Cases
Gulfmark Offshore N.S. Ltd. v. The Queen, 2007 DTC 5563, 2007 FCA 302
Before the taxation year in question, the taxpayer, which was a U.K. company with a fleet of 27 supply vessels including a ship that was operated for 88 days in that year in the Nova Scotia offshore area, borrowed money from its parent company to construct new ships in addition to the refinancing of the taxpayer's outstanding debts. The taxpayer was unable to deduct any portion of the interest on the loan from its parent in the absence of more complete evidence on how that loan was used.
Cudd Pressure Control Inc. v. The Queen, 98 DTC 6630, Docket: A-369-95 (FCA)
The taxpayer, which was resident in the United States, entered into a contract to provide two "snubbing" units to Mobil Oil Canada Ltd. for use in connection with an underground blowout in an exploratory gas well off the coast of Nova Scotia, at a rate of U.S. $15,000 per day. In computing its Canadian profits for Canadian income tax purposes, the taxpayer deducted an amount for notional rent. The finding of the Tax Court Judge that, in the circumstances, it was more reasonable to assume that the Canadian branch would have purchased the snubbing unit (claiming capital cost allowance, rather than a rent deduction) was affirmed.
Utah Mines Ltd. v. The Queen, 92 DTC 6194 (FCA)
The taxpayer, which was a U.S. corporation with a mining operation in B.C., was prohibited by s. 18(1)(m) from deducting royalties payable by it to the Province of B.C. notwithstanding the provisions of the 1942 Canada-U.S. Income Tax Convention which provided that in determining the net industrial and commercial profits of a permanent establishment there shall be allowed as deductions all expenses reasonably allocable to the permanent establishment. Hugessen J.A. stated (p. 6197):
"The interpretation proposed by the appellant ... would have the effect of giving a U.S. taxpayer with a permanent establishment in Canada a more favourable tax treatment than its Canadian competitor engaged in the same business in this country. Such a result would not be in accordance with the policy expressed in the preamble to the Convention ..."
Sun Life Assurance Co. of Canada v. Pearson, 1986 BTC 282 (C.A.)
A statutory method of allocation whereby the portion of the gross profits of a Canadian life insurance company attributable to its U.K. branch were determined (that determination being based on the ratio of the company's liability to U.K. policyholders to its liability worldwide) then the actual expenses of the branch deducted from that gross profit figure, was found to be an acceptable measure of the net profit that the branch would have earned as an independent enterprise. (1980 Canada-U.K. Convention, Article 7(4))
It was also stated that the word "profits" in Article 7 means "income" rather than "income less expenses".
Abed Estate v. The Queen, 82 DTC 6099, [1982] CTC 115 (FCA)
The exemption in Article I of the 1942 Canada - U.S. Convention, for the commercial profits of a U.S. enterprise that are not attributable to a Canadian permanent establishment, did not apply to the Canadian profits of a U.S. resident that were not attributable to an enterprise or undertaking carried on in the United States. Here, the U.S. - resident appellant was not exempt because he never had any business activities in the United States, and he accordingly was taxable under what is now S.2(3)(b) on his profits from trading in Montreal real estate.
Loeck v. The Queen, 78 DTC 6368, [1978] CTC 528 (FCTD), aff'd 82 DTC 6071, [1982] CTC 64 (FCA)
The German plaintiff owned and managed property in Hamburg that contained 17 rented apartments, and he was a shareholder in a public company that operated residential properties in West Berlin. It was held that gains from the sale of properties owned by him in Ontario were not the profits of a West German enterprise.
Ostime v. Australian Mutual Provident Society (1959), 38 TC 492 (HL)
Rule 3 applicable to Case III of Schedule D of the Income Tax Act, 1918 provided that a life insurance company with a head office overseas (in this case, in Australia) should pay tax on a proportion of its world-wide income from investments, determined on the basis of premiums received in the United Kingdom as a percentage of all its premium income. Lord Radcliffe held that this method of computation was inconsistent with the independent enterprise hypothesis contained in Article III(3) of the U.K.-Australia Convention.
