Developing an International Tax Policy Strategy for NAFTA Countries

On January 1, 1994, Canada, the United States, and Mexico formed the North American Free Trade Agreement to promote their economic interests by lowering barriers to international trade and investment. A concern exists that national tax differences harm or inhibit cross-border investment.

Yet NAFTA is almost silent regarding tax measures. For the most part, the tax treatment of cross-border trade and investment flows is still governed by bilateral tax treaties negotiated between the NAFTA states.

Why does NAFTA permit national tax differences to remain a barrier to cross-border trade and investment? The answer lies in the unique place tax policy plays in a nation’s fortunes: Taxation is intensely political. The citizens and governments of each NAFTA state have a different view about how much tax should be collected to pay for government services like schools, roads, and the military. Tax regimes also promote different social and economic agendas, such as wealth distribution.

Governments jealously protect their sovereign right to maintain tax differences despite the growing economic cost of doing so, creating a clash between economic and sovereignty interests. That clash reflects the dynamic tension inherent in globalization: In 1944 the economic historian Karl Polanyi wrote that a double movement’s propels modern society.On one hand, governments seek to better the lives of their citizens by increasing economic prosperity through heightened ties with other countries. On the other hand, as market forces expand, they increasingly constrain government policymaking, and people demand that their governments protect them from the socially disruptive effects of those market forces

That tension, endemic to international trade discussions, is perhaps no more pronounced than with respect to potential cooperative tax initiatives among nations. Governments considering such initiatives find the prospect of ceding the power to shape tax policies ó policies traditionally used to pursue domestic political, social, and economic goals ó unnerving. However, governments are forced to balance the political costs of ceding control over national tax policymaking with their desire to heighten economic efficiency.

This article explores how the tensions inherent in globalization play out regarding potential tax reform efforts under NAFTA. Part I discusses problems created by the different North American tax regimes concerning cross-border transactions. Part II turns to Europe to see whether North Americans can draw useful lessons from the European experience with cross-border tax reform efforts. Part III asserts that, given the current political/institutional/economic environment in North America, the appropriate international policy is one of heightened multilateral coordination among NAFTA countries.

I. Policy Challenges

The economic stakes appear to be high in North America, at least in terms of the size of trade and investment flows among the NAFTA countries. Those flows take place within a regionally integrated economic bloc that consists of more than 406 million people who produce more than US $11 trillion in goods and services. Canada is the largest trade partner of the United States; in fact, those two countries conduct more trade than any two countries in history, with Canada’s exports to the United States totaling US $211 billion, and its imports from the United States totaling US $161 billion, in 2002.[1] Mexico is the second-largest U.S. trade partner, with exports to the United States totaling US $134 billion and imports from the United States totaling US $98 billion in 2002.[2] Trade between Canada and Mexico increased roughly threefold from 1994 to 2001: Mexico now is Canada’s largest trade partner in Latin America, and Canada has become Mexico’s second largest export market after the United States.

Foreign direct investment (FDI) among the NAFTA countries is becoming increasingly important. Investors in the United States account for roughly two-thirds of all the inward FDI stock in Canada.[3] Canadians accounted for approximately US $105 billion in U.S. FDI by 2003, up from US $72 billion in 1998. Canadian FDI in Mexico has tripled since 1994, and Canada now is the third-ranking foreign direct investor in Mexico. By 2002, U.S. investors accounted for more than US $58 billion in FDI in Mexico, representing a significant increase since the adoption of NAFTA.[4]

Enhanced trade and investment among the NAFTA countries, combined with the maintenance of different national tax systems, has led to the following concerns.

A. Transfer Pricing and Arbitrage

Differences in tax systems among the NAFTA countries encourage tax arbitrage when taxpayers attempt to gain tax benefits offered by one country without altering their economic activity in any real sense. For example, a company in one NAFTA country may try to increase the price of inter company transfers of goods being shipped to a subsidiary in another NAFTA country that has a heavier tax burden, thereby shifting its accounting profits to the low-tax NAFTA country. The company’s profits are thus allocated for tax reasons through this income shifting, but do not reflect true economic profitability. Artificial transfer pricing transactions undertaken to take advantage of tax differences generally are considered undesirable because they waste business resources and divert revenues away from the treasury of a NAFTA country where the value adding economic activity took place.

