Withholding under Regulation 105: May 30, 2002.
During the December 2001 liaison meeting with representatives of the Department of Finance, members of Tax Executives Institute expressed a number of concerns about the withholding tax required under Regulation 105. Specifically, TEI believes that Regulation 105 is a significant impediment to the competitiveness of Canadian companies because it erects artificial barriers that inhibit access to the expertise of non-resident service providers, especially those in the United States. During the meeting, the Department invited TEI to submit written comments elaborating on its concerns. On behalf of TEI, I am pleased to submit the following comments.
Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,300 professionals manage the tax affairs of the leading 2,800 companies in Canada, the United States, and Europe and must contend daily with the planning and compliance aspects of Canada's business tax laws. Canadians constitute 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our eight geographic regions. Many of our non-Canadian members (including those in Europe) work for companies with substantial activities in Canada. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.
TEI is concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government.
Since the North American Free Trade Agreement (NAFTA) came into force, there has been explosive growth in cross-border trade in goods and services within the free-trade zone. Before NAFTA, cumbersome procedures limited the opportunities in Canada for small and medium-sized non-resident cross-border service providers and limited access to such providers by small and large Canadian companies. Besides removing the trade barriers, publicity surrounding NAFTA spawned greater awareness among non-residents of the business opportunities in Canada. As a result, many more non-resident firms are soliciting business in Canada thereby providing greater competition for price and performance on services for Canadians. Moreover, Canadian businesses and consumers increasingly recognize that the market for services is not limited to domestic providers. Hence, more than ever, Canadians obtain services from niche foreign companies that provide unique services that may not be available domestically.
Regrettably, vestiges of the pre-NAFTA regime remain. Specifically, Regulation 105, issued prior to NAFTA under the authority of section 153 of the Income Tax Act (hereinafter "the Act"), imposes withholding tax on fees paid to non-residents for services rendered and stands as a barrier to the full promise of NAFTA, both in the form of taxes and burdensome compliance costs. During liaison meetings and roundtable discussions with Canada Customs and Revenue Agency (CCRA) and the Department of Finance, TEI has noted that the policies underlying the statute and the regulation are outmoded in the post-NAFTA environment. (1) What's more, CCRA's administration of the waiver process is too restrictive to afford meaningful relief to non-resident service providers and Canadian payers. Finally, the combined cost of the withholding tax and the compliance burden imposed on non-residents and Canadian payers undermines the economic competitiveness of Canadian businesses.
In an analogous fashion, the Part XIII tax on royalties paid on sales and licenses of software formerly imposed comparable administrative and economic burdens on Canadian companies. In 1993, the Minister of Finance acknowledged that the incidence of the Part XIII tax on software royalties falls on Canadian businesses rather than on the non-resident vendors and crafted an effective remedy to substantially mitigate the burden. We urge the Department of Finance to work with TEI and CCRA to devise a similarly effective legislative or regulatory remedy to eliminate the anachronistic effects of Regulation 105.
Paragraph 153(1)(g) of the Act and subsection 105(1) of the Regulations impose a withholding tax of 15 percent on fees, commissions, or other amounts paid to non-resident individuals, partnerships, or corporations in respect of services rendered in Canada, other than in the course of regular and continuous employment in Canada. Amounts withheld by a Canadian payer under Regulation 105 do not constitute the final Canadian income tax liability of the service provider in respect of its income earned from carrying on a business in Canada. Rather, the amount serves as a deposit or instalment of the non-resident's ultimate tax liability.
Regulation 105 authorizes CCRA to develop administrative procedures to enforce or waive the application of the withholding rules. Under the current waiver procedure, the non-resident service provider applies to CCRA for a waiver of all or part of the withholding tax. Where the service provider demonstrates that the required 15-percent withholding tax will exceed its ultimate Canadian tax liability, CCRA may authorize a reduction in the amount that the Canadian payer is required to withhold. To qualify for reduced withholding, the non-resident must demonstrate that it is entitled to treaty benefits or that its estimated expenses in providing the services in Canada will result in a liability less than the required withholding tax.
Regrettably, it is impractical in many cases for a non-resident to utilize the waiver process. To obtain a waiver, the non-resident must apply directly to CCRA 30 days prior to the start of the performance of services in Canada or 30 days prior to the first payment for services. Frequently, the non-resident is unaware of either the withholding tax or the waiver process until the Canadian payer draws attention to it. As important, the clerical staff responsible for administering the withholding tax within large payer companies is rarely even aware of the contracts or services being performed until an invoice is received and readied for payment. Thus, in practice, waivers are not available in many cases where they should be. Indeed, retaining trained personnel capable of identifying and questioning whether an invoice requires withholding is a challenge for many companies. Moreover, system-based solutions to ensure proper withholding at the time of payment are difficult to design and implement and are rarely foolproof. Finally, a post-payment review by tax department personnel may be impractical, especially where there are a large number of payments to residents or non-residents that are not subject to withholding tax.
