The 5th Protocol to the Convention Between Canada and the United States of America with Respect to Taxes on Income and Capital (Canada-U.S. Treaty1 and 5th Protocol), which came into effect on December 15, 2008, introduced several significant and highly anticipated changes to the Canada-U.S. Treaty. One significant change that arose as a consequence of the 5th Protocol relates to the computation of income attributable to a permanent establishment (PE), with such change providing, it would appear, that certain notional expenses are now deductible in computing the income attributable to a PE under Article VII (Business Profits) of the Canada-U.S. Treaty. The 5th Protocol amendment supports the application of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines, by analogy, for the purposes of determining the business profits attributable to a PE. While most of the amendments to the Canada-U.S. Treaty have been analyzed at length by the tax community, this change relating to the computation of income attributable to a PE seemed to go quietly under the radar. However, on June 26, 2012, more than three and a half years following the coming into force of the 5th Protocol, the competent authorities of the United States and Canada entered into an agreement (Competent Authority Agreement) regarding the application of Article VII of the Canada-U.S. Treaty which provides that the competent authorities will interpret Article VII of the Canada-U.S. Treaty in a manner entirely consistent with the full authorized OECD approach (AOA).
This Competent Authority Agreement, confirming the application of the AOA and, indirectly, the deductibility of certain notional expenses in computing income attributable to a PE may yield interesting Canadian tax planning opportunities for U.S. taxpayers; however, some questions regarding its application remain unanswered. For instance, the Competent Authority Agreement does not address whether there is a conflict between Article VII of the Canada-U.S. Treaty (and its adherence to the AOA) and domestic tax laws, and, if a conflict does exist, whether the Canada-U.S. Treaty overrides the Income Tax Act (Canada) (ITA). In the absence of additional clarification from the Canada Revenue Agency (CRA) regarding the interaction of the AOA and the ITA, U.S. residents carrying on business in Canada may still face some uncertainty in computing their taxable income for purposes of filing their Canadian income tax returns. In addition to discussing the background to the AOA and the 5th Protocol amendment to Article VII, this article will examine other issues which may ultimately need to be addressed by the CRA in the context of Article VII and the AOA.
2008 Report on Attribution of Profits to Permanent Establishment
There have always been considerably differing views in the international tax community regarding the interpretation of the provisions of Article 7 of the OECD's Model Tax Convention on Income and on Capital (OECD Model Treaty and Article 7). Article 7 fully maintains source state taxation rights for business profits only to the extent that the resident carries on business in the source state through a PE, and only in respect of profits attributable to the PE. In essence, Article 7 creates a fiction that the PE is a distinct and separate person. The lack of consistency in interpreting Article 7 often resulted in cases of double taxation. Consequently, the OECD Committee on Fiscal Affairs (Committee) spent considerable time and effort over the years trying to ensure a more consistent interpretation and application of the provisions of Article 7.
In 1995, the OECD began a project to examine the feasibility of treating a PE as a hypothetically distinct and separate enterprise. This included an examination of ways in which transfer pricing principles could be applied by analogy in order to attribute profits to a PE in accordance with the arm's length principle. This work resulted in a 2008 report entitled Attribution of Profits to Permanent Establishments (2008 Report). The focus of the 2008 Report was on formulating the most preferable approach to attributing profits to a PE under Article 7 given modern-day multinational operations. Inconsistencies between some of the conclusions of the 2008 Report and the interpretation of Article 7 in the OECD's commentary to the OECD Model Treaty (Commentary) led the Committee to conclude that a new version of Article 7, together with an accompanying Commentary, was needed to provide maximum certainty on how profits should be attributed to a PE. These changes were introduced as part of the 2010 update to the OECD Model Treaty.
The Authorized OECD Approach – A Two-step Approach
The 2008 Report developed the AOA to address the application of the arm's length principle when attributing profits to a PE under Article 7. The interpretation of Article 7 under the AOA consists of a two-step analysis.
Step one: a functional and factual analysis
must be performed in order to hypothesize the PE as if it were a
separate and independent enterprise, undertaking functions, owning
and/or using assets, assuming risks, and entering into dealings
with the remainder of the enterprise of which it is a part and
transactions with other related and unrelated enterprises.
Step two: the remuneration of any dealings has to be determined by applying the OECD Transfer Pricing Guidelines by analogy.
Notional Expenses under Article 7
In the context of notional expenses, the 2008 Report suggests that royalties and interest can be notionally deducted by PEs and their related entities. A notional royalty may be appropriate where the PE has performed the function of creating an intangible or bears an extraordinary marketing expenditure in relation to the intangible. Notional royalties may be attributed to the PE where the functional and factual analysis shows that the PE is using intellectual property attributable to another part of the enterprise. Notional interest charges within non-financial enterprises are permitted in limited circumstances (e.g., treasury function). The Commentary on Article 7 also mentions the possibility of deducting notional charges, and like the Report, reiterates that the arm's length fiction created by Article 7 does not extend to other Articles.
