Canada: Canadian Tax @ Gowlings - May 3, 2011

Last Updated: May 15 2011

Edited by Jim Wilson

Article XIII(8) of the Canada-U.S. Treaty – Not a Simple Rollover Provision

The purpose of this article is to provide an update on current developments at the Canadian Competent Authority regarding Article XIII(8) of the Canada-United States Tax Convention (1980)1 ("Convention") and similar provisions found in other Canadian tax treaties.2 It is generally well understood that the primary purpose of an income tax treaty is to avoid double taxation. One common cause of juridical double taxation is where there are timing differences between the income recognition tax laws of two Contracting States. The OECD Model Tax Convention on Income and on Capital3 (the "OECD Model") addresses these timing mismatches by attempting to put some obligation on Resident States to rectify the double tax by providing relief regardless of when the tax is levied by the Source State.4 The OECD Model does not, however, require either a Resident State or a Source State to defer the recognition of that income at the first incidence of taxation in an attempt to coordinate both States' rules as a means of avoiding double tax. Deferral of a Contracting State's immediate right to tax would generally require a clear provision in a tax treaty empowering that State to defer recognition of the profit, income or gain otherwise taxable immediately under its domestic laws. The Convention has incorporated several of these special deferral provisions5 allowing the competent authority of each state, at its sole discretion, to defer income in order to avoid potential double tax.

Article XIII(8) Agreements

Paragraph 8 of Article XIII of the Convention attempts to address the potential for double taxation in the context of a tax-free corporate (or other organization) reorganization in one State ("Resident State") when the assets, that are the subject of the corporate restructuring, are not all located within that State and the State of situs of the non-domestically located assets considers those assets to have been alienated as a result of the reorganization and taxes the profit, gain or income therefrom. Where Canada is the State of situs of the non-domestically located assets, upon a request received by the acquirer of such assets, the Canadian Competent Authority may enter into an agreement with the acquirer to defer the recognition of the profit, gain or income in accordance with Article XIII(8) of the Convention and section 115.1 of the Income Tax Act6 ("Act"). Relief from double taxation would then be achieved through a deferral of taxation in Canada. As mentioned above, the deferral, however, is not automatic and the deferral provisions leave its granting to the "sole" discretion of the Competent Authority of that State.

Paragraphs 72 to 85 of Information Circular 71-­17R5, Guidance on Competent Authority Assistance Under Canada's Tax Conventions7 ("Circular"), summarize the Canadian Competent Authority's policies regarding agreements made pursuant to Article XIII(8) of the Convention. However, since the publication of the latest version of the Circular in 2005, the Canadian Competent Authority has undertaken a major policy review regarding the administration of Article XIII(8). This review was completed in 20068 and focused largely on the manner in which these agreements should be drafted (e.g. rollover versus suspended gain approach) and the types of subsequent transactions (i.e. transactions subsequent to the transaction that was the subject of the Article XIII(8) agreement) that are offensive in policy terms and should cause the Canadian Competent Authority to cease to defer the income, profit or gain. Even though there has been no official announcement by the Canadian Competent Authority, another major policy review began in 2010 and is still ongoing.9 However, the 2010 Policy Review is more focused on cross border divestitures and public company spin-offs and whether it is appropriate to enter into Article XIII(8) agreements in such circumstances.

2006 Policy Review of Article XIII(8)

The results of the 2006 Policy Review were summarized by the Canadian Competent Authority in its written response to Question 16 of the 2006 TEI Conference.10 The Canadian Competent Authority's policy with respect to agreements under Article XIII(8) of the Convention was broadened at that time to include individuals residing in the United States who enter into transactions described therein where the circumstances warrant relief. The Canadian Competent Authority also announced at that time that Article XIII(8) agreements would continue to follow a rollover approach where the vendor's cost base in the Taxable Canadian Property ("TCP") at the time of the reorganization will become the acquirer's cost base of the TCP. However, agreements concluded by the Canadian Competent Authority would be subject to a number of terms and conditions (generally referred to in such agreements as "triggering events") that require the immediate recognition of the deferred profit, gain or income in Canada if certain events occur during the deferral period that are considered offensive to Canada in policy terms. The following are some examples of the key triggering events that might cause the immediate recognition of the deferred profit, gain or income:

  • where the TCP alienated consists of shares of a corporation resident in Canada, the payment of dividends in contemplation of a subsequent sale of the shares of that corporation may cause a triggering event. Consideration should therefore always be given by taxpayers to tax planning strategies which may alleviate these effects;
  • any other transactions whereby the TCP initially alienated is no longer subject to tax in Canada, such as a change in the asset-mix of a corporation so that its shares no longer derive their value principally from real property situated in Canada11;
  • transactions involving an arm's length sale, whether directly or indirectly, of the consideration (e.g. shares) issued to the vendor at the time of the Article XIII(8) transaction. The rationale for this is that a fundamental principle underlying the negotiation of terms and conditions for a deferral is that the Canadian Competent Authority will only agree to defer a gain up to the point in time when tax in the Resident State becomes payable in connection with the deferred gain, whether directly or indirectly; and
  • with respect to individuals, date of death will be a triggering event since the Canadian Competent Authority is concerned that individuals could utilize Article XIII(8) agreements to reorganize their Canadian holdings to avoid future "date of death" tax consequences in Canada.

