2022 Canadian Federal Budget: International Tax

On April 7, 2022 (Budget Day), The Honourable Chrystia Freeland, deputy prime minister and minister of finance, delivered the highly anticipated 2022 Canadian federal budget (Budget 2022).

In addition to the key business, personal and other tax measures discussed in other parts of our series, Budget 2022 included several key proposals and consultations on proposed international tax changes impacting Canadian businesses. Unless otherwise stated, all statutory references are to the Income Tax Act (Canada) (the Tax Act).

International tax reform

On October 8, 2021, Canada and 136 other member states of the Organisation for Economic Co-operation and Development (OECD)/Group of 20 (G20) Inclusive Framework on Base Erosion and Profit Shifting (the Inclusive Framework), joined the Statement on the Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy (the October Statement), which outlines a two-pillar structure aimed at addressing the tax challenges arising from the digitalisation of the global economy. In Budget 2022, the federal government confirmed its commitment to implement both Pillar One (styled as a digital services tax) and Pillar Two (styled as a global minimum tax) into Canadian law.

Update on Pillar One and the Digital Services Tax

The purpose of Pillar One is to re-allocate the right to tax a portion of the profits of large multinational enterprises (MNEs) to market countries (i.e., where the consumers/users of the MNEs are located) by updating the framework for profit allocation under current income tax treaties, subject to some specific exclusions for regulated financial services and extractive industries. Draft rules were released for public consultation in February 2022, with a view to implementation (by a multilateral convention) in 2023. Pillar One would initially apply to MNEs with revenue in excess of €20 billion and profitability in excess of 10% (i.e., profit before tax divided by revenue).

Following the October Statement, Canada confirmed its commitment to Pillar One and announced it still intended to move ahead with legislation finalizing a domestic digital services tax (DST) by January 1, 2022 (as announced in the federal government’s 2021 budget). 

In Budget 2022, the federal government confirmed its intention to proceed with implementing the DST as of January 1, 2024, if the multilateral approach of the Inclusive Framework on Pillar One does not come into force by January 1, 2024. Draft legislation to implement the DST was released for public consultation in December 2021 and Budget 2022 indicated the government was reviewing public comments received on the proposals. Under the draft legislation, a 3% DST would be imposed on Canadian digital services revenues (generally, revenues from certain online marketplace and advertising services, social media services and the sale or licensing of user data) in excess of C$20 million earned in 2022 and later calendar years by an entity or consolidated group with at least €750 million total revenues. If the DST does come into force, it would be payable for revenues earned as of January 1, 2022. 

In Budget 2022, the government confirmed it is actively working with its international partners to implement Pillar One and it remained "the government’s hope and underlying assumption that the timely implementation of the new international tax framework will make" implementing the DST unnecessary. 

Pillar Two – Global Minimum Tax 

Pillar Two of the Inclusive Framework provides a framework for imposing a minimum tax of 15% on MNEs with annual revenues of €750 million or more. Pillar Two is generally intended to be implemented through changes to each member country's domestic law (rather than through a multilateral instrument like Pillar One). To ensure consistency in the coordinated implementation of Pillar Two under domestic law, the Inclusive Framework approved model rules (Model Rules, published in December 2021) and commentary providing guidance on the interpretation and operation of the Model Rules (published in March 2022).  

Under Pillar Two, an MNE is generally required to calculate the effective tax rate on its profits in each jurisdiction where it operates. If the effective tax rate for a particular jurisdiction is less than 15%, the MNE will be subject to a top-up tax that brings the effective tax rate on profits from the MNE's operations in that jurisdiction to the 15% minimum rate. Pillar Two comprises two core rules – the income inclusion rule (the Income Inclusion Rule) and the undertaxed profits rule (the Undertaxed Profits Rule) (together, the OECD/G20 refers to these as the Global anti-Base Erosion Rules or GloBE rules).

• The Income Inclusion Rule is the primary rule. Under this rule, if the country where the ultimate parent entity of an MNE is located has implemented the Income Inclusion Rule, it has the primary right to impose a top-up tax on the ultimate parent entity for income from the MNE’s operations in any jurisdiction where it is taxed at an effective tax rate below 15%. If the ultimate parent jurisdiction has not implemented the Income Inclusion Rule, the right to impose the top-up tax under the Income Inclusion Rule shifts to the jurisdiction of the highest-tier intermediate parent entity within the MNE’s structure that has adopted the Income Inclusion Rule.
• The Undertaxed Profits Rule is a backstop rule that generally applies where neither the ultimate parent jurisdiction nor any intermediate parent jurisdiction of an MNE has implemented the Income Inclusion Rule. In that circumstance, the Undertaxed Profits Rule permits other jurisdictions in which the MNE operates to impose a top-up tax on group entities located in their jurisdictions, with the top-up tax being allocated among those jurisdictions on a formulaic basis. 

