Open this photo in gallery Built by Lockheed Martin, the F-35 is a stealth aircraft developed by an international consortium of allied militaries as part of a deal that specifically rejects the application of traditional industrial benefits. Max Faulkner /The Associated Press

The U.S. military is threatening to pull the F-35 fighter jet out of the competition to replace Canada’s fleet of CF-18s, further disrupting the controversial acquisition program and increasing the tension between the two countries.

The dispute, laid out for the first time in a Pentagon letter published Monday in a think-tank report, centres on Canada’s insistence on receiving guaranteed industrial benefits – mandatory investments in the Canadian economy – if it were to purchase F-35s.

But it also adds to a list of disagreements between the Trump administration and the Canadian government. The two countries are already fighting over steel and aluminum tariffs imposed by Washington, and the future of a renegotiated North American free-trade agreement remains up in the air.

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Canada is also caught in a power struggle between the United States and China and is suffering economic reprisals from Beijing after Canadian authorities arrested a senior executive of Chinese telecommunications giant Huawei last December in response to a U.S. extradition request.

The acquisition of new fighter jets at an estimated cost of $26-billion will be one of Canada’s biggest-ever military purchases. Both the previous, Conservative government and the current, Liberal one have struggled to get the project off the ground because of the increasing price tag and continuing questions over the best aircraft to meet Canada’s needs.

Built by Lockheed Martin, the F-35 is a stealth aircraft developed by an international consortium of allied militaries as part of a deal that specifically rejects the application of traditional industrial benefits. Canada has been a member of the program since 2006.

The competition for new fighter jets is expected to be launched by the end of the month. However, the U.S. government is refusing to bid as long as Ottawa requires the winner to invest the equivalent of the acquisition cost under Canada’s Industrial and Technological Benefits (ITB) Policy, according to a letter obtained by defence analyst Richard Shimooka and published in a report by the Macdonald-Laurier Institute.

“If the ITB requirement remains in effect, an F-35 offer will not be provided,” said the letter from Vice-Admiral Mathias Winter of the U.S. Navy and dated Dec. 18, 2018. “We look forward to Canada reaffirming its status as an F-35 partner and hope the ITB issue will be resolved quickly so the F-35 is able to compete.”

Vice-Adm. Winter is the program executive officer for the F-35 Lightning II Joint Program Office. His letter was addressed to Paula Folkes-Dallaire, the senior director of the fighter-jet program at Public Services and Procurement Canada (PSPC).

The Canadian government said it is engaged in discussions with all potential aircraft suppliers and working to create “a level playing field and a fair and open competition with as many eligible suppliers as possible.”

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The government plans to continue to participate in the F-35 program.

“This ... gives us the option to buy aircraft through the program, should the F-35 be successful in the competitive process for the future fleet,” said Ashley Michnowski, a spokeswoman for PSPC Minister Carla Qualtrough.

In a statement, Lockheed-Martin said it did not commission the report and that it is up to the U.S. government to conduct negotiations with Canada.

Mr. Shimooka, the author of the report, said this dispute has damaged relations with the Pentagon.

"The Americans are really not happy. To them, it’s just ridiculous,” he said.

He said that if Canada doesn’t alter its approach, it could end up losing its place in the F-35 consortium. If that happens, Canada might still be able to purchase F-35s – but at a premium. Under this arrangement, Ottawa could negotiate industrial-regional benefits with Lockheed Martin, but it would end up paying as much as 30 per cent more for each jet.

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Mr. Shimooka said the F-35 is nearing peak production and that a lot of supply contracts will only be open to Canadian companies if Canada remains a member of the F-35 consortium. Ottawa has previously estimated that Canadian industry could potentially win more than US$10-billion in contracts over decades to supply the production of F-35 fighters.

Mr. Shimooka said that, to his knowledge, Canada has not replied to the Pentagon letter.

In the last federal election, the Liberal Party of Canada said it would not buy the F-35, promising instead to select “one of the many, lower-priced options that better match Canada’s defence needs.” However, the party also promised to launch an “open and transparent” competition, in which the F-35 will now be invited to compete.

Other potential competitors include the Boeing Super Hornet, the Eurofighter Typhoon, made by a consortium that includes Airbus, and Saab’s Gripen.

Under the rules of the F-35 consortium, partner countries such as Canada must forgo such regional offset programs with guaranteed industrial benefits. Instead, members of the consortium receive contracts for work on the aircraft on a competitive basis. Ottawa has spent more than $500-million to be a partner in the program over the past 20 years, including $54-million last year.

Vice-Adm. Winter said in his letter that Canada has received US$1.3-billion in economic benefits to this point. He added that if Canada remains part of the consortium, it will be eligible for additional work over five decades, which is longer than the 15-year period in the ITB policy.

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“The F-35 supplier team will submit an F-35 offer only if (1) the ITB requirement is waived entirely and (2) there is no future ITB obligation arising from selecting the F-35,” the letter said.

In a previous letter dated Aug. 31, 2018, the U.S. government warned Canada that calling for the F-35 bid to include regional benefits “would be fundamentally and structurally prejudicial to any F-35 bid.” That letter, which was also obtained by the Macdonald-Laurier Institute, was sent by the under secretary of defence, Ellen Lord, to André Fillion, the assistant deputy minister of defence procurement at PSPC.