The principal message given by the Canadian Competent Authority in its written response to TEI on Question #16 was:

The main outcome of these consultations is a focus on the purpose of Article XIII(8) of the Convention, which is to avoid double taxation due to timing differences between the rules of both countries with respect to the recognition of gains, and not to facilitate tax planning.12 [Emphasis added]

It is evident that the Canadian Competent Authority is attempting to strike a delicate balance between safeguarding Canada's right to tax the deferred gain and achieving the desired objective of avoiding double taxation. The consequences, unfortunately, are that certain tax planning strategies that could have been accomplished had the non-resident taxpayer structured its Canadian holdings appropriately in the first place cannot achieve the new structure through the use of an Article XIII(8) agreement. Because of the Canadian Competent Authority's objective to protect their domestic right to tax the deferred gain, the fact that certain tax planning techniques would have been acceptable at the outset have been determined, in Article XIII(8) policy terms, not to be relevant.

2010 Policy Review (Public Company Spin-Offs and Internal Divisive Reorganizations)

With respect to the subject of public company spin-offs and internal divisive reorganizations, the Canadian Competent Authority has not been prepared to enter into Article XIII(8) agreements in certain scenarios. However, various tax practitioners have raised reasonable arguments against these existing policies and the Canadian Competent Authority has decided to revisit the matter. The project currently under review by the Canadian Competent Authority involves several scenarios fitting into the above category and the policy issues related thereto are quite complex. A full discussion of these structures and policy concerns is beyond the scope of this article. However, the author will give a brief explanation of the two main contentious issues under review, as well as a third issue regarding whether it is appropriate for the Canadian Competent Authority to even enter into such agreements where the treaty partner (i.e. Resident State) does not tax the capital gain on the disposition of TCP.

Public Company Spin-Offs

To illustrate a simple scenario, consider a U.S. public corporation ("U.S. Vendor") who is proposing to spin-off the shares of its Canadian subsidiary ("Canco") to its shareholders. As a preliminary step, the U.S. Vendor transfers the shares of Canco to a wholly-owned U.S. subsidiary ("U.S. Newco") and then spins-off the shares of U.S. Newco to its shareholders. The series of transactions is done on a tax deferred basis for U.S. tax purposes. The first transaction in that series, that is, the transfer of the Canco shares to the U.S. Newco by U.S. Vendor, is the transaction that would be the subject of the Article XIII(8) agreement on the assumption, of course, that the shares of Canco are not "treaty protected property" as that term is defined in section 248 of the Act. At that stage there is nothing really offensive with the transaction in policy terms. However, the triggering event described above under the heading "2006 Policy Review of Article XIII(8)" regarding transactions involving an arm's length sale, whether directly or indirectly, of the consideration (e.g. shares of U.S. Newco) issued to the vendor (e.g. U.S. Vendor) at the time of the Article XIII(8) transaction will, for all intent and purpose, render the Article XIII(8) agreement pointless as the spin-off by U.S. Vendor of the shares of U.S. Newco to the public shareholders will cause the deferred gain to be brought immediately into income. Even if the Canadian Competent Authority was prepared not to apply that particular triggering event in its Article XIII(8) agreement to that particular transaction, because it does not find the spin-off transaction offensive13, it would not matter. That is, even if the triggering event is not applied to the spin-off transaction, the same triggering event will apply when the public shareholders begin to sell the shares of U.S. Newco in the open market, the latter transaction being a taxable event in the U.S.

The obvious concern with this current Canadian Competent Authority policy is that the U.S. public shareholders had always been in a position to dispose of the shares of U.S. Vendor (and indirectly the shares of Canco) without generating any tax consequences in Canada. Therefore, since the treaty protection for the public shareholders already existed and was not being created as the result of the reorganization, the disposal of the shares of U.S. Newco should not result in any tax consequences in Canada. However, the Canadian Competent Authority has maintained this policy because they are of the view that it is not appropriate to allow a deferral in these cases because, among other factors, arm's length parties would be indirectly acquiring the Canco shares and U.S. Vendor would no longer have any interest in the property at the end of the series of transactions. They are of the view that Article XIII(8) was not intended to apply to a divestiture of TCP. Rather, the granting of a deferral was only intended to apply to reorganizations where the initial owner maintained its interest in the property, albeit through a different structure.

Internal Divisive Reorganizations

The other contentious issue currently under review by the Canadian Competent Authority relates to those reorganizations that involve the spin-off of various companies or assets in the corporate group but do not result in a disposition or divestiture of such property (TCP) by the existing owner to arm's length parties. Commonly this type of internal divisive reorganization within a corporate group of companies is intended to segregate certain assets of the group for commercial reasons such as streamlining business operations or creditor proofing. The problem that occurs is where the steps undertaken in the Resident State for the divisive reorganization cannot be generally accomplished on a tax-deferred basis in Canada. The concern here is that the Canadian Competent Authority does not want to give a more preferential treatment to a non-resident of Canada than it would to its own residents in similar circumstances. For example, where the divisive reorganization involves a direct distribution of the TCP by the U.S. Vendor to its shareholder(s), regardless that these transactions may be able to be accomplished on a tax free basis in the Resident State, they do not meet the condition outlined in subparagraph 76(c) of the Circular in that there is no similar rollover provision in Canadian law that would be applicable to the proposed reorganization if it involved only residents of Canada. In other words, had a Canadian resident corporation distributed its assets directly to a shareholder, subsections 69(4) or (5) of the Act would generally apply to deem there to be a disposition of such assets at fair market value. This type of reorganization (direct spin-off of corporate assets to its shareholders) cannot be done in Canada on a tax deferred basis. Canadian residents are required to structure these reorganizations in a manner that complies with the rules in the Act for divisive reorganizations (e.g. paragraphs 55(3)(a) and (b) of the Act). Therefore, the Canadian Competent Authority has requested taxpayers in the past to restructure their affairs in the Resident State in a way that simulates a paragraph 55(3)(a) or (b) type divisive reorganization.

