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EVIDENCE

[Recorded by Electronic Apparatus]

Tuesday, October 3, 1995

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[English]

The Chair: I now call the meeting to order. The finance committee is looking into Bill S-9, an act to amend the Canada-United States Tax Convention Act, 1984.

We have appearing before us today, from the Department of Finance, Jean-Marc Déry, David Walker, and Brian Ernewein.

Welcome, gentlemen. We look forward to your brief presentation before we begin our discussion of this issue.

Mr. David Walker (Parliamentary Secretary to the Minister of Finance): Thank you, Mr. Chairman. Before I begin, I have a point of business for the committee.

[Translation]

Three bills will be ready for the committee's consideration after the week-long break, namely bills C-90, C-102 and C-103.

[English]

For the opposition critics, Mr. Chairman, Bill C-103 deals with the heritage department, but it's amendments to the Income Tax Act. So you may wish to speak to your critics in the heritage department to see if you wish to have any briefings, or if they're up to date, or if they're coming in or not. We will give you notice for that.

The Chair: Who is going to begin, Mr. Walker?

Mr. Walker: I will begin, and then we'll turn to officials.

[Translation]

The Chair: Mr. Loubier.

Mr. Loubier (Saint-Hyacinthe - Bagot): If I understood correctly, Mr. Walker, we will be confining our discussions today to Bill S-9.

Mr. Walker: That's correct.

Mr. Loubier: And in two weeks' time, we will consider bills C-90, C-102 and C-103.

Mr. Walker: Yes, if that meets with the Chair's approval.

The Chair: I'm at your service, Mr. Walker.

Mr. Walker: I want to thank the committee for this opportunity to speak on Bill S-9.

As you know, this bill amends the recently revised and signed Protocol amending the Canada-United States Tax Convention.

The purpose of this bill is twofold: ensuring tax equity and establishing sound international relations.

Double taxation conventions, 55 of which are in force in Canada, are an integral part of the legal infrastructure underlying the trade relations carried out by different countries.

It is not hard to imagine the devastating effects that the risk of having two different countries fully tax the same income could have on businesses and the free movement of persons.

These conventions are regularly amended. The Protocol reflects the third official amendment made since the Convention was ratified by Canada and the United States in 1980.

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Many of these protocols have to do with technical questions such as the definition and clarification of ambiguous rules. Provision is also made for several important changes which will benefit Canadians and improve the fairness of the two tax systems that apply to non-residents.

[English]

One important change is the reduction or elimination of the rate of withholding tax that each country will apply to certain types of revenue. The rate on interest payments will be reduced to 10% from 15%; the rate on direct dividends will go down to 5% from 10%; and the rate on royalties on computer software and on patents and technological information will be eliminated entirely. These changes bring the rates out of the Canada-U.S. convention into line with those provided at the OECD model tax convention, accepted by most of the OECD's 25 members. More to the point, the reduced rates will facilitate trade and investment between our two countries.

For example, the elimination of the withholding tax on certain kinds of information technology will make it cheaper for Canadian companies to access technology from the United States, and easier for our own high-tech firms to sell to the United States.

Let me turn now to another benefit of this protocol: restoring fairness to the application of U.S. estate taxes on Canadians with property there.

I recognize that there has been some suggestion that the changes here represent a tax break for the wealthy. However, to put it bluntly, any such suggestion rests on a misunderstanding of tax treaties generally and this protocol in particular.

Our achievement with respect to estate taxes is twofold. First, we are ensuring that Canadians with property in the United States don't get a harsher deal at the hands of the American government than do Americans. Secondly, we are doing what tax conventions are all about: eliminating double taxation.

With respect to the first point, it should be borne in mind that U.S. state taxes don't kick in for American citizens until the value of their estate exceeds $600,000, but under a law enacted in 1988, the threshold for Canadians with properties in the U.S. is only $60,000. In our opinion, that's simply not fair. This protocol changes that, ensuring that Canadians are entitled to the same treatment as our American neighbours.

Secondly, there's the matter of double taxation. For half a century, tax treaties have been combating the unfairness and financial disincentives of double taxation. It is standard practice in such treaties for each jurisdiction to provide a credit against its own taxes on revenue from the other jurisdiction that has already been taxed in that jurisdiction.

The complicating factor in this case is that while both Canada and the United States impose taxes upon death, these taxes take two different forms. The U.S. applies an estate tax, whereas in Canada the levy takes the form of an income tax on any appreciation of a deceased's property over his or her lifetime. Bill S-9 simply recognizes this situation and addresses the anomaly that would otherwise result.

Without the proposed change, combined Canada and U.S. tax on the estate of a Canadian with U.S. property could actually exceed the property's value. That is quite literally confiscatory and plainly unfair. Let me stress that there is no way this can be fairly characterized as a gift to the wealthy. They will continue to pay substantial taxes on property owned at death.

