Canada Should Refrain from Imposing New Digital Sales Taxes

Canada appears to be barreling ahead with a new, ill-advised 3 percent digital services tax on revenue earned by large digital services providers that would include online marketplace services revenue, online advertising services revenue, and social media services revenue. The tax would take effect January 1, 2024, and would be retroactive to 2022. The tax hike is problematic for several reasons.

●      Canada’s tax would preempt OECD negotiations on international taxation, jeopardizing the possibility of a successful conclusion. Pillar One negotiations that would reallocate some taxes to countries where sales occur instead of where corporations are based were scheduled to take effect in 2024. Based on that timetable, countries that had planned to implement DSTs agreed to hold off until the end of 2023 or until the Pillar One agreement took effect.

However several months ago, with the exception of Canada and a handful of other states such as Belarus and Russia, nearly every country involved in the negotiations agreed to delay implementation of any DSTs for at least another year in an effort to reach an international consensus on tax policy.

OECD’s Pillar One and Pillar Two Framework is far from perfect, and we have written extensively on the Framework’s numerous policy and administrative flaws. For example, while February 2023 OECD guidance recognizes the current U.S.-based Global Intangible Low-Taxed Income regime as a “blended Controlled Foreign Corporation” arrangement under Pillar Two, this does not answer numerous technical issues. Among these are whether the Qualified Domestic Minimum Top-Up Tax under Pillar Two would be creditable in the U.S., how the so-called substance carveout should account for interest expenses, and how the corporate alternative minimum tax created in the Inflation Reduction Act would mesh with OECD’s scheme Fundamental questions also remain about the Under Taxed Profits Rule in the OECD framework, which could subject U.S. companies’ domestic income to foreign countries’ taxes.

Key portions of the administrative aspects of the plan likewise remain less than concrete, including how dispute resolution mechanisms will be upsized for multi-party tax controversies, and how oversight of the Pillars’ implementation will allow for ongoing formal input from affected taxpayers.

Not only does OECD have further questions to answer, but so do the Biden administration and Congress, including how other portions of U,S. law such as the Foreign Derived Intangible Income deduction will be protected, and how exemptions sought by other countries can be minimized.

Nonetheless, by jumping the gun and implementing a DST before the OECD negotiations are complete, Canada’s action could threaten efforts to bring them to a successful, or at least more productive conclusion than encouraging a proliferation of worse tax schemes. Indeed, other countries are already following Canada’s lead.

●      The tax would function as a gross receipts tax, levying taxes on revenues instead of net income. Gross receipts taxes fail to take into account profit margins — meaning that firms with smaller profit margins face arbitrarily higher effective tax rates. As the Office of the U.S. Trade Representative (USTR) observed: “With respect to tax policy, the DSTs may diverge from norms reflected in the U.S. tax system and the international tax system in several respects. These departures may include: Extraterritoriality; taxing revenue not income; and a purpose of penalizing particular technology companies for their commercial success.”

●      The USTR’s reference to “extraterritoriality” highlights another key issue: Canada’s tax would potentially violate one of the key principles of international trade conducted under the auspices of the U.S.-Mexico-Canada Agreement (USMCA) and the World Trade Organization (WTO), that governments should not discriminate between domestic and foreign suppliers. Digital services taxes, whether crafted by foreign nations or even states like Maryland, are consistently crafted in a way that exempts domestic service providers and targets those based outside their borders.

Digital service taxes by definition discriminate against digital services. For international trade purposes, the concern is that they also discriminate against innovative and successful businesses in the tech industry — an industry which is dominated by U.S. based multinational firms. Article 19.4 of USMCA provides for non-discriminatory treatment of digital products.

In addition, Article 19.3 of USMCA prohibits the imposition of customs duties, fees, or other charges on digital services imports or exports. The United States could argue that Canada’s tax is effectively a tariff. There are clear similarities between a hypothetical 3 percent tariff on U.S.-made cars and a 3 percent tax that primarily targets U.S. digital services firms.