If the vendor is a resident of the U.S., these requests to restructure in order to get an Article XIII(8) agreement may be possible in some cases but is sometimes not practical for the taxpayer. However, other countries that have a treaty with Canada and a similar provision to Article XIII(8) may not have tax laws that would allow for this type of restructuring and the only tax deferred transaction possible in that country is a direct spin-off of the corporate assets. The Canadian Competent Authority's current policy is to reject requests for Article XIII(8) agreements in those cases where a direct spin-off of corporate assets is undertaken.

The main argument against this policy is that it really restricts the application of Article XIII(8), and its equivalent in other treaties, in an unreasonable manner. For example, it is highly unlikely that the treaty negotiators would have expected the two treaty partners to have similar or identical corporate reorganization tax laws when it negotiated the inclusion of this provision into the treaty. The policy objective should simply be, after looking at the overall purpose and final result of the foreign reorganization, that as long as a deferral could have been obtained in Canada in an all Canadian context, regardless of the precise steps that would have been necessary under the Act (e.g. a paragraph 55(3)(a) reorganization), that should be sufficient.

As there are reasonable arguments that have been put forth by practitioners, the Canadian Competent Authority has agreed to re-examine its policy on this. However, as the policy issue described in subparagraph 76(c) of the Circular is fairly long standing, the Canadian Competent Authority intends to maintain its current policy until they have had an opportunity to consult with their policy advisors on this and other related issues.

Gains not Taxable in Resident State due to Territorial or Exclusionary Tax Systems

As mentioned above, the Canadian Competent Authority has stated that the main purpose of Article XIII(8) of the Convention is to "avoid double taxation due to timing differences between the rules of both countries". Historically, the Article XIII(8) type workload received by the Canadian Competent Authority has predominately involved U.S. residents disposing of TCP where the gain was not taxable in the U.S. due to a special deferral or non-recognition provision in its domestic tax laws. The scenarios have always involved TCP that will ultimately be taxable in the Resident State (i.e. the U.S.) upon a subsequent arm's length disposition of the TCP, hence the "timing" issue between the two Contracting States. However, recent cross border reorganizations involving residents of other countries in which Canada shares a tax treaty, and that has an Article XIII(8) type provision in the treaty, have raised an issue where the gain on the disposition of the TCP is permanently not taxable in the Resident State.

As a simple example, consider a treaty partner of Canada that has an exclusionary tax system which provides an exemption method of relief with respect to certain foreign source income (including the gain on the disposition of the Canadian TCP). In light of the Canadian Competent Authority's stated purpose of Article XIII(8) of the Convention, this certainly raises an interesting policy issue with respect to whether the Canadian Competent Authority should even entertain a request for deferral. It also begs the question as to why an Article XIII(8) type provision was included in the treaty in the first place. One would only have to look at the Canadian Competent Authority's current Article XIII(8) template agreement, which is available to taxpayers upon request, to see that the majority of the triggering events described therein are based on the policy objective that the Canadian deferral should not continue past a point in time where there is no longer a double tax exposure. In the case of a permanent deferral or exemption in the Resident State, there will never be double tax exposure.

If the Canadian Competent Authority were to enter into Article XIII(8) type agreements where the capital gain on the disposition of the TCP is permanently exempt from tax in the Resident State, then it is possible that they would have to go back to square one to completely revise, and simplify, their approach to Article XIII(8) in general. For example, it will be difficult for the Canadian Competent Authority to maintain the position that the purpose of these treaty provisions is to avoid double tax. Entering into a XIII(8) type agreement where the capital gain is not taxable in the other state due to a territorial or exclusionary tax system would seem to suggest an admission that the true purpose of these treaty provisions is strictly to facilitate cross border reorganizations where no actual economic realization of proceeds of disposition have occurred. This would be a significant change in direction for the Canadian Competent Authority and their previous policy advice. This would also seem inconsistent with the primary purpose of a tax treaty which is to avoid double tax.

On the other hand, should it be relevant whether Canada's treaty partner has a territorial or exclusionary tax system versus a residency based tax system, where, for example, foreign tax credit relief is provided to alleviate double tax on foreign source income? In the latter case, the Resident State has only residual taxing rights anyhow. But if the Canadian Competent Authority was prepared to give Article XIII(8) type agreements to taxpayers residing in a Contracting State with a territorial or exclusionary tax system, would that not be akin to treating Article XIII(8) like a tax sparing provision? This is an extremely difficult treaty policy issue that could have ramifications on the entire current competent authority process.

