This article was originally published in Blakes Bulletin on Cross-Border Taxation May 2005
Article by Kenneth Snider, ©2005, Blake, Cassels & Graydon LLP
Non-Canadian investment funds (a Fund) routinely engage Canadian residents to provide a broad spectrum of investment-related services ranging from administrative to advisory and portfolio management.
There was a concern that a Fund (or its members) might be treated as "carrying on business" in Canada for purposes of the Canadian Income Tax Act (the Act) solely by reason of engaging a Canadian service provider (CSP). This would result in the Fund or its members becoming subject to Canadian income tax subject to any treaty protection.
This concern arose because of a confluence of considerations. There is not a bright line test in the case law distinguishing gains on the sale of securities held in the course of carrying on a business which are treated as fully taxable as opposed to securities held as capital property, only one-half of which is taxable as a taxable capital gain. In this regard, non-residents are subject to tax under the Act on capital gains only from the disposition of "taxable Canadian property" subject to any treaty protection whereas the extended statutory meaning of "carrying on business" applicable to non-residents is very broad. For purposes of the Act, where a non-resident person solicits orders or offers anything for sale in Canada, through an agent or servant, whether the contract or transaction is to be completed inside or outside Canada, that person shall be deemed in respect of that activity to have been carrying on business in Canada. This deeming rule does not apply if the Fund only holds securities on capital account and carries on no business. Finally, there is generally the practical need by the Funds and their managers for certainty that Canadian taxes will not be payable solely because of engaging a CSP which in many cases could not be satisfactorily addressed by legal opinions.
In the case of solely administrative "back room" services, Canada Revenue Agency (CRA) had issued favourable advance tax rulings that the Fund, its members and its administrator would not become subject to Canadian tax solely because of such services being provided by a CSP. However, CRA would not issue advance tax rulings in respect of advisory and portfolio management services. In the absence of administrative certainty, an amendment to the Act was sought. Subsequently, section 115.2 was enacted as a "safe harbour" rule providing protection to the Fund from the risk that the Fund – or its members – might be considered to be carrying on business in Canada. This rule only applies if numerous conditions are satisfied at all relevant times. As noted in the Department of Finance Technical Notes, the rule is not intended to create any implication as to whether or not a business is being carried on in Canada in cases where the conditions for application of the rule are not satisfied.
All the conditions summarized below must be satisfied.
Scope of Services
Not all services provided by the CSP will be protected. The services provided by the CSP to the Fund must be "designated investment services". This means any one or more of the following services:
(a) investment management and advice with respect to "qualified investments" (as defined by the Act), regardless of whether the manager has discretionary authority to buy or sell;
(b) purchasing and selling qualified investments, exercising rights incidental to the ownership of qualified investments such as voting, conversion and exchange, and entering into and executing agreements with respect to such purchasing and selling and the exercising of such rights;
(c) investment administration services, such as receiving, delivering and having custody of investments, calculating and reporting investment values, receiving subscription amounts from, and paying distributions and proceeds of disposition to, investors in and beneficiaries of the person or partnership, record keeping, accounting and reporting to the person or partnership and its investors and beneficiaries; and
(d) in the case of a corporation, trust or partnership, the only undertaking of which is the investing of its funds in qualified investments, marketing investments in the corporation, trust or partnership to non-resident investors.
Consequently, the rule will not apply to any services in respect of an investment that is not a "qualified investment".
"Qualified investment" of a person or partnership means:
(a) a share of the capital stock of a corporation, or an interest in a partnership, trust, entity, fund or organization, other than a share or an interest
(i) that is either
(A) not listed on a prescribed stock exchange (e.g., the NYSE, NASDAQ, TSE), or
(B) listed on a prescribed stock exchange, if the person or partnership, together with all persons with whom the person or partnership does not deal at arm’s length, owns 25% or more of the issued shares of any class of the capital stock of the corporation or of the total value of interests in the partnership, entity, trust, fund or organization, as the case may be, and
(ii) of which more than 50% of the fair market value is derived from one or more of
(A) real property situated in Canada;
(B) Canadian resource property; and
(C) timber resource property;
(d) commodities or commodities futures purchased or sold, directly or indirectly in any manner whatever, on a commodities or commodities futures exchange;
(e) currency; and
(f) options, interests, rights and forward and futures agreements in respect of property described in any of paragraphs (a) to (e) or this paragraph, and agreements under which obligations are derived from interest rates, from the price of property described in any of those paragraphs, from payments made in respect of such a property by its issuer to holders of the property, or from an index reflecting a composite measure of such rates, prices or payments, whether or not the agreement creates any rights in or obligations regarding the referenced property itself.
Canadian Service Provider
The CSP must be a corporation or trust resident in Canada, or a partnership all the members of which are residents of Canada. Note that an individual (other than a trust) will not be a CSP by definition.
Independence of the CSP – Relationship with Fund
A CSP might be a multi-national financial institution or a sole purpose subsidiary of the manager of the Fund. There are, however, important conditions described below regarding the relationship between the Fund and the CSP, and a non-ownership of the Fund by Canadian residents. As a policy matter, the first condition requires that the CSP be "independent" of the Fund. Essentially, if any of the owners of the Fund are "affiliated" for purposes of the Act with the CSP, the ownership by such persons cannot exceed 25% in the aggregate. The "affiliation" rules are very broad and employ both a legal and factual control test. Consequently, it is essential to review all the relevant details of the relationship between the Fund and CSP and ownership of the Fund having regard to this condition.
(a) If the Fund is an individual (other than a trust), he or she must not be "affiliated" (for purposes of the Act) with the CSP.
(b) If the Fund is a corporation or trust, the following conditions must be satisfied:
(i) the Fund has not directly or indirectly through agents,
(A) directed any promotion of investments in itself principally at Canadian investors, or
(B) sold an investment in itself to a person that it knows or ought to have known after reasonable inquiry, resident in Canada,
(ii) the Fund has not filed any document with a public authority in Canada (or any province) to permit the distribution of interests in the Fund to person resident in Canada,
(iii) when the particular time is more than one year after the Fund was created, the total of the fair market value of investments in the Fund that are beneficially owned by persons that are "affiliated" (for purposes of the Act) with the CSP cannot exceed 25% of the fair market value of all investments in that Fund. One does not include in computing whether this 25% threshold is met investments owned in the Fund by a "designated entity in respect of the CSP." A person or partnership is, at a particular time, a designated entity in respect of a CSP if the total of the fair market value at the particular time, of investments in the entity that are beneficially owned by persons and partnerships (other than another designated entity in respect of the CSP) that are affiliated with the CSP does not exceed 25% of the fair market value, at the particular time, of all investments in the entity.
(c) Where the Fund is a partnership, a look through approach is adopted and rules similar to those in (b) are applicable.
In summary, section 115.2 provides desired certainty for Funds in respect of certain services but care must be taken that all the conditions are satisfied.
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.