See Also
AB LLC and BD Holdings LLC v. Commrs. of South African Revenue Services, Case No. 13276, 15 May 2015, South Africa Tax Court
A US corporation, which spent 15 months based in the boardroom in South Africa of a South African client providing consulting services argued unsuccessfully that it did not have a permanent establishment in South Africa. Vally J went on to find that a success fee received by the taxpayer in a subsequent taxation year during which it had no presence in South Africa was "attributable" to its previous permanent establishment there, and therefore was not exempted from South African tax.
See summary under Treaties – Art. 5.
Wuslich v. MNR, 91 DTC 704 (TCC)
In addition to carrying on an orthodontic practice at various locations in the U.S., the taxpayer also maintained a professional office in Regina. Although examinations and consultations of patients were carried out there, he reviewed his records, prepared treatment plans, fabricated retainers, ordered supplies and carried out administrative functions from his office in Pittsburgh. The profits arising from his Regina practice were allocated between Canada and the U.S. on the basis of the time spent in Pittsburgh on the latter functions compared to the total time spent by him in relation to his Regina practice.
Administrative Policy
20 November 2014 Memorandum 2014-0539631I7 - Restrictive Covenants-Part XIII (Luxembourg)
After CanCo had sold shares of a partly-owned subsidiary (SubCo), it made a payment to the other share vendor (LuxCo) pursuant to what was assumed to be a "restrictive covenant" in a related agreement, and withheld and remitted 25% of the payment. Luxco was unsuccessful in a refund claim based inter alia on Art. 7 of the Canada-Luxembourg Treaty. CRA noted that although it used the term "profits" rather than "business profits," under Art. 3, para. 1(c) of the OECD Model, the term "enterprise" applies to the "carrying on of any business," so that the reference to "profits of an enterprise" means profits from carrying on a business. Given that the shares of SubCo were held by LuxCo on account of capital, there was no reason to believe the payment constituted income from a business.
See summary under Treaties - Art. 22.
Canada-U.S. Income Tax Convention - Agreement between Competent Authorities on the interpretation of Article VII (Business Profits) CRA Notice dated 19 July 2012
The competent authorities of Canada and the US agreed on 26 June 2012 pursuant to Article XXVI, para. 3 (resolution of interpretive doubt), that Article VII of the Canada-US Income Tax Convention is to be interpreted consistently with the OECD 2010 Report on the Attribution of Profits to Permanent Establishments.
14 November 2007 T.I. 2007-025332 -
Respecting whether franchise fees paid to a U.S. resident were subject to withholding tax, the Directorate stated that:
"Where a payment represents in part a royalty and in part business profits for purposes of the Treaty, a taxpayer must make reasonable efforts to separate the two. Where a taxpayer fails to, or is unable to, identify the royalty component with the business profits component, the entire payment will be taxed as a royalty ... ."
Income Tax Technical News, No. 18, 16 June 2000
Discussion of Cudd Pressure case.
17 January 1996 T.I. 952006 (C.T.O. "Borrowing is Effectively Connected to a Permanent Establishment")
Before indicating that borrowings by a U.S. Parent to acquire flow-through shares issued by one of its wholly-owned subsidiaries would not be considered to be attributable to the assets or activities of a permanent establishment of the U.S. parent in Canada through which it carried on business (with the result that the resulting interest expense would not be deductible in computing the income of the permanent establishment), RC stated that "the meaning of the term 'attributable to' as used in paragraph 7 of Article VII of the Treaty has the same meaning as the term 'effectively connected' as used in Articles X, XI and XII of the Treaty since in both cases the term is relating the income or the income source to the PE of U.S. Co."
10 May 1995 T.I. 933235 (C.T.O. "Capital Gains")
The Canada-Denmark Convention does not deal with the taxation of capital gains. Accordingly, the transfer of shares of a Canadian private company from one Danish corporation to a related Danish corporation (on a basis that would not be subject to tax in Denmark) would be subject to tax under the Act with no relief provided by the Convention.
