Canadian DST on the Horizon
By Nathaniel Nurse, Lucile Flandinette & Allison Christians
As expected, Canada recently announced its plans for a digital service tax, housed within a larger plan towards a “fair taxation system” as a response to COVID-19. The plan indicates Canada will likely go with a DST styled largely on the example set by France, but this is not the only path that Canada could ultimately follow. In fact, Canada has a number of options, each facing distinct implementation challenges. In this entry of the DST Log, we take a look at the three options and consider the one Canada chose in light of two ready alternatives.
[Visual: Overview of DST Options for Canada - View full-sized image here]
Canada’s announced plans for taxing the digital economy includes two main strategies, only one of which is a DST as we have previously defined it in DST Log Entry 03. The other is an extension of its current goods and services tax registration rules to remote sellers. As explained in that DST Log Entry, this kind of move does not strictly constitute a DST in the sense that it is not a surtax on the profits of highly digitalized firms. It is instead a logical extension of consumption tax collection obligations to firms that would otherwise escape them. The exclusion of remote sellers from such taxes creates an inequity for domestic competitors that has been clear for quite some time, and has thus already prompted reforms at the provincial level.
The outlines of the federal approach are laid out in its Fall Economic Statement 2020: Supporting Canadians and Fighting COVID-19. The Statement explains that under current rules, foreign-based digital businesses can sell their goods and services to Canadians without charging the Goods and Services Tax/Harmonized Sales Tax (GST/HST) as is required of domestic providers of competing goods and services. To level the playing field, the Statement announces that GST/HST registration will become mandatory for non-resident vendors that supply digital products or services to customers in Canada under a simplified online registration and remittance system. These measures include non-resident operators of digital platforms but are limited to business-to-consumer suppliers.
Additionally, the government proposes to apply the GST/HST on all sales to Canadians of goods located in Canadian fulfillment warehouses. Under this proposal, “the GST/HST will be required to be collected and remitted by either the foreign-based vendor or the digital platform that facilitates the sale.” Further, pertaining to short-term accommodation digital platforms (such as AirBnB), the government proposes that “the GST/HST be required to be collected and remitted – by either the property owner, or the digital accommodation platform – on short-term accommodation that is supplied in Canada through a digital accommodation platform.” Estimated to increase federal revenues by $1.2 billion over 5 years, these reforms are proposed to be effective July 1, 2021.
The Statement also announced the government’s intention to impose a new DST on foreign firms providing digital services to Canadians. Of course, Canada has been working closely with the OECD since 2013 to develop a multilateral approach regarding digital taxation, with the current deadline for consensus scheduled for mid 2021. But the government is concerned about delays to reach consensus and accordingly its plan is to implement a provisional or temporary DST until such multilateral approach comes into effect. This brings us to the details of option 1 for taxing digital services in Canada, namely, a Canadian DST.
Option 1: Canadian Digital Service Tax
In the federal budget for 2021-2022 released in April 2021, the government proposed to implement a 3% DST on revenue derived from digital services that rely on data and content contributions from Canadian users. As mentioned above, the proposal closely models the French DST. The DST would apply to “large” businesses, namely, those generating gross revenues of at least EUR 750 million as of January 1, 2022. The government estimates that the DST will raise $3.4 billion in revenue over five years.
As we explored in DST Log Entry 05, implementing this form of unilateral DST risks landing Canada on the list of jurisdictions targeted by internal U.S trade investigations under Section 301 of the Trade Act of 1974. Canada’s free trade agreement with the U.S may be relevant if that happens, but the scope for conflict and the prospects for resolution are uncertain. As such, it is worth considering: what other options are available, and would they be any less susceptible to the same trade-based inquiry?
We find two additional options readily available to Canada, but neither is free from difficulty. The first of these is to adopt a withholding tax on income associated with specified services, which would be in line with a treaty provision recently developed by the United Nations; the other is a more uniquely Canadian solution, in the form of a denial of deduction for advertising payments made to foreign firms. Each is explored in turn.
