima f a c i e discriminatory and i n some way have a negative impact on i n t e r n a t i o n a l trade may well be j u s t i f i a b l e under in t e r n a t i o n a l agreements or i n l i g h t of an overriding sovereign i n t e r e s t . However, i f they are not j u s t i f i a b l e , and even i f they are, p o l i c y 191 decisions may benefit from t h i s sort of review by s h i f t i n g the approach and c r i t e r i a f or evaluating tax p o l i c y to a process which i s more applicable to the global marketplace. This approach also highlights p o t e n t i a l outcomes of tax p o l i c y decisions which Canada•s trading partners may view negatively from a free trade perspective. The intent i s not to promote free trade at the expense of overriding sovereign i n t e r e s t s . Rather, the recommended approach i s to look at a range of available a l t e r n a t i v e s for any p a r t i c u l a r tax p o l i c y and sel e c t from among those a l t e r n a t i v e s the p o l i c y that best achieves the underlying national objectives, based on appropriate c r i t e r i a , while minimizing p o t e n t i a l d i s t o r t i v e e f f e c t s on free trade. The e x p l i c i t l i n k i n g of in t e r n a t i o n a l trade and tax po l i c y i n the decision making process ensures that, at a minimum, domestic and international concerns are thoroughly canvassed. In each of the case studies examined, al t e r n a t i v e s e x i s t which may achieve a preferable balance between domestic and inte r n a t i o n a l concerns from both a domestic and inte r n a t i o n a l perspective. The next section considers the in t e r s e c t i n g r o l e of tax p o l i c y and international trade agreements i n approaches to f i s c a l harmonization. PART I I : RECOMMENDATIONS The views presented by authorities on public finance i n a forward looking analyses of taxation i s that: 3 3 Donald J.S. Brean, "Here or There? The Source and Residence P r i n c i p l e s of International Taxation", i n R. Bi r d and Jack Mintz, eds., Canadian Tax Paper No. 93 (Toronto: Canadian Tax Foundation, 192 tax p o l i c y must take f u l l and e x p l i c i t account of the f a c t that the world economy i s become increasingly integrated and national economies are becoming ever more interdependent. This Part considers how to approach convergence of tax p o l i c y and i n t e r n a t i o n a l trade p o l i c y . A. GATT Tax Code Two fundamental features of the i n t e r n a t i o n a l tax structure are r e l i e f from double taxation and non-discrimination; these features are consistent with global free trade. 4 I t has been suggested that the future may hold a GATT-type arrangement on i n t e r n a t i o n a l tax issues, 5 a General Agreement on T a r i f f s , Trade and Taxes (a "GATTT"). Although the e x i s t i n g GATT does contain provisions which have application to c e r t a i n domestic tax p o l i c i e s , such as those dealing with i n t e r n a l taxes, customs duties, and some of the subsidies provisions, there i s no comprehensive code which deals with matters of d i r e c t taxation. A GATTT would emphasize the r e l a t i o n s h i p between trade and taxation i n the broader sense of focusing on p r o t e c t i o n i s t tax p o l i c i e s and the impact of domestic taxation on trade flows. 1992) at 303, r e f e r r i n g to papers presented at a Washington conference on tax p o l i c y i n the twenty-first century (reported i n Herbert Stein, ed., Tax P o l i c y i n the Twenty-First Century (Toronto: Wiley & Sons, 1988). 4 J o e l B. Slemrod, "Free Trade Taxation and P r o t e c t i o n i s t Taxation", International Tax P o l i c y Forum, Tax Analysts, Tax Notes International. A p r i l 1, 1994 at 21. 5 Stanford G. Ross, "International Tax Law: The Need for Constructive Change", Herbert Stein, ed., Tax P o l i c y i n the Twenty F i r s t Century (New York: John Wiley & ons, 1988) 87 at 93. Also see references i n section B. U n i l a t e r a l and B i l a t e r a l Approaches, below. 