16 March 1993 T.I. (Tax Window, No. 30, p. 15, ¶2478)
Payment to a U.S.-resident engineer for his services would be exempt from Part XIII tax if such payments did not fall within Article XII of the U.S. Convention.
6 January 1992 T.I. (Tax Window, No. 15, p. 14, ¶1679)
Re taxability of rental payments derived from the use of moveable property in Canada by a Norwegian limited partnership.
IC 87-2 "International Transfer Pricing and Other International Transactions", para. 32
Most treaties do not require that management fees be treated as anything other than a component of industrial, commercial or business profits.
IT-468R "Management or Administration Fees Paid to Non-Residents"
Where the treaty does not contain a specific article on management or administration fees, such fees paid to the non-resident will, to the extent they are reasonable, be considered to be covered by the business profits article.
Articles
Joshua Lawrence, "New York Nexus Widens", Canadian Tax Highlights, Vol. 22, No. 8, August 2014, p. 1.
No physical nexus under NY franchise tax (p.1)
[U]nder New York's new nexus standard, any corporation "deriving receipts from activity" within New York is subject to franchise tax obligations if its New York receipts total at least $1 million for the taxable year, even if it has no physical presence in the state. However, a non-USco—even if it meets the receipts-based threshold—is subject to franchise tax under the new law only if it also has ECI for federal purposes or if it is a deemed domestic corporation such as a stapled stock entity) under the Code…
No PE exemption (p.1)
A Canco that lacks a US PE currently enjoys protection from US federal income tax under the Canada-US treaty, but treaty protection does not extend to the taxes of an individual state. New York State generally requires that a non-USco with sufficient nexus pay franchise tax on an apportioned amount of its entire net income (ENI)….
Exemption if no ECI (p.1)
Effective in 2015, only a non-USco's ECI is included in its New York ENI. However, for the purposes of the new economic nexus threshold, it is irrelevant whether the ECI is associated with a trade or business carried on in New York or in other states, or whether the corporation has ever had property, employees, inventory, or any other form of physical presence in New York;…
Michael Kobetsky, "Inter-Bank Loans: Determining a Branch's Business Profits Under Article 7 of the OECD Model", International Bureau for Fiscal Documentation, February 2005, p. 48.
David A. Ward, "Attribution of Income to Permanent Establishments", Canadian Tax Journal, Vol. 48, No. 3, 2000, p. 559.
Purdy, Zanchelli, "Calculating and Supporting Management Fees (A Departure from the 'Back of the Envelope' Approach)", International Tax Planning, 1996 Canadian Tax Journal, Vol. 44, No. 1, p. 157.
Markovitz, "Permanent Establishment - Home Office Relations", International Tax Planning, 1996 Canadian Tax Journal, Vol. 44, No. 4, p. 1127.
OECD
OECD, 2010 Report on the Attribution of Profits to Permanent Establishments, 22 July 2010:
Part I: General Considerations
B-1 The "functionally separate entity approach"
"[T]here should be no 'force of attraction principle'....Profits may therefore be attributed to a permanent establishment even though the enterprise as a whole has never made profits" (para.8).
B-2 Basic premise of the authorised OECD approach
"[T]he authorised OECD approach is not designed to prevent the application of any domestic legislation aimed at preventing abuse of tax losses or tax credits by shifting the location of assets or risks" (para. 9).
"[A] two-step analysis is required. First...[a] functional and factual analysis must identify the economically significant activities and responsibilities undertaken by the PE....Under the second step, the remuneration of any dealings between the hypothesised enterprises is determined by applying the analogy the Article 9 transfer pricing tools...." (para. 10).
B-3 Step one: hypothesising the PE as a separate and independent enterprise
"[T]he authorised OECD approach attributes to the PE those risks for which the significant functions relevant to the assumption and/or management (subsequent to the transfer) of risks are performed by people in the PE and also attributes to the PE economic ownership of assets for which the significant functions relevant to the economic ownership of assets are performed by people in the PE" (para. 15).