Before I conclude my remarks, I would like to mention some of the other beneficial changes provided in the protocol.

One concerns the treatment of social security payments such as old age security and the Canada Pension Plan. Under the existing convention, these are not taxable in the source country and only one-half of the benefit is taxable in the other country. Once a protocol is ratified, however, benefits paid from one country will be taxable exclusively in that country.

Other more technical but nonetheless beneficial amendments that should be mentioned include: a provision improving the operation of the rules for charitable contributions to tax-exempt organizations of the other country; an arbitration mechanism for settling disputes over the interpretation or application of the convention; and lastly, articles providing for assistance in collecting the taxes of another country and to improve the exchange of tax information.

To sum up, the protocol that this bill will ratify reflects careful, considered negotiations between Canada and the United States. By improving the operation of our tax systems as they apply in tandem, it enhances the environment for cross-border investment and trade.

Thank you, Mr. Chairman.

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The Chair: Thank you, Mr. Walker. I take it you approve of this bill.

Mr. Walker: Yes, I do.

The Chair: Could I ask one question? I don't mean to be presumptuous, but since the OECD model convention for the avoidance of double taxation and prevention of fiscal evasion is the model that most of the world has followed over the last two to three decades, could you tell us how the Canada-U.S. tax convention would be modified by this bill in any way that would derogate from the OECD model convention? Are there any significant deviations from the OECD model?

Mr. Jean-Marc Déry (Chief, Tax Treaties, Department of Finance): Yes, Mr. Chairman, I think there are quite a few differences. For example, on the taxation of royalties the OECD model suggests a full exemption in the source country. The protocol with the United States provides for a rate of 10% on royalties, except that a number of royalties are exempt, namely computer software and patent and know-how. That's an example where we're close to the OECD, but we're not right there yet.

Another change from the OECD is the ``other income'' article, which deals with whatever items of income are not dealt with in the convention or the treaty. Under the OECD rules such income is taxable only in the country of residence of the person receiving the income. All Canadian treaties depart from that. Canada always protects its right to tax other income at source.

There are differences as well in terms of the pension article. Under the OECD rules all private pensions for past employment are taxable only in the country of residence of the recipient. All government pensions for past employment are taxed only in the country of source, except if the individual receiving the pension is a national and a resident of the other country.

In terms of rates, the 5% on direct dividends is the OECD recommendation, 15% on other dividends. On interest, we follow the OECD suggestion of 10% for all interest.

I think, Mr. Chairman, these are the -

The Chair: In other words, you have virtually followed, with a couple of minor exceptions, the OECD model in revising the Canada-U.S. tax convention through Bill S-9.

Mr. Déry: That's correct.

The Chair: Thank you.

Mr. Déry: It has been adapted because this is a negotiated instrument and we had to reply to the Americans' own position vis-à-vis the OECD.

The Chair: The major difference is the taxation of pensions and withholding tax on royalties paid to American residents, whereas the OECD model exempts royalty payments.

[Translation]

Mr. Loubier.

Mr. Loubier: Mr. Chairman, I'm happy to announce, and I'm sure this will please you tremendously, that the Official Opposition supports this bill. We agree with the provisions amending the Canada-U.S. Tax Convention.

However, as the Official Opposition has been demanding for the past two years, we would have liked to see the 16 tax conventions signed between Canada and countries such as Barbados, Bermuda, Switzerland in some respects and other West Indian countries to have been tabled before this committee so that we could have examined them. We consider these countries, among others, to be tax havens where hundreds of millions of dollars in lost federal government tax revenues are sheltered.

Therefore, we would have hoped that after two years of your government, the scandalous situation of tax conventions signed with countries considered to be tax havens would have been a thing of the past.

Since nothing has been done to address this problem, you can be certain that we will not let this matter rest, since we feel that this is one of the biggest tax scandals around, that is the existence of conventions with these countries that allow Canadian companies to declare losses or profits that are totally tax exempt, repatriate these profits to Canada and brazenly evade taxation while Quebecers and Canadians are being asked to tighten their belts.

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Getting back to Bill S-9, as I was saying, the Official Opposition supports the amendments to the Canada-U.S. Tax Convention.

However, I have a question for the parliamentary secretary. According to one of the bill's provisions, Canada has agreed to provide a credit against its tax arising in the year of death on U.S. source income for any U.S. estate tax payable.

It is further stated that these provisions will be effective retroactively for deaths occurring after November 10, 1988, the date on which the major changes to the U.S. estate tax affecting Canadian residents were introduced. Why the retroactive provision? Why does the bill to amend the Canada-U.S. Tax Convention apply retroactively? I suspect that the most disadvantaged Canadians will not necessarily be the ones who will benefit from the tens of millions of dollars that are involved here.