Option 2: Withholding of Income from Automated Digital Services
As the OECD’s work on the two pillars demonstrates, there is now widespread consensus that the current rules governing digital services under Article 7 of the UN model tax convention (business profits) no longer cover the reality of a highly digitalized economy. The key problem identified is that income from digital services is only taxed by market jurisdictions “if the companies providing these services would do so through,inter alia,a fixed place of business situated in these market jurisdictions.” A fixed place of business is needed to overcome the nexus threshold to taxation found in tax treaties based on the OECD model, which includes all of Canada’s tax treaties. As readers of this DST Log are no doubt aware, a fixed place of business typically requires physical presence, the very thing that remote sellers are lacking. But the OECD’s two pillar approach is not the only possible solution to overcome this barrier to taxation. On August 6, 2020, the United Nation (UN) Committee of Experts on International Cooperation in Tax Matters proposed another, namely in the form of a withholding tax.
The new Article 12B would effectively grant additional taxing rights to countries in which an automated digital services provider’s customers are located by providing for a gross-basis withholding tax on certain income derived from such services. The rate would be subject to negotiation between the contracting states but presumably would be in line with other type of withholding taxes (which are customarily higher than the typical DST rate). Similar to the OECD’s Pillar 1, the UN Article 12B defines “automated digital services” broadly, covering online advertising services, online search engines, social media platforms, online gaming, and cloud computing services but excluding consumer-facing businesses. During the Committee’s 21st virtual session, the UNCommittee of Experts on International Cooperation in Tax Matters agreed to add a version of the proposed article 12B to its UN Model Double Taxation Convention between Developed and Developing Countries. On April 20, 2021, the UN approved the final version of the Article.
How different from a DST is a withholding tax? In reality, withholding taxes are and always have been gross basis (excise) taxes even when they are embedded in income tax regimes. But withholding is a well-accepted means of extending domestic (net) income taxes to cover non-residents, while a DST is effectively a separate excise tax. The naming matters because in theory a standard withholding tax should be eligible for foreign tax creditability, thus allowing source-based taxation while mitigating the risk of double taxation. The United States has already made it clear that it views DSTs as non-creditable, and its Treasury recently issued proposed regulations that would further strengthen its overall resistance to such taxes. But since most OECD countries including the United States have long accepted specified gross-basis taxes as “in lieu of” net-basis income taxes which would apply were domestic nexus thresholds exceeded, withholding taxes embedded in an income tax might get the benefit of the doubt where DSTs do not.
The problem for Canada and other countries is that existing tax treaties specify exactly what kinds of income are subject to withholding taxes at source, and the list traditionally excludes most forms of “active” business income. Advertising revenues are not listed in any of the specified categories, and probably constitute business income to most non-resident recipients. These categories are relatively rigid in the minds of some, but they are not unchangeable. The development of Article 12B introduces a rationale for a change in this traditional thinking, but it is by no means a foregone conclusion that all treaty partners will agree.
The fact that Article 12B is in a Model Convention specifically designed for treaties between countries of dissimilar economic status in no way prohibits its use in any given treaty relationship. Indeed, many U.S. tax treaties reflect the UN Model’s historic preference for greater taxation at source, regardless of the development level of the treaty partner, and this list includes the Canada-U.S. tax treaty. But compared to a DST, adding Article 12B to the Canada-US tax treaty (or any other Canadian tax treaty, such as that with China, the other major exporter of automated digital services) is not necessarily an easier policy approach because of course any such change must be bilaterally negotiated. It is not obvious that either the United States or China would be willing to negotiate this change, or if they would, what tax rate would meet with the approval of both. Arguably, the apparent rigidity of the current bilateral tax treaty situation is precisely why Canada and other countries chose to forego this relatively simpler approach to taxing digital services in favour of a DST, even though the latter has raised trade issues where the former presumably would not.
As such, a withholding tax on automated digital services tax might be a relatively much easier way to raise taxes on remote providers of digital services to Canadians, but there are clear reasons why the government might not have chose this route. Even so, there remains another possible option for Canada that might be more unique, namely, in the form of a denial of deduction.