New U.S. Tax Legislation Regarding "Foreign Tax Splitters"

A new section of the Internal Revenue Code (the "Code") will likely need to be considered by the Canadian Competent Authority to determine the potential impact of the new legislation on the Canadian Competent Authority's Article XIII(8) program. Section 909 was added to the Code in 2010 (generally applicable after December 31, 2010) and is evidently intended to deal with "foreign tax splitters". According to the IRS in Internal Revenue Bulletin 2010-52 (the "IRS Bulletin"), it contains new rules that suspend a foreign tax credit for US tax purposes when the item of income that gave rise to the foreign tax is not immediately recognized for US tax purposes. The IRS Bulletin explains that under the new section, the foreign tax credit is allowed in the year the item of income is recognized for US tax purposes. These rules would appear to remove any double tax exposure to U.S. taxpayers eligible for the domestic relief. Although these rules seem to be intended to apply mostly to hybrid entities, they may be applicable in certain Article XIII(8) scenarios. If so, this will raise similar policy issues to those discussed above where the gain on the disposition of the TCP is permanently not taxable in the Resident State due to territorial or exclusionary tax systems. Again, the Canadian Competent Authority will have to seriously reconsider its policy that the main purpose of Article XIII(8) is to "avoid double taxation due to timing differences between the rules of both countries".


As can be seen from above, Article XIII(8) is not being administered by the Canadian Competent Authority as a simple automatic rollover provision. In reality, the XIII(8) agreements are more of a quasi rollover-suspended gain approach and are quite complex. Taxpayers and their advisors should not assume that the provision will apply in all cross border reorganizations where there is a timing mismatch. Early discussions with the Canadian Competent Authority should be done before significant hours and resources are invested preparing Article XIII(8) submissions. This will ensure that if there are policy impediments that would otherwise prevent the Canadian Competent Authority from entering into an agreement, it is at least brought to the attention of the taxpayer and their advisor at a very early stage. Also, some specialized tax planning may be a good idea before the Article XIII(8) transactions are actually carried out to avoid unfavourable tax treatment.

On the flip side, the 2010 policy review may eventually broaden the eligibility for Article XIII(8) relief and taxpayers and their advisors should be aware of that possibility, especially with respect to U.S. public company spin-offs and internal divisive reorganizations. As a further possibility, Canada's Department of Finance may ultimately amend the Act to allow for a deferral of the gain in certain transactions involving non-residents disposing of TCP to non-Canadian entities. They have already introduced provisions to accommodate Canadian shareholders of foreign entities that are involved in spin-offs14. Also, the need for such amendments to the Act is clearly evident in cases involving U.S. absorptive mergers where the U.S. entity that legally ceases to exist, as a consequence of the merger, held TCP. Even though the latter scenario is a typical transaction that is granted Article XIII(8) relief by the Canadian Competent Authority, the complexity of those agreements and the potential adverse tax consequences where a subsequent triggering event occurs make Article XIII(8) agreements an option of last resort for taxpayers.

Finally, where a tax-free corporate (or other organization) reorganization takes place in a country with which Canada has entered into a tax treaty, but that particular tax treaty does not have an Article XIII(8) type provision, and the reorganization results in a taxable event in Canada (e.g. a disposition of TCP by a non-resident of Canada), then no deferral of the gain, for Canadian tax purposes, will likely be possible. As alluded to in the opening paragraph above, in the absence of a specific deferral provision in the treaty, the Canadian Competent Authority, to date, has refused to defer the recognition of any such gain as a means of avoiding potential or future double tax. It would generally be expected, as a means of resolving double taxation, that the resident state will provide a foreign tax credit for the Canadian taxes payable, ideally in the year it taxes the gain. It is evident that the Canadian Competent Authority is of the view that, in the absence of a special deferral provision in the treaty, and where a timing issue has arisen regarding the income recognition laws of both states, deferral of tax at the first incidence of taxation is a benefit that goes beyond its mandate of relieving double tax.


1. Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital, 26 September 1980, SC 1984, c 20, Part I (entered into force 16 August 1984) as amended by the protocols done in 1983, 1984, 1995, 1997 and 2007 (Fifth Protocol, SC 2007, c 32 (entered into force 15 December 2008)) [Convention].

2. Estonia, (art 13, para 5), Finland (art 13, para 6), Germany (art 13, para 5), Hungary (art 13, para 5), Iceland (art 13, para 5), Korea (art 13, para 9), Latvia (art 13, para 5), Lithuania (art 13, para 5), Luxembourg (art 13, para 6), Mongolia (art 13, para 5), Netherlands (art 13, para 6), Norway (art 13, para 9), Peru (art 13, para 5), Switzerland (art 13, para 5), Tanzania (art 13, para 6), Venezuela (art 13, para 8) and Zimbabwe (art 14, para 6).

3. OECD, Model Tax Convention on Income and on Capital, Condensed Version (OECD Publishing, 2010) [OECD Model].

4. See OECD Model, ibid at para 32.8 of the commentary to articles 23A and 23B.

5. See Convention, supra note 1 at articles XIII(8), XXIXB(5) (Death) and XVIII(7)(Pensions and Annuities).

6. Income Tax Act, RSC 1985 (5th Supp), c 1 [ITA].

7. Canada Revenue Agency, Information Circular 71-17R5, "Guidance on Competent Authority Assistance Under Canada's Tax Conventions" (1 January 2005).

8. Tax Executives Institute Inc, "Income Tax Questions Submitted to Canada Revenue Agency [with Responses from CRA]" (December 5, 2006), (2010) Thomson Reuters Canada Ltd TaxPartner [TEI Questions].

9. The Canadian Competent Authority has been informing tax practitioners who have current files with them, or who have simply made enquiries, that another policy review is ongoing.

10. See ibid.

11. See Convention, supra note 1 at article XIII, para 4 (Denies Canada the right to tax the gain arising on the disposition of the TCP in that scenario).