Economic Burden of Regulation 105
As with the Part XIII tax on non-exclusive software licenses, where a non-resident without a permanent establishment (PE) in Canada learns (most often from the Canadian payer) that a 15-percent withholding tax applies to service fees, the result is predictable. The non-resident supplier requests a gross-up payment in order to maintain the same cash-flow position (i.e., net of the withholding tax. As a result, a service for which the vendor normally charges $100 is inflated to approximately $118 to take account of the withholding tax. Alternatively, the Canadian purchaser may be able to persuade the non-resident to file an application for a waiver under Regulation 105 and also file a Canadian income tax return to claim a refund of excess tax withholding. (2) In order to avail itself of the waiver process or to obtain tax refunds, the non-resident supplier must hire Canadian tax consultants. (3) Regardless of whether the supplier obtains a waiver or incurs the withholding tax, the Canadian purchaser ultimately bears the non-resident's tax and compliance costs rendering the Canadian company less competitive with similar foreign businesses.
Regulation 105 authorizes CCRA to adopt procedures to govern the enforcement or waiver of the withholding tax. In TEI's view, CCRA's administrative practice in granting waivers is far too restrictive. Hence, the default choice for most non-resident suppliers is simply to add approximately 18 percent to the normal service price. In addition to incurring an increased out-of-pocket cost, the Canadian payer's deduction of the payment may be challenged by CCRA in a non-arm's-length situation if the payment is considered to be in excess of a reasonable amount in the circumstances. Alternatively, in order to avoid or reduce the withholding tax, the non-resident may choose to render the services outside Canada to the extent feasible thereby producing inefficiency in the performance of the services and increasing the cost.
Where a payer inadvertently fails to withhold the Regulation 105 tax and no additional payments are owed to a supplier from which under-withheld tax can be recouped, the Canadian payer will bear the burden of the tax. In this case, the burden is even greater than a grossed-up payment to the supplier because the amount actually paid to the non-resident service provider is treated as the net amount to which the supplier was entitled and the tax remitted by the payer under its secondary liability is nondeductible. Moreover, even where the Canadian payer bears the withholding tax under Regulation 105--whether through a grossed-up payment for services or under its secondary liability for the tax--an information slip is provided to the service provider. As a result, the non-resident is in a position to obtain an economic windfall at the expense of the Canadian payer by filing a claim for potential refund of the Canadian withholding tax.
Regulation 105 can also cause severe cash flow problems for a non-resident service providers because the withholding will generally exceed its final tax liability. Indeed, where the service provider operates with a thin gross margin, a 15-percent withholding tax can exceed the gross profit on rendering the services. The cash-flow problem will be exacerbated if subcontractors are involved and demand immediate payment. In the absence of a waiver, withholding will be required and a refund of all or part of the withholding will be delayed until the non-resident prepares and files its tax return and CCRA assesses it. Because of the complexity of the factual issues in many cases, the assessment is generally delayed by several months after the tax return is filed.
In light of the administrative and economic costs to Canadian taxpayers of complying with Regulation 105, TEI questions whether the provision should be retained. Moreover, in assessing the fiscal effect the government should not include any windfall revenue collected under Regulation 105 to which it is not otherwise entitled. (4)
TEI has discussed its concerns about the administration of Regulation 105 with CCRA on numerous occasions, but has met with little success in persuading the Agency to revise its policies. (5) For example, CCRA has declined to permit undertakings (e.g., guarantees of payment) by a Canadian resident company in lieu of imposing the withholding taxes on payments to related non-resident service-provider companies. (6) As important, for purposes of applying Regulation 105 and administering the waiver rules, CCRA has adopted an overbroad interpretation of a PE. Indeed, CCRA's expansive view of what constitutes a PE for purposes of determining whether non-residents are eligible for a withholding exemption conflicts with the decision in Dudney v. Queen, 2000 DTC 6169 (FCA). Moreover, one TEI member reports that CCRA denied a request for waiver where it was clear that no services were to be performed by a non-resident in Canada. (7) As a result, TEI believes that CCRA's administration of the waiver process renders it a hollow promise of relief. Thus, changes should be made to the Act or Regulation to ensure that the legitimate policy objectives that underlie Regulation 105 are satisfied without imposing undue economic and compliance burdens on Canadian taxpayers.
