Canada: Canadian Tax @ Gowlings - September 15, 2011

Last Updated: September 22 2011
Article by Pierre G. Alary, Eric Koh and Jim Wilson

Edited by Laura Monteith and Henry Chong

CRA Provides Much-Needed Guidance by Issuing PE Ruling

By: Jim Wilson and Pierre Alary.

Background

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. 

ATR process

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:

  1. there is no agency relationship between the non-resident entity and any Canadian entity;
  2. the non-resident does not own or lease a place of business in Canada; and
  3. 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 disagree.7 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 direction for CRA.

Footnotes

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.



Foreign Spin Off Transactions and Dividend in Kind - Conflicting Rulings that Reinforce an Earlier Precedent

By: Eric Koh

On June 29, 2007, Tyco International Ltd. ("Tyco") underwent a corporate reorganization that involved spinning off Tyco Electronics Ltd. ("Electronics") and Covidien Ltd. ("Covidien"), and a stock consolidation.  This simple and common place corporate reorganization spawned a series of separate cases in the Tax Court of Canada ("TCC") that examined whether the shares of Electronics and Covidien distributed to Tyco's shareholders, pursuant to the reorganization, are taxable dividends in kind.  Although each of the four cases arose from a single corporate reorganization, the TCC arrived at two different sets of rulings.  Despite the different outcomes, these decisions actually reinforce the precedent that certain share distributions from foreign spin off transactions are not taxable as dividends in kind.

Background

Under the corporate reorganization, Tyco distributed to its shareholders one share in Electronics and Covidien for every four Tyco shares.  After this distribution, every four shares of Tyco were consolidated into one new share in Tyco.  Tyco's press release about the corporate reorganization described the share distribution as a tax free dividend distribution in the U.S.  The taxpayers' brokers treated the distribution as dividends and issued T5 forms to each taxpayer.

Each of the four Canadian resident taxpayers were shareholders of Tyco who received the shares of Electronics and Covidien, and had their respective holdings of Tyco shares reduced.  None of them included the fair market value of the shares received as income.

Tyco, Electronics and Covidien were all residents of Bermuda.  Since there is no tax treaty between Bermuda and Canada, the shares distributed did not qualify as an "eligible distribution" under paragraph 86.1(2)(d) of the Income Tax Act ("ITA").  Canada Revenue Agency ("CRA") reassessed the taxpayers and treated the shares in Electronics and Covidien as dividends in kind.  This increased the taxpayers' income by the fair market value of the shares received.  All four taxpayers appealed to the TCC. 

The TCC Decisions

At trial, the taxpayers argued that they did not receive any net economic benefit from the shares distributed.  In their view, the shares in Tyco were simply replaced by shares in Electronics and Covidien and the value of their overall shareholdings did not change.  Thus, they argued that there is no increase in income on which to levy a tax.  Conversely, CRA argued that the shares were taxable dividends in kind by virtue of section 90, paragraph 12(1)(k) and subsection 52(2) of the ITA. 

In Capancini v. Canada1 ("Capancini"), heard under the TCC informal procedure, the TCC rejected CRA's categorization of the shares as dividends in kind.  Bowie J. held that the facts in this case were indistinguishable from the facts in Morasse v. The Queen2 ("Morasse").  Morasse is an earlier TCC decision, also heard under the informal procedure, that favored the taxpayer. 

In Morasse, the taxpayer owned 400 American Depository Receipts of Telmex, a company resident in Mexico.  This company underwent a reorganization and spun off a business segment into a new company using a procedure unique to Mexican corporate law.  Prior to this, the business segment was never a separate corporate entity with issued and outstanding shares.  The shares in the new company were only created when the business segment was spun off.  As part of the reorganization, the shareholders of  Telmex received one share in the newly formed company for every share of Telmex.  In Morasse, the TCC ruled that the new shares distributed to the taxpayer were not stock dividends nor were the shares distributed in lieu of payment of dividends.  Furthermore, the judgment stated that the shares received were "not as part of any distribution of profits, but as recognition of a shift of capital"3 from the Mexican company to the new company. 

