CRA Provides Much Needed Guidance by Issuing PE Ruling
The Canada Revenue Agency ("CRA") recently issued the first Canadian Advance Income Tax Ruling ("ATR")1 regarding whether a non-resident corporation ("NRco") has a permanent establishment ("PE") in Canada where part of its business activities have been sub-contracted to its wholly-owned subsidiary in Canada ("Canco") (the "Ruling"). In this particular case, CRA ruled on a business operation of what could arguably be described as a contract manufacturer, but these issues come into play for all types of captive service providers such as marketing companies. Gowlings assisted NRco in obtaining a favourable ruling that the relocation of part of its manufacturing operations to Canada to be operated by Canco would not, in and by itself, create a PE in Canada for NRco. In doing so, CRA took a giant step in providing tax certainty to the international tax community, and particularly corporations looking to expand their operations in Canada, in an area that has recently come under attack by CRA auditors.
In our experience, we have seen CRA auditors conclude that a parent-subsidiary relationship was in fact an agent-principal relationship when interpreting Canada's bilateral tax treaties, thus resulting in a PE assessment for the foreign parent even in situations where the so-called dependent agent is not habitually concluding contracts on behalf of the principal. CRA auditors have occasionally relied upon paragraph 10 of the Commentary to Article 5 of the Organisation for Economic and Co-operative Development's ("OECD") Model Tax Convention on Income and on Capital ("OECD Model Treaty"), incorrectly in our opinion, to arrive at such conclusions. By doing so, CRA auditors are seemingly lifting the corporate veil, even though Canadian Courts have made it clear that an agency determination is not one that should be easily arrived at2.
It is unclear to us how CRA can arrive at the agency conclusion with so much apparent ease, because, generally speaking, a wholly-owned subsidiary acting as a captive service provider simply enters into a service agreement with the parent and not an agent-principal relationship. If CRA adopted the position that all wholly-owned subsidiaries solely providing services to their parent were in fact dependent agents of their foreign parent and continued to interpret paragraph 10 of the OECD Commentary to Article 5 in the manner some auditors have, it would seem to render Article 5(5) of the OECD Model Treaty, which is used in most of Canada's tax treaties, somewhat meaningless. That is, what is the purpose of having a deemed PE rule for dependent agents who habitually conclude contracts when a tax administration is treating the facilities of any dependent agent as a fixed place of business of the principal (the parent) under the general PE rule. It would also likely mark the end of structures in Canada using wholly-owned subsidiaries as captive service providers as foreign parents would opt to contract with third party service providers who would not be economically dependent on the one service contract rather than risk having a PE in Canada.
Concerns regarding this issue are not limited to Canada3. A growing trend has emerged where tax authorities in many jurisdictions are seriously examining subsidiaries' operations to consider whether they constitute a PE of the foreign parent. With this Ruling, CRA has confirmed that such a determination cannot be made automatically and must be supported by the principles and guidance of the OECD.
When submitting an ATR request, the taxpayer is requesting CRA's confirmation that a proposed transaction will result in the tax treatment anticipated by the taxpayer in its ATR request. CRA's Information Circular 70-6R5 provides guidance regarding the ATR process. A proposed transaction is required in order to qualify for an ATR and the ATR must be requested before audit activity begins. Therefore, an ATR will be issued for transactions that are seriously contemplated and are not of a hypothetical nature. The required proposed transaction can come as a result of a new or amended service agreement between parent and subsidiary.
The ATR will be binding provided that the statement of facts and the proposed transaction are accurate and constitute complete disclosure and provided further that the proposed transaction is carried out as described in the ATR request. ATRs are issued on questions of fact scenarios but only if it is possible to determine all the material facts and those facts can reasonably be expected to prevail. As stated in paragraph 15(j) of IC 70-6R5, the CRA will not issue an ATR "for a matter on which a determination is requested is primarily one of fact and the circumstances are such that all the pertinent facts cannot be established at the time of the request for the ruling. This could include issues involving residence, carrying on of a business and the existence of a partnership." The ATR will remain binding so long as the facts and transactions remain unchanged. With respect to ATR requests regarding PEs, the pertinent facts to be established are generally that:
- there is no agency relationship between the non-resident entity and any Canadian entity;
- the non-resident does not own or lease a place of business in Canada; and
- the non-resident's personnel will not be present in Canada, such as at the premises of its Canadian subsidiary, for a significant period of time that would create a fixed place of business for the non-resident4.
By establishing a lack of physical presence in Canada by personnel of the non-resident, the CRA should have the pertinent facts it needs to ensure that a PE will not arise due to "space at the disposal" of the non-resident (see discussion below).
As mentioned above, the recently issued Ruling is the first of its kind in the context of a PE determination in Canada. For the purpose of an ATR request for a PE determination, the ruling can be limited to the impact that a particular subsidiary may have on the non-resident's PE status in Canada. Given that a PE analysis is entirely fact dependent, Gowlings and CRA were in constant communications to ensure that the pertinent facts relating to the issue of the existence of a PE could be ascertained to the degree of comfort needed by CRA in order to give a favourable ATR.