Regulation 105 in an E-Commerce Environment
Taxpayers and governments throughout the world are currently struggling to define and apply tax principles to many e-commerce transactions. While the many issues inherent in the taxation of e-commerce transactions are beyond the scope of these comments, we urge the Department to consider carefully whether Canadian payers or non-resident taxpayers can comply with, or CCRA can even administer, Regulation 105 in an e-commerce environment. In many factual circumstances, it may be unclear whether cross-border services are being rendered or a digitized product is being supplied through a website. Even assuming a service is rendered, the location where the service is provided is difficult if not impossible to determine under current international tax law and treaty principles.
TEI recommends that the Department of Finance repeal Regulation 105 in its entirety or amend it to apply solely to artistes and athletes. If the fiscal cost of repealing Regulation 105 for ordinary commercial cross-border services is prohibitive, other alternatives should be considered. For example, as with the Part XIII tax on software royalties, the Department should eliminate the withholding tax for service providers resident in designated treaty countries. Alternatively, the Department should eliminate the withholding tax for service providers resident in countries with which Canada has free-trade agreements. Finally, in lieu of repealing the tax or eliminating its application to service providers from selected countries, the Department should consider establishing a meaningful de minimis exemption amount for payments to non-resident service providers. For example, the threshold triggering reporting of payments to related parties on Form T-106 under the foreign affiliate rules is one million dollars. To minimize the compliance burden on Canadian payers that arises from multiple small service contracts, we recommend that the Department establish an exemption of one million dollars per service contract.
TEI would be pleased to meet with you at your earliest convenience in order to discuss these recommendations, elaborate on the compliance challenges of Regulation 105 and CCRA's administration of the waiver process, and to respond to questions from the Department about these and other possible approaches that will afford taxpayers administrative and economic relief from an outdated provision.
TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney. If you should have any questions about the submission, please do not hesitate to call Mr. Penney at 905.644.3122, or Alan Wheable, TEI's Vice President for Canadian Affairs, at 416.982.8003.
(1) These comments do not address the special issues surrounding withholding on artists and athletes.
(2) Quebec's practice is to follow the federal tax treatment. Where a waiver of withholding is granted for federal tax purposes, no Quebec withholding is required. Where federal withholding tax is required, Quebec imposes an additional nine-percent withholding tax. As a result, a $100 pre-tax cost to companies for non-resident services rendered in Quebec is often inflated to approximately $132.
(3) In the case of non-resident companies with affiliates or a parent company in Canada, the company's tax department will often file the waiver application and work with CCRA until the waiver is issued. The resulting diversion of corporate resources is burdensome.
(4) TEI believes that most of the $230 million in revenue collected in fiscal year 2000-2001 pursuant to Regulation 105, over and above amounts to which the government is legitimately entitled for the activities of Canadian "branches" and for which a return likely is filed, is an unwarranted windfall. The windfall arises from two scenarios. In the first, Canadian companies have been required, as a result of the bargaining strength of the vendor (e.g., a monopoly service provider), to bear the tax cost through a gross-up provision. Since there is no mechanism afforded the Canadian company to recoup the tax, and since the non-resident is indifferent to filing for a refund because it has been made "whole," the revenues collected are a windfall for the government. In the second case, the Canadian purchaser has superior bargaining power and withholds the tax from a non-resident lacking a PE in Canada. Non-residents lacking a PE in Canada are quite likely to be unsophisticated in Canadian tax matters, and unless that non-resident is willing to pay high fees for sophisticated tax planning and compliance advice on "foreign" tax issues, the lack of formal guidance on the compliance process for non-resident service providers inhibits the filing of refund claims. Finally, even the $230 million figure likely overstates the total net tax collected because it does not take account of refunds paid or credited.
(5) TEI submitted written comments on CCRA's draft Guidelines for Treaty-Based Waivers of Regulation 105 Withholding on October 21, 1998. In addition, TEI members have had frequent discussions with CCRA on the waiver process and a host of related issues prior and subsequent to the written comments.
(6) The administration of Regulation 105 by CCRA is especially frustrating in the context of non-arm's-length transactions. In many circumstances, the current rules are administered in a fashion that can be viewed as a mandatory interest-free loan from affiliated groups to the government--loans that impose substantial compliance costs on the taxpayer to ensure repayment from the government. Where the Canadian payer can demonstrate that an affiliated non-resident service provider will incur no net Canadian tax liability as a result of the transaction, no withholding should be required.
(7) Specifically, the member's company contracted for services to be rendered in the United States. Preliminary preparatory work, however, was to be performed in Canada by an independent agent (an arm's-length company) resident in Canada. No waiver was granted for any portion of the payments even though (i) the services performed by the U.S company were outside Canada, and (ii) the services in Canada were performed by an independent Canadian company fully taxable in Canada.
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|Date:||May 1, 2002|
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