It was generally understood that the recommendations of the 2008 Report would be implemented by a two-step process, not to be confused with the two-step approach in the AOA described above. First, the updated Commentary on existing Article 7 would confirm that the ban on notional interest and other expenses such as royalties and rent would continue to apply. However, once new treaties are negotiated or amended to reflect the new Article 7 in the 2010 OECD Model Treaty, which would reflect the intentions of the treaty negotiators, then notional expenses would be deductible in computing income attributable to a PE.
Amendments to Article 7 of the OECD Model Treaty and the Commentary
Prior to the 2010 update to the OECD Model Treaty, it was generally recognized by many in the international tax community that treaties negotiated following the 2008 OECD Model Treaty would not provide for the deduction of notional expenses in the computation of income attributable to a PE. Article 7 in the 2010 OECD Model Treaty was amended by deleting paragraph 3 and slightly amending the wording in paragraph 2. However, significant changes were made to the Commentary which were instrumental in accomplishing the objective of the 2008 Report and AOA in achieving a higher degree of symmetry between a branch scenario and a scenario involving two true separate legal entities with respect to the allocation of economic profits between countries, including the deductibility of certain notional expenses.
II. NEW ARTICLE VII OF THE CANADA-U.S. TREATY
The text of Article VII of the Canada-U.S. Treaty, both before and after the 5th Protocol, is very similar to the text of the old Article 7 of the OECD Model Treaty (our concerns regarding the failure to adopt the wording of new Article 7 are discussed below). However, in Annex B of the Diplomatic Notes to the 5th Protocol to the Canada-United States Tax Convention (2007) (Diplomatic Notes)2,Canada and the U.S. appeared to agree to a particular understanding with respect to the application of Article VII, which included adopting the AOA outlined in the 2008 Report, even though the 2008 Report was not specifically referenced.
In addition, the Technical Explanation to Article 4 of the 5th Protocol (TE) stated, under paragraph 9 of the General Note, that "...internal dealings may be used to attribute income to a permanent establishment in cases where the dealings accurately reflect the allocation of risk within the enterprises." The TE also stated that the contracting states agree that "notional payments used to compute the profits that are attributable to a permanent establishment will not be taxed as if they were actual payments for purposes of other taxing provisions of the Convention, for example, for purposes of taxing a notional royalty under Article XII (Royalties)." This example in the TE is fully consistent with applying the AOA in its entirety.
Adherence to the 2008 Report's conclusions and the adoption of the AOA have been confirmed by the Competent Authority Agreement, as Canada and the U.S. have agreed that business profits attributed to a PE will only include profits that are derived from the assets used, risks assumed and functions performed by the PE.
Uncertainty as to the Status of 5th Protocol on Notional Expenses
Article VII of the Canada-U.S. Treaty, as a consequence of the Diplomatic Notes and the TE, created some confusion for U.S. taxpayers with PEs in Canada due to the fact that, as mentioned above, Canada and the U.S. ignored the recommended wording from Article 7 of the new OECD Model Treaty in drafting Article VII of the Canada-U.S. Treaty. This failure to adopt the wording of the OECD Model Treaty, despite the general understanding that contracting states would need to negotiate or amend an existing treaty to reflect the new wording of Article 7 of the OECD Model Treaty, is questionable in light of the OECD's work on this project.
The Competent Authority Agreement has since confirmed that the intention of the treaty negotiators was to adopt the AOA. Presumably, this confirms that certain notional expenses are now deductible in computing income attributable to a PE. Hence, given the Diplomatic Notes, the TE, the Competent Authority Agreement and the underlying Canadian treaty policy that Canada's goal is to ultimately allow for notional expenses3 in computing income attributable to a PE, certain taxpayers may have sufficient comfort to begin claiming notional expenses on their Canadian tax returns. However, taxpayers should proceed with caution so long as certain fundamental questions, some of which are briefly discussed in the following section, remain unanswered.
Interaction (and Potential Conflict) Between New Article VII and Domestic Tax Laws
Pursuant to section 4(b) of the Income Tax Conventions Interpretation Act4 (ITCIA) regarding the attribution of income to a PE, notwithstanding the provisions of a tax treaty, "there shall, except to the extent that an agreement between the competent authorities of the parties to the convention expressly otherwise provides, not be deducted in the determination of those profits any amount with respect to that activity that is attributable or allocable to the permanent establishment and that would not be deductible under the Income Tax Act . . . " As a consequence of, for example, provisions such as paragraph 18(1)(a)5 and 20(1)(c)6 of the ITA, it is arguable that notional expenses are generally not deductible in computing the income of a non-resident of Canada from a business carried on in Canada. Furthermore, the Cudd Pressure decision7 has been interpreted by the CRA as support for the premise that notional expenses are not deductible. Accordingly, it would appear that the intention of the Competent Authority Agreement, at least from the Canadