A Big Beautiful Blog: Base Erosion, Canada, and a Big American Bill

On May 22, 2025, the U.S. House of Representatives passed the One Big Beautiful Bill Act (the “OBBBA”). The OBBBA includes a proposal (referred to as “Section 899” or “§899”)  taking direct aim at countries that have implemented certain tax measures in line with the OECD’s base erosion and profit shifting (“BEPS”) initiatives. If enacted, §899 would impose additional U.S. withholding taxes on the repatriation of funds from the U.S. to Canada, which would have material adverse impact on Canadian investors.

Background: BEPS 2.0

The OECD BEPS initiatives target tax planning strategies where multinational enterprises artificially shift profits to low or no-tax jurisdictions to reduce tax burdens. The OECD’s view is that these tax avoidance strategies encourage unhealthy global tax competition which results in a net reduction in global tax revenues (i.e., a race to the bottom). The OECD has released recommendations to target BEPS. The second phase of recommendations, BEPS 2.0 released in 2020, has two pillars: Pillar 1 targets challenges posed by large enterprises taking advantage of the digitalization of the global economy, and Pillar 2 is a framework for a global minimum tax.

Pillar 1 – Tax on digital services

The global taxation system for multinational enterprises (reflected in double tax treaties) allocates taxing rights among countries, often based on outdated principles. For example, business income is usually taxable only where the income is earned through a “permanent establishment” in a country, which requires a physical presence, such as a branch, office or factory. Many digital businesses derive substantial income from “market countries” without any physical presence. This allows some of the world’s largest digital businesses to earn substantial income in market countries in which they pay little (if any) corporate tax.

Pillar 1 proposes a coordinated international approach to increase the rights of market countries to impose tax on the world’s largest international businesses. The OECD’s objective is to prevent piecemeal domestic measures (such as digital services taxes) which could result in double taxation and which otherwise conflict with the principles of international taxation.

Pillar 1 has not progressed, largely because of objections from the U.S., which is home to the majority of the multinational enterprises likely to be subject to additional tax under Pillar 1. In the absence of any foreseeable international consensus on Pillar 1, Canada is one of the countries that has enacted its own domestic digital services tax (as discussed below).

Pillar 2 – Global minimum tax

The objective of Pillar 2 is to ensure that large multinational enterprises are subject to a minimum effective tax rate of at least 15% on worldwide income. The purpose of this is two-fold: first, it disincentivizes multinationals from shifting profits to low tax jurisdictions, and second, it discourages countries from adopting low tax regimes to attract such profits.

The application of Pillar 2 is limited to multinational enterprises with annual global revenue in excess of €750 million (a “Qualifying Group”), with exemptions for certain entities such as government entities and non-profits.

The global minimum tax has three components applicable to members of Qualifying Groups:

1. Domestic Minimum Top-Up Tax (“DMTT”): The country where a subsidiary member of a Qualifying Group is resident may adopt a DMTT, which ensures that its taxpayers pay tax of at least 15% on income as computed for Pillar 2 purposes. This allows the member’s residence country to have first rights to tax the income.
2. Income Inclusion Rule (“IIR”): If a subsidiary member is not subject to tax of at least 15% under a Qualified DMTT (“QDMTT”) in its residence country, then the country where the parent entity of the Qualifying Group is resident may impose a top-up tax on the parent in respect of the subsidiary member’s income. This is similar to a controlled foreign corporation regime (such as FAPI in Canada or GILTI in the US) which imposes tax on a parent where one of its controlled subsidiaries earns undertaxed income.
3. Undertaxed Profits Rule (“UTPR”): If: (a) there is no QDMTT applicable to a member’s income, and (b) the parent entity of the Qualifying Group is not subject to an IIR, then the UTPR applies and allows the country of residence of any member of the Qualifying Group to apply a top-up tax in respect of the undertaxed profits.

The UTPR is particularly controversial because it imposes tax on profits that belong to neither the taxpayer nor a subsidiary of the taxpayer. This is a novel approach to taxing corporate groups and is analogous to making a group of taxpayers jointly and severally liable for undertaxed profits within the entire consolidated group. The UTPR is intended (in theory) to incentivize countries to adopt Pillar 2, since if they do not, other countries will be entitled to indirectly tax any undertaxed income.

As discussed below, however, the US is not willing to adopt Pillar 2, and it has particular objections to the UTPR. Under the UTPR, for example, a Canadian company that is a member of a U.S.-based multinational may be taxed on income of any entity in the multinational group that has been “undertaxed” according to the Pillar 2 computations, despite the fact that the income is neither income of the Canadian entity nor any subsidiary of the Canadian entity.   

