Could US tax reform be a catalyst for disruption for Canadian businesses?
In the wake of the November elections that gave Republicans control of the White House and both houses of Congress, the chances that the United States will enact comprehensive tax reform are greater than they’ve been in more than 30 years. Both the executive and legislative branches of the government have declared tax reform to be one of their top priorities. Current proposals would reduce corporate and individual tax rates, change the expensing of capital assets, move US international taxation to a territorial system and significantly alter the international trade landscape.
On 2 March 2017, EY convened a panel discussion in Toronto on what these changes could look like and their potential impact on Canadian businesses and bilateral relations. The following is a summary of the views of the three distinguished panelists.
What are the different tax reform proposals? President Donald Trump and Speaker of the House of Representatives Paul Ryan have put forward proposals for tax reform. Both the president’s plan, as outlined during his campaign, and the House Republicans’ plan, known as the Blueprint, propose significant changes to the federal tax system. And while there is common ground between the two, there are some noteworthy differences. (See Appendix for more details.) Both Trump and the House Republicans favor the concept of incentivizing exports over imports, however, only the Blueprint has a provision addressing the issue. Whether Trump will put forth a separate proposal or will support the border adjustment outlined in the Blueprint remains to be seen.
Timing The panelists noted that the House Republicans’ first priority is the repeal and replacement of the Affordable Care Act, or Obamacare, after which they will proceed with tax reform. The participants generally agreed that the House of Representatives will likely pass a tax reform bill in calendar 2017, and are aiming to move the legislation before the Congressional recess in August. The Senate would then likely take up the measure. Key Republican leaders have stated their desire to pass tax reform legislation by year-end. House Speaker Ryan and Senate Majority Leader Mitch McConnell have both pledged to move tax reform legislation using what’s known as the budget “reconciliation” process, which requires the support of only 50 senators to pass, rather than the standard supermajority of 60 that’s needed for most legislation. Reconciliation, which is intended to facilitate the passage of legislation involving tax increases or spending cuts, carries special restrictions limiting debate time and the types of provisions that can be considered. The panelists generally agreed that passage of the legislation will not be a bipartisan process, with resistance likely from Congressional Democrats.
The Republicans generally agree that they want any tax reform to be revenue neutral when taking into account economic growth that would result from the tax changes.
What’s the potential impact on Canadian competitiveness? Looking to the Blueprint and what Trump has put forth to date, the panelists opined that the proposed changes, if enacted, could have a significant impact on Canada. The House Blueprint’s cut in the top federal corporate tax rate, combined with the border adjustment tax (BAT), would effectively replace the US corporate income tax with a destination-based cash flow tax. The Trump plan, as outlined during his campaign, is less detailed and calls for a broadening of the tax base to achieve economic growth. He has also called for a “reciprocal” approach to taxation between the United States and other countries. Any significant decrease in the tax burden on new investments in the United States, if unmatched by Canada, could pose competitive challenges by drawing new international investment toward the United States and away from Canada. One of the panelists noted that the deficit financing of the Canadian government is happening at precisely the wrong time as the United States is aiming to significantly cut taxes. The Trudeau government had originally projected a modest annual $10 billion deficit during the election campaign, but significantly higher budgetary deficits are now projected and they are expected to continue in the coming years.
In the face of these higher revenue shortfalls, the federal finance minister may look to raise revenues by increasing the tax burden on higher-income earners, which, combined with the post-reform lower tax environment in the United States, could significantly exacerbate the flow of investment away from Canada toward the United States as well as a “brain drain” of high-income earners.
What actions should the Canadian government consider in response to US tax reform? The panelists noted that Canada is seen as having a favorable business environment, but when businesses look at where to set up shop in North America, the United States is generally seen as the more favorable destination given its larger domestic market and generally more entrepreneurial business culture. Significant tax reductions and deregulation south of the border will only increase that preference. Carbon taxes, which the Canadian government favors and which are not part of the US tax reform proposals, will also impact the competitiveness of Canadian companies, especially those in carbon-intensive industries. The panelists opined that the Canadian government should not make any significant tax changes in its 2017 budget pending greater clarity on the final tax reform package in the United States so it can then respond accordingly.
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Looking ahead The panelists agreed that US tax reform is coming in one form or another given the Republicans’ control of both houses of Congress and the White House. Canada will be affected and must begin taking measures to deal with the potential impact. They also stated that the Canadian government should strive to accelerate regulatory approvals on the natural resources front. They noted that Canada has a serious issue with getting its landlocked oil and gas to tidewater. Canada needs to diversify its export markets for natural resources and rely less on the United States, but it first needs the infrastructure to do so. They said the government should prioritize pipelines to get our resources to market. Canada sells its oil at a discount, and its major customer, the United States, is aiming to become energy independent. Natural gas projects have been slow getting the regulatory approvals needed before final investment decisions can be taken and acted upon. This is a problem because importing countries make long-term commitments to exporters, and Canada is late to the game and is getting left behind by exporting competitors in Australia and the United States. Another issue the government should be addressing is interprovincial trade barriers that restrict access, reduce competition and foster inefficiency and in the process add unnecessarily to costs.