Facts of the Ruling
The facts of the Ruling are briefly summarized as follows:
- NRco carries on a multitude of separate business divisions worldwide, which includes manufacturing, processing and distribution activities.
- NRco entered into a supply agreement ("Supply Agreement") with a Canadian client ("Client") whereby NRco would provide parts to Client. Dealings between NRco and Client usually consist of commercial meetings, the frequency and duration of which never exceed an aggregate of 90 days over any 12 month period.
- NRco incorporated Canco as a 100% wholly-owned Canadian subsidiary. NRco and Canco entered into a service agreement ("Service Agreement") pursuant to which Canco performed a portion of the manufacturing duties regarding the parts sold by NRco to Client. As per the Service Agreement, Canco would not in any case carry out such activities as receiving orders, negotiating commercial issues with customers and/or concluding sales contracts on behalf of NRco.
- In connection with the Service Agreement, NRco's personnel visited Canco from time to time for business meetings and to audit and monitor Canco's performance.
- Under the proposed transaction, NRco would modify the Service Agreement to subcontract to Canco additional activities, in connection with NRco's obligations to Client under the Supply Agreement that were initially being carried out by NRco in NRco's country of residence. This would include the relocation of a further portion of the manufacturing operations to Canada to be performed by Canco.
Analysis – PE determinations and OECD principles
The fact structure briefly described above is a fairly routine structure that, on the surface, would not appear to create a Canadian PE issue for the parent company. However, as alluded to above, transactions similar to that described in the Ruling have come under attack by CRA auditors from the perspective of PEs. As a matter of fact, it is now not uncommon for CRA to raise both a transfer pricing adjustment and a PE assessment, effectively triple taxing the same economic income. The technical basis for PE determinations by CRA auditors as a consequence of structures involving wholly-owned subsidiaries acting as captive service providers of foreign parent companies is not always clear, but commonly can involve some variation of the "space at the disposal" argument (coupled with CRA's questionable interpretation of paragraph 10 of the OECD Model Commentary5), the "agency" argument or the "place of management" argument, or a combination thereof.
Unfortunately, in the absence of formal interpretive policies by CRA regarding scenarios where parent companies establish wholly-owned subsidiaries in Canada, along with the fact that there is sufficient ambiguity within the text of Article 5 of the OECD Model Treaty as well as the Commentary pertaining thereto, CRA auditors seem to have some flexibility in assessing parent companies as having a PE in Canada where they feel the circumstances support it. However, due to the fact that the subsidiary is a separate legal entity in Canada, it cannot be said that the CRA's default position is that a PE would exist "solely" on the grounds that the premises of such subsidiary is at the disposal of the foreign parent company. The CRA has issued formal guidance on the "space at the disposal" issue and has indicated that it is always a question of fact whether space at a subsidiary company's premises in Canada would be considered to be at the disposal of employees and dependent agents of the foreign parent company. This Ruling would seem to confirm that it remains CRA's official interpretive position that it is always a question of fact and that adherence will be made to the OECD Model Commentary on Article 5.
With respect to the agency argument, captive service providers like Canco are generally not the kind of wholly-owned subsidiary for which a tax administration should pierce the corporate veil and ignore its existence (i.e. a "puppet"). Justification to pierce the corporate veil is rare in Canada and generally only accepted by the Canadian Courts in cases of fraud or improper conduct. It is our opinion that CRA should only be challenging those captive service subsidiaries that are mere shell companies with little activity or minimal employees where every aspect of their Canadian operations is controlled and approved by the parent. Unfortunately, however, that is not always the case. Until this Ruling, the CRA had not published any formal guidelines as to the circumstances in which it may consider whether a subsidiary can constitute a PE of its parent company. However, CRA did put a scare in the tax community when it recently released a technical interpretation6 with which we strongly disagree7. With so much uncertainty in the tax community as to whether CRA auditors will challenge these structures in the context of the parent company having a PE in Canada, this Ruling is an extremely positive step in the right in the right direction for CRA
1. CRA document # 2011-0396421R3 (E)
2. See United Geophysical Company of Canada v. Minister of National Revenue, 61 DTC 1099.
3. For an in-depth country by country analysis of this issue, please see BNA International's Transfer Pricing Forum – Attribution of Profits to Permanent Establishments – Parts I and II (May and July 2011). The authors provided the submission for Canada and direct the reader's attention to Issues 2 and 9 of the publication for an analysis of the subsidiary as PE issue.
4. The CRA generally follows the 183 day threshold in determining the "permanence" criteria needed to be considered a fixed place of business in Canada.
5. In our opinion, paragraph 10 simply provides guidance to the meaning of the third element of the PE definition, that being a fixed place of business "through which the business of an enterprise is wholly or partly carried on". The non-resident entity still must have its own fixed place of business as that term is further described in paragraphs 4 to 6 of the OECD Model Commentary on Article 5.
6. See 2010-0391541E5 E - Article V (9) of the Canada-US Tax Convention (Released April 13, 2011).
7. Jim Wilson and Pierre Alary, Deemed Services PEs - Subcontractors vs Agents - CRA Adds Fuel to the Fire, Canadian Tax @ Gowlings, May 2011.
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