Canada: Insight – In Search Of Better Tax Outcomes

Taxing decisions

With highly efficient labour markets, a solid institutional environment and a strong banking system, Canada has long been considered one of the most competitive nations in the world. In fact, in its most recent rankings in 2014, Bloomberg declared Canada the second best country in the world for business (behind only Hong Kong), due in part to the receptivity of its consumers – measured by the size of its middle class, household consumption and GDP per capita.

Yet one of Canada’s true differentiators is missing from these rankings: its corporate tax rates. As of 2015, Canada’s combined federal corporate tax rate ranges from 25 percent to 31 percent (depending on the applicable provincial rate). Admittedly, some other countries have lower total tax rates, including Ireland at 12.5 percent, the UK at 20 percent and Denmark at 23.5 percent.

Other countries hover within a similar range to Canada, including New Zealand at 28 percent, Australia at 30 percent and Germany at 30.2 percent.

The sole outlier among developed nations is the United States, which levies a 35 percent tax rate on its corporations—a number that rises to an average of 39 percent when state taxes are factored in. In addition to higher tax rates, US corporations are also required to pay that rate on their worldwide income, unlike Canadian corporations, which generally do not pay tax on their foreign profits from active business operations. This goes a long way towards explaining why US corporations are always on the lookout for tax reduction strategies. One such strategy that has seen a surge in popularity in recent years is tax inversions.

What are tax inversions?

In a nutshell, an inversion occurs when a company merges with a similarly-sized foreign company and then locates the new parent company either in the same foreign jurisdiction as its merger partner or in a third country. The key is to ensure the new parent is located in a jurisdiction with a lower tax rate.

The main implication for Canadian companies is that US companies may consider Canadian companies potential merger partners if they hope to use a tax inversion to reduce their corporate tax rates. If a Canadian company does become a merger partner in a tax inversion transaction, the new parent company may choose to continue operating in Canada or move to a different jurisdiction with an even lower tax rate.

Although these transactions are complex, the benefits of tax inversions often outweigh the cons. The primary advantage of an inversion is that companies can reduce their effective tax rates, realizing higher returns to investors and other stakeholders as a result. But that’s not all. As an added benefit, the newly inverted company’s retained US operations can take advantage of existing US tax rules that permit them to deduct interest on properly structured related party debt payments made to foreign affiliates.

On the flip side, tax inversions are not always viewed favourably by US regulators. When a US company inverts, it is deemed to have sold its shares to a foreign entity, triggering a taxable event for its shareholders. In some cases, this means existing shareholders will need to pay capital gains taxes. As a result, companies that engage in tax inversions often see their share prices drop—at least in the short term.

For its part, the US Treasury—in a bid to safeguard its tax base— recently introduced new rules that make it harder to invert. Despite these efforts, however, the United States is unlikely to engage in comprehensive tax reform in advance of the 2016 federal elections (if at all)—giving US corporations at least a one-year window (and likely much longer) to pursue strategies such as tax inversions.

Inversions in action

To understand how tax inversions work in practice, one need look no further than two recent such transactions: last year’s merger between Burger King and Tim Hortons, and the more recent merger between Pfizer and Allergan.

Although motivated by business reasons rather than tax purposes, the Burger King/Tim Hortons deal saw the creation of a new Canadian-based parent company called Restaurant Brands International Inc. Had the parent company been located in the United States, it would have had to pay a 40 percent tax rate on any foreign profits it repatriated to the United States. This would have translated into an extra USD$5.5 billion in taxes in just the first five years.

While Burger King’s stock fell by US$0.83 per share after announcing the deal, and Tim Hortons’ shares fell by CAD$0.09, the combined entity reported a six percent share increase as of October 2015—just one year following the merger.

For its part, Pfizer’s US $150 billion merger deal with Allergan represents one of the healthcare industry’s largest takeovers ever. Aside from its obvious business benefits, the deal is structured to enable Pfizer to reduce its corporate tax rate, which reached 26.5 percent in 2014 and 25 percent in 2015. By having Ireland-based Allergan act as the acquirer in this transaction, Pfizer should see its tax rates fall significantly. Allergan reported a 4.8 percent tax rate in 2014 and a 15 percent tax rate for 2015. This comes as good news for a company that is believed to be sheltering over $70 billion in earnings offshore in an attempt to keep its corporate taxes under control.

Finding opportunity

As long as US corporate tax rates remain high, US-based companies will continue to pursue tax reduction strategies. According to some estimates, US companies have as much as USD$2 trillion in foreign earnings parked offshore awaiting tax reform or a repatriation holiday (similar to the one enacted in 2004).

This represents a significant opportunity for Canadian companies interested in potential mergers with, or acquisitions by, US corporations. With a comparatively low corporate tax rate and favourable policies on taxing foreign income, Canada’s tax regime— and overall business environment—create an attractive option for foreign investors.