Towards an Exemption Regime for the Taxation of Outbound Direct Investment

Abstract

Over the past 15 to 20 years, Canada and most other developed countries have experienced substantial increases in foreign direct investment. In this context, it is not surprising that several of these countries have begun to reconsider their income tax rules governing outbound direct investment in order to determine whether they are optimal in an era of increased economic globalization. In theory, countries may employ one of three approaches for the taxation of outbound direct investment. Under an accrual regime, resident corporations are subject to tax on all income earned by foreign affiliates (with a credit for foreign taxes paid), whether or not this income is repatriated through a dividend. Under a deferral regime, resident corporations are taxable on income earned by foreign affiliates (again with a credit for foreign taxes paid) only when this income is repatriated through the payment of a dividend. Under a territorial or exemption system, on the other hand, foreign source income is generally exempt from tax. In practice, no country applies a pure version of any of these methods, and most developed countries employ either deferral or exemption systems for active business income earned by foreign affiliates, and an accrual system for income from property and other mobile sources earned by controlled foreign corporations. While many countries have introduced controlled foreign corporation rules over the last 30 years, a more recent trend involves a shift from deferral regimes to territorial regimes for active business income. This paper considers the rationale for a territorial or exemption system for foreign direct investment, as well as key issues in the design of such a system. Part II presents an argument for a territorial system as opposed to an accrual or deferral regime. Part III examines key elements in the design of an exemption system, considering the entities and income that should qualify for exemption and the entities and income that should be subject to accrual taxation under controlled foreign corporation rules. Part IV concludes.