12. TEI Questions, supra note 8.

13. For example, since the spin-off did not result in a taxable event in the U.S., it should not be considered offensive in Canadian Article XIII(8) policy terms and thus it should not be necessary to cause the deferred gain to be brought back into income).

14. ITA, supra note 6 at s 86.1.

Article XV(2) of the Canada - U.S. Treaty – Problems Impacting Canadian Employees Working in the U.S.

By Jim Wilson

The 5th Protocol to the Canada-United States Tax Convention (1980)1 (the "Treaty"), which entered into force on December 15, 2008, introduced several significant and highly anticipated changes to the Treaty. There were also several minor amendments made to the Treaty, including one to Article XV that was intended only to be clarifying in nature. There is evidence that some auditors of the Internal Revenue Service ("IRS") are interpreting the amendment to Article XV in a manner that goes beyond what was intended by the Treaty negotiators.2 If a trend begins to develop, this could have major ramifications on cross-border services, particularly intra-group services where Canadian employees are sent to work in the U.S. for short periods of time.


The 5th Protocol amended subparagraph 2(b) of Article XV of the Treaty to change the word "employer" to "person". However, the Technical Explanation ("TE") of the 5th Protocol reads as follows:

New Subparagraph 2(b) refers to remuneration that is paid by or on behalf of a "person" who is a resident of the other Contracting State, as opposed to an "employer". This change is intended only to clarify that both the United States and Canada understand that in certain abusive cases, substance over form principles may be applied to recharacterize an employment relationship, as prescribed in paragraph 8 of the Commentary to Article 15 (Income from Employment) of the OECD Model. Subparagraph 2(b) is intended to have the same meaning as the analogous provisions in the U.S. and OECD Models. (underlining for emphasis)

The Canada Revenue Agency ("CRA") has also addressed this issue in writing at the 2008 TEI-CRA Liaison Meetings3 and has stated that "[w]hether the word "person" or the word "employer" is used in subparagraph 2(b) of Article 15 (Income From Employment) in Canada's income tax conventions, the intention is to determine who, in fact, is exercising the functions of employer. In making this determination, the CRA generally will refer to principles developed under Canadian jurisprudence and the Quebec Civil Code."4

Hypothetical Scenario

Consider a corporation resident in Canada ("Canco") which has a wholly-owned subsidiary in the U.S. ("US Opco"). Canco is in the business of providing engineering services and employs a number of full-time engineers. US Opco carries on the same business as Canco, solely in the U.S., and has its own staff of engineers. However, Canco has a few engineers ("Canco Employees") with unique skill sets who, on occasion, are sent down to job sites in the U.S. to assist US Opco and its engineers. At no time do the Canco Employees have an employee-employer relationship with US Opco, in substance or in form, while performing their duties of employment in the U.S. The arrangement is not in the nature of a secondment or employee sharing and is purely a contract of services between Canco and US Opco. US Opco reimburses Canco for the remuneration paid to the Canco Employees in respect of their time spent in the U.S. The Canco Employees spend less than 90 days in the U.S. each year but do earn more that US$10,000. Canco does not have a permanent establishment ("PE") in the U.S.

There is no dispute between the relevant taxpayers and the IRS as to there being a possible employee-employer relationship between Canco Employees and US Opco. In addition, as a consequence of the reimbursement, there is also no dispute as to the fact that US Opco bears the cost of the Canco Employees' wages with respect to their duties exercised in the U.S.

Article XV of the Treaty Prior to the 5th Protocol

Prior to the 5th Protocol, subparagraph 2(b) of Article XV of the Treaty read as follows:

"The recipient is present in the other Contracting State for a period or periods not exceeding in the aggregate 183 days in that year and the remuneration is not borne by an employer who is a resident of that other State or by a permanent establishment or a fixed base which the employer has in that other State." (underlining for emphasis)

Under the pre-5th Protocol version of subparagraph 2(b) of Article XV ("Article XV(2)(b)"), there would not have been a debate, in respect of the hypothetical scenario above, as to whether the Canco Employees were entitled to exemption from U.S. income tax on their remuneration earned in respect of duties exercised in the U.S. Since Canco is a resident of Canada and there is no dispute as to it being the "employer" of the Canco Employees at all relevant times, the conditions in the pre-5th Protocol version of Article XV(2)(b) would have been met by the Canco Employees.

The Issue

Upon an IRS audit of taxpayers with circumstances similar to those described in the hypothetical scenario above, some Canadian residents (employees) are being challenged on their claims for treaty benefits in accordance with Article XV(2)(b) of the Treaty. This is happening in spite of the TE, the CRA announcements on this issue and the Commentary to Article 15 of the 2010 Model Tax Convention on Income and on Capital of the Organisation for Economic Co-operation and Development5 ("OECD" and the "OECD Model Treaty"). Article XV(2)(b) states that the remuneration must not be paid by, or on behalf of, a person who is a resident of the U.S. Since Canco is reimbursed by US Opco and US Opco is claiming a deduction in computing its income for U.S. tax purposes, the author has come across situations where the IRS considers the remuneration to be paid either by a person resident in the U.S. or on behalf of a person resident in the U.S. This of course is not consistent with the TE or the CRA announcements on this topic. It is also inconsistent with the application of that same provision for pre-5th Protocol taxation years.

