Ten Problems With Canada’s Plan to Tax U.S. Internet Services Companies
My Canadian mother used to say: “Two wrongs do not make a right.” The Trudeau administration seems to have taken the opposite view, as it has justified its proposed protectionist and extractionist digital services tax (DST) as ensuring that Canada won’t left behind the several nations that jumped the “OECD BEPS gun” to put in place their own DST tax grabs. But just as those countries were wrong not to wait for the BEPS process to be completed, so is Canada.
As far as one can ascertain, Deputy Prime Minister Freeland has justified Canada’s proposed imposition of a DST as a response to cross-border tax shifting, something the OECD Base Erosion Profits Shifting (BEPS) plan seeks to address in Pillar One. Minister Freeland stated in July: “Two years ago, we agreed to pause the implementation of our own Digital Services Tax (DST), in order to give time and space for negotiations on Pillar One.” But Pillar One is not about digital services; it’s about the potential for firms in any industry to shift revenue from high-profit jurisdictions to low-profit ones. Picking out one industry, digital—an industry overly represented by U.S. firms—is not only discriminatory, but also harms Canadian growth and competitiveness.
The OECD Inclusive Framework released an Outcome Statement on 11 July 2023, which included an additional one-year hold on imposing any new DST legislation as members realized that Pillar One would not be fully implemented by the end of 2023. While 138 member counties approved of the Outcome Statement, Canada, along with Russia and several others, did not.
Now Canada is on track to enact its own DST by 1 January 2024, with retroactive effect to 1 January 2022. Under the proposed rules, many companies would be subject to a 3 percent tax on all digital earnings in Canada if they have global consolidated revenues of €750 million or more (in digital and non-digital revenue) and earns Canadian digital services revenue from providing online marketplace services, online advertising, social media services, or the monetizing of user data in excess of CA$20 million. The Canadian law differs from some other countries’ DST laws in that the global revenue thresholds apply to total revenues, not just digital services revenues. As such, it would sweep in many companies that happen to sell some products online in addition to in physical stores.
Such a discriminatory tax grab from U.S. companies will not only lead to reduced services or increased prices for digital services in Canada, but also surely lead to a retaliatory response by the U.S. government. U.S. Senate Finance Committee Chairman Ron Wyden (D-OR) and ranking member Mike Crapo (R-ID) recently wrote to the U.S. trade representative asking her to impose trade measures on Canada if its DST takes effect. Even if the United States resists such measures, a Canadian DST would certainly strain relations at a time when both nations need to be working hand-in-glove to address the most important threat to our two nations, China.
There are at least 10 problems with the Canadian proposal.
1. The DST discriminates against one sector. Many industries can earn revenue in a country and legally shift that revenue to other nations for tax purposes. OECD’s Pillar One is the solution to this. But Pillar One is not designed only to address digital services. As the OECD has explained, “Pillar One will ensure a fairer distribution of profits and taxing rights among countries with respect to the largest MNEs, including digital companies.” The OECD has made it clear that the issue of digitalization and international tax goes far beyond narrow digital companies: “instead, it considered digitalization as a transformative process affecting all sectors brought by advances in ICT.” It went on to state: “Because the digital economy is increasingly becoming the economy itself, it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes.” Yet that is exactly what the Canadian DST would do.
2. The DST discriminates against larger firms. The proposal arbitrarily sets tax thresholds with no logic behind them other than to sweep in the largest U.S. firms. The DST thus perversely gives firms, including Canadian ones, an incentive to not grow. Once a firm hits the magic threshold of CA$20 million in Canadian digital services revenues, it would face a 3 percent tax on those revenues. If a firm is earning CA$19 million in Canada, the smart thing for it to do would be to stop growing there. If it earns $1 million more, it would face a tax of $600,000. This incentive not to grow will mean fewer Canadian jobs.
3. It discriminates against firms with low profit rates. International tax treaties have generally agreed that profits, not revenue, should be taxed. That way, firms that earn few profits are taxed less and highly profitable firms are taxed more. A tax on sales means that lower-profit firms will have extremely high taxes relative to their profits. And this will make it more likely that less-profitable firms go out of business.