A carve-out from these top-up taxes would be provided for certain "substance-based" income. 

In addition to the Model Rules, Pillar Two allows a jurisdiction to introduce its own domestic minimum top-up tax, which may be credited against the top-up tax otherwise applicable under Pillar Two. This effectively permits a jurisdiction to collect the top-up tax on the low-taxed income of its domestic entities in priority to other jurisdictions. 

The October Statement indicated that Pillar Two should be brought into member countries’ domestic laws in 2022, with the Income Inclusion Rule coming into effect in 2023 and the Undertaxed Profits Rule in 2024. Consistent with the October Statement, Budget 2022 proposes to implement Pillar Two, along with the domestic minimum top-up tax that would apply to Canadian entities of MNEs that are within the scope of Pillar Two, with the Income Inclusion Rule and the domestic minimum top-up tax proposed to come into effect in 2023 and the Undertaxed Profits Rule proposed to come into effect no earlier than 2024. 

Budget 2022 also launched a public consultation on implementing the Model Rules in Canada and the domestic minimum top-up tax, and included a series of detailed questions to guide the consultation process. The deadline to submit comments is July 7, 2022. 

Exchange of tax information on digital economy platform sellers

Budget 2022 proposes to implement the OECD’s model rules requiring collecting and reporting certain information to tax authorities by digital platform operators with respect to platform sellers. The model rules, which were developed by the OECD to address concerns that not all platform sellers are aware of the tax implications of their online activities and the lack of visibility that tax authorities have into online platforms, are intended to ensure revenues arising from online activities are properly taxed in the jurisdiction in which they are earned.  

Under the model rules, an online platform is generally only required to report information with one jurisdiction, which will then share the information collected with partner jurisdictions that also implement the model rules. In Canada, a reporting platform operator will be required to report this information to the Canada Revenue Agency (CRA), which will then be responsible for exchanging information with Canada's partner jurisdictions. 

Budget 2022 proposes that reporting platform operators would generally include entities that:

• are either (i) resident in Canada; or (ii) if not resident in Canada (or a partner jurisdiction), are entities that facilitate relevant activities by sellers resident in Canada or with respect to rental of immovable property located in Canada; and
• either (i) contract directly or indirectly with sellers to make the software that runs a platform available for the sellers to be connected to other users; or (ii) collect compensation for relevant activities facilitated through the platform.

It is proposed that platform operators would not be subject to the proposed rules if their software exclusively facilitates (i) the processing of compensation in relation to relevant activities (i.e., pure payment processors), (ii) the mere listing or advertising of relevant activities (i.e., classified ads boards) or (iii) the transfer of users to another platform (i.e., online aggregators), provided in each case that there is no further intervention in the provision of relevant activities by the platform operator. 

In addition, it is proposed that the definition of a reporting platform operator will exclude an operator that can demonstrate to the CRA that its business model does not allow sellers to profit from the compensation received, or its platform does not have any reportable sellers. Finally, it is also proposed that platform operators that facilitate the provision of relevant activities for which the total compensation over the previous year is less than €1 million may elect to be excluded from collecting and reporting information.

Budget 2022 proposes that:

• relevant activities will generally include the provision of relevant services (generally, the provision of personal services, the rental of immovable property and the renting of the means of transportation) and the sale of goods; and
• a reportable seller would be an active user who is registered on a platform to provide relevant services or sell goods. However, a reportable seller is proposed to exclude certain entities that are considered a low compliance risk: governmental entities, certain publicly traded entities, certain large providers of hotel accommodation and sellers of goods who make less than 30 sales a year for a total of not more than €2,000. 

Under this proposed measure, reporting platform operators would need to complete due diligence procedures to identify reportable sellers and their jurisdiction of residence. For platform operators that become reporting platform operators for the first time, the due diligence procedures would be required to be completed by December 31 of the second calendar year in which the platform operator is subject to the reporting rules. A reporting platform operator could continue to rely on the due diligence undertaken for a previous year if the operator has verified the seller’s address within the last 36 months and has no reason to believe the seller’s information is unreliable or incorrect. 

A reporting platform operator will be required to report to the CRA certain specified information about a reportable seller by January 31 of the year following the calendar year for which the seller is identified as a reportable seller. The reporting platform operator will also be required to provide the same information to the reportable seller by the same date. The proposed rules also contain provisions that prevent the duplicative reporting of a reportable seller’s specified information. 

Finally, Budget 2022 states that the CRA would (i) automatically exchange with partner jurisdictions the information received from Canadian platform operators on sellers resident in the partner jurisdiction and rental property located in the partner jurisdiction, and (ii) receive information on Canadian sellers and rental property located in Canada from partner jurisdictions.