While the bilateral relationship between President Trump and Prime Minister Trudeau got off to a positive start at their first meeting in Washington in February, and with Trump giving a personal shout-out to Trudeau during his first address to the joint session of Congress on 28 February, Canada is going to need to quickly take stock of the new landscape and respond to protect Canadian business interests. As our current prime minister’s father once noted with respect to the Canada-US relationship, “Living next to you is in some ways like sleeping with an elephant. No matter how friendly and even-tempered is the beast, if I can call it that, one is affected by every twitch and grunt.” No matter how big a twitch or grunt US tax reform turns out to be, Canadians will very likely experience some disruption.
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Appendix Trump and House Republican Blueprint proposals at a glance Trump plan
House Blueprint
Top corporate tax rate (now 35%)
• 15%, corporate AMT eliminated
• 20%, corporate AMT eliminated
Top pass-through rate (now 39.6%)
• 15% rate within the personal income tax system for pass-through entities that want to retain profits within the business
• 25% rate for the “active business income” of sole proprietorships and pass-through entities
Cost recovery
• Elective 100% expensing for manufacturers
• 100% expensing of tangible, intangible assets (except land)
Interest
• Manufacturers electing to expense capital investment lose the deductibility of corporate interest expense
• No current deduction for net interest expense
Net operating losses (NOLs)
• Not addressed
• Carrybacks of NOLs not permitted. Deduction allowed for NOL carry forward limited to 90% of net taxable amount for year determined w/o regard to carry forward. • NOLs allowed to be carried forward indefinitely
Other business preferences
• Calls for them to generally be eliminated, except for R&D credit
• Calls for them to generally be eliminated, except for R&D credit and LIFO
Mandatory tax, untaxed accumulated foreign earnings
• 10%
• 8.75% for cash/cash equivalents, 3.5% otherwise, payable over eight years
Taxation of future foreign earnings
• In September 2015, proposed immediate worldwide taxation, repeal of deferral; unclear if he still supports
• Territorial, 100% exemption for dividends paid from foreign subsidiaries
Border adjustability
• No provision. Trump initially criticized the idea, but has since indicated he may be open to further exploring the concept.
• Destination-based system with exports exempt from tax with cost of goods sold remaining deductible. • All imports nondeductible. Applies to services as well as to tangible and intangible property. • Emphasis is on a “Made in America” policy with goal of eliminating tax incentives to move operations outside the United States.
Individual rates (now 10%, 15%, 25%, 28%, 33%, 35%, 39.6%)
• 12%, 25%, 33%
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• 12%, 25%, 33%
Trump and House Republican Blueprint proposals at a glance (cont’d)
Capital gains
Trump plan
House Blueprint
• 3.8% Net Investment Income Tax (NIIT) repealed, existing capital gains rates:
• 50% deduction for capital gains, dividends, and interest, leading to basic rates of:
• 0%
• 6%
• 15%
• 12.5%
• 20%
• 16.5%
Dividends
• Existing rates but NIIT repealed
• Repeal of NIIT and other ACA taxes is called for under separate Better Way health care reform plan
Carried interest
• Ordinary income
• Not addressed
Estate tax (now 40% rate, $5.45 million exemption)
• Repealed, but capital gains held until death will be subject to tax, with the first $10 million tax-free
• Repealed • Eliminated
State tax deduction Charitable contribution deduction
• Cap itemized deductions at $100,000 for single filers and $200,000 for couples
• Retained, but could be modified
Mortgage Interest deduction Standard deduction, personal exemption
• Retained, but could be modified
• Personal exemptions, head-of-household filing status eliminated; Standard deduction of:
• Consolidate basic, standard deduction, exemptions to standard deduction of:
• $30,000 for married filing jointly
• $24,000 for married filing jointly
• $15,000 for other individuals
• $18,000 for singles with a child • $12,000 for other individuals
Child tax credit
• Not addressed
• Child credit and personal exemptions for dependents consolidated into an increased child credit of $1,500 • First $1,000 will be refundable as under current law • Nonrefundable credit of $500 also will be allowed for non-child dependents
Dependent care expenses
• Deduction for care expenses, up to four children, elderly dependents, capped at the average cost of care for state of residence
• Not addressed
• Available to those earning $250,000 per year or less for individuals, $500,000 couples Personal exemption phase-out (PEP), and Pease limitation on itemized deductions (now for families with income over $311,300, individuals over $259,400)
• Unspecified “steepening the curve” of PEP and Pease
• Not addressed
Personal AMT
• Eliminated
• Eliminated
Life insurance build-up
• Included in income for high earners
• Not addressed
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Contact us Alycia Calvert Canadian Leader, Tax Services +1 416 943 4441
[email protected]
Tony Pampena Central Market Leader, Tax Services +1 416 941 1825
[email protected]
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EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. © 2017 Ernst & Young LLP. All Rights Reserved. A member firm of Ernst & Young Global Limited. 2214414 EYG no. 01544-171Gbl ED None This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.
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