Also, related companies sometimes employ financial strategies, such as thinly capitalizing foreign subsidiaries, to shift income to relatively lower-tax jurisdictions. Transfer pricing strategies and related-party financial strategies are a particularly sensitive area because most trade and investment in North America takes place within the same related companies because of the highly integrated business environment. For example, approximately two thirds of overall trade between firms located in Canada and the United States takes place between related parties.

There are no empirical studies that measure the revenue losses associated with those strategies. There are, however, anecdotal reports that North American firms are increasingly employing sophisticated tax planning strategies, such as the use of hybrid entities (for example, Nova Scotia unlimited liability companies) and hybrid financial instruments, that take advantage of national income tax differences to reduce global tax liabilities while still maintaining full compliance with each country’s tax laws.

Moreover, firms with North American operations are concerned that increasingly aggressive transfer pricing audits by U.S., Canadian, and Mexican tax authorities are leading to international double taxation because of the different views on appropriate transfer pricing laws held by each NAFTA country. Double taxation inhibits cross-border trade and investment, which is antithetical to the purpose of NAFTA.

B. Distortion of Economic Activity

Differing NAFTA tax regimes may distort investment patterns and reduce overall North American capital productivity. The tax systems of the NAFTA countries were designed, in part, to promote investment in selected activities deemed worthy of promotion by North American legislatures. For example, the tax policy of each NAFTA country is configured to promote investments in research and development by increasing after-tax returns on those activities. Such policies can cause inefficiency by artificially inflating rates of return on otherwise unprofitable activities. As a result, investment decisions are sometimes undertaken for tax reasons, rather than for purely economic reasons. The different rates of return arising from the tax differentials can influence the amounts and direction of investment in North America, including what types of asset investments are undertaken (for example, investments in machinery rather than buildings), how those investments are financed (for example, debt instead of retained earnings), as well as which industry to choose (for example, industrial manufacturing instead of services).

That leads to tax distortion as resources are allocated among the NAFTA countries in a manner that is not considered economically efficient. The distortion of investment decision making can harm the economy of one NAFTA country by diverting resources to another NAFTA partner. In some cases the diversion of resources reduces the productive capital of NAFTA as a whole. Reduced productivity in turn lowers the overall economic welfare and living standards of the citizens of the NAFTA countries. Furthermore, reduced capital productivity may harm the ability of the NAFTA countries to compete with other countries or regionally integrated trade blocs.

To what degree is investment distortion promoted by the different North American tax systems? Marginal effective tax rate studies generally show that the overall tax burdens imposed on new capital investments in North America are comparable, but the research also suggests that Canada continues to impose the heaviest tax burden on cross-border capital while Mexico tends to impose the lightest burden.[5] Moreover, notable differences exist among the NAFTA countries for investments in different assets, industries, and financing alternatives. As a result, tax considerations continue to serve as an incentive to locate investments in relatively lower taxed NAFTA countries. Again, however, no studies measure the actual welfare losses associated with maintaining different national tax systems in North America.

C. Harmful Tax Competition

A related concern is that harmful tax competition has or will occur in North America to the extent that the NAFTA countries continue to develop their own distinct tax systems. Tax competition takes place when a government uses its tax system to maximize a payoff. For example, a NAFTA country could lower its corporate income tax rate to attract mobile economic factors, such as capital, away from another NAFTA country that imposes relatively less favorable tax treatment on those factors. A race to the bottom may develop as jurisdictions respond to competition by reducing capital income tax burdens to compete for foreign investment. Continued rate lowering might ultimately lead to a tax burden that is too low to fulfill the revenue needs of a NAFTA country.

The Canadian and Mexican governments sometimes change their tax policies to ensure that they impose tax burdens on capital similar to those found in the U.S.

That scenario is unlikely to play out in North America. In 2002 the United States accounted for most of the North American gross domestic product at 86 percent, with Canada and Mexico accounting for 8 percent and 6 percent, respectively.[6] The economic size of the United States relative to Canada and Mexico dictates that the U.S. tax regime will have a greater impact on capital movement in North America. Moreover, U.S. economic interests are not affected to a significant degree by the tax policies of the United States NAFTA partners.