Unfortunately, USMCA gutted the enforcement provisions of its predecessor, the North American Free Trade Agreement. Under USMCA Article 32.2, “Nothing in this Agreement shall be construed to preclude a Party from applying measures that it considers necessary for … the protection of its own essential security interests.” If Canada chose to say that it considers its DST to be necessary to protect its essential security interests, the United States would be unable to challenge it under USMCA. Canada Finance Minister Chrystia Freeland laid the groundwork for such a claim earlier this year, stating: “it is really important for us to defend our national interest.”

WTO dispute settlement negotiations, time-consuming in the best of circumstances, are an even less viable option due to the organization’s non-functioning appellate body. If the United States won a WTO dispute, Canada could appeal the ruling. Since there is currently no appellate body to review an appeal, the WTO win would be unenforceable.

The remaining alternative, unilateral retaliatory tariffs imposed by the United States under Section 301 of the Trade Act of 1974, would jeopardize trade with our largest export market and second-largest trading partner as of July. On the other side of things, the United States is by far Canada’s largest trading partner. Canada should not jeopardize this mutually beneficial trade relationship.

●      A DST could likewise invite retaliatory tax actions from the United States. In May of this year, every Republican Member of the House Ways and Means Committee backed new legislation requiring the Treasury to identify “extraterritorial taxes and discriminatory taxes enacted by foreign countries that attack U.S. businesses,” and then phasing in higher U.S. tax rates of up to 20 percentage points on offending nations. Recently, Rep. Ron Estes (R-KS) led a letter from many House Ways and Means Committee lawmakers urging Treasury Department “to engage in robust consultations with Congress, provide Congress with previously and repeatedly requested revenue and economic impact data, and reverse Treasury’s many anti-U.S. business, anti-U.S. tax collection, and anti-U.S. economy concessions” regarding OECD’s framework.

●      Furthermore, USMCA secured important de minimis thresholds for customs duties on goods entering Canada from the U.S. or Mexico that provide relief from taxes and customs duties. Other parties raised their thresholds too. These thresholds, which benefit the flow of commerce among all parties to USMCA as well as reduce administrative headaches for governments and taxpayers, could become more vulnerable to harmful retaliatory proposals from policymakers in the future.

●      Perhaps most importantly, Canada’s action would place a new burden on Canada taxpayers. A 2019 Deloitte/Taj analysis of a similar 3 percent tax proposed by France found that just 5 percent of the burden of the tax would be borne by large internet companies. Consumers would bear 55 percent of the costs, and businesses using digital platforms, such as newspapers or review crowd-sourcers like Yelp, would bear the remaining 40 percent.

Notably, when France temporarily instituted its 3 percent tax, Amazon simply increased the prices it charged French customers, passing the bill to them. Much like with a tariff, it is ultimately domestic consumers who pay.

Digital taxes have often been justified by claims that tech firms face lower corporate income tax obligations than traditional firms. This argument is not backed up by the evidence, however, as researchers have found no systematic difference in income taxes paid by digital corporations compared to their peers.

In 2020, Canada issued the following statement at the WTO: “Canada remains convinced that ensuring a permanent, tariff-free space for cross-border electronic transmissions, including content, is a meaningful way to provide a long-term predictability, certainty and openness for businesses and consumers.” This conviction should extend to Canada’s tax policies.

For its part, the United States could consider offering Canada an olive branch – or in this case, a maple leaf. Canada recently issued a new challenge to U.S. lumber tariffs that harm Canadian exporters and increase home prices in the United States. The Biden administration could offer to pause them in return for a similar pause in Canada’s proposed tax.

These disputes have made it clear that the United States should also work to include explicit language banning discriminatory taxes in future trade agreements, like that in the U.S.-Japan digital agreement, along with beefing up the enforceability of our existing agreements.

In 1987, the United States and Canada agreed to a historic trade agreement that opened the door to expanded trade around the world. We should not allow new discriminatory taxes to slam that door shut.