[English]

Mr. Walker: Mr. Chairman, before I turn it over to the officials, I want to clarify for the record that we don't sign tax havens; we sign tax treaties. We have systematically improved the tax relationship with ourselves and a number of countries, and we will continue to do that. You'll have an opportunity to review some of our new agreements later this fall.

Mr. Brian Ernewein (Chief, Corporate and International Tax, Department of Finance): Mr. Chairman, the question is a very clear one. It's indeed a rare occurrence that we agree to a provision that has retroactive effect.

In this case the retroactivity, the application to deaths occurring after November 1988, was at Canada's request. It reflects the fact that that's the date on which changes to U.S. estate tax laws came into effect, reducing the exemption from U.S. estate tax for Canadians and other non-U.S. citizens from $600,000 U.S. to $60,000 U.S. In our view, that rendered the tax applicable to many people who were not what you would describe as wealthy Canadians, perhaps those simply owning a fairly modest retirement home or the like in the U.S. or having similarly modest amounts of property in the U.S.

In order to deal with the situations where deaths occurred between November of 1988 and the implementation of the protocol, the provision was made applicable back to that date.

[Translation]

Mr. Loubier: I accept your explanation. I would like to know how much this retroactive provision is going to cost Revenue Canada. Have you estimated the cost involved? Before you answer my question, I would like to respond to the parliamentary secretary who just said that we do not sign tax havens, only tax treaties with countries willing to sign them with Canada.

In 1992, 1993 and 1994, the Auditor General himself called into question the validity of 16 tax conventions that Canada had signed with countries considered true tax havens. If the Auditor General questioned these tax conventions, thereby opening the door to a review, you cannot blame the Bloc Québécois and say that this is a partisan issue. It's a matter of taxation fairness for the thousands of Quebec and Canadian taxpayers of whom you have been demanding incredible sacrifices for the past 10 years. These conventions must be reexamined. This is also the view of Canada's chartered accountants.

In their latest publication, they encouraged businesses to take advantage of tax conventions signed with Barbados, the West Indies and other countries to avoid paying taxes to the federal government. They even recommended that businesses invest in certain West Indian countries since profits were taxed at a rate of only 2% or 3%. Examples were even given.

Another study reported that the five major Canadian banks have approximately 50 branches in the West Indies, whereas they have only 80 branches elsewhere in the world. What reason is there for this, if not tax evasion?

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Are there so many individual investors in the West Indies that the Royal Bank, the Bank of Montreal and other banks feel the need to open 50 branches? They do so because they receive preferential treatment somewhere.

I would like to bring up another matter which makes me think that these tax conventions should be reopened. Up until 1988, the Department of Finance published statistics on corporations that had earned profits, but had not paid taxes over the years. It stopped publishing these figures in 1988 because the information was too disturbing.

In 1988, the last year for which these figures were available, $27 billion in Canadian business profits were not taxed. Twelve years earlier, the figure was $3 to $4 billion.

Therefore, I am somewhat disappointed. I am pleased with Bill S-9, with the tax convention with a country such as the United States where taxation rates are relatively similar, but I am truly disappointed with your record as parliamentary secretary. Even the Auditor General feels that you should have reopened the tax treaties signed with the 16 countries considered to be tax havens. You have not done so in the last two years.

However, you have asked taxpayers to reduce their spending and tighten their belts. You have shamelessly squeezed several billion dollars from the unemployment insurance fund, money that came from the contributions of workers and employers in Quebec and in Canada, but you have not bothered to reexamine the tax conventions signed with tax havens where hundreds of millions, if not billions, of tax dollars owing to Revenue Canada are sheltered.

I know that you have friends in the Canadian corporate world, but at some point, Canadians and Quebecers will see that it is not in their best interest to continue under this kind of system.

[English]

Mr. Ernewein: Mr. Chairman, perhaps I can respond to the question on the estate tax. That's what I'm prepared to deal with today. We believe that the bulk of the cost associated with the changes in relation to the estate tax will be borne by the United States. That's simply because they're the ones who are agreeing to reduce their estate tax by increasing the threshold for exempt estates in the U.S.

There is one aspect of the changes in those rules of the provision dealing with taxes on death that is an obligation upon Canada. That's to provide foreign tax credit relief on death for taxes paid in the U.S. under the U.S. estate tax.

We don't have direct numbers on that. I'm not sure we're in a position to obtain direct numbers on that. I can note, as an aid to guessing at that number, that we have some figures stating that in 1992 the total amount of foreign income earned by individuals in the year of death was only $10 million.

If you simply took that number and applied the maximum personal tax rate to that at the federal level, you'd have, in round numbers, $3 million. Deducting the foreign tax credit relief already claimed of $1 million would leave you with a maximum of $2 million that might be reduced by estate tax credit relief.

That assumes that all the income earned by people in the year of death comes from the U.S. and that it's all mashed by U.S. estate tax, which are both fairly large assumptions. Therefore, the figure of $2 million could be easily quartered or divided into tenths, with only a tenth relating to that cost.