One way to inhibit tax competition would be to harmonize the corporate income tax bases and/or rates of the NAFTA countries. But the NAFTA countries derive value from preserving the ability to determine their own tax destinies. In a three-player game with one large player, it may be more cost effective and rational for the two smaller players to follow the U.S. lead, as unilateral tax harmonization does not carry the same perceived sovereignty costs. That scenario also permits the smaller players to engage in limited tax competition by undercutting U.S. changes to make up for their loss of tax autonomy. They can engage in that competition without triggering a race to the bottom because the United States does not have to be over concerned with the potential loss of capital resulting from those moves in comparison to the loss of utility associated with giving up tax sovereignty to respond to the foreign developments.

In fact, the Canadian and Mexican governments sometimes change their tax policies to ensure that they impose tax burdens on capital that are similar to those found in the United States. In recent years, the Canadian government appears to be striving to impose tax burdens on investments in Canada that are equal to or less than the burdens imposed on investment activity in the United States. A 2003 Department of Finance Tax Bulletin titled The Canadian Tax Advantage sets out a number of comparisons between the U.S. and Canadian tax system and points out, The average corporate tax rate in Canada is now below the average U.S. tax rate, and will be more than 6 percentage points lower by 2008. Those acts are consistent with the view that it is rational for Canada and Mexico to engage in limited tax competition by undercutting U.S. tax burdens to make up for the loss of sovereignty that occurs when they reform their tax systems to match U.S. developments.

It is also worth mentioning that the NAFTA countries are all OECD member states and have agreed to eliminate nonconforming domestic tax provisions that amount to harmful preferential tax regimes as part of the OECD’s effort to combat harmful tax competition in the context of mobile financial services and other services.[7] The OECD project already imposes limited restrictions on the ability of the NAFTA countries to initiate tax incentives designed to attract investments from the other NAFTA partners.

D. Tax Discrimination

At times, a NAFTA country’s tax system can also discriminate against foreign investment and favor domestic investment. For example, Canada offers partial shareholder relief on dividend taxation through a gross-up of dividends received from Canadian corporations, along with a dividend tax credit against the shareholders federal tax liability. As a result, the Canadian corporate tax system is said to be partially integrated, in the sense that most corporate profits are taxed only once. Nonresident shareholders of Canadian companies, however, are not permitted the same level of tax relief as resident effect, the Canadian corporate tax system discriminates against those nonresident shareholders by increasing their tax burden relative to Canadian shareholders, which may ultimately influence investment decisions. Discriminatory tax treatment admittedly is inhibited in many circumstances by tax treaties and the NAFTA deal itself.[8]

E. Trade Flows

The tax regimes of the NAFTA countries distort trade flows by granting tax subsidies to a variety of businesses, including companies that export goods as well as selected domestic industries. Apart from that type of trade distortion, the cross-border tax treatment of goods and services is not a major area of concern at the moment. Economists generally assert that exchange rates offset the impact of taxes on goods and services, such as Mexico’s VAT or Canada’s goods and services tax, which are imposed on a destination basis (that is, taxes are levied on imported goods while exports leave the country tax-free). Both NAFTA and tax treaties contain anti discrimination provisions to ensure that national (and at times, subnational) taxes placed on goods and services do not discriminate against foreign goods and services.[9]

Moreover, as a free trade area rather than a European-style customs union, NAFTA does not strive to create a truly free flow of goods across borders. Under NAFTA rules, custom officials often stop goods at the border to ensure that the goods are properly marked as originating from a NAFTA country. Accordingly, there is not yet an impetus to remove border tax adjustments in North America because goods already have to stop at the border.

Nevertheless, it is clear that, at least in the short term, indirect consumption taxes can have a dramatic impact, as evidenced by the millions of Canadians who flooded across the U.S. border to purchase goods after the imposition of the GST in 1991. Furthermore, Canadian efforts to impose higher taxes on cigarettes have failed to a certain extent because they encourage illegal smuggling of cigarettes from the United States. An area of greater policy concern is likely the misallocation of goods and services that is encouraged by the different provincial sales tax and GST regimes in Canada and the state and local sales tax regimes in the United States.