193 The evolution of a GATT-type tax code 6 may be s i m i l a r to the General Agreement on Trade i n Services (GATS), which was very controversial, and thought by many to be i n f e a s i b l e to implement: 7 There was... a wide range of views concerning the necessity and a d v i s a b i l i t y of extending the GATT to cover services. Some members of the Group expressed concern over the complexity of services and the existence of other i n t e r n a t i o n a l organizations whose functions covered various important service sectors. Other members f e l t that work i n t h i s area was premature and doubted the f e a s i b i l i t y of extending the GATT to services. There was, however, no opposition to further "exploratory" work by the Secretariat, and the parti e s agreed that a report on the a c t i v i t i e s of other organizations• work i n the area of services should be prepared for consideration at a future meeting of the group. 8 As a r e s u l t of the exploratory work, and due to the increasing 6 As with the GATS, consideration would have to be given to whether an agreement on taxation would come under the auspices of the GATT or under a separate code, such as the subsidies code. Less developed countries, which i n i t i a l l y opposed the i n c l u s i o n of trade i n services i n GATT negotiations, proposed the GATT Code approach so that each party would have the option of becoming a signatory to the agreement at the end of the negotiations or at a l a t e r date. This allowed a party to p a r t i c i p a t e i n negotiations and i n the end not sign the agreement without jeopardizing gains made i n other negotiations (Terence P. Stewart, ed., The GATT Uruguay Round: A Negotiating History (1986-1992) v o l . 2, (Cambridge, MA: Kluwer Law and Taxation Publishers, 1993), at 2361 - 2362) . 7 For the negotiating h i s t o r y of the GATS, see Terence P. Stewart, ed., i b i d . . at 2335 - 2662. The Uruguay Round of GATT (launched September 20, 1986 during a s p e c i a l session of the GATT at Punta del Este, Uruguay) was the f i r s t attempt to address the elimination or reduction of b a r r i e r s and d i s t o r t i o n s i n trade i n services. P r i o r to the 1970's trade i n services was viewed as a matter of domestic commerce and subject only to the rules and regulations of each country (2341, 2342). 8 Terence P. Stewart, ed., supra. at 2345. Note that the Central Product C l a s s i f i c a t i o n system l i s t s over 600 d i f f e r e n t types of "services" (See Reference L i s t of Sectors. GATT Doc. No. MTN.GNS/W/50 (Apr. 13, 1989). The e f f o r t s to bring services to the m u l t i l a t e r a l negotiating table began i n 1980 and culminated i n the GATS, Annex IB to the Agreement Establishing the World Trade Organization. Uruguay Round F i n a l Act, Marrakesh, A p r i l 15, 1994. 194 importance of services to world trade, m u l t i l a t e r a l negotiations were undertaken by the GATT Members to reduce or eliminate b a r r i e r s and d i s t o r t i o n s i n trade i n s e r v i c e s . 9 S i m i l a r l y , i t can be argued that despite opposition to a s i m i l a r agreement on t a x a t i o n , 1 0 given 9 Although GATT pa r t i e s were divided on whether a m u l t i l a t e r a l system should be developed to govern trade i n services, a m u l t i l a t e r a l system was recommended on the grounds that world trade i n services was on the r i s e , and that without a m u l t i l a t e r a l system, discriminatory b i l a t e r a l and regional r u l e s would develop (Terence P. Steward, ed., supra. at 2348). 1 0 See Emilio Romano, Taxation i n the North American Free Trade Area, paper presented at International F i s c a l Association, 1994 Annual Congress, Toronto at 1 - 4 regarding taxes and trade i n NAFTA: A r t i c l e 2103 of NAFTA provides for the coordination of the NAFTA with e x i s t i n g b i l a t e r a l tax conventions and a balance between tax p o l i c y and the prevention of i n t e r n a t i o n a l trade discrimination. However, unqualified a p p l i c a t i o n of the p r i n c i p l e of non-discrimination (national treatment and most-favoured-nation) was not considered to be appropriate because i t would impose standards that could s i g n i f i c a n t l y a f f e c t generally accepted tax p o l i c y measures and because d i