Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
A number of amendments to the Canada-U.S. Income Tax Convention (the Treaty) included in the Fifth Protocol (the Protocol) to the Treaty and the accompanying diplomatic notes in Annex B to the Protocol (the General Note) update the Treaty to bring it into closer alignment with (a) current international standards authorized by the current and proposed articles of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention and the current and proposed commentary to the OECD Model Tax Convention (OECD Commentary) and (b) the current articles and commentary of the U.S. Model Income Tax Convention. The Technical Explanation (TE) provides additional explanation as to application, and limits, of those amendments.
Attributing Profits to Permanent Establishments
The General Note contains guidance in respect of the interpretation of Article VII (Business Profits), which article limits the taxation of the business profits of a resident of one Contracting State by the other (host) Contracting State to circumstances where the resident carries on business through a permanent establishment in the host State. In these circumstances, the host State is entitled to tax the profits that are attributable to the permanent establishment by estimating the profits it would make if it were a distinct and separate person that is wholly independent of the resident.
The TE acknowledges that the "attributable to" concept provides an alternative to the U.S. tax law concept of "effectively connected," and that amounts of income that may be "attributable to" a permanent establishment may well differ from those that would be treated as "effectively connected" under U.S. tax law. Taxpayers are entitled to use the Treaty to reduce taxable income, but are not entitled to use both the Treaty rules and U.S. tax rules to thwart the intent of either set of rules. The TE also clarified that (i) profits attributable to a permanent establishment may be from sources within or outside the host state; (ii) expenses permitted in the profit computation for a permanent establishment are not limited to expenses incurred exclusively for the permanent establishment, expenses can also relate to the entity as a whole; and (iii) expenses attributable to the permanent establishment are not limited to those actually "booked" in the permanent establishment, rather an expense recorded in another accounting unit may be appropriately deducted, provided that the expense was incurred for the purposes of the permanent establishment.
The "separate and distinct entity" fiction involved in profit attribution to a permanent establishment raises a number of issues, including the treatment of intra-enterprise "dealings" and corresponding cost and income allocations, and whether an enterprise should attribute some portion of its total profits or losses to a permanent establishment (generally referred to as the "relevant business activity approach") or whether the permanent establishment should be treated as a separate profit centre whose loss or profit is independent of whether the enterprise as a whole realized a loss or profit in the relevant period (generally referred to as the "functionally separate entity approach").
In the General Note, the parties adopted the approach and methodology accepted by the OECD, namely the "functionally separate entity approach," which requires the determination of the profits of a permanent establishment as if it were a separate legal entity performing its own functions, taking its own risks and owning or using assets on its own. The OECD's conclusion that functional analysis is the appropriate mechanism for attributing risk, assets and capital to the permanent establishment is also endorsed by the parties in the General Note, as is the application, by analogy, of any of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the Guidelines) prepared for Article 9 (Associated Enterprises) of the OECD Model Tax Convention to determine an arm's-length result for intra-enterprise dealings, provided the appropriate method is applied in accordance with the Guidelines and takes into account the different economic and legal circumstances of a single legal entity.
The TE gave a number of illustrations to assist in the application of this approach in dealing with intra-entity amounts and emphasized that use of the Guidelines to attribute profits within the legal entity does not, in and of itself, create legal obligations or other tax consequences that could result from such notional payments or receipts. The TE provides further that the appropriate method to be used to calculate payments from a branch to head office (or another branch) for services performed for the benefit of the branch is dependent on the terms of arrangements between the entities or general entity policy. It illustrates this principle by giving two examples of methods to allocate head-office legal costs among different branches, one that is a cost-sharing arrangement and the other that is an arm's-length fee arrangement. Provided the particular arrangements are consistently honoured by the parties, either is stated to be acceptable to calculate a branch's corresponding deduction.
The TE also provides an example of the "different economic and legal circumstances of a single legal entity" in the context of attributing risk, assets and capital to the permanent establishment: the generally lower capital requirements of an entity that operates through branches (because all of the entity's assets are available to support all of its liabilities) as compared to the capital requirements of an entity that operates through separate subsidiaries. The TE further provides that the benefit that generally results from such lower capital costs must be allocated among an entity's branches for the purpose of attributing profits.
The General Note provides that a permanent establishment is to be treated as having the amount of capital it would need to support its activities if it were, in fact, a separate and distinct person. The TE interprets this statement as a prohibition on funding a branch entirely with debt and states that to the extent capital is attributed to a permanent establishment under this arm's-length principle, taxing authorities can deny interest deductions on a corresponding amount.
For financial institutions (other than insurance companies), the General Note requires that the amount of capital to be attributed to a permanent establishment may be determined by allocating the institution's total equity between its various offices on the basis of the proportion of the financial institution's risk-weighted assets attributable to each of them. The TE acknowledges that this method is more flexible and more complicated than the corresponding U.S. tax rule, and permits a U.S. permanent establishment to choose between the applicable U.S. tax rule and this method, even if it has chosen to apply the principle of "attributable to" over "effectively connected" in determining branch profits. The TE notes that the election is not binding on Canada unless it is otherwise in accordance with the arm's-length principle. For insurance companies, the parties agreed in the General Note that not only premiums earned through a permanent establishment should be attributed to it, but also that portion of the insurance company's overall investment income from reserves and surplus that supports the risks assumed by the permanent establishment.