II. Lessons From Europe

Given the concerns identified above, how should NAFTA companies address the problems that result from the interaction of the different North American tax regimes? A natural place to look for solutions is the European Union, as Europeans have been struggling with cross-border tax issues under regional economic integration at least since the Treaty of Rome (the EC Treaty) was signed in 1957. As a customs union with a broad political and economic integration agenda, the member countries of the European Union have considered whether they should sacrifice tax sovereignty by agreeing to a set of common tax rules. Accordingly, the European experience ostensibly offers a number of lessons to countries considering further tax linkages in a regionally integrated trade area.

A. EU Reform Efforts

In fact, the Europeans appear to be positively obsessed with international tax harmonization, as compared with their North American counterparts. Since 1960 the European Commission has appointed various fiscal and financial committees to study how direct and indirect taxation differences impede the realization of an integrated market. Those committees ranging from the Neumark committee of 1962 to the Ruding committee of 1992óhave issued a number of recommendations that taxes (with the exception of taxes on individuals) be centrally regulated.

However, discussion did not give rise to action, as none of the proposals was ratified or implemented. In 1990 the European Commission published a document with more modest expectations, in line with the new subsidiarity principle and the view that centralized rules should be developed only for activities that are indispensable for the functioning of the common market.[10] Efforts then were concentrated on the removal of double taxation of cross-border flows, and two directives (on mergers and parentsubsidiary dividends) and an arbitration convention for transfer pricing disputes were adopted unanimously by the European Council in June 1990.

Still, the issue of corporate income tax disharmony within the European Union refuses to go away. In 2001 the European Commission announced it would begin to emphasize, as part of a longer-term strategy, the consolidation of corporate income tax bases, while still permitting member countries to impose their own tax rates. The commission hoped this form of limited harmonization would inhibit tax distortions that lead to an inefficient allocation of resources, which harms the competitiveness of European companies as compared with companies located outside the European Union. Interestingly, the commission rejected earlier proposals to harmonize tax rates even though more recent empirical work confirmed that corporate tax rates are the main factor that promotes locational inefficiencies, and that the adoption of a common tax base might result in an even greater dispersion of effective tax rates among different EU countries.

NAFTA does not create any obligation to harmonize and does not give power to any institution to mandate harmonization.

In 2003 the commission announced it would concentrate on studying the viability of a home state tax system, as well as the possibility of using harmonized accounting standards as the basis for a consolidated tax base for companies with EU-wide activities. Under home state taxation, the profits of a multinational company would be computed according to the rules of one tax system only ó that of the home state of the parent company or its head office. Each country would continue to tax its share of the firm’s profits at its own corporate tax rate. Unlike full-blown harmonization, the proposed corporate tax consolidation regimes would coexist with existing national tax regimes, thus preserving tax sovereignty to a greater extent. However, that approach may be problematic, as it would promote different tax treatment in many instances for economically equivalent cross-border transactions. In addition to the long-term strategy, the European Union is targeting short-term measures to address more pressing problems. For example, the commission adopted an interest and royalty directive that promotes information exchange among tax authorities (with temporary exceptions for countries that want to maintain their bank secrecy laws but agree to impose withholding taxes on cross-border payments).[11]The commission also continues to explore ways to achieve cross-border loss offsetting, such as the approach under the Danish joint taxation system, in which parent companies can take into account losses incurred by their foreign branches and subsidiaries.

The European Court of Justice also continues to play an important role in EU tax developments. While EU countries retain the right to develop theirdirect tax systems as they wish, they must do so in a way that does not infringe on freedoms guaranteed by the EC Treaty (for example, the free movement of goods and persons and the rights of establishment, services, and capital). For example, in its decision in Lankhorst-Hohorst[12] (for the text of that judgment, see 2002 WTD 241-23 or Doc 2002-27361), the ECJ ruled that thin capitalization rules cannot impose unequal treatment between resident and nonresident EU companies, leading many EU countries to redesign those rules.

Regarding cross-border VAT, since January 1, 1993, EU countries have applied a standard VAT rate of at least 15 percent, along with one or two optional reduced rates (to a minimum of 5 percent) on certain defined goods and services. At the time of this writing, the European Union continues to operate a transitional arrangement that combines VAT origin- and destination-based taxation.

