Taxation and Trade – Again!
There is strong and enduring connection between trade and a country’s tax law dealing with international connections of taxpayers and their income earning activities. Most commonly, as in Canada’s case, this connection underlies domestic tax rules to reconcile overlapping tax claims of Canada and other countries by providing suitable credit for foreign taxes as a reduction of Canadian taxes and through the application of the distributive rules of tax treaties dealing, for example, with the allocation of rights to tax business income, interest, dividends and royalties.
These rules do not exist in a vacuum. They manifest a fundamental alignment of Canada’s and other countries’ entitlement to tax income that in some way has a connection to those countries.
In the case of business income earned by a non-resident, the “norm” is to favor the taxing rights of the country where the income is actually earned, called its “source” in international tax terms, provided that the non-resident earns the income through an established and generally observable local business presence, again in international tax terms called a “permanent establishment” . While far from uncontroversial, typically a permanent establishment is an enduring (at least with reference to typical requirements of a business) physical presence of some kind in the source country, which may be an agent acting with authority on the non-resident’s behalf. Generally, though not always is also associated with an active human presence propagating the business conducted through that presence.
Fairly clearly, the object of tax rules to reconcile intersecting inter-country tax claims is to avoid unwarranted costs that would be trading frictions. In large part, this is why modern tax treaties exist, and this objective very much is a part of their history from their genesis in work originally sponsored and conducted by the League of Nations shortly after the conclusion of the First World War. In fundamental respects contemporary tax treaties are not much changed from their model precursors, notably in their adoption of more or less physical measures of whether a non-resident conducts business through a taxable presence in a source country.
Therein lies a modern “rub”: what is the “right” approach if the nature of the business does not require a typical or traditional business presence in the source country, for this discussion Canada or the United States, but nevertheless all of the economic features of a business of that kind are just as “present” – that is, take advantage and even depend on the source country market and public infrastructure – as if a more clumsy physical presence was required? The question is not about the hegemony or intricacy of technology, but rather about the perpetuation of legitimate markers of tax jurisdiction, taking account of taxation’s role to fund collective consumption, direct patterns of economic development and business activities considered have public worth, and in so doing to elicit private payment for public good inputs in productive private enterprise.
The “Digital Economy”
How to deal with the “digital economy” is the more direct question that the earlier, more discursive question, manifests. “Digital economy” is something of a misnomer. It connotes transfers of goods and services by digital means, as well as the digital sale and distribution of digital products – which may or may not be “goods” or “services” according to traditional standards. Digital is a fashionable word for transmission by electronic means, which in the international tax sense mentioned earlier reflects the possibility of conducting business “in” a source country without a physical or animate human presence there – not because of an elaborate tax plan, but because the nature of the business does not require it, that is such a presence is irrelevant and unnecessary.
There is a fierce – for those concerned with international tax — debate ongoing about how to align traditional tax treaty based notions of source country business presence with digital means of conduction business. Partly this arises from work undertaken by the Organisation for Economic Co-operation and Development (the “OECD”) and the G-20 in their project on “Base Erosion and Profit Shifting”; Action 1 of that Project, the first report on the Action in the late Fall of 2015 and an ensuing further report in March of this year deal with the impact of digital means of conducting business on the assertion by countries of what they consider to be legitimate tax jurisdiction concerning economic activities in and with customers in a source country. The European Commission is proposing to move forward with a digital services tax and the adoption of a notion of digital presence. The United Kingdom and Australia have recently announced similarly directed initiatives, and other countries notably in Europe have been considering or are acting to further like initiatives.
What is at stake? Fundamentally, it is the reliability and resilience of a (source) country’s income tax base when the means by which income is earned escape the physical bonds associated with earning income and being accountable for it as a taxpayer.
Enter Canada and Trade
Canada is a leader in international tax policy. Many of the issues that now are cast under the rubric “digital” in another tax generation were called “E-Commerce”. Canada studied the tax impacts of E-Commerce in the late 1990s and concluded, generally, that actually or constructively Canada’s tax system was sound and resilient enough to deal with changing modalities of conducting business without losing the tax base.
The issue is alive again, in a most unusual and understated way. It has not really been noticed yet.
New Chapter 19 of the very new “United States-Mexico-Canada Agreement” is entitled “Digital Trade”. These are early days for drawing conclusions about its significance in a trade agreement or its implications for the intersection and interaction of trade and tax rules. But the following are notable and should attract attention, for all the reasons foreshadowed by the comments above. These pose questions that have embedded in them important and in some cases imponderable international tax and trade issues; they do not offer, necessarily at least, conclusions.