r e c t taxation i s already covered by b i l a t e r a l tax t r e a t i e s . For example, the imposition of national treatment of income taxes r a i s e d concerns regarding: 1) differences i n imposing and c o l l e c t i n g income taxes for c e r t a i n categories of taxpayers (eg. withholding taxes on c e r t a i n payments to non-residents) ; 2) the income tax may make v a l i d d i s t i n c t i o n s among taxpayers i n d i f f e r e n t circumstances (eg. residents and no-residents) ; 3 ) d i s t i n c t i o n s i n the design or a p p l i c a t i o n of i n d i r e c t taxes (eg. sales taxes) are seldom j u s t i f i a b l e on tax p o l i c y grounds and, therefore, may be for the purpose of r e s t r i c t i n g i n t e r n a t i o n a l trade; and 4) income taxes usually contain provisions designed to ensure equity, progressiveness, income r e d i s t r i b u t i o n and other s o c i a l and economic objectives. MFN treatment r a i s e d the following concerns: 1) tax conventions are entered into on a b i l a t e r a l basis r e f l e c t i n g the p a r t i c u l a r preferences and circumstances of the p a r t i e s ; and 2) i t would reguire that the advantages accorded to one treaty be extended to signatories of other tax t r e a t i e s . Submitting income taxes to the dispute settlement provisions of NAFTA was raised the following concerns: 1) duplication of dispute resolution mechanisms; 2) dispute settlement mechanisms would provide for l e g a l l y binding solutions; 3) the settlement of tax disputes would be l e f t i n the hands of persons without expertise i n tax p o l i c y ; and 4) access to an addi t i o n a l forum for dispute settlement was thought to undermine the treaty process. 195 the importance of taxation to world trade i t i s a proper concern of the GATT.11 Studies on trade i n services prepared by t h i r t e e n GATT Members showed t h a t : 1 2 1. A clea r d e f i n i t i o n of trade i n services was lacking and that trade i n services data were incomplete. 2. Heavy regulation i s common i n many service i n d u s t r i e s . . and that the va r i e t y of regulations maintained by the d i f f e r e n t countries complicated trade i n services. 3. A wide v a r i e t y of trade b a r r i e r s impeded trade i n services... 4. The importance of services requires countries to reassess the r o l e which trade i n services play i n the formulation of trade p o l i c y . S p e c i f i c a l l y , the United States and United Kingdom c a l l e d f o r negotiation of a m u l t i l a t e r a l framework s i m i l a r to the GATT for trade i n services. P a r a l l e l s can be drawn to taxation matters: 1) there i s no clear d e f i n i t i o n of what a "tax" i s ; 2) taxation i s heavily regulated and the va r i e t y of regulations maintained by d i f f e r e n t countries complicates international trade; 3) a wide v a r i e t y of tax p o l i c i e s impede trade i n goods, services, c a p i t a l and technology; and 4) the importance of taxation suggests that countries should 1 1 In the early 1980s the United States persuaded the OECD to conduct a study on trade i n services which provided the i n i t i a l groundwork f o r the movement to include trade i n services i n m u l t i l a t e r a l trade negotiations. Also the GATT Consultative Group of Eighteen (composed of 18 GATT Signatories and organized to study ways of improving the GATT system) met i n 1980 and considered a document prepared by the GATT Secretariat which analyzed the l i n k of c e r t a i n services with trade i n goods. The Group determined that the document "demonstrated an e s s e n t i a l l i n k between trade i n goods and c e r t a i n services" and suggested that trade i n services might by a "proper concern of the GATT" (Terence P. Steward, ed., supra, at 2345) . 1 2 i b i d . . at 2347. 