B. Europe Ain’t North America

The EC Treaty created significant centralized institutions with the power to adjudicate and legislate. The European Commission, the European Council, the ECJ, and the European Parliament are all charged with bringing to life the legislative aspirations of the treaty. Some of those bodies assist in taking a general notion, such as greater tax coordination, and implementing detailed plans. The ECJ’s decisions, which promulgated the idea that those centralized institutions have legal authority over national institutions, assisted in the process of ceding authority to supranational bodies with the power to make and implement laws. In short, the European Union can be described as institution intensive, with all the necessary tools to pursue the harmonization of differing national tax systems.

In contrast, NAFTA goals are more modest and focus on the progressive elimination of tariff and non tariff barriers to trade in goods, and the establishment of reciprocal national treatment obligations concerning trade in services and investment. Although there are certain provisions that deal with approximating regulations for health and technical standards, NAFTA does not create any obligation to harmonize and does not give power to any institution to mandate harmonization. Because its objectives are less ambitious, NAFTA requires much less institutional support. Unlike a customs union, a free trade area does not attempt to create the free movement of goods, services, labor, or capital. The major NAFTA institutions exist as a setting for consultation and cooperation among the NAFTA countries. The negotiators of NAFTA apparently took great care to avoid granting to any centralized body the power to make decisions that would directly bind the NAFTA countries.

The following summarizes some of the factors that encourage tax harmonization initiatives in Europe:

– the EC Treaty calls for the harmonization of all legal regimes that impede the free flow of goods, services, capital, and labor;

– the EU countries created a deal with political linkages and centralized institutions that encourage discussion and consensus to develop surrounding tax harmonization issues;

– the passage of several decades has taught the EU countries to trust each other and accept further integration;

– the citizens of the EU countries arguably feel that tangible benefits result from the economic union and thus are prepared to accept further integration;

– a new approach toward harmonization promoted the idea that the European Commission would impose centralized harmonization only in areas that are indispensable to the functioning of the internal market; and

– ECJ decisions require changes to many direct tax laws that interfere with the free flow of goods, services, persons, or capital.

None of those factors is present in North America, highlighting the crucial difference between the European Union (a supranational polity) and NAFTA (a mechanism to promote economic efficiencies). Moreover, in contrast with the situation in Europe, North Americans have had little time to digest their deal. The American public is not convinced of the benefits of the deal. Furthermore, Mexican and Canadian wariness of potential U.S. interference in their public policy makes those two countries reluctant to transfer power to any centralized system of tax rules. For those reasons, the current political climate in North America suggests that the NAFTA countries would be extremely reluctant to cede autonomy to gain the potential benefits of a more uniform tax system.

III. Multilateral Tax Coordination

In addition to political and institutional concerns, a number of other factors support the view that comprehensive tax linkages among the NAFTA states, such as tax harmonization or formulary taxation, are not appropriate. Foremost, the similarity in tax burdens on North American cross-border investment flows suggests that those flows are not being unduly distorted by tax measures. Furthermore, there is, arguably, no evidence that tax competition is leading to reduced tax revenues; there are no empirical studies that try to quantify the welfare losses associated with maintaining national tax differences; and the federal systems of Canada and the United States grant constitutional rights to provinces and states to develop their own distinct tax policies, which frustrates efforts to harmonize at the national level.

Nevertheless, an agreement calling for freer trade and investment among NAFTA countries calls for a corresponding movement to reduce barriers to efficiency promoted by tax differences among the NAFTA countries. Under an environment of increased economic integration, the NAFTA countries should take steps to address those barriers as long as minimal constraints are placed on each country’s tax policy. The NAFTA countries need to get to the bargaining table to reach consensus on the mechanisms that should be adopted to limit some of the more obvious problems created by the interaction of their tax regimes. An incremental approach to gaining a better understanding and resolving those problems through heightened multilateral tax coordination is preferable under the current environment.

