Source of Income Rules and Treaty Relief from Double Taxation within the NAFTA Trading Bloc

AuthorMichael S. Schadewald; Tracy A. Kaye
PositionAssociate Professor, School of Business Administration, University of Wisconsin-Milwaukee
Pages354-415

Page 354

Associate Professor, School of Business Administration, University of Wisconsin-Milwaukee; B.B.A., Accounting, University of Wisconsin-Whitewater; M.S., Taxation, University of Wisconsin- Milwaukee; Ph.D., Accounting, University of Minnesota.

Associate Professor, Seton Hall Law School, Seton Hall University; B.S., University of Illinois; M.S.T., DePaul University; J.D., Georgetown University Law Center. The authors gratefully acknowledge the support provided by the Ernst & Young Foundation that enabled us to conduct this research. The authors also gratefully acknowledge the research assistance provided by Gretchen McGarry and Thomas Yang, while students at Seton Hall University School of Law. Terry McDowall, Vivian Dzau, Frederico Aguilar, Jose Dominguez, and Karen Nixon of Ernst & Young L.L.P. provided helpful comments. We also benefitted greatly from comments by Brian Arnold and Ricardo Leon- Santacruz.

Page 355

I Introduction

The level of trade and investment among the NAFTA countries is significant and growing. As cross-border activity continues to grow, the NAFTA countries will experience greater pressure to harmonize their respective tax systems. A principal objective of the NAFTA accords is to promote economic neutrality by eliminating barriers to cross-border trade of goods and services. Because source of income is a primary determinant of which country is entitled to tax the income arising from a particular cross-border activity, the source of income rules of the NAFTA countries must be consistent if the goal of economic neutrality is to be fully achieved. The problem with inconsistent source rules is that they can lead to double taxation and, in turn, to differential tax burdens on a multinational business enterprise's domestic versus foreign profits. Such differences can distort the operating and investment decisions of businesses, leading to a misallocation of resources among the countries involved, and a resulting loss in overall economic welfare. The purpose of this article is to compare the source of income rules of the United States to those of Canada and Mexico in order to identify any inconsistencies that can result in double taxation.1 Thus, two basic comparisons are made, the U.S. versus Mexico and the U.S. versus Canada.

Inconsistencies in the source of income rules employed by Canada, Mexico, and the United States can be found in the rules governing gains from the sale of stocks and other securities, gains from the sale of inventory, and interest expense. For example, in the U.S. gains from the sale of stocks and securities are sourced according to the residence of the seller; however, in Mexico the residence of the entity that issued the securities determines the source of such income. While the Page 356 Canada-U.S. Treaty and the U.S.-Mexico Treaty generally resolve these inconsistencies, these treaties do not resolve the source rule inconsistencies with respect to inventory sales and interest expense.

The source of gains from the sale of inventory is based primarily on the title passage rule for U.S. tax purposes, but in Canada and Mexico the source is determined by the location of the actual underlying economic activity. As a U.S. tax incentive for stimulating export sales, the title passage rule does not create a double taxation problem for a U.S. exporter. However, it does create the possibility that a portion of a U.S. exporter's profits will escape taxation altogether. In contrast, the U.S. interest expense allocation rules have the potential for creating international double taxation. These rules require a U.S. parent corporation to apportion interest expense against its foreign source income based on the ratio of foreign assets to total assets, even though the U.S. parent corporation's foreign subsidiaries may not deduct interest expense costs in computing their foreign taxable income. Because NAFTA indicates that the U.S. views trade with Canada and Mexico as more integral to its economic future than trade with other foreign countries, U.S. policy should favor harmonization of the inconsistent source rules in the areas of inventory sales and interest expense allocations.

Further, a consequence of NAFTA is an increase in the commuting of individual employees across national borders as well as more frequent transfers between domestic and foreign affiliates of multinational corporations. Thus, the tax treatment of compensation packages, such as stock options and contributions to foreign pension plans, is of great importance as the mobility of the workforce continues to grow. At present, the difference in the source rules applicable to the income attributable to the exercise of a stock option can lead to double taxation. Also, as Canada and Mexico do not respect the salary reduction portion of a U.S. section 401(k) plan, there is likely to be a mismatch of the inclusion of earnings in Canadian or Mexican gross income and the foreign tax credits attributable to the U.S. tax on subsequent distributions from such plans.

In general, the source of income rules of the three NAFTA countries are similar, and to the extent differences exist, the applicable tax treaties for the most part resolve the inconsistencies so as to prevent double taxation. However, problems remain with respect to the compensation and benefits packages of expatriates and cross-border employees, inventory sales and interest payments, as well as the tax consequences of corporate reorganizations within the NAFTA bloc. These issues should be addressed during the modification and renegotiation of the bilateral treaties. The United States should also consider the negotiation of a multilateral treaty between Canada, Mexico, and the United States.2

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II Overview of The Income Tax Systems of The Nafta Countries

In the international trade arena, the current trend is toward the formation of regional trading blocs. For example, by 1998, the World Trade Organization, (replacing the General Agreement on Tariffs and Trade (GATT) in 1995), had been notified of almost 180 regional trade arrangements (a third of which had been registered since 1990)3 and reported that there were ninety-one regional trade areas.4 On December 17, 1992, Canada, Mexico and the United States agreed to the terms of the North American Free Trade Agreement (NAFTA)5 in order to create a trade area in which goods and services are exchanged free of tariffs and other trade restrictions. Article 102 of NAFTA states that the objectives of the Agreement include the elimination of barriers to cross-border trade, the promotion of fair competition in the NAFTA area, and the increase in investment opportunities within the NAFTA countries. With limited exceptions, NAFTA does not address the subject of taxation,6 except to specify that tax issues will generally be governed by the applicable income tax treaties in effect between the NAFTA countries. However, almost...

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