196 reassess the converging r o l e of taxation and trade p o l i c y . A GATT tax code would i n i t i a l l y require d e f i n i t i o n and categorization of taxes as well as i d e n t i f i c a t i o n of taxes that may be appropriate f o r i n c l u s i o n i n such a code. 1 3 A number of well established GATT p r i n c i p l e s should be the s t a r t i n g p o i n t , 1 4 such as transparency, national treatment and non-discrimination, although such p r i n c i p l e s may have to be adapted to taxation. Also any such agreement would have to consider appropriate exceptions to the basic obligations to take into account sovereign concerns of Members as well as s p e c i a l treatment for developing countries. E x i s t i n g i n t e r n a t i o n a l arrangements would have to be considered. A GATTT would be a prospective code, with Members i d e n t i f y i n g tax laws which are impediments to trade and conducting negotiations on the basis of r e c i p r o c i t y . 1 5 1 3 Due to d i f f i c u l t i e s i n assessing the p o t e n t i a l e f f e c t s of an o v e r a l l non-discrimination provision f o r taxation, f o r example, i t w i l l be necessary to attempt to i d e n t i f y tax p o l i c i e s for which non-discrimination and a high l e v e l of harmonization and compliance would be b e n e f i c i a l to the global community. Despite the d i f f i c u l t i e s inherent i n such a task, the i d e n t i f i c a t i o n of items that are subject to negotiation i s a basic issue that needs to be s e t t l e d at the outset. Note that s i m i l a r "coverage" issues arose i n the GATS negotiations: whether the GATS should cover a l l services or whether c e r t a i n service sectors should be excluded from coverage. (Terence P. Stewart, ed., supra. at 2363). 1 4 Jock A. Finlayson, "Canada and International Trade Regulation: The General Agreement on T a r i f f s and Trade" i n Robert K. Paterson and Martine M.N. Band, eds., International Trade and Investment Law i n Canada (2d) (Toronto: Carswell, 1994) at 1-9 for an overview of basic GATT p r i n c i p l e s . 1 5 Reciprocity i s a system of continuous trades or swaps of measures to l i b e r a l i z e (or r e s t r i c t ) trade such as was used i n GATT t a r i f f negotiations. (John H. Jackson, The World Trading System: Law and Po l i c y of International Economic Relations. (Cambridge, MA: The MIT Press, 1989) at 305; and Jock Finlayson, i b i d . . at 1-9. 197 The European Economic Community (the "EEC") has been grappling with harmonization of taxation since 1962,16 with the report of the Neumark committee. 1 7 L i t t l e s i g n i f i c a n t progress was made u n t i l 1990, which marked a turning point i n the r o l e of d i r e c t taxation i n the EEC. 1 8 In assessing which tax measures may be appropriate for a GATTT, the EEC Guidelines on Company Taxation 1 9 are i n s i g h t f u l : 2 0 According to the guidelines, any form of corporate taxation i s 1 6 The Treaty Establishing the European Economic Community, signed at Rome on March 25, 1957 (reproduced i n Treaties Establishing the European Communities, abridged ed. (Luxembourg: O f f i c e for O f f i c i a l Publications of the European Communities, 1987), contains a number of provisions r e l a t i n g to i n d i r e c t taxation, but does not e x p l i c i t l y r e f e r to d i r e c t taxation. I t also does not define d i r e c t or i n d i r e c t taxation. For an overview of harmonization of d i r e c t taxation i n the EEC see Alex Easson, "Harmonization of Direct Taxation i n the European Community: From Neumark to Ruding", 40 Canadian Tax Journal 3 (Toronto: Canadian Tax Foundation, 1992) 600 - 638. 1 7 The EEC Reports on Tax Harmonisation. trans. H. Thurston (Amsterdam: International Bureau fo r F i s c a l Documentation, 1963). The committee was chaired by Professor Dr. F r i t z Neumark. A. Easson, i b i d . . at 604. The Neumark report was concerned primarily with the impact of d i r e c t taxation on conditions of competition and recommended that the f i r s t phase of tax harmonization i n the EEC deal with the taxation of dividends and i n t e r e s t and with the problem of double taxation. The second phase of tax harmonization was to include the reform of company taxation systems. 1 8 i b i d . . at 610. 