General Comments

Most multi-national enterprises ("MNE") provide a wide variety of services to their members. These intra-group services include a wide range of potential services in respect of many functions, including technical services such as engineering. Whether such services are formalized in a written contract or whether a mark-up is appropriate does not have any bearing on the nature of the relationship between the employees of the MNE and its member company. There may be a transfer pricing issue if proper consideration is not charged by the MNE for that particular service. There may also be PE issues and withholding tax issues since the MNE, say in our hypothetical scenario, may be considered to have taxable income which is effectively connected to a trade or business in the U.S. Regardless of the other issues, this does not impact the nature of the relationship between the employees of the MNE and other corporations within the corporate group.

In light of the TE and the recent work done by the OECD regarding Article 15 of the OECD Model Treaty, it is generally understood that, for Treaty purposes, the determination of employee-employer relationships is primarily a question of fact. Tax administrations may ignore the formal legal employment relationship and instead analyze the functions performed to determine who the true employer is. The true employer is generally understood to be the person having the rights to the work as well as the one who bears significant responsibilities and risk. In Canada, several tests for determining employee-employer relationships have been established under Canadian jurisprudence and should be referred to in determining whether such a relationship exists (i.e. tests of control, integration, economic realty and specific results).6 The change in wording in Article XV(2)(b) as a consequence of the 5th Protocol ensures that the IRS and CRA can challenge those employment situations where it is not clear who the real employer is. It is evident that the Canada and U.S. Treaty negotiators felt a change in wording from "employer" to "person" would give their tax administrations more flexibility in challenging those borderline cases or abusive cases, even though one could question why such an amendment was necessary in light of all the work done by the OECD on Article15 in the context of the meaning of the term "employer". Regardless, the 5th Protocol amendments were not intended to allow either tax administration to deny Treaty benefits where there is clearly no employee-employer relationship between the Canadian employee and the person bearing the cost of that remuneration. If either tax administration were to establish a pattern of taking this approach to interpreting the new Article XV(2)(b) in this manner, it would risk rendering the Treaty exemption provision somewhat meaningless in circumstances where the source (or host) country is paying for a contract of service, whether by straight reimbursement or a fee that includes a mark-up.

Generally speaking, the cross border utilization of employees in cases similar to the hypothetical scenario described above are characterized as either secondments or employee sharing (i.e. an employee-employer relationship is established with the temporary employer in the U.S.) or as a transfer of service. Where the scenario is in fact a transfer of service, which is what the author has described in the hypothetical scenario above, then the transfer must take into consideration the amount that an arm's length entity is prepared to pay for such a service in comparable circumstances. Often, that price will not only include the service provider's (e.g. Canco) costs, but also an element of profit. Whether an element of profit is appropriate will come down to a question of economic alternatives to the recipient of the service. The fact that only a reimbursement of costs was charged by Canco to US Opco for the services it provided is not relevant regarding the ultimate taxation of the employment remuneration of Canco Employees. That is, a reimbursement of Canco's costs does not change the nature of the Canco Employees' relationship with US Opco from a transfer of service to an employee-employer relationship. It is the latter scenario, whether in substance or form, that new Article XV(2)(b) is trying to address by denying Treaty benefits to the employees where they have truly changed employers. If Canco should have charged a mark-up on those services, as opposed to a straight reimbursement, then there is a valid transfer pricing issue for the tax administrations to consider.

The most significant fact in the hypothetical scenario above is that it involves a "transfer of service". If a tax administration is not challenging that particular fact, regardless of the fact that no mark-up was charged by Canco, then it should not be denying Treaty benefits to Canco Employees unless those employees are present in their country for more than 183 days. If the IRS establishes a pattern of denying Treaty benefits in the hypothetical scenario described above, then all Canadian companies providing services to U.S. companies, assuming the Canadian company's employees physically perform some of their duties in the U.S., could be at risk of being taxable in the U.S. For example, if the US Opco (a "person" resident in the U.S.) is paying (thus claiming a deduction in computing its taxable income) a fee to the Canadian service provider (i.e. Canco) that includes a mark-up as opposed to a straight reimbursement, would the same arguments not be available to a tax administration to deny Treaty benefits to the employees? For example, their interpretation of Article XV(2)(b) would still likely be that the remuneration received by the Canadian service provider's employees is being paid, or the costs are being borne, albeit indirectly through the service fee, by a person resident in the U.S. Based on a literal interpretation of Article XV, how can one distinguish between a service contract where there is a mark-up and one where there is not? That fact does not seem relevant. The author is not aware of any evidence that the IRS would or has denied Treaty benefits in a scenario involving a mark-up, but based on some early evidence regarding their approach taken in the hypothetical situation, it is not clear to the author how they could distinguish the two scenarios. As a result, this issue could potentially be problematic on a larger scale.


Hopefully, the cases where the IRS have taken a broad interpretation of the word "person" in Article XV(2)(b) are isolated cases and will not become common practice. The reality is that if a tax administration is offended by losing source (or host) country taxation rights where an entity ("person") resident in its state bears the actual costs of the wages earned in its country by employees of the foreign company, and such employees are not employees of that entity while temporarily working in that country, then the tax administration needs to consider other audit avenues such as whether the foreign company was carrying on business in its country through a PE. The 5th Protocol amendments to Article XV(2)(b) should not be viewed by either tax administration as an opportunity to circumvent or bypass the extra audit work that might be otherwise necessary in verifying whether a foreign employer had a PE in its state. For greater certainty, in the hypothetical scenario described above, if Canco had a PE in the U.S. as a consequence of the duties the Canco Employees performed in the U.S., then Article XV would maintain U.S. taxing rights and deny Treaty benefits to the Canco Employees.

