UN’s Digital Services Tax Warning Won’t Sway Canada to Change Law

Warnings from a United Nations official that digital services taxes are effectively income taxes and could violate countries’ tax treaty obligations are unlikely to convince the Canadian government to repeal its own DST, for which the first returns will be due in 2025.

Canada clearly disagrees that its DST would be an income tax and appears to have taken steps in structuring the tax to insulate it from such a challenge.

From the beginning, Canada has characterized its DST as a non-income tax. The Canadian tax authorities seem to have recognized the risk the tax being challenged under Canada’s tax treaties as an income tax and have made several choices in drafting the rules to protect against such a label.

Instead of implementing the DST as a new part of the Income Tax Act, it was implemented through an entirely new and separate law, the Digital Services Tax Act. This may be significant because many Canadian tax treaties specifically refer to the Income Tax Act. The authorities further insulated the DST by having it operate independently from the normal income tax system, applying to the gross amount of relevant digital services revenue, regardless of whether the taxpayer profits or otherwise is subject to income taxes.

Some other gross-basis taxes, such as withholding taxes on dividends and royalties, are considered income taxes subject to Canadian tax treaties. Those other taxes can be seen as an integrated backstop to the normal income tax system because only non-residents who generally aren’t subject to regular income taxes pay them.

By contrast, both residents and non-residents would pay the DST in Canada and wouldn’t receive any credit against normal income tax liabilities. They could, like for other non-income taxes, deduct it when computing income in some cases. Making the DST operate separately from income taxes comes with some costs in terms of fairness—some Canadian-resident taxpayers, who already pay income taxes in Canada, are expected to pay additional DST on top of that.

Some other countries haven’t been as thorough in separating their income tax and DST systems. The UK’s DST allows taxpayers to use an alternative formula based on operating margins, with the result that DST liability is reduced, or even eliminated, for unprofitable businesses.

India’s version (which was partially repealed) applies only to non-resident operators of e-commerce platforms and excluded Indian residents. These examples indicate that conclusions about the nature of DSTs imposed by other countries may not necessarily carry over to Canada.

It’s notable that the US isn’t challenging Canada’s DST in terms of the Canada-US tax treaty, but under the free trade agreement among the US, Mexico, and Canada instead. The US objection apparently is that the tax, although technically neutral in its drafting, in practice discriminates against US businesses because most of the large digital service providers are located in the US.

From that perspective (and leaving aside the wisdom of the DST), a continued international proliferation of DSTs actually may have some strategic benefit for Canada because it could help diffuse potential US retaliation to the tax.

Opposition to Canada’s DST has been widespread in the US, including across both political parties. This has led to broad worries from business groups and others in Canada, given the importance of the US relationship. Recently, the leader of Canada’s largest province called for a pause on implementation in the interests of improving relations.

The Canadian government included some potential off-ramps for itself in drafting its DST. While the government has publicly maintained its DST commitment, it’s possible that the prospect of a DST is being kept alive solely as a bargaining chip for future discussions with the incoming Trump administration.

If the DST ultimately fails to take effect, we expect it will have been done in by concerns about Canada-US relations, rather than any technical tax treaty issues.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Ian Caines is partner at Davies Ward Phillips & Vineberg, focused on domestic and international income tax law.

Sabina Han is partner at Davies, focused on Canadian commodity tax matters.

Michael Kandev is partner at Davies, focused on transactional taxes.

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