1 9 Guidelines on Company Taxation. Commission Communication to the Parliament and Council, A p r i l 20, 1990, Doc. COM (90) 601 f i n a l . Also r e f e r to Fred C. de Hosson, ed., The Direct Investment Tax I n i t i a t i v e s of the European Community (Deventer, The Netherlands: Kluwer Law and Taxation Publishers, 1990); A.J. Easson, Tax Law and P o l i c y i n the EEC (New York: Oceana Publications, 1980); and Clara K. S u l l i v a n , The Search f o r Tax P r i n c i p l e s i n the European Economic Community (Chicago:Commerce Clearing House, Inc., 1963) A. Easson, supra, at 626. 198 l i k e l y to bring about economic d i s t o r t i o n s , and t h i s j u s t i f i e s the harmonization of corporate tax systems with the community to ensure complete tax n e u t r a l i t y . There are, however, good reasons why the community should hold back on the harmonization of corporate tax systems, " p a r t i c u l a r l y i n view of the p r i n c i p l e of s u b s i d i a r i t y " and "member states should be free to determine t h e i r tax arrangements, except where these would lead to major d i s t o r t i o n s " , (emphasis added) "Subsi d i a r i t y " means:21 that the Commission has chosen not to i n t e r f e r e i n every f i e l d of economic l i f e , but to intervene only when i t i s necessary to a t t a i n the s p e c i f i c objectives agreed by the member states... For the rest, the market forces play. In the NAFTA context, A r t i c l e 2103 was drafted as a general carve-out of tax measures from the Agreement. Except for s p e c i f i c circumstances, d i r e c t taxes were l e f t to the domain of b i l a t e r a l tax t r e a t i e s ; non-discrimination provisions required i n order to prevent international trade discrimination through taxation are to be included i n b i l a t e r a l or m u l t i l a t e r a l tax t r e a t i e s . 2 2 However, the following tax harmonization issues have been i d e n t i f i e d i n the NAFTA23 context: 2 4 2 1 i b i d . , at 625. 2 2 See Emilio Romano, supra. at 3 - 4; and NAFTA A r t i c l e 2103 and Annex 2103.4 2 3 In the EEC, the Ruding Committee concluded that p r i o r i t y should be given to the following: i) removing those discriminatory and d i s t o r t i o n a r y features of national tax arrangements that impede cross-border business investment and shareholding; i i ) s e t t i n g a minimum l e v e l for the statutory corporation tax rate and common rules for a minimum tax base to l i m i t excessive tax competition among member states to a t t r a c t mobile investment; and i i i ) encouraging the maximum transparency of any tax incentives granted by member states to promote investment. The Ruding committee did not include among i t s l i s t of p r i o r i t i e s the harmonization of corporate tax regimes although i t observed that the adoption of a common system remained a desirable long-term objective meriting further consideration. (Alex Easson, supra, at 629). 199 1. Some of the f i s c a l differences between Canada, the United States and Mexico, have p o t e n t i a l d i s t o r t i o n a r y e f f e c t s on the inter n a t i o n a l a l l o c a t i o n of resources as well as on the trade patterns f o r the region. This, i n turn, may a f f e c t the competitiveness of the trade block with respect to others. 2. Under these circumstances, i t i s e s s e n t i a l that a u t h o r i t i e s of the three countries analyze the p o t e n t i a l l y most harming aspects i n order to make the necessary e f f o r t s towards tax harmonization on these issues. *** 4. The d e s i r a b i l i t y to achieve n e u t r a l i t y i n respect to both c a p i t a l export and import, makes i t convenient to engage i n the necessary e f f o r t s to harmonize not only the tax rates but also the taxable bases... 