In other words, it can't be stated with certainty, but I think a reasonably plausible view is that the cost of the relief provided in the taxes-on-death article in the protocol is very modest.

Mr. Grubel (Capilano - Howe Sound): I would like some clarification on the taxation of income of Canadian pensioners in the United States. This is now taxed, if I understood Mr. Walker correctly, to the extent that no taxation takes place in Canada before this law and 50% of the income of pensioners is taxed in the United States. Is that correct? Does this apply to people who are permanently in the United States or is it applicable also to those who are going as ``snowbirds'' for only a few months per year?

Mr. Ernewein: The answer is that it applies only to those who are residents of the United States; those who maintain their residence in Canada would not be affected in that context by the treaty or the protocol to the Canada-U.S. convention.

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Mr. Grubel: For those who are permanent residents, the new law says Canada gets to tax it all and the Americans will get no more taxation.

Mr. Ernewein: That's correct. The current treatment under the treaty allows social security payments to be taxed only in the state or the country in which the recipient lives or resides. The new treaty's protocol will reverse that, reserving to the country that provides the pension benefits the right to decide how it wants to tax those benefits.

Mr. Grubel: If someone only gets pension benefits from Canada and has no other income, or if the sums involved are trivial or zero, how does other income by those Canadians living in the United States affect the taxation of their pension income here? Will it be treated as marginal income?

Mr. Ernewein: The process for taxing such income was announced by the minister at the time the protocol was first signed. I say ``first signed'' because it was signed in August and, with minor revisions, re-executed in April of this year.

The legislation to implement that is part of the 1995 budget law currently before Parliament. That would impose a 25% withholding tax, subject to a person filing an application and submitting a basic income tax return. If I am correct, that only takes into account Canadian sources of income in determining what the marginal rate would be. For the purpose of determining entitlement to certain tax credits, one would also have regard to income outside of Canada.

I believe there is another provision in the 1995 budget that extended the recovery of old age security payments to high-income earners. If the legislation is passed, as of July of next year that will also apply to non-residents, at least where our treaties authorize us to, and through this protocol it will. In that case a person would be subject to a complete recovery of the the OAS, unless he or she submits a return supporting or demonstrating that world income is below the threshold and thus not subject to withholding.

Mr. Grubel: I would like to congratulate you and the minister, or whoever negotiated this. In my judgment, this is a most generous gesture by the U.S. taxpayers, who, number one, typically tax world income, whether you're a resident or a citizen, if you happen to live in the United States. Furthermore, on simple grounds of...I hate to say ``equity'', but certainly efficiency, people who are permanent residents in the United States are using U.S. government services - police protection, FBI, army, highways and all those kinds of things - and part of their income, which they are spending there and benefiting from, is now being taxed first by the Canadians. I'm very surprised and I congratulate you for having been able to get the Americans to agree to such a provision.

The Chair: Congratulations accepted. Thank you very much.

Mr. Grubel: My friend and colleague just said it works the other way too, but I think there is a significant imbalance in terms of residence, so I stand by my words. I worked for the U.S. Treasury once and I'm very surprised.

The Chair: We accept your kind words, Mr. Grubel. The only drawback is that they will provoke Mr. Baker into a tirade against this bill.

Mr. Baker (Gander - Grand Falls): Mr. Chairman, I'd like to ask the witnesses, who were the negotiators for Canada? Who wins in this protocol? Who comes out ahead and by how much? Is it Canada or the United States? Surely you have some idea of who comes out ahead in this protocol.

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Mr. Ernewein: Thank you for the question.

No, we don't keep a score card per se in negotiations on tax treaties. Two basic goals as stated in the opening or preamble of most tax treaties are designed to prevent double taxation and fiscal evasion. We hope those goals have been advanced in this case. A classic example of reducing double taxation is the interweaving, if you will, through the foreign tax credit provisions of the U.S. estate tax and Canada's capital gains tax on death.

An example of something preventing fiscal evasion is the mutual assistance and collection procedure under which we're entitled to ask the U.S. tax authorities to assist in collecting outstanding taxes from, as I refer to them, absconding debtors - Canadians citizens who might move to the U.S. Reciprocally, the U.S. authorities are entitled to ask Revenue Canada for assistance in collecting taxes from U.S. citizens who have moved to Canada.

Mr. Baker: Let me be more specific. Who would be the winner and who would be the loser in the reduction of taxes - the 50% reduction in taxes - on dividends from direct investment? Would it be American multinationals and the U.S. government or would it be Canadian multinationals and the Canadian government, and by how much?

Mr. Ernewein: The current treaty provides that the reduction in the withholding tax rate on dividends paid to significant shareholders, that is, those owning more than 10% of the votes and value of the company resident in the other country, is 10%. It is proposed to go down to 5% by 1997, 6% for 1996 as a transitional phase. That policy was announced in the 1992 budget papers by the previous government, and cost estimates were provided at the time. I've brought it along with me.