The author recommends that tax advisors be prepared to have examples ready to support their arguments with the IRS in the event they are being challenged on this provision. An example that could be helpful would be to describe a situation where the Canadian parent company sent one of its employees to work at the U.S. subsidiary's office for only a few weeks to assist the subsidiary with some year end accounting functions. Assuming the U.S. subsidiary reimbursed its parent company for the three weeks of wages which we will assume exceeded the $10,000 safe harbour rule in subparagraph 2(a) of Article XV, the IRS would deny Treaty benefits to the Canadian employee under this interpretation of the word "person" in Article XV(2)(b). This example would be similar to the hypothetical scenario above, but might better drive home the message regarding how absurd a broad interpretation of the word "person" in Article XV(2)(b) of the Treaty would be.

In the event assessments of this nature are carried out by either tax administration, recourse should be available through the Mutual Agreement Procedure of the Treaty where the Canadian and U.S. competent authorities will have the opportunity to quickly resolve the matter.


1. Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital, 26 September 1980, SC 1984, c 20, Part I (entered into force 16 August 1984) as amended by the protocols done in 1983, 1984, 1995, 1997 and 2007 (Fifth Protocol, SC 2007, c 32 (entered into force 15 December 2008)).

2. There may be situations where CRA auditors have taken a similar interpretation, but the author is unaware of such and therefore cannot comment.

3. Canada Revenue Agency, CRA Views, Conference 2008-0300571C6 "5th Protocol - changes to Article 15(2)(b)" (9 December 2008) (TaxNetPro).

4. Ibid.

5. OECD, Model Tax Convention on Income and on Capital, Condensed Version (OECD Publishing, 2010).

6. See generally Wiebe Door Services Ltd v MNR, 87 DTC 5025 (FCA); Sagaz Industries Canada Inc v 671122 Ontario Ltd, 2001 SCC 59; Lawrence Wolf v The Queen, 2002 DTC 6853 (FCA); Dynamic Industries Ltd v The Queen, 2005 FCA 211; OLTCPI Inc v MNR, 2010 FCA 74.

TCC Rules on First Canadian Non-Discrimination Treaty Case: Saipem UK Limited v. The Queen

By Pierre G Alary and Jim Wilson

One of the purposes of tax treaties is to encourage international trade and investment. Discriminatory taxation runs counter to that purpose. Hence, the prevention of discriminatory taxation is an important role of tax treaties. It is then surprising to think that until this year, a Canadian court had yet to rule on a case involving the non-discrimination article of Canada's bilateral tax treaties.1


Before looking at the language of some key paragraphs of the non-discrimination article of the Model Tax Convention on Income and on Capital of the Organization for Economic Co-operation and Development2 ("OECD" and the "Model") and how the article differs in Canada's tax treaties, we will first describe two common concepts of non-discrimination found in international treaties in general.

The first concept is that of "national"3 treatment whereby a State promises that it will give nationals of another State the same treatment that it gives to its own nationals in similar circumstances. By preventing locals from benefitting from an unfair advantage, this concept is widely seen as encouraging foreign investment.

Paragraph 1 of Article 24 of the Model reads as follows:

1. Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall, notwithstanding the provisions of Article 1, also apply to persons who are not residents of one or both of the Contracting States.

The first concept is clearly a principle heavily endorsed by the OECD under Article 24 of the Model. The same cannot be said for the second concept which relates to the "most favoured nation" treatment. Under this requirement, a State that is party to a treaty must grant to the parties of that treaty the same treatment it grants to third parties. A State must therefore treat its treaty partners as it treats other States. Despite what the name might seem to imply, "most favoured nation" treatment is really a promise to provide an equal treatment among treaty partners, not to provide better treatment than has been provided to other States. As alluded to above, the provisions of Article 24 were not intended by the OECD to be interpreted as to require most-favoured nation treatment.4 Countries in their bilateral negotiations would generally have to draft particular language into the treaty to achieve that concept.

Non-discrimination in Canada's tax treaties

We should first note that Canada has registered a reservation on the Article as a whole5 as it does not accept the broad principle of non-discrimination which is encouraged in the Model. For example, Canada's treaties do not generally include a provision equivalent to paragraph 4 of Article 24 of the Model because Canada is not prepared to give up its thin capitalization regime.6 Furthermore, paragraph 1 of the Non-Discrimination Article of Canada's tax treaties does not normally contain the last sentence of paragraph 1 of Article 24 of the Model. Based on this, it is evident that Canada is of the view that this Article should only apply to nationals covered by a particular treaty as it would be inappropriate to give a taxpayer the benefit of a Canadian treaty with a country in which the taxpayer is not a resident. Presumably, this is a bigger concern to Canada where the national is resident in a non-treaty country.

Paragraph 5 of Article 24 of the Model also provides that an entity of one of the Contracting States which is owned or controlled by residents of the other Contracting State may be treated no less favourably than entities owned or controlled by residents of the first-mentioned State. In other words, the Model requires national treatment for foreign–owned entities. Again, based on Canada's existing treaty network, it would appear that Canada is only prepared to accept a most-favoured nation rule. That is, the provision seen in many of Canada's treaties provides only that entities owned by residents of the treaty partner will be treated the same as any other foreign–owned entities. The intention is most likely to protect Canada's special tax regimes pertaining to small businesses in Canada and Canadian-controlled private corporations.