5. As a f i r s t stage i n harmonizing the d i r e c t tax systems, and i n according [sic] with the e f f o r t undertaken and recommendations [by the Ruding Committee], i t would be convenient to pursue the following: - Elimination of withholding taxes on dividends paid by 2 4 Emilio Romano, supra f at 11 -12. Also see Norman C. Loveland, Harmonization of Tax Under the North American Free Trade Agreement. paper presented at the International F i s c a l Association, 1994 Annual Congress, Toronto, August 31, 1994, regarding, tax harmonization and Canadian tax aspects of cross-border reorganizations, mergers and acqui s i t i o n s under NAFTA; and Paul R. McDaneil, "Tax Po l i c y i n the North American Free Trade Zone" (Professor of Law, New York University, 1994) [unpublished] for discussion of both an incremental approach to meshing tax and trade p o l i c y within the NAFTA zone as well as a more sweeping approach to r e v i s i o n of the corporate tax systems of the NAFTA Members. McDaniel i d e n t i f i e s and discusses numerous provisions i n tax l e g i s l a t i o n and tax t r e a t i e s that p o t e n t i a l l y impede the a b i l i t y of NAFTA countries to achieve t h e i r free trade objective. Subject to v e r i f i c a t i o n by quantitative analysis, he ranks the urgency for addressing these issues as follows, Category A being the most urgent (at 70 - 71) : Category A: elimination of withholding taxes, coordination and s i m p l i f i c a t i o n of transfer p r i c i n g r u l e s and procedures, harmonization of source rules for income and deductions, elimination of taxation of cross-border taxes on corporate formations, reorganizations and l i q u i d a t i o n s . Category B: harmonization of tax base. Category C: harmonization of provisions mitigating i n t e r n a t i o n a l double taxation, elimination of l i m i t a t i o n of benefits a r t i c l e s i n US tax t r e a t i e s f o r intra-NAFTA zone investments and operations, and harmonization of corporate / shareholder tax regimes. 200 sub s i d i a r i e s to parent corporations... - Elimination of withholding taxes on i n t e r e s t and royalty payments between rel a t e d enterprises. - Setting common rules and procedures to determine transfer p r i c e s . - An analysis of the instances i n which i t would be convenient to allow the compensation of losses, h o r i z o n t a l l y and v e r t i c a l l y within a multinational corporation with enterprises i n two or more of the NAFTA countries. S i m i l a r l y , a GATTT may be a useful forum f o r c e r t a i n taxation issues on which i t i s appropriate, and necessary, f o r the inte r n a t i o n a l community to achieve harmonization and where the a b i l i t y to enforce compliance with a GATTT would be b e n e f i c i a l . Although i t i s u n r e a l i s t i c to expect that a GATTT could achieve broad based tax harmonization, at le a s t i n the foreseeable future, there are areas where a GATTT may be more appropriate than the current system of b i l a t e r a l tax t r e a t i e s and model tax conventions. For example, of the three case studies examined, transfer p r i c i n g may be adaptable to int e r n a t i o n a l c o d i f i c a t i o n and would l i k e l y benefit from the a b i l i t y to access binding dispute mechanisms to e f f e c t i v e l y deal with tr a n s f e r p r i c i n g disputes. In the EEC, an A r b i t r a t i o n Convention 2 5 was adopted with the objective of eliminating double taxation a r i s i n g out of cross-border transfer p r i c i n g disputes. 2 6 This convention i s not as comprehensive i n scope as the OECD Model on double taxation, as i t r e l a t e s only to double taxation r e s u l t i n g from the adjustment of p r o f i t s of 2 5 Convention 90/436/EEC, July 23, 1990, OJ 1990 L 225. 2 6 Also see Paul McDaniel, supra. who ranks t r a n s f e r p r i c i n g as among the most urgent tax matters to address (at 70). 201 associated enterprises, yet i t seems to "provide a better procedure for achieving the desired r e s u l t . " 2 7 B. U n i l a t e r a l and B i l a t e r a l Approaches As i t i s u n r e a l i s t i c to expect a GATTT arrangement, no matter what the scope, i n the immediate future, i t i s necessary to continue to pursue u n i l a t e r a l and b i l a t e r a l harmonization e f f o r t s : 2 8 Tax harmonization i s the i d e a l s o l u t i o n . However, national differences are so great that harmonization i s not a r e a l i s t i c p o s s i b i l i t y . U n i l a t e r a l and b i l a t e r a l l i m i t a t i o n s on discrimination against non-residents and foreign a c t i v i t i e s represent an important and f e a s i b l e , although second-best, course of action for most countries. In h i s address to the GATT M i n i s t e r i a l Conference i n Marrakesh on A p r i l 12, 1994, The Honourable Roy McLaren, Minister for International Trade, stressed Canada's commitment to developing a strong i n t e r n a t i o n a l trading system. He emphasized that the GATT has been the cornerstone of Canada's trade p o l i c y , 2 9 and that countries must work harder to leave u n i l a t e r a l i s m and protectionism behind. 