"[I]n the case of financial assets of financial enterprises, the same significant people functions wil generally be relevant both to the assumption of risk and to the economic ownership of those assets....Because of the special relationship between risks and financial assets in these specific sectors, the authorised OECD approach uses the 'key entrepreneurial risk-taking function ( 'KERT function') terminology in describing the functions relevant to the attribution of both risks and assets..." (para.16).
"The functional and factual analysis will attribute 'free' capital (i.e. funding that does not give rise to a tax deductible return in the nature of interest) to the PE for tax purposes, to ensure an arm's length attribution of profits to the PE. The starting point for the attribution of capital is that under the arm's length principle a PE should have sufficient capital to support the functions it undertakes, the assets it economically owns and the risks it assumes. In the financial sector regulations stipulate minimum levels of regulatory capital to provide a cushion in the event that some of the risks inherent in the business crystallize into financial loss. Capital provides a similar cushion against crystallization of risk in non-financial sectors" (para.28).
"[C]apital needed to support risks is to be attributed to a PE by reference to the risks attributed to it and not the other way around" (para. 29).
"Save in exceptional circumstances...dealings between a PE and the rest of the enterprise...should be priced on the basis that both share the same creditworthiness" (para. 33).
B-4 Step two: determining the profits of the hypothesised separate and independent enterprise based upon a comparability analysis
Tax administrations should give effect to contemporaneous documentation of dealings between the PE and the rest of the enterprise provided various conditions are satisfied including that "the documentation is consistent with the economic substance of the activities taking place" and the documented arrangements "do not deffer from those which would have been adopted by comparable independent enterprises behaving in a commercially manner or, if they do so differ...reasonably accurate adjustments can be made to eliminate the material effects of such differences" (para. 36, 40).
B-5 Summary of the two-step analysis
Summary of two-step approach in para. 44-45.
D-2 First step: determining the activities and conditions of the hypothesised separate and independent enterprise
"The guidance in the [Transfer Pricing] Guidelines on functional analysis seems capable of being applied fairly directly in the PE context in order to determine the 'activities' of the hypothesised separate and independent enterprise. The main difficulties are with determining how to take into account risks assumed and assets used" (para. 61).
"[W]here it is accepted that the location of a server of itself constitutes a PE...the same principles apply and the functional analysis will determine what automated functions are performed by the server-PE and what assets are used and risks assumed in the performance of those functions" (para. 66).
'A PE may 'assume' a risk and may subsequently use the services of another part of the enterprise to 'manage' that risk, without necessarily transferring the risk to that other part of the enterprise to 'manage' that risk" (para. 70).
"The amount and nature of the risks assumed by the PE also affects the amount of capital that needs to be attributed to the PE. This is because an enterprise assuming material additional risks would need to increase its capital correspondingly in order to maintain the same creditworthiness. This is most clearly seen in the financial sector..." (para. 71).
"Economic ownership of an asset is determined by a functional and factual analysis and in particular rests upon performance of the significant people functions relevant to ownership of the asset..." (para. 72).
"[T]here was a broad consensus among the OECD member countries for applying use [as contrasted to significant people functions] as the basis for attributing economic ownership of tangible assets in the absence of circumstances that warrant a different view" (para. 75).
"The functional and factual analysis [respecting internally developed intangible property] should therefore describe and evaluate the dynamics of the particular enterprise's research and development programme....[F]unctions which may be relevant include designing the testing specifications and processes within which the research is conducted, reviewing and evaluation the data produced by the tests, setting the stage posts at which decisions are taken and actually taking the decisions on whether to commit further resources to the project..." (para. 88).
"Just as with internally developed intangible property, the key question in determining economic ownership of acquired intangibles is where within the enterprise the significant people functions related to active decision-making relating to the taking on and management of risks are undertaken" (para. 94).
