Canada’s 3% Digital Services Tax Faces Backlash Amid US Trade Tensions

Canada’s decision to impose a 3% digital services tax (DST) on large foreign technology companies has sparked criticism from local experts, who warn it could inflame US trade relations in a presidential election year and increase costs for consumers.

Despite warnings from the US, Canada confirmed the DST's implementation in a government notice posted online on June 28, with Bloomberg reporting it on July 4. Tax advisers have slammed the DST for adding complexity for companies, potentially igniting a US-Canada trade war, and raising consumer costs.

The DST was introduced following the OECD Inclusive Framework's failure to finalize a multilateral convention on amount A of pillar one by the June 30 deadline. Amount A aims to allocate profits of in-scope multinational enterprises to countries where they sell products and services. Experts had predicted that a lack of consensus on amount A would lead to the introduction of DSTs by various jurisdictions.

Canada’s DST imposes a 3% levy on large tech companies earning over C$20 million (US$14.7 million) annually from Canadian users. It applies from 2024 onward and covers taxable revenues since January 1, 2022. Many affected companies, such as Meta and Google, are US-based.

The Office of the United States Trade Representative stated on July 2 that it would take necessary actions to halt Canada’s DST, as reported by CBC.

“There is little doubt that bringing a DST into force will trigger punitive trade retaliation from the US, likely far more costly to the Canadian economy than whatever tax revenue would be collected,” said Steve Suarez, a tax partner at Canadian law firm Borden Ladner Gervais. Suarez, also co-chair of the Canadian Chamber of Commerce’s Economics and Taxation Committee, added, “There is no doubt whatsoever that the US business community views Canada’s DST as discriminatory and unfair, and one of the few areas of bipartisan agreement in Washington is the importance of protecting US business from foreign taxes they perceive to be disproportionately directed at US companies.

“For Canada to proceed with this initiative during a US election year, when politicians are looking for high-profile ‘America first’ issues, is particularly tone-deaf, and this development is quite likely to end up as a spectacular own goal for Canada.”

Randy Schwartz, an indirect tax partner at Canadian law firm McCarthy Tétrault, also believes the DST could exacerbate US-Canada trade tensions. “From a US perspective, politically, there is bipartisan opposition to the DST and significant, influential US industry sectors and businesses who would like to see the US take strong retaliatory measures,” he said. “When you mix in a presidential election later this year and Canada acting as an outlier moving forward in implementing a new DST in 2024, it’s not difficult to foresee challenging times ahead for US-Canada trade relations.”

Schwartz argued that Canada is taking a bold gamble with the DST and the potential implementation of pillar one. “Unless Canada really believes that pillar one or a similar multilateral agreement will not be implemented any time soon, one wonders whether acting now on the DST was really worth it,” he added.

A key question is whether pillar one will materialize despite the missed amount A deadline in June. Suarez called for patience: “For Canada to proceed with adopting a DST while other countries continue to maintain the status quo as negotiations on the OECD/G20 IF proceed, it casts Canada as an outlier from the global consensus on international tax policy. This is especially harmful to a country that depends heavily on good relations with countries to which we export our goods and services. Hard issues take time and effort to resolve, and going ahead with a DST at this time sends the wrong signal to our trade partners working in good faith on a compromise on the taxation of multinational digital services.”

Despite the DST’s implementation, comments last week from Canada’s finance minister, Chrystia Freeland, suggested that Canada’s support for pillar one remains steadfast. “Canada's preference is, and has always been, a multilateral solution,” she reportedly said. “It’s simply not reasonable, not fair, for Canada to indefinitely put our own measures on hold. A number of other countries have a DST in place right now, and they have had a DST in place for a number of years with no retaliation [from the US],” she added.

Schwartz noted that this stance could create complexity for Canadian businesses affected by the DST. “Based on her recent comments…the finance minister seems to be betting that the perceived benefits of the DST outweigh the risks of potential US retaliation and the reaction of those businesses affected,” he said. “At the same time, Canada has reiterated its commitment to pillar one and its intention that the DST is a temporary measure. This may mean that businesses could ultimately need to manage not one, but two, new taxing regimes if the DST is ultimately replaced by pillar one or another multilateral solution.”

Canada’s government hopes the DST will generate additional revenue from in-scope companies while awaiting a resolution on pillar one. However, experts expressed doubts about the tax’s effectiveness. “At the end of the day, it’s likely that Canadians will end up bearing the [brunt of the] DST, as those businesses forced to pay it will likely find ways to pass it on through increased fees and prices to their Canadian customers,” Schwartz reflected.

Suarez agreed and criticized Canada’s policymakers: “These companies are very likely to simply adjust their pricing to pass on the cost of this tax to Canadian consumers. The resulting increase in costs for Canadian consumers is particularly unwelcome in today’s inflationary environment…Canada’s DST represents a triumph of politics over sound economic policy.”

Clearly, a solution for adequately taxing the digital economy is needed. While DSTs may appear to be a sensible interim measure, the risk of increased consumer costs and international tensions underscores the importance of reaching a pillar one solution.

By fLEXI tEAM