In the short term, the NAFTA governments should alleviate some of the tax barriers faced by highly integrated North American companies by promoting binding arbitration for transfer pricing disputes, multilateral tax treaty negotiations, the elimination of parent/subsidiary dividend withholding taxes, and mechanisms to reduce tax compliance costs. The longer-term strategy involves the creation of a NAFTA Tax Working Group to study how tax differentials are harming the economic welfare of NAFTA and to consider reform measures to address those concerns. That learning process could begin with the creation of a permanent tax group composed of tax experts from each NAFTA country. (The tax authorities currently hold informal trilateral meetings on North American tax compliance issues.) The group could be created under the auspices of the NAFTA Trade Commission with the consent of the NAFTA countries. This Tax Working Group could resemble the current NAFTA Working Group on Trade and Competition, which was charged with reporting on the relationship between the competition laws of the NAFTA countries and trade within North America. The group could be composed of officials from the NAFTA-country governmental departments that traditionally negotiate tax treaties: Mexico’s Treasury Department, the U.S. Treasury Department, and the Department of Finance in Canada.

Regarding specific short-term proposals, NAFTA countries should:

– harmonize tax treaty provisions that deal with highly mobile factors, such as investment flows, under the view that it makes more sense to offer the same tax benefits to all trade partners tied together within a multilateral free trade area;

– implement binding arbitration for transfer pricing disputes (now contemplated within the Canada-U.S. tax treaty and the Mexico-U.S. tax treaty only after the countries have exchanged notes);

– promote consistent documentation requirements for transfer pricing and common procedures for advance pricing agreements (uniform documentation has been permissible for taxpayers in Canada and the United States since 2004 under the Pacific Association of Tax Administrators Mutual Agreement Procedure Operational Guidance for Member Countries);

– abolish parent-subsidiary withholding taxes on cross-border dividends and interest payments (in 2004 the United States and Mexico agreed to eliminate withholding on parent/subsidiary dividends by way of their tax treaty, and U.S. and Canadian treaty negotiators are reviewing a similar step for the Canada-U.S. tax treaty);

– create a centralized body to grant case-by-case approval of tax-free or tax-deferred North American mergers and acquisitions;

– enhance cooperation among North American tax authorities by expanding joint and multilateral audit procedures, including the use of simultaneous examination procedures, whereby two or more countries conduct a simultaneous audit of a multinational firm and exchange the audit findings (all three NAFTA countries are signatories to the Convention on Mutual Administrative Assistance in Tax Matters developed by the OECD and the European Council and thus already contemplate information sharing on a multilateral basis, and Canadian and American tax authorities also have participated, since 2004, in a Joint International Tax Shelter Information Centre task force); and

– implement measures to reduce administrative and compliance costs for cross-border investments from one NAFTA country to another, including the exemption of both parties taxpayers from compliance with some of their more onerous international tax rules (especially the controlled foreign corporation rules) that are designed to counter tax avoidance and tax evasion.

Consistent with global international tax trends, the recommendations emphasize administrative cooperation among tax authorities to smooth over problems promoted by the interaction of the different

trend, consider a recent Memorandum of Understanding between the U.S. Internal Revenue Service and the Canada Revenue Agency to assist with competent authority settlements in areas such as transfer pricing. Both tax authorities agreed to defer to the OECD transfer pricing guidelines to help resolve transfer pricing disputes.[13] Canada and Mexico already track the OECD approach closely,[14] but the United States departs from the OECD approach in some circumstances through its own transfer pricing laws (set out in regulation section 1.482 of the Internal Revenue Code), so the agreement appears to be a significant concession by the Americans.

In the short term, the NAFTA governments should alleviate some of the tax barriers faced by highly integrated North American companies.

Moreover, the Canadian and American tax authorities have signed another agreement to implement a binding independent review process to resolve disputes regarding the underlying facts and circumstances of specific cases brought before the competent authorities of each country.[15] Those administrative efforts should reduce compliance costs for firms with intracompany trade within Canada and the United States because, for example, those firms now can comply with the same transfer pricing rules. Moreover, a common understanding of the applicable rules and principles, along with a mechanism to force agreement on underlying facts and circumstances, probably will assist in the effective resolution of cross-border transfer pricing disputes between the two countries.