"The significant people functions relevant to the determination of economic ownership of [marketing intangibles such as brands]...include, for example, functions related to the creation and control over branding strategies, trademark and trade name protection, and maintenance of established marketing intangibles" (para. 97).
"The authorised OECD approach does not recognise dealings in respect of guarantee fees between the PE and its head office or between the PE and another PE" (para. 103).
"The consultation process has shown that there is an international consensus amongst governments and business on the principle that a PE should have sufficient 'free' capital to support the functions, assets and risks it assumes. However, the consultation process has also shown that it is not possible to develop a single internationally accepted approach for attributing the necessary 'free' capital" (para. 147).
Once the required funding of the PE and the portion thereof which is free capital is determined, "[t]he balance of the funding requirement is therefore the amount by reference to which the interest deduction is calculated...." (para. 150).
"Just as for capital attribution, it does not seem possible to develop a single approach for determining the amount of attributable interest expenses that could be applicable in all circumstances. Some countries favour a fungibility approach, whilst others want to retain tracing of funds for non-financial institutions...Other countries may want to use appropriately recognised 'treasury dealings' to reward a treasury function....Accordingly, all these approaches should be treated as authorised under the authorised OECD approach (para. 156)."
"Where the amount of free capital allotted by the enterprise is less than the arm's length amount as determined by one of the authorised approaches, an appropriate adjustment would need to be made to reduce the amount of interest expense claimed by the PE in order to reflect the amount of the enterprise's 'free' capital that is actually needed to support the activities of the PE. The adjustment will be made following the rules of the PE's host country, subject to Article 7" (para. 162).
"Any...domestic tax law requirement that provided for an amount of 'free' capital in excess of the arm's length range would be restricted by Article 7 to an amount that was within the limit set by the arm's length range" (para. 166).
"[U]ltimately it is the functional and factual analysis which determines whether the dealing [between the PE and the rest of the enterprise] has taken place, not the accounting records....This will require the determination of whether there has been any economically significant transfer of risk, responsibilities and benefits as a result of the 'dealing' (para. 177-178).
"[T]he authorised OECD approach treats 'dealings' as analogous to transactions between associated enterprises and so the guidance in paragraphs 1.52-1.54 of the [Transfer Pricing] Guidelines can be applied in the PE context by analogy" (para. 179).
D-3 Second step: determining the profits of the hypothesised separate and independent enterprise based upon a comparability analysis
"In the factual situation where the PE is regarded as becoming the economic owner of the tangible asset from that time forward, the fair market value of the asset at the time of transfer would generally provide the basis for computing an allowance for depreciation in the host country, subject to that country's domestic law" (para. 196).
"[I]n the context of the authorised OECD approach, the use of the word 'royalty'...is intended to refer to the arm's length compensation that one would have had to pay (and deduct from income) for the use of the intangible if the provider of the intangible were a separate and independent enterprise' (para. 201).
"In circumstances where an intangible developed by one part of the enterprise is to be further developed by the enterprise as a whole, it might be that such further development would be conducted in a cost contribution arrangement-style (CCA-type) activity in which the PE is a participant. In such circumstances the PE would be treated for tax purposes as if it had acquired an interest in the pre-existing intangible property (a buy-in) and any subsequent dealings related to the further development of the intangible property would be determined by following, by analogy, the guidance given in Chapter VIII of the [Transfer Pricing] Guidelines" (para. 211).
"[T]he degree of sophistication of the notional construct that is required by an economic CCA between parts of a single legal enterprise precludes claims that are not backed by convincing contemporaneous documentation" (para. 215).
D-5 Dependent agent PEs
"Issues arise as to whether there would remain any profits to be attributed to the dependent agent PE after an arm's length reward has been given to the dependent agent enterprise....However, the authorised OECD approach recognises that it is possible in appropriate circumstances for such profits to be attributed to the dependent agent PE" (para. 234).
Parts II, III and IV (banks, financial traders and insurance companies, respectively) not summarized.