Nonetheless, Canada does accept the general principle of non-discrimination on the basis of nationality that is supported in the Model, albeit, as noted above, with the exception of a few extensions of the principle as found in the Model. In the recent case of Saipem UK Limited v. The Queen7 ("Saipem"), the application of paragraph 1 of Article 24 of the Model, as modified under Canada's tax treaties as described above, was the main issue before the Canadian court.

The Saipem decision

In Saipem, the question before the Tax Court of Canada (the "Court") was whether the restriction in subsection 88(1.1) of the Income Tax Act (Canada)8 (the "Act") pertaining to "Canadian corporations" violated the taxpayer's rights to non-discriminatory treatment under Article 22 of the Canada-United Kingdom Tax Convention9 (the "Treaty"). The appellant ("Saipem UK"), a UK resident, carried on business in Canada through a permanent establishment ("PE") from 2004 to 2006. Saipem UK's subsidiary, Saipem Energy International Limited ("SEI"), also a resident of the UK, carried on business in Canada through a PE from 2001 to 2003. In 2003, SEI was wound up into its parent company (i.e. Saipem UK). In computing its income from its Canadian business for the 2004 to 2006 years, Saipem UK claimed deductions for the losses incurred by SEI in prior years. The Canada Revenue Agency disallowed the deductions for the SEI losses on the basis that Saipem UK and SEI were not "Canadian corporations" as required under subsection 88(1.1). Subsection 88(1.1) is a provision in the Act that allows, in certain cases, the losses incurred by a Canadian corporation that was wound up to be carried forward and deducted by the parent company in circumstances where, among other criteria, not less than 90% of its issued shares are owned by another Canadian corporation (i.e. the parent company).

Saipem UK argued that the limited application of subsection 88(1.1) of the Act to Canadian corporations violated Saipem UK's right to non-discrimination in accordance with Article 22 of the Treaty. The Court was asked to consider both paragraphs 1 and 2 of Article 22. With respect to paragraph 1 of Article 22, it concluded that Saipem UK was not being treated "less favourably" and that subsection 88(1.1) does not discriminate based strictly on nationality. For example, the term "Canadian corporation" is defined in subsection 89(1) of the Act as a corporation that was either incorporated in Canada or resident in Canada since June 18, 1971. The Court concluded that the proper approach would be to compare Saipem UK "with a Canadian national that is a non-resident of Canada and that has a non-resident wound-up subsidiary. That non-resident Canadian national would not qualify as a "Canadian corporation" under subsection 89(1) and therefore would not have access to its wound-up subsidiary's losses under subsection 88(1.1) of the Act." With respect to paragraph 2 of Article 22, the Court also concluded that the "equal treatment principle only applies to the taxation of the PE's own activities. It does not therefore extend to provisions that take into account the relationship between an enterprise and other enterprises and that allow the transfer of losses." This conclusion is consistent with Article 7 of the Treaty which deals with the determination of profits of a PE situated in a contracting state.

Interestingly, this was the first Canadian court case materially dealing with the non-discrimination article of one of Canada's tax treaties. Therefore, this case is significant as it offers the first judicial guidance in Canada on the matter. More importantly, the Court, in applying and interpreting the expression "in the same circumstances"10, confirmed that the residence of a taxpayer is one of the factors that must be taken into account when determining whether the taxpayer is placed in similar circumstances for the non-discrimination provision to apply.

Even though the Court ruled against the appellant, the Court did describe certain situations when the non-discrimination provisions of the Treaty could apply. One interesting situation, while not raised by the Court, is the case where a foreign company is resident of Canada from the date of its incorporation.11 In light of the definition of "Canadian corporation" in subsection 89(1) of the Act, discussed above, a corporation created after 1971 would always have to be created in Canada to be considered a Canadian corporation and allowed benefits under the Act such as rollovers under section 88. Thus, the definition of "Canadian corporation" is clearly discriminatory. Regardless, the Court's analysis in Saipem should be helpful for future cases of non-discrimination.


1. Canadian courts have previously ruled on minor issues regarding the non-discrimination article. See for example Crawford v. The Queen, 51 DTC 99 and Ramada Ontario Ltd v. The Queen, 94 DTC 1071. However, we view the recent Saipem UK Limited decision as the first ruling of substance on the article.

2. OECD, Model Tax Convention on Income and on Capital, Condensed Version (OECD Publishing, 2010) [Model].

3. The term "national" is defined in Article 3 of the Model as, in relation to a Contracting State, any individual possessing the nationality or citizenship of that Contracting State and any legal person, partnership or association deriving its status as such from the laws in force in that Contracting State.

4. See paragraph 2 of the commentary on Article 24 of the Model.

5. See paragraph 85 of the commentary on Article 24 of the Model.

6. Where a Canadian treaty does include paragraph 4 of the Model, Canada will generally ensure that its thin capitalization regime is protected under a special overriding provision of the treaty (see, for example, paragraph 7 of Article 25 of the Canada-U.S. Treaty).

7. Saipem UK Limited v. The Queen, 2011 TCC 25 (decision rendered on January 14, 2011). Saipem UK Limited has appealed the decision to the Federal Court of Appeal (docket #A64-11, filed February 9, 2011).

8. Income Tax Act, RSC 1985, (5th Supp), c 1.

9. Convention Between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, as amended.

10. As found in paragraph 1 of Article 24 of the Model and Canada's treaties in general.

11. For example, a corporation created in a foreign jurisdiction, after June 18, 1971, but had its central management and control in Canada and subsection 250(5) of the Act did not apply to deem the corporation to be a non-resident of Canada.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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