Mr. Baker: I'm asking you who won and lost, not how much money the Canadian government would have to pay out. That's quite a different question.

Mr. Ernewein: I'm not sure how else to approach the question.

Mr. Baker: Okay, go ahead.

Mr. Ernewein: Immediate effects benefit the taxpayer through reduced withholding. It is hoped that will produce or maintain interest in investment in Canada and therefore will return to us over time. There are no guarantees of that. It's important to keep our rates in competition with other countries, and that's the purpose of this change.

As to whether or not the taxpayer garners the benefit of that and is therefore going to change or maintain his investment stance because of it, that depends on whether the other jurisdiction taxes it away.

In terms of dividends coming from U.S. subsidies to Canadian companies, generally we don't tax it. So the benefit accrues to the taxpayer. In the case of payments going from the Canadian companies to U.S. shareholders, the U.S. does impose a tax in those circumstances. But we're often told the level of tax in Canada is sufficiently high that there's already enough foreign tax credit that is Canadian tax-paid in Canada to cover off any U.S. tax so that this reduction will accrue to the taxpayers.

Mr. Baker: In other words, you don't know.

Mr. Ernewein: In other words, I don't know precisely.

Mr. Baker: Let me ask you this question. I am interested in this part of the treaty negotiations. Every country that negotiates tax treaties usually does so when it's advantageous to that nation. That's a fair statement, wouldn't you say?

Now, in this case, in looking at the evidence from the United States, I want to ask you what you think of this. It's a hearing before the committee on foreign relations - I can give you a copy of it if you want - a couple of months ago in the United States Senate. A chap by the name of - I think you know him, personally, perhaps - the honourable Leslie Samuels, assistant secretary of the Treasury for the U.S. government, said this on page 42, and I want to ask your opinion on what he said:

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Later on, in the hearings, Mr. Robert Green has something to say. He is the vice-president for tax policy for the National Foreign Trade Council of the U.S. This has 500 U.S. companies, and I understand some Canadian companies also are members. Mr. Green says this on page 81:

The quotes go on. Daniel Berman of the Joint Committee on Taxation says:

What do you think of that? Do you think they're all wrong?

Mr. Ernewein: I don't dispute the level of investment in Canada by U.S. firms relative to the level of investment by Canadian firms in the U.S. I don't have figures on that. I almost take it as a notice that this would be the case. That would imply also that dividend flows, which are investment flows coming to Canada, are going to return greater dividends back from Canadian companies to U.S. shareholders than vice versa.

Mr. Baker: Let me go further and ask you about the second reduction, which is from 10% to 5%. That's the 50% cut in taxes to U.S. multinationals through direct-investment dividends flowing back to the U.S.

Let's leave that for a second. I understand you have figures there that show it's going to cost the government $125 million or $135 million this year. You have figures there showing that, don't you?

Mr. Ernewein: The 1992 budget projections for the 1995-96 period were $125 million.

Mr. Baker: Good. That's fair enough.

The second cut is from 15% to 10% on interest. I'm going to ask you what you think of this statement from the U.S. Treasury on page 24 of the hearings in the United States Congress:

This is a one-way street providing a great tax benefit to the United States and we get nothing back in return, according to Mr. Samuels. What do you think of that? Is he wrong or did we make a mistake here?

Mr. Ernewein: I have two points. First, in practical terms a large part of the interest payments made out of Canada are, like interest payments made out of the U.S., already exempt from withholding tax. Probably the greatest amount that is subject to withholding would be between related parties, for which we don't provide any relief, but the U.S. does.

The second observation is that again it would seem reasonable to me to accept that there are greater investments by U.S. firms by way of debt investment in Canada than there is Canadian investment in U.S. debt securities. That, again, would suggest that a withholding tax reduction would have some greater effect for Canada than it would for the U.S.

Mr. Baker: So it's $125 million that we lose on the first cut. We lose substantially because you haven't quantified the amount on the second cut on interest. Then there's a third cut on royalties.

There are many quotes that I could give you on the royalty cuts favouring the United States. This is money in hand to U.S. companies.

How much now do you figure we lost to U.S. multinationals, in comparison to the United States, on those three tax cuts? How much money? That's the bottom line? One is $125 million. How much do the other two add up to?

Mr. Ernewein: We have economists who tell us what that is. In the case of the royalties changes, those estimates of the cost of the change in treaty policy, which have already been worked into the fiscal tract, are $30 million a year.

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We don't have a number, to my knowledge, on the interest issue. I gather it's thought to be smaller than either of those two numbers, but by adding $125 million and $30 million , I get $155 million for this year.

I should emphasize again that there was a direct effect from the withholding tax reduction. They don't take into account changes of investment decisions or the rest.