1. Article 19.3(1) foreshadows digital trade unimpeded by any governmental charges, of which tax notably is one. While the heading on the Article is “Customs Duties”, long experience in other trade law contexts – the GATT and WTO contexts in particular – reflect more than a possibility, intended or not, that trade law may regulate direct income taxation and not merely indirect taxes. Article 19.1 to “other charges on or in connection with” trade in “digital products” (a broadly defined term) in contradistinction to “customs duties fees”. So, apparently these other charges, which need only be “in connection with” traded digital products, are other than customs duties and not restricted to indirect taxes.
a. This Article foreshadows an open skies approach to digital trade, in clouds that drift across those skies. It does so while being specifically agnostic on whether a “digital product” is a “good” or a “service”, an important tax classification question the answer to which can make all the difference to the nature and scope of taxing rights under a tax treaty.
b. There is at least a grudging acceptance in international trade and tax circles that trade and competition law may affect the scope and legitimacy of direction income taxation, reflecting the long-standing connection between tax and trade. Ongoing challenges in Europe concerned with “state aid” in the context of Article 107(1) of the Treaty on the Functioning of the European Union, affecting taxpayers such as Amazon, Google Starbucks, McDonalds and others are about the reciprocal effects on each other of trade and competition law, and tax law.
2. Article 19.3(2) says “for greater certainty” preserves an entitlement to impose “internal taxes, fees or other charges on digital products transmitted electronically” but only if those taxes, fees and charges are imposed “in a manner consistent with this agreement”. What does this mean? Does this preserve the assertion of tax on digital trade, as long as the underlying trade understanding is respected? And what does “for greater certainty” mean following the first part of the Article that asserts what amounts to open skies?
3. Consistency of tax and trade measure in “North American” trade agreements is addressed in a separate article. This is the case in the North American Free Trade Agreement, in Chapter 21, Article 2103, and remains the case in the new Agreement, in Chapter 32, Article 32.3. Both are similarly directed, but not entirely the same.
a. Generally but subject to specific exceptions, the trade agreement is not meant to affect, that is “to apply to” taxation – “taxation measures”. This term is defined inclusively, subject to some specific exclusions. Generally, the orthodox trade law view has been that only indirect tax measures are concerned in a trade agreement. But, a thorough consideration of relevant trade law considerations reveals that this is far from obvious. Other views competing views take account of the possibility that otherwise impugnable trade law distortions can be effected indirectly through direct income tax measures.
b. That said, the Article also provides that “rights and obligations” under a “tax convention” – typically, a direct income tax convention – are unaffected by the trade agreement. If a trade agreement cannot, presumptively, affect direct income taxation, then an affirmation of a tax convention’s primacy, which is an instrument of direct income taxation, might be thought to be redundant. Income tax conventions, of course, exist to parse and allocate direct income tax rights between countries able, otherwise, to justify their application.
c. Special exculpatory treatment is provided for certain “non-conforming” “taxation measures” extant when the trade agreement comes into existence.
d. It is not necessarily clear , or at least there are questions about, how Articles 19.3 and 32.3 fit together and what, if any, the effects of the Agreement are on direct income taxation measures.
i. In particular it is not clear whether Article 19.3 preserves or limits government charges that are direct income tax; it seems that it could do both, inviting much more considered trade and tax law inquiries. Other context in the Agreement may, specifically, be important.
ii. Article 32.3 seems to suggest that the tax law including tax conventions generally stands unaffected by the trade agreement. It further provides that an “inconsistency between this Agreement and any such convention” shall be resolved in favor of the convention. But like many things the detail matters, in this case what an “inconsistency” means – an issue in other contexts with which tradition al trade law in the GATT and WTO context has experience.
- What it is and who decides are both important. In that connection, the Agreement provides specifically that any dispute in this regard will be resolved under the Agreement’s provisions for this purpose, in Article 32.3(4).
- This too is reminiscent of another more recent feature of international trade law found in Article XXII: 3 of the General Agreement on Trade in Services, the “GATS”, which in directionally similar ways provides a means, controversial in international income tax circles as Commentary to Article 25 (Mutual Agreement, or more broadly dispute resolution) of the OECD Model Tax Convention reflects. In part the controversy is about under which authority, a trade agreement or a tax convention, a conflict may exist.
Concluding With Questions
In some ways, the new Agreement simply reveals the complex but inevitable connection between trade and tax law. While to some extent trade and tax thinkers and practitioners have been able to treat some of these issues as merely posing academic interest, the recent assertions by the European Commission that trade and competition law limit direct income taxation illuminate the importance of the connections between the two regimes. The advent of digital means of conducting even traditional business heightens the importance of these questions. And these questions are extant and welcoming in the new trade agreement among the United States, Mexico and Canada.
The importance of understanding the tax implications of borderless business which this Agreement may seek to entrench should not be underestimated. We will all need to be attentive – and curious.