Option 3. Denial of Deduction for Advertising Expenses
Canada’s third option for raising revenue from remote providers of digital services is one that directly targets the buyers of such services rather than the sellers. Doing so involves expanding current limitations on the tax deductibility of certain advertising expenses paid to foreign media firms. Currently, only advertising expenses associated with foreign-owned print, television and radio broadcasting providers are covered. The relevant provisions are found in ITA Section 19 and 19.1. Expanding these limitations to cover expenses for advertising paid to foreign digital services providers would in effect impose a higher rate of tax on Canadian businesses that choose to advertise on foreign-owned platforms as compared to those advertising on Canadian alternatives.
The mechanics of the current limitations on deductibility are relatively simple even if the trade implications are a bit murky. In brief, ITA s. 19 denies a deduction for expenses incurred for advertising space “in an issue of a newspaper for an advertisement directed primarily to a market in Canada,” unless the issue is one of a Canadian newspaper (with some technical exceptions). An issue of a Canadian newspaper is then defined to effectively exclude foreign-owned media firms of various kinds. ITA s19.1 in turn denies deductibility of an expense for an advertisement “directed primarily to a market in Canada and broadcast by a foreign broadcasting undertaking,” with a foreign broadcasting undertaking defined as “a network operation or a broadcasting transmitting undertaking located outside Canada or on a ship or aircraft not registered in Canada. The definition does not explicitly exclude internet-based platforms as a form of broadcasting, but that has been the interpretation taken to date.
This interpretation, according to FRIENDS of Canadian Broadcasting and the Public Policy Forum, a Canadian broadcasting trade group, has resulted in a crisis for Canadian media as advertising flees print in favour of digital media alternatives, most of which is foreign-owned. In evidence presented to the Standing Senate Committee on Transport and Communications, the Executive Director of FRIENDS explained that “in 2017, Canadian advertisers spent an estimated $6.2 billion on digital ads and eighty per cent of that — $5 billion — flows to foreign media companies, principally Google, its subsidiary YouTube, and Facebook” even as “Canadian newspapers, both in print and digital formats, have seen advertising revenues decline by more than 50 per cent since 2006.”
After hearing from FRIENDS and others, the Standing Senate Committee determined that the current limitation of deductibility for advertising expenses associated with foreign media firms ought to be extended to online media. In a report on The Tax Deductibility of Foreign Internet Advertising In Canada, the Standing Senate Committee agreed with FRIENDS and other witnesses that reform of the ITA was an appropriate way to effectively, if indirectly, tax foreign providers of advertising platforms. The Report cited a FRIENDS estimate that such a reform could shift an estimated 10% of foreign internet advertising expenditures back to Canada while raising the tax collected from affected Canadian businesses by $1 billion.
Would extending the terms of ITA s. 19 and 19.1 to cover foreign automated digital services providers be a way for Canada to achieve the apparent objectives of a DST, without the same trade-based risks? The answer is not at all clear. The provisions of ITA 19 and 19.1 explicitly discriminate against foreign firms and have been the subject of U.S. Congressional scrutiny over the years. According to one Congressional report, the U.S. took issue with the then-newly adopted ITA s.19.1 in the course of renegotiating the Canada-US tax treaty but Canada “refused to discuss this provision.” The U.S. Senate then approved various resolutions in objection and some U.S. some broadcasters filed a complaint under section 310 of the Trade Act of 1974 alleging that the Canadian provision was as unreasonable practice that burdened U.S. commerce. Congress considered but ultimately took no further action on a bill that would have mirrored the Canadian provision. There is clearly some history here that would benefit from study in determining the risks to Canada should amending the provisions of ITA s. 19 and 19.1 be seriously considered.
◄ Back to Digital Tax Log
Nathaniel Nurse, Lucile Flandinette & Allison Christians, CTF Digital Tax Log, Entry #6, 1 June 2021, at http://www.ctf.ca/CTFWEB/EN/Newsletters/Blogs_and_Reports/Digital_Services_Updates/Entries/Entry06.aspx
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