Mr. Baker: Why would you negotiate a treaty when all its provisions, according to the evidence...? Let me put it to you this way. You say that the 5% is down to the OECD target. That's not the agreement the U.S. has with Japan, Australia, Germany or China, or any of the countries of the former U.S.S.R. They have 43 comprehensive tax treaties in the world. Half of them, 20, are not down to that 5% rate.

Spain was negotiated at the same time as Canada. The U.S. government claimed the reason why they couldn't get Spain to come down to 5% directly and wait for the EEC agreement to kick in was as follows. The case of Spain is on page 96:

Back on page 19, they go on to say:

If you took the word ``Canada'' and put it where I just said ``U.S.'', what do we get back? According to the United States, we were walked over. According to this testimony before the federal foreign relations committee they got a deal out of Canada; they didn't get one out of the other countries.

These negotiations started way back, I understand that, but what did we actually get back in return? Are you telling the committee that you got back an agreement from the U.S. that enables you to give a tax credit to everybody with property in the U.S. in excess of $600,000 under that death tax agreement? Is it to prevent double taxation for people who have more than $600,000 in the United States?

That's why the Canadian government in the Mulroney administration went after this tax agreement. It was to change the death tax. These were the changes that came in 1988.

Is that the thing we got back? What did we get out of all this? I'm puzzled. Why would we negotiate an agreement like this that the Americans say we got nothing back for?

Mr. Ernewein: I suppose the difficulty, Mr. Chairman, is I don't accept the characterization of the testimony before the U.S. Senate. I think it's a fair comment on their part to suggest that the withholding tax reductions will, in some circumstances, open up income to be taxed in the U.S. That may have some positive revenue effects for the U.S.

Because of our tax rates, with the overall tax burden, I think it's reasonable to assume that most of the benefit is going to accrue in favour of the taxpayers rather than the tax administration and that the benefits they might achieve are probably quite modest. In terms of what Canada got for this, we got what we wanted in terms of estate tax relief, not for people whose estates were over $600,000 in value but for people whose estates had a value of less than $600,000.

Finally, we got into, or back into, a better competitive position vis-à-vis our tax rates. On that point, the U.S. has a number of treaties that are higher than 5%. That's agreed. Most of the recent treaties are not. I don't think Mexico is. I think their treaty rate with the U.K., Germany, and France is 5% for all. If you consider the importance of those countries, one can form a reasonably different view of matters.

Mr. Baker: We'll now not give a tax credit to somebody who's subjected to the estate tax in the United States with property over $600,000 on foreign return? We won't give a tax credit?

Mr. Ernewein: No, not at all. First of all, they'll be many situations in which a tax credit won't be necessary because the U.S. will have relieved the tax in the first place. They'll be nothing, in other words, to credit.

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Secondly, we have undertaken to integrate the U.S. estate tax with Canadian income tax, meaning that we will give a credit to the extent that we charge U.S. tax, or would charge U.S. tax, on the very same amount that the U.S. has already taxed. Like all of our treaties, like our income tax system in the domestic legislation, we cede to the country in which the income in situated, in which the property is situated, first right to tax. This is no different.

Mr. Baker: But the U.S. estate tax is normally about 55% on property over $600,000. They come in and look at your furniture, your paintings, your silverware, everything like that, and they tax you. You get ripped at about half of everything above the $600,000. If you have investment from U.S. stocks and bonds, even if they're purchased from a Canadian broker, and you have returns on that on your death, under this bill you can get a tax credit against that money that you make from U.S. investment.

Mr. Ernewein: That's not entirely correct. We will give a tax credit to the extent that there's income tax payable in Canada on the same property. So the U.S. may tax that property at a maximum of 55%. We didn't change that in the protocol. We can't be expected to ask them to reduce their tax rates; they didn't ask us to reduce ours. To the extent that we tax the same amount, we will give credit. If there's no profit on those properties and therefore no tax payable in Canada, there's no credit to seek.

Mr. Baker: Of course, but what's new here is the introduction of the foreign tax credit to cover this aspect. Normally a foreign tax credit only applies to income tax, correct? This is the new change that we're talking about.

The provision concerning the charitable donation to any college in the United States, the Canadian taxpayer.... I suppose the government's argument could be that this has been in existence since 1987 or 1988. You get a tax credit for your donation where your son or daughter has been attending - was it 1987 or 1988 or 1984?

Mr. Ernewein: It was a tax credit as of the conversion from deductions to credits in 1988. There has been relief in such instances since 1967 or 1968.

Mr. Baker: Why are you putting that back into this agreement? Why did you take out the present article XXI.6 and replace it with this new XXI.6 with exactly the same wording, exactly the same exception? Did you give consideration to taking out those brackets and not giving a credit for some rich people to send their kids down to some fancy university in the United States when they couldn't make it in Canada?