4. The tax will be passed on to Canadian consumers, including small businesses that use these services. For example, the DST will mean that sellers or advertisers on platforms will pay more. The Montreal Economic Institute found that, “Once the so-called GAFA tax was implemented in [France] that prices went up by 2 percent for clients of Google and by 3 percent for clients of Apple and Amazon.” This is because the firms passed the tax onto local customers.”
5. A DST is designed to ensure foreign companies pay tax on local revenue. As such, there is no rationale for including domestic firms. Yet that is what Canada’s DST would do. But if the Ministry of Finance thinks that firms like Canada Tire and grocery platform Loblaws are shifting profits out of the country unfairly, it can step in under its own tax rules. This gets to the real motivation for including Canadian firms: to rebut the argument that the DST targets U.S. firms. But this is a ruse. Its purpose is definitely to tax U.S. firms.
6. Tax retroactivity is unprecedented. Yet, Canada wants firms to pay DSTs for prior years because it held off imposing them while the OECD was negotiating the BEPs agreement. This is simply capricious. Why 2 years, why not 5? 10? 20? Imagine if Finance were to tell individual Canadian taxpayers that they retroactively eliminated a tax deduction from prior years and that consumers had to cough up the tax this year?
7. The entire premise of a DST violates international tax norms and is based on the false view that the production of digital services occurs in the nation imposing the tax. When I buy Canadian Honey Butter from my local grocery store in Washington, D.C., the U.S. government does not impose a tax on Dickey Bee Honey, because Dickey Bee pays its corporate taxes to Canadian governments (federal and provincial). Likewise, when a Windsor resident buys their Canadian honey butter at a Walmart in Detroit, Canada cannot tax Walmart’s earnings just because some of it came from Canadian purchases. It’s no different when a resident of Windsor searches Google. They are coming to Canada and the actual production of value is occurring in the United States. Despite what DST advocates say, digital services consumers are not producers that trigger tax nexus. This would be like saying that I am a producer of honey butter if I, as someone living in the United States, send Dickey Bee Honey a suggestion for how to improve its label.
8. There is nothing new about goods or services being able to be imported. In its discussion of BEPS, the OECD writes: “Certain processes previously carried out by local personnel can now be performed cross-border by automated equipment, changing the nature and scope of activities to be performed by staff. Thus, the growth of a customer base in a country does not always need the level of local infrastructure and personnel that would have been needed in a ‘predigital’ age.”
It goes on to note, “Advances in business practices, coupled with advances in ICT and liberalization of trade policy, have allowed businesses to centrally manage many functions that previously required local presence, rendering the traditional model of doing business in market economies obsolete.”
So what? But there is nothing new here. 150 years ago, most goods were made and consumed locally or regionally. But with the rise of factory production, many more industries were characterized by a strong geographical separation of production and consumption and more exports and imports. While digitalization extends that dynamic, it does not change it in any fundamental ways. At the time, the international tax treaties dealt with this by taxing where production occurred, and that regime can do the same today, especially if BEPS is enacted.
9. DST is an arbitrary “Rube Goldberg” scheme. As the OECD acknowledges, in the digital economy it’s almost impossible to ring fence digital services. But the Canadian government valiantly tries to do this. Its proposal, for example, states that, “many online gaming platforms with an interactive component allow users to find and interact with other users or with user-generated digital content, but often such features of the game are incidental to the main purpose (i.e., the service of providing a gameworld). However, if the interactive component of an online game is the game’s main purpose, the game would be a social media platform.”
Leaving aside the arbitrariness of defining “main purpose,” what possible logic is there to tax one gaming platform where the players play against each other and not tax one where they do not? Similarly, with regard to social media platform revenue, the proposal excludes revenue “from the provision of private communication services consisting of video calls, voice calls, emails and instant messaging, if the sole purpose of the platform is to provide such services.” Why? What if it’s the main purpose but not the sole purpose? Similarly, “online marketplace” excludes digital interfaces that have as their main purpose the making of advances or the lending of money. Why?
10. The DST will hurt Canada’s efforts improve its global competitiveness in the IT and information services sector. As ITIF has shown, this industry is the largest advanced industry in Canada. Imposing a discriminatory tax would likely reduce Canada’s growth, in part by sending a message to the world that Canadian policymakers see the industry as a cash cow to be milked and not a core industry to be supported.