Tax Debates Create Certainty and Uncertainty for North American Energy

In an uncertain world, it is often said that the two things you can count on are the inevitability of death and taxes. But while taxes are a fact of life, governments in North America are contemplating changes that will add to the uncertainty confronting investors and businesses in 2018.

“While taxes are a fact of life, governments in North America are contemplating changes that will add to the uncertainty confronting investors and businesses in 2018.”

The Harper government lowered Canadian tax rates in a number of areas, from the Goods and Services Tax (GST) rate cut from 7 to 5 per cent, to a corporate tax rate cut from 22 to 15 per cent. When the Trudeau government took over in late 2015, Canada’s tax rates were more favorable to business and households than those in the United States. Investors noticed, and foreign direct investment, employment rates, and GDP growth in Canada were all better than those in the United States.

That gave Ottawa room to increase spending and pursue policy priorities – and the Canadian federal budget deficit grew accordingly. In 2017, Finance Minister Bill Morneau signaled a shift to bring the deficit under control with a mix of spending cuts and higher taxes.

The Canadian federal budget in March changed the deductibility of exploration and development expenses.1 Small (CDN $15 million in expenses) firms used to be able to treat the first $1 million in development expenses as exploration expenses, shifting them from 30 per cent to 100 per cent deductibility. With this option eliminated, companies can renounce the lower deduction and pass the opportunity of the deduction on to individual investors (known as flow-through) to lower the after-tax cost of the company’s shares, but the added complexity is likely to limit access to capital for energy exploration and research for small firms, including many in the renewable sector.

Tax reform in the United States, as always, has been a less predictable process. Some proposals that worried investors in 2017 failed to make it into U.S. tax legislation; others emerged late in the year to cause concern.

Throughout the year, various proposals have alarmed energy markets. For example, the idea for a border adjustment tax was proposed by U.S. Speaker of the House of Representatives Paul Ryan to raise revenue from imports and encourage firms and consumers to source domestically. This would have raised the cost of Canadian oil and gas imports at a time of low prices and abundant supply. Later, this idea was dropped.

A proposal to tax the transportation of energy by pipeline was floated when U.S. President Donald Trump issued a presidential permit for the Keystone XL pipeline. This would have had a similar effect to the border adjustment tax, raising the cost of Canadian energy in the U.S. market and beyond (in the case of energy later exported from the United States). This idea did not make it into the congressional tax reform legislation.

One idea that did make it into the House and Senate tax bills was a change to the way that overseas earnings are taxed by the United States. The relatively high U.S. tax rate led some U.S. companies to book revenue abroad in low tax jurisdictions like Ireland and Singapore. For other multinationals, the high U.S. tax rate was an incentive to invest earning in local business operations, a boost to many Canadian communities.

“Throughout the year, various tax proposals have alarmed energy markets.”

Under the latest U.S. tax reform, firms that bring foreign earnings back to the United States qualify for a new, lower rate2 of 20 per cent. In addition to bringing in more revenue for the U.S. Treasury, this change could help finance an expansion of U.S. infrastructure including energy-related construction as firms seek to placed this repatriated capital to use and displace borrowing (likely to fall as interest rates are allowed to rise by the U.S. Federal Reserve).

U.S. tax reform also lowers tax rates for corporations (to 21 per cent; in contrast with Canada’s 25 per cent federal rate) and many individual filers. Pass-through corporations (those small businesses and sole proprietorships that pay taxes at the individual rate on their owners) will also pay the 21 per cent rate, a cut of as much as 11 per cent. Note that this is the opposite direction to the Trudeau budget, which is raising rates and scrutiny for small businesses.

Dollars

The prospect of these lower tax rates and the Trump administration’s campaign to reduce the regulatory burden on business has already delivered steady 3 per cent GDP growth for most of 2017. A growing economy provides another reason for U.S. and Canadian firms to invest in the United States. All good news for the U.S. economy, but some analysts3 believe that because no Democrats in Congress voted for the tax reform legislation, the coming years will see legal challenges and attempts to claw back or repeal some tax cuts – just as was seen with the Affordable Care Act passed with only Democratic votes. Political polarization and the unpredictability of the Trump White House cast a shadow of uncertainty over most predictions for the United States today.

Next consider the potential for carbon taxes. The Trump administration’s withdrawal from the Paris Accord has left carbon pricing to the states, and only a few states such as California have established a carbon pricing system. These states are also among those that will be hardest hit by another element of the U.S. tax reform: an end to the deductibility of state and local taxes on federal tax returns in the United States. The prior deductibility lowered the individual cost of high taxes in states like New York and California, in effect providing a subsidy for these states paid by taxpayers in low tax states, who had to pay higher federal taxes to meet growing federal revenue requirements but did not get the benefit of state and local services provided in the high tax states. If California, Illinois and New York tax payers must bear the full burden of federal taxes along with state and local taxes, enthusiasm for raising carbon prices to levels that would be adequate to address climate change is likely to dim.

“Without U.S. participation in a similar carbon pricing system, Canadian costs will be higher – offset to some extent by the exchange rate.”

FiguresAt the same time, 2019 will mark the first year of the Trudeau government’s new federal carbon tax, imposed at $10 per tonne Canadian in the absence of a higher provincial carbon price system. This is a low rate to begin with, but will increase by an additional $10 per tonne each year until 2022. Without U.S. participation in a similar carbon pricing system, Canadian costs will be higher – offset to some extent by the exchange rate.

The greatest uncertainty of all is the status of NAFTA, currently being renegotiated. Tariffs imposed on imports are another form of tax. Changes to the rule of origin, or even the collapse of talks followed by a U.S. withdrawal from the agreement, could impose additional burdens on Canadian exports to the United States.

Yet at the start of 2018, on balance there is a growing certainty that Canada’s tax burden is going up for most Canadian households and firms, while the U.S. tax burden is trending downward. Economic growth, tax changes designed to promote domestic investment, and the protectionist attitude of the White House on trade policy all combine to make the United States look like a more certain place to do business than Canada in the near term.

The uncertainty that remains is over whether, and how, Canada will respond to a newly tax competitive United States.

Christopher Sands is Senior Research Professor and Director of the Center for Canadian Studies at the Nitze School of Advanced International Studies (SAIS) and a nonresident Senior Associate at the Center for Strategic and International Studies (CSIS), both in Washington, D.C.

  1. Bloomberg Politics, Trump to Call for U.S. ‘Dominance’ in Global Energy Production, online: <https://www.bloomberg.com/news/articles/2017-06-25/trump-to-call-for-u-s-dominance-in-global-energy-production>.
  2. KPMG, Tax Reform – KPMG Report on New Tax Law – Analysis and observations, online: <https://home.kpmg.com/content/dam/kpmg/us/pdf/2018/02/tnf-new-law-book-feb6-2018.pdf>.
  3. The Wall Street Journal, GOP Tax Bill Would Set Up Years of Challenges, online: <https://www.wsj.com/articles/gop-tax-bill-would-set-up-years-of-challenges-1513557742>.