By: Jim Wilson and Pierre Alary. 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: 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. The facts of the Ruling are briefly summarized as follows: 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) 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. 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. 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. 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.
CRA Provides Much-Needed Guidance by Issuing PE Ruling
Background
ATR process
Facts of the Ruling
Analysis – PE determinations and OECD
principles
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
Background
The TCC Decisions
Concluding Remarks
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.