3 0 In today's global marketplace, i t i s not s u f f i c i e n t for Canada to implement tax p o l i c i e s without considering the broader systems of international trade. Taxes can have a s i g n i f i c a n t 2 7 A. Easson, supra. at 618. 2 8 Brian J. Arnold, "Tax Discrimination Against Aliens, Non-Res idents and Foreign A c t i v i t i e s : Canada, A u s t r a l i a , New Zealand, the United Kingdom, and the United States", Canadian Tax Paper No. 90 (Toronto: Canadian Tax Foundation, 1991) at x i v . 2 9 Canada and the Uruguay Round; Information K i t , (Ottawa: Government of Canada, A p r i l , 1994) at 1. i b i d . . at 4. 202 e f f e c t on in t e r n a t i o n a l trade flows and, to the extent possible, domestic tax p o l i c i e s should u n i l a t e r a l l y undertake to promote free trade. While international trade agreements seek to remove ba r r i e r s to trade, domestic tax regimes should not create new, or maintain u n j u s t i f i a b l e e x i s t i n g , b a r r i e r s - even ones that may " s l i p through" the GATT or other i n t e r n a t i o n a l trade agreements. Tax t r e a t i e s attempt to harmonize national tax systems i n order to eliminate i n t e r n a t i o n a l double taxation, prevent tax avoidance and to a l l o c a t e revenues between nations. 3 1 However, int e r n a t i o n a l taxation issues often focus on the s e l f - i n t e r e s t e d goal of ensuring the domestic tax system i s competitive. 3 2 Yet: 3 3 Despite the development of double-taxation agreements, many governments continue to believe that c a p i t a l income taxation at the in t e r n a t i o n a l l e v e l involves s i g n i f i c a n t d i s t o r t i o n s 3 1 Stanford G. Ross, "International Tax Law: The Need for Constructive Change" In Herbert Stein, ed. supra. 87 at 92. 3 2 See for example, Brian A. Bethune, "The Competitiveness of the Canadian Tax System", 41 Canadian Tax Journal 6 (Toronto: Canadian Tax Foundation, 1993) 1119 - 1127; The Honourable Donald Mazankowski, "Competitiveness, Tax Reform and Economic Unity", The Honourable Otto J e l i n k "Changing Revenue Canada: Canadian Competitiveness Our Goal", Jo e l Slemrod "What Makes a Nation Prosperous, What Makes i t Competitive, and Which Goal Should We Str i v e For", Jack M. Mintz, "Competitiveness and Tax P o l i c y : How Does Canada Play the Game", Edward P. Neufeld, "Tax and F i s c a l P o l i c y : Constraints on Competitiveness" and Robert Couzin, "Tax Options f o r Competitiveness" i n Report of Proceedings of the Forty-Third Tax Conference. 1991 Conference Report (Toronto: Canadian Tax Foundation, 1992); Robert D. Brown and V i v i e n Morgan, "International Competitiveness and Taxation" 37 Canadian Tax Journal 3 (Toronto: Canadian Tax Foundation, 1989) 745 - 762; and Jack Mintz and John Whalley, eds., "The Economic Impacts of Tax Reform", Canadian Tax Paper No. 84 (Toronto: Canadian Tax Foundation, 1989) 3 3 Jack M. Mintz, "Is There A Future f o r C a p i t a l Income Taxation", 42 Canadian Tax Journal 6, (Toronto: Canadian Tax Foundation, 1994) 1469 - 1503 at 1500. 203 and serious enforcement problems. The current agreements have several general shortcomings. One i s that they are b i l a t e r a l , thus the terms of the agreements, p a r t i c u l a r l y i n respect to matters such as withholding tax rates, vary considerably across countries. A second problem i s that double-taxation agreements do l i t t l e to reduce tax exportation and smooth out differences i n e f f e c t i v e tax rates on c a p i t a l . *** I f current methods of tax coordination have f a i l e d , what i s there l e f t f o r countries to do? McLure 3 4 and Leechor and Mintz 3 5 have argued i n favour of an i n t e r n a t i o n a l or regional agreement