IV. Conclusion

The political, economic, and social tensions that inevitably accompany proposals for international economic integration are particularly acute in the context of tax policy. Countries considering international tax integration initiatives must weigh the economic benefits of greater tax uniformity with the political costs that such initiatives would impose by constraining domestic tax policy decisions. Sovereignty concerns are well placed, because modern tax regimes are important tools for ensuring the satisfaction of citizens social, economic, and institutional needs. Accordingly, a reduction in the ability to use tax measures to meet those needs is unpalatable to North American governments, which view their deal as a mechanism to achieve further trade and investment efficiencies, and not as creating sovereignty compromising political linkages. Tax proposals that impose significant constraints on the tax autonomy of the NAFTA countries are thus inappropriate at this time.

Still, the need for greater coordination increases as trade and capital markets become more integrated under NAFTA. The inevitable corollary is that real governmental sovereignty over certain aspects of taxation will erode, especially for Canada and Mexico. As a result, a strategy of heightened multilateral coordination has been recommended to deal with some of the existing problems. That strategy can be broken down into a short-term strategy that targets the removal of certain tax barriers harming the interests of highly integrated North American firms, and a longer-term strategy that studies how more fundamental reforms can resolve the ways national tax differences are subverting the broader economic interests of the NAFTA countries.

That two-pronged approach represents a compromise between sovereignty concerns and the desire to reap greater efficiencies: It permits the NAFTA countries to adapt their tax policies to the distinct needs of their citizens while ensuring that some economic costs are controlled at a centralized level. In sum, the strategy accommodates the double movement of modern society, responding to market pressures for greater economic efficiency while ensuring that the socially disruptive effects of international economic integration are minimized.

[1]These trade number are based on the first place of destination and therefore may overstate the amount of trade, as some goods go on to other countries after first landing in Canada or the United States. See U.S. Department of Commerce, U.S. Total Imports and Exports from Individual Countries, 1996-2002 (2003).

[2]See U.S. Department of Commerce, U.S. Total Imports and Exports from Individual Countries, 1996-2002 (2003).

[3]See U.S. Bureau of Economic Analysis, U.S. Direct Investment Abroad: Country and Industry Detail for Capital Outflows, 1992 to 2002 (Washington: U.S. Department of Commerce, 2003).

[4]See U.S. Bureau of Economic Analysis, U.S. Direct Investment Abroad: Capital Outflows, 2002 (Washington: U.S. Department of Commerce, 2003).

[5]See, for example, Jorge Martinez-Vazquez and Duanjie Chen, The Impact of NAFTA and Options for Tax Reform in Mexico (Atlanta: Georgia State University International Studies Program, Working Paper 01-2, 2001); Duanjie Chen and Jack M. Mintz, Taxing Investments: On the Right Track, but at a Snail’s Pace (Toronto: C.D. Howe Institute, Backgrounder no. 72, 2003).

[6]See OECD, Main Economic Indicators (2003), at p. 243 (using 1995 exchange rates).

[7]See OECD, Harmful Tax Competition: An Emerging Global Issue (OECD: 1998).

[8]See, for example, Article XXV of the Canada-U.S. tax treaty, which provides for nondiscriminatory tax treatment of most cross-border transactions.

[9]Nevertheless, discriminatory treatment against goods and services from other NAFTA parties continues to a certain extent under NAFTA.

[10]See Guidelines on Company Taxation, Commission Communication to the Parliament and the Council, Apr. 20, 1990, Doc. COM (90) 601 final.

[11]See Council Directive 49/2003/EC of June 2003.

[12]Lankhorst-Hohorst GmbH v. Finanzamt Steinfurt (C- 324/00), Dec. 12, 2002.

[13]CRA and IRS, Memorandum of Understanding between the Competent Authorities of Canada and the United States regarding the Mutual Agreement Procedure (June 3, 2005), at paragraph III (The Competent Authorities will follow the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations to resolve substantive issues in cases involving transactions between related parties.).

[14]Canada has adopted the OECD approach through an administrative pronouncement by its tax authorities. See CRA, Information Circular 87-2R (Nov. 1, 1999).

[15]See CRA and IRS, Memorandum of Understanding between the Competent Authorities of Canada and the United States Regarding Factual Disagreements under the Mutual Agreement Procedure (Dec. 8, 2005), at Section III.7.

Previously published by the Tax Notes Int’l, June 2006