Independent Services
The Protocol adds new paragraph 9 to Article V (Permanent Establishment) to deal with enterprises providing cross-border services and concurrently eliminates the separate treatment of independent service providers by deleting Article XIV, treating their income as business income under Article VII. This approach is consistent with the recommendations of the OECD and the new provision is similar to the sample provision contained in the proposed draft OECD Commentary. Its inclusion reduces the high "fixed place of business" threshold for establishing a permanent establishment for service providers that was demonstrated in the Dudney decision of the Canadian Federal Court of Appeal.
Where a service provider would not otherwise have a permanent establishment under Article V (because it does not have a fixed place of business, for example), it will be deemed to have a permanent establishment if it fulfills one of two tests. The new rule is expressly subject to the other "exceptions" to permanent establishment found in paragraph 6 of Article V – for example, engaging solely in activities such as advertising, supplying information or activities that are preparatory or auxiliary in nature.
The first test, contained in subparagraph 9(a) of Article V, applies to an "enterprise" whose services are provided substantially by one individual (applying primarily to the self-employed or incorporated employees). If that individual spends more than 183 days in the host State in any 12-month period and more than 50% of the gross active business revenues of the enterprise consists of income derived from the services performed by that individual in the host State during that period, the enterprise will be deemed to have a permanent establishment.
The second test, contained in subparagraph 9(b) of Article V, applies to the same or connected projects. Where an enterprise's services are provided in a host State for a total of 183 days or more in any 12-month period with respect to the same or connected project for customers who are either residents of the host State or who maintain a permanent establishment in the host State (where such services are provided in respect of that permanent establishment), the enterprise will be considered to have a permanent establishment in the host State. In the General Note, the parties agree that projects will be considered to be connected if they constitute a coherent whole, commercially and geographically.
The TE explanation of the new rules, though voluminous, raises a number of questions. For example, the TE states that the tests only apply to services provided to "third parties" and explains the statement by asserting that an enterprise will not have a permanent establishment only because services are provided to it. What is a third party? Are related parties third parties? What constitutes an "enterprise" for this purpose? The changes to the Commentary on Article 5 included in the 2008 Update to the Model Convention recently adopted by the OECD contain a thorough explanation and discussion of many of the observations and statements included in the TE and provide useful insight to the questions raised by the new rule and the TE.
In respect of the first test (subparagraph 9(a)), the TE notes that the individual's total days spent in the country are counted, irrespective of whether the individual was working on those days – i.e., personal/vacation days count towards the total. The TE states that "gross active business revenues" include revenues that the enterprise charges or should charge, irrespective of the timing of the actual billing or the timing of the recognition of income for any other purpose. In addition, the TE stipulates that active business activities that generate such revenue are not restricted to the activities related to the provision of services (without further direction except to exclude income from passive investment activities).
In respect of the second test (subparagraph 9(b)), the TE clarifies that only days in which services are actually provided in the host State are counted (excluding vacation or personal days upon which no services are provided). Days where multiple people provide services on behalf of the enterprise are counted as one day (i.e., if 20 employees are providing services in the host country for 10 days, only 20 (not 200) days result).
The TE also provides guidance in respect of the "connection" required for projects under subparagraph 9(b). It states that the determination of whether projects are connected should be determined from the point of view of the enterprise (not the customer) and will depend on the facts and circumstances of each case. In respect of "commercial coherence," the TE lists the following factors as potentially relevant: (1) whether the projects would, in the absence of tax-planning considerations, have been concluded pursuant to a single contract; (2) whether the nature of the work involved under different projects is the same; and (3) whether the same individuals are providing the services under the different projects. An example of non-commercial coherence given in the TE is separate law firm mandates – one to provide tax advice and another to provide trade advice, each to the same client but by different individuals. In respect of geographic coherence, the TE provided only an example: a consultant is hired to execute separate auditing projects at different branches of the same bank located in different cities. The TE indicates that although the services are commercially coherent, they should be considered separately for the purpose of subparagraph 9(b) for lack of geographic coherence.
In apparent anticipation of an increased number of permanent establishments that will result from the application of this new rule, and its effect on the number of employees who may become taxable under Article XV of the Treaty, the TE encourages the competent authorities to consider adopting rules to reduce the potential for excess employment withholdings or tax payments that may result. Taxpayers will have to implement new procedures to track, on a rolling 12-month basis, the physical presence of their service providers including, in the case of the test in subparagraph 9(a), for personal and non-work purposes. Taxpayers and the competent authorities do have time to adapt — these changes are effective as of the third taxation year after the Protocol enters into force, but taxpayers will not include in making a determination under paragraph 9 any days spent, services rendered or gross active business revenues that occur or arise prior to January 1, 2010.
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.