to coordinate taxes (as McLure c a l l s i t , a "GATT for tax") . Although the future may hold a GATT for tax, the e x i s t i n g treaty network i s l i k e l y to be around f o r a long time and may be the most appropriate mechanism fo r addressing a number of tax issues. In t h i s b i l a t e r a l context, i t i s suggested that there must be a s h i f t i n focus from protectionism to one i n which inte r n a t i o n a l trade agreements are considered i n developing domestic and i n t e r n a t i o n a l tax p o l i c y . This s h i f t i n focus w i l l a i d i n ensuring that advances i n i n t e r n a t i o n a l trade are not impeded by developments i n domestic or i n t e r n a t i o n a l taxation. Of the case studies examined, Canada has reduced the withholding tax on payments fo r licensed software to n i l i n two b i l a t e r a l tax t r e a t i e s . However, Canada should go further and take the u n i l a t e r a l step of characterizing these payments as business p r o f i t s to coordinate p o l i c i e s with the broader i n t e r n a t i o n a l 3 4 C E . McLure, J r . "International Aspects of Tax P o l i c y for the 2 l s t Century" (mimeograph, 1990). 3 5 Chad Leechor and Jack Mintz, "Taxation of International Income by a Capital-Importing Country: The Perspective of Thailand," i n Javad Khalilzaded-Shiraze and Anwar Shah, eds., Tax Pol i c y i n Developing Countries (Washington, DC: World Bank, 1991), 100-24. 204 taxing community. This would not only achieve a measure of f i s c a l harmonization but, as was indicated, would remove d i s t o r t i v e e f f e c t s on such transfers of technology. Thus, a combination of cooperative u n i l a t e r a l and b i l a t e r a l approaches can be used to e f f e c t i v e l y address p a r t i c u l a r tax measures. SUMMARY The recurring theme i n t h i s paper has been the balancing of the 2 basic premises of free trade set out i n Chapter 1: 1. The most e f f i c i e n t use of resources of trading nations w i l l be achieved i f trade among them i s free from a r b i t r a r y interventions by i n d i v i d u a l governments; and 2. The preservation of sovereign r i g h t s as expressed i n the maintenance of d i f f e r e n t politico-economic systems and sets of p o l i c i e s among nations i s es s e n t i a l f o r increasing the welfare of c i t i z e n s of the nations concerned. This free trade perspective of tax p o l i c i e s has provided an alt e r n a t i v e framework for considering domestic and inte r n a t i o n a l tax systems. Ideally f i s c a l harmonization i n free trade areas should ensure that trade among member countries i s not d i s t o r t e d by tax p o l i c i e s . Domestically, t h i s means choosing from among alt e r n a t i v e tax p o l i c i e s those that least i n t e r f e r e with free trade while achieving the national p o l i c y o b j e c t i v e s . 3 6 An integrated and f l e x i b l e approach i s required to deal with the i n t e r n a t i o n a l aspects of convergence of taxation and 3 6 See Hirofumi Shibata, F i s c a l Harmonization under Freer Trade; P r i n c i p l e s and Their Applications to a Canada-U.S. Free Trade Area (Toronto: University of Toronto Press, 1969) at 4 - 8. 205 i n t e r n a t i o n a l trade. Although u n i l a t e r a l tax p o l i c i e s , tax t r e a t i e s , and model tax conventions, are the t r a d i t i o n a l approaches for dealing with international taxation issues, attention i s now being given to a l t e r n a t i v e m u l t i l a t e r a l approaches fo r e f f e c t i v e l y and meaningfully managing the convergence of taxation and free trade. Further research i s needed i n order to assess how various tax p o l i c i e s measure up to i n t e r n a t i o n a l trade p r i n c i p l e s and obligations, and how to best approach convergence on a m u l t i l a t e r a l scale. Quantification of tax p o l i c y d i s t o r t i o n s on trade i s also necessary to c l e a r l y i d e n t i f y tax measures of highest p r i o r i t y . Some suggestions have been advanced as a s t a r t i n g point f o r work on a GATT tax code. 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