This measure is proposed to apply to calendar years beginning after 2023.

Interest coupon stripping

Generally, interest paid or credited by a person resident in Canada to a non-arm’s-length, non-resident person is subject to Part XIII withholding tax (Part XIII Tax) at a rate of 25%, subject to reduction under an applicable income tax treaty between Canada and the jurisdiction in which the non-resident is resident. For example, the rate of withholding may be reduced under an applicable income tax treaty to 10%, 15% or, in the case of the Canada-US income tax treaty, 0%.

Some taxpayers have entered into arrangements (referred to as interest coupon stripping arrangements) that have sought to eliminate or reduce the Part XIII Tax on non-arm’s-length interest. These arrangements generally involve a non-resident lender selling its right to receive future interest payments (interest coupons) in respect of a loan made to a non-arm’s-length Canadian-resident borrower to a party that is not subject to Part XIII Tax, or would be subject to a lower tax rate than would apply to a payment directly to the non-resident lender. The non-resident lender generally retains its right to the principal amount under the loan.

The Tax Act was amended in 2011 to override the Federal Court of Appeal decision in Lehigh Cement Ltd v R, 2010 FCA 124, in which the court found that the general anti-avoidance rule in the Tax Act did not apply to the particular interest coupon stripping transaction at issue in that case.  

As a result of the 2011 amendment, where a non-arm’s-length non-resident lender makes an interest-bearing loan to a Canadian resident and sells the interest coupons to an arm’s-length person, the interest would remain subject to Part XIII Tax because the interest is in respect of a debt owing to a non-arm’s-length non-resident. The 2011 amendment did not, however, apply to interest payments made to a coupon holder that was a Canadian resident and did not override the availability of treaty-reduced withholding rates under some of Canada's tax treaties on the interest payments, including the 0% withholding rate available under the Canada-US income tax treaty.

Budget 2022 proposes to further amend the interest withholding tax rules in the Tax Act to ensure the amount of Part XIII Tax paid under an interest coupon stripping arrangement is the same as if the arrangement had not been undertaken and the interest had been paid to the non-resident lender. Specifically, it is proposed that the Tax Act be amended by introducing a new anti-avoidance rule in proposed subsection 212(21) that will apply where:

• a taxpayer pays or credits a particular amount as, on account or in lieu of payment of, or in satisfaction of, interest to a person or partnership (the interest coupon holder) in respect of a debt or other obligation (other than a specified publicly offered debt obligation) owed to another person or partnership (the non-arm’s-length creditor) that is either (i) a non-resident person with whom the taxpayer is not dealing at arm’s length or (ii) a partnership other than a Canadian partnership; and
• the Part XIII Tax that would be payable in respect of the particular amount, if the particular amount were paid or credited to the non-arm’s-length creditor rather than the interest coupon holder, is greater than the tax payable under Part XIII in respect of the particular amount.

Where the anti-avoidance rule applies, proposed subsection 212(22) deems, for purposes of the interest withholding tax rules, the taxpayer to have paid interest to the non-arm’s-length creditor such that Part XIII Tax applies to the deemed interest payment in the same amount as the Part XIII otherwise avoided as a result of the interest coupon stripping arrangement.

As noted above, Budget 2022 proposes that a debt that is a "specified publicly offered debt obligation" will not be subject to the proposed rules. A "specified publicly offered debt obligation" is proposed to be defined to mean a debt or other obligation that meets the following conditions: 

• it was issued by the taxpayer as part of an offering that is lawfully distributed to the public in accordance with a prospectus, registration statement or similar document filed with and, where required by law, accepted for filing by a public authority; and
• it can reasonably be considered that none of the main purposes of a transaction or event, or series of transactions or events, as a part of which the taxpayer pays or credits an amount as, on account or in lieu of payment of, or in satisfaction of, interest to a person or partnership in respect of the debt or other obligation is to avoid or reduce tax that would otherwise be payable under Part XIII by a non-resident person or partnership to whom the debt or other obligation is owed.

This measure is proposed to apply to relevant interest payments or accruals to the extent that such interest accrued on or after Budget Day, unless the interest payment (i) is in respect of a debt or other obligation incurred by the Canadian-resident borrower before Budget Day; and (ii) is made to an interest coupon holder that (x) deals at arm’s length with the non-arm’s-length creditor and (y) acquired the interest coupon as a consequence of an agreement or other arrangement entered into by the interest coupon holder (evidenced in writing) before Budget Day. For interest payments or accruals falling within this exception, the measure is proposed to apply to the extent that such interest accrued on or after April 7, 2023.

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