Mr. Ernewein: Mr. Chairman, by way of background possibly for the benefit of other members of the committee, Canada allows charitable contributions to Canadian colleges and universities. It has for 30 years, or nearly so, provided relief for foreign universities and colleges if they were prescribed. In the 1980 Canada-U.S. tax treaty, that relief was made bilateral and the U.S. agreed to give relief for contributions by U.S. taxpayers to Canadian colleges and universities. In the case of the relief we gave Canada, the way we identified that, rather than keep adding to this list of some hundreds of universities and colleges, was to require that the individual donor or a member of his or her family attend that institution.

To my knowledge, it's not the purview or within the domain of the rich to get relief under that heading. In any event, the protocol didn't change it at all, as I think the member's question indicates.

Mr. Baker: Why did you replace it?

Mr. Ernewein: It was to accommodate the fact that the tax relief Canada provides for charitable donations made by individuals was converted from a deduction in the mid-1980s to a tax credit in 1988. That provision was essentially untouched in this protocol other than to make reference to tax relief as opposed to deduction, thereby accommodating what in fact had been the practice of Revenue Canada in its administration since 1988.

The Chair: Thank you, Mr. Baker.

In terms of international investment flows, the United States taxes its own taxpayers on their Canadian-source income in such a way that the U.S. taxpayer pays the higher of the Canadian or the American rates. They receive a credit, of course, for the Canadian taxes they've paid. When you have income flows, the result is you're often paying in the States more than 50%, assuming the U.S. rate is 50%, because you do have the Canadian withholding tax. Is that correct?

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Mr. Ernewein: If I understand the question correctly, the answer is certainly yes, that you will pay the greater of the two taxes.

The Chair: It will often be greater than 50% in the United States, which is higher than their regular tax. No, let me rephrase it. It will often be the U.S. rate that's paid because it's higher than the Canadian. The total rate you will pay will be increased by the amount of the Canadian withholding tax, which often puts you at a higher rate than you would ordinarily pay in the United States when you take into consideration the tax credit in the United States that's offered on a worldwide or per country basis.

Mr. Ernewein: Indeed, my understanding is somewhat in contrast to that, which is that Canadian tax rates or the amount of Canadian tax payable, particularly by corporations, is often higher in Canada than in the U.S., which means the tax you pay in Canada will exceed that payable in the U.S.

The Chair: That's what I meant to say, sir. The Americans have an excess foreign tax credit they can't use up.

Mr. Ernewein: That's exactly the term that's used.

The Chair: That means that to the extent Canadian combined corporate and withholding tax rates exceed the American rates, there's a tax penalty to the American investor that is a detriment to investment in Canada.

Mr. Ernewein: That's certainly the premise. It ties back to a question raised earlier, which is whether or not the benefit of reduced withholding will accrue to the taxpayer or simply transfer money from our treasury to that of the foreign jurisdiction.

The Chair: I agree with you. Could I also ask you one more question. When we set out to avoid double international taxation, we've made throughout the years a number of rules that have become internationally acceptable. When you're taxing the gains from, say, real estate, the country that has the primary taxing jurisdiction is the country of title of the real estate. Is that correct? Throughout the entire civilized world, the primary taxing jurisdiction lies with the country where the real estate is situated.

Mr. Ernewein: Offhand I'm not aware of any exceptions to that.

The Chair: It would be the same with the mine. If you have a corporation in Canada owned by a foreigner, the primary jurisdiction for taxing the gains is Canada where the corporation is situated. Is that correct?

Mr. Ernewein: Yes.

The Chair: So in terms of our taxing foreign investment in Canada, we will tax all the direct investment in Canada and that will be our primary jurisdiction. If the Americans sell out a Canadian affiliate, we get the first tax bite at it and they get tax relief in the United States to the extent that Canada imposed taxes. Is that correct?

Mr. Ernewein: When you start talking about sales at second levels, that is, of the corporation itself, there are some provisions where sometimes under our tax treaties there will be an exemption. In your example, where the corporation's value is attributable primarily to Canadian real property or mining property, for instance, we will retain the right to tax first.

The Chair: So we should.

Mr. Grubel: I just would like to add to this. It's not quite as simple as you made it out to be, because there's a difference between nominal and effective tax rates. It turns out that what corporations pay is not just a function of the rate on the reported profit, but the profit base is determined by depreciation rules and various other payroll taxes and things of this sort.

I have seen studies that suggest that in fact because of all our concern about being neutral with United States when you take it all into account, the effective tax rate between Canada and the United States is actually identical.

Mr. Baker: Mr. Chairman, it's an interesting subject, but let me ask the witness a question concerning that. One would think that a multinational corporation would like to locate where the taxes are lowest. Corporate tax in Japan is 52%; corporate tax in Canada is 38% federally. It works out to an average of 43% if you take into account federal and provincial tax. In the U.S. it's 35% national tax. If you work out the state tax as well, it works out to 40%.