Canadian Taxes Implementing Pillars 1 and 2

Digital Services Tax (“DST”)

Pillar 1 appears likely to be abandoned. However, Canada  agrees with its underlying principle that countries should treat their consumers (and particularly consumer data) as a resource. The DST is a 3% tax on Canadian-source digital services revenue earned by large domestic and foreign taxpayers from Canadian consumers. The DST applies retroactively to January 1, 2022.[1]

Taxpayers are subject to DST with respect to a particular calendar year if they meet both of the following requirements:

• the taxpayer had global revenue from all sources of at least €750 million in the prior calendar year; and  
• the taxpayer earned Canadian digital services revenue of more than CAD $20 million in the particular calendar year.

The 3% tax is levied on the amount by which the Canadian digital services revenue for the particular calendar year exceeds CAD $20 million.

In-scope revenue would generally be comprised of revenue arising from:

• online marketplace services to Canadian consumers;
• online advertising services targeting Canadian consumers;
• social media services provided to Canadian consumers; and
• the sale or licensing of Canadian consumer user data obtained from an online marketplace, a social media platform, or an online search engine.

The DST thresholds are such that, in practice, only large U.S. technology companies are in scope.

Global Minimum Tax Act (“GMTA”)

Canada adopted Pillar 2 by enacting the GMTA in 2024, which at the time of enactment included a QDMTT and an IIR. Proposed amendments would enact the UTPR effective in 2026.

The OBBBA – §899

Many jurisdictions (including Canada, Australia, the United Kingdom, and the EU) have enacted legislation to implement Pillar 2 and digital services taxes based on Pillar 1 principles.

The United States opposes Pillar 1 and digital services taxes, and does not intend to comply with Pillar 2. While the most recent measures are being proposed by the Trump administration, the Biden administration had previously launched investigations and initiated various trade complaints regarding Canada’s DST.

§891:  America’s Depression-Era Retaliatory Taxation Power

§891 of the Internal Revenue Code, enacted in 1934 in the wake of the Smoot-Hawley Tariff Act, gives the President the power to proclaim when U.S. citizens or corporations are being subjected to “discriminatory or extraterritorial taxes” under the laws of a foreign country. Where such proclamation is made, U.S. income tax rates on the citizens or corporations of that country are automatically doubled. §891 has never been invoked in its 91-year history.

On his first day in office, President Trump signed an executive order to investigate whether any foreign countries subject U.S. citizens or corporations to “discriminatory or extraterritorial taxes”. If President Trump invokes §891 against Canada, the results should be relatively minor compared to the effects of proposed §899. The increased U.S. income tax rates under §891 would only impact individuals that are Canadian citizens and subject to income tax in the U.S., and Canadian corporations with branches in the U.S. (or that are for some other reason subject to U.S. income tax). §891 would not impact U.S. resident corporations that belong to a multinational group, nor would it affect US withholding tax rates on distributions from such corporations.

§899: A New Retaliatory Tax for the New American Protectionism

The proposed §899 is significantly more punishing than §891. §899 proposes to impose additional withholding tax on certain payments made from a U.S. taxpayer to a person resident in a “discriminatory foreign country”. A “discriminatory foreign country” is defined as any country which has one or more “unfair foreign taxes” including DSTs and the UTPR. The withholding rate will increase by 5% for each year that a country imposes an unfair foreign tax. The starting point is the lower of the U.S. statutory withholding rate (30%) or the applicable tax treaty rate. The upper limit of additional withholding is 20% above the U.S. statutory rate (so 50%).

§899 applies more broadly than §891. It captures interest, dividends, rents, salaries, wages, dispositions of U.S. real property interests, branch profits, and other forms of  payment from a U.S. resident to a foreign entity in a jurisdiction with unfair foreign taxes. For Canadian corporations with U.S. subsidiaries, this could mean a potential doubling or tripling of their U.S. withholding tax burden (in the short term) and up to a tenfold increase (in the long term). The current treaty-reduced U.S. withholding tax rate imposed on dividends payable by a U.S. corporation to its sole Canadian corporate shareholder is 5%.

It is uncertain if and when the OBBBA will be passed, but the increase to withholding taxes would take effect 90 days after the bill is signed into law. The rate increases impact payments from corporations as well as tax-exempts and potentially partnership structures including, for example, private equity funds. It is unlikely that the Canada-U.S. tax treaty would apply to give relief to Canadians since §899 is intended to override tax treaties.

Conclusion

The OBBBA is currently being considered by the U.S. Senate. It is possible that the Senate, facing pressure from relevant stakeholders, will remove §899 or scale back its impact. However, threats and actions to impose punishing countermeasures on countries which have enacted DSTs is neither a new nor fleeting American policy position. There is some justification for the American concern that DSTs and the UTPR unfairly target U.S. companies, but the potential big repercussions for Canadian investors are anything but beautiful.

Assuming that the U.S. continues its big and beautiful belligerence towards its trading partners, Canada’s federal government is faced with a choice: either maintain the DST and UTPR as a matter of principle, or accept the reality of the economic threat imposed by §899 and withdraw these measures (which are not anticipated to generate significant revenue in any event).  Canadian elbows may be raised, but these may not be the elements of the BEPS project that are worth heading to the penalty box for.

[1] Updates on the implementation of the new DST requirements can be found here and here.