In Capancini, Bowie J. made a finding of fact that, just like the distributing company in Morasse, Tyco never owned the shares of Electronics and Covidien, which were only created as part of the reorganization.  According to Bowie J., the distributed shares in Electronics and Covidien were not dividends in kind "as is the case when a wholly owned subsidiary is spun off by a distribution of its shares to shareholders of the parent company".4  Rather, the shares of Electronics and Covidien are part of the capital of Tyco albeit in a different form.  Consistent with Morasse, Bowie J. also ruled that the fact that the taxpayer's broker described the shares received as stock dividends and issued a T5 form is not determinative of the issue.  Finally, Bowie J. defined "dividend" as a pro-rata distribution of a company's profits to its shareholders.  He held that the shares distributed were not from Tyco's profits, and hence, are not dividends. 

Capancini was followed by three additional cases in the TCC, all relating to the same Tyco reorganization.  Arranged chronologically, these cases are Hamley v. Canada5 ("Hamley"), Yang v. Canada6 ("Yang"), and Rezayat v. Canada7 ("Rezayat").  Again, each case was heard under the informal procedure.  However, unlike Capancini, the TCC ruled against each of the three appellant taxpayers.  This is a curious result considering that the facts in each case were largely identical.

None of the three judges declined to follow Capancini or Morasse even though they had that option since the decisions from Capancini and Morasse were rendered under the informal procedure and are not binding precedents.  Instead, the basis used by the judges in Hamley, Yang and Rezayat to support their respective decisions was a different finding of fact than that in Capancini.  In all three cases, unlike Bowie J. in Capancini, the judges found that Tyco did indeed own all the shares of Electronics and Covidien prior to the reorganization and that the shares were distributed as part of the reorganization.  Therefore, the three judges ruled against the taxpayers and held that the distributed shares in Electronics and Covidien were dividends in kind.

McArthur J. in Rezayat stated that Bowie J. had a different and incomplete set of facts when he heard the appeal in Capancini.  McArthur J., and Sheridan J. in Yang, referred to multiple documents that pointed to Tyco's ownership of shares in Electronics and Covidien.  For example, Sheridan J. referenced a decision of provincial securities regulators which included a representation by Tyco that Electronics and Covidien were fully owned subsidiaries, and a statement by Tyco that the distributions were dividends in kind.  Filings with the U.S. Securities and Exchange Commission show that Electronics and Covidien were incorporated and issued stock prior to March 20, 2007.

In addition, McArthur J. highlighted the timing and ordering of the transactions whereby a distribution of shares in Electronics and Covidien was followed by a consolidation of Tyco's shares.  Based on this, McArthur J. concluded that the transactions were not an exchange or redemption.  He also held that there was no evidence that the shares were a return of capital.  Furthermore, McArthur J. disagreed with the taxpayer's assertion that she did not receive an economic benefit from the distributions.  The consolidation of Tyco's shares reduced the number of Tyco shares held by the taxpayer, but did not reduce her total adjusted cost base of those shares.  Thus, this will reduce the capital gain or increase the capital loss from any subsequent sale of the Tyco shares.    

Concluding Remarks

Even though the outcomes in Hamley, Yang and Rezayat differed from that in Capancini, all four cases support the precedent set in Morasse that shares distributed pursuant to a foreign spin off transaction is a dividend in kind only if the parent corporation owned the shares prior to the distribution.  Therefore, where a particular business or division of a corporation is spun off into a newly created corporation, the shares of which were not owned by the distributing corporation, the shareholders of the distributing corporation who acquire shares of the new corporation will likely not be taxed in Canada.  It is unclear how wide the scope of this exception will be in practice as it will depend on the structuring of spin-offs under foreign tax and corporate law.  For instance, under the U.S. tax regime, one of the requirements of a tax free spin off in the U.S. is that the corporation being spun off is controlled by the distributing corporation.  Thus, Canadian shareholders of a U.S. corporation who receive shares pursuant to a tax free spin off transaction in the U.S. will likely not benefit from the aforementioned TCC rulings.

While subsequent courts do not need to follow judgments from cases heard under the informal procedure, these decisions still carry persuasive authority.  This is evinced from the fact that the judges in Hamley, Yang and Rezayat chose to distinguish Capancini on the facts, rather than simply declining to follow Capancini.  Regardless, taxpayers should still be mindful of the risk that subsequent courts may depart from the precedent set in the aforementioned cases, especially if engaging in tax planning activities.

Footnotes

1. 2010 TCC 581.
2. 2004 TCC 239.
3. Ibid at para 21.
4. Supra Note 1, para 13.
5. 2010 TCC 459.
6. 2011 TCC 187.
7. 2011 TCC 286.

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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