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If in fact the premise is correct that a corporation would in fact locate, or try to have a location, where the corporate tax is lower and use that nation, then, to perhaps treaty shop.... I think you know the question I'm going to ask. Brian has a smile on his face, so he knows exactly what I'm going to ask.

Mr. Ernewein: I swear I don't.

Mr. Baker: He does, because our witnesses -

The Chair: The question, Mr. Baker.

Mr. Baker: Well, Canada in these negotiations opted out of the protection against treaty shopping. It was a unilateral clause in this agreement that covers just the United States. Could you explain to the committee why Canada took that position?

Mr. Grubel: What's treaty shopping?

Mr. Baker: Say you were a company from Japan, and you located your company in the United States, for all intents and purposes, but if you weren't a resident of the United States and then you conducted business in Canada, the U.S. says, look, we're only going to honour, under this agreement, true Canadian residents. If you're really a Canadian resident, then you can take advantage of our low withholding tax rate in the United States if you invest in the United States.

But Canada opted out of that. I'm wondering why. In my reading of the agreement, it's obvious you opted out. That is the only country in the world that the United States has a tax agreement with that has opted out of the provision that prevents treaty shopping.

Do you want people from all over the world to go to the United States and take advantage of the treaty shopping that's available with Canada under these new reduced rates?

Mr. Ernewein: Mr. Chairman, we're not very enthused about the U.S. approach to combating treaty shopping. From our experience, and from what we hear, Canada's not well-renowned as a tax haven.

An hon. member: That's an understatement.

Mr. Baker: To say the least.

Mr. Ernewein: During the course of the negotiations we certainly weren't made aware of many cases, or any cases, indeed, where Canada had been used as the beachhead or the country from which the benefits provided by the U.S. under its treaties might be exploited or obtained. The U.S. has, as its treaty negotiating policy for several years now, and I believe in all of its treaties signed within the past few years, sought and obtained the inclusion of a so-called treaty shopping rule. Our lack of enthusiasm for it is that it's based on a series of mechanical tests, followed by some more subjective determinations, followed finally by a requirement that one go and ask the IRS, if you didn't need any of the other tests, if treaty benefits might otherwise be obtained.

We have some concerns about treaty shopping. I don't think we have any particular concerns about treaty shopping in the context of the U.S., but we don't think the approach or the way to deal with that is by adopting a series of mechanical rules that can often just provide a road-map for people to avoid them.

What we did do instead in this protocol was explicitly state that this is not to be read as us opting out of the application of general principles of treaty interpretation and general limitations on the right to use treaties to abuse or exploit benefits that should be limited to legitimate commercial or investment situations.

The Chair: Thank you, Mr. Baker, for your interesting line of questions.

I want to thank members, and I want to thank our guests today.

With your permission, can we proceed to Bill S-9?

Some hon. members: Agreed.

Clauses 1 to 4 inclusive agreed to

The Chair: Shall schedule IV carry?

Some hon. members: Agreed.

The Chair: Shall Bill S-9 carry?

Some hon. members: Agreed.

The Chair: Shall I report the bill to the House?

Some hon. members: Agreed.

The Chair: Ladies and gentlemen, may I thank you for your cooperation and interest.

Yes, Mr. Silye.

Mr. Silye (Calgary Centre): I didn't understand George's definition of treaty shopping. He forgot to tie it back to Japan. Can Brian or George try again?

Mr. Baker: If you're a Japanese firm, you wouldn't like to operate out of Japan, because you have a 52% corporate tax rate. You'd like to operate somewhere else.

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Mr. Silye: So they're in the States.

Mr. Baker: Yes. You want to operate in Canada, really, but you go to the States because all of your profits that go over the border, all of the dividends and profits that go from your subsidiary in Canada, which you set up to do your business, will be at these reduced rates of taxation, down to 5%.

Mr. Silye: George, you said he went to the States. That's what's throwing me. He went to the States. He set up there.

Mr. Baker: Yes, that's right. He set up in the States, but he wouldn't set up in Canada. If he set up in Canada, he would not be a Canadian resident. He's still a resident of Japan. So if he set up in Canada and conducted his business throughout North America, it wouldn't be to his advantage. The U.S. government would say, no, you're from Japan, so you can't move money across the border, because if you do, we're going to charge you 30%; you're not a resident. They charge 30% gross on dividends that are not covered by this treaty.

So they would set up in the States and have a subsidiary in Canada and use this treaty. As the witnesses said, there's not much danger of very many companies doing that. I just wondered why they would opt out of something every other nation has agreed to.

The Chair: Might I suggest that we adjourn so that those people who want to leave can? We could have time for an informal discussion with officials.

Some hon. members: Agreed.

The Chair: Shall I report the bill to the House?

Some hon. members: Agreed.

The Chair: We are adjourned until Thursday at 11 a.m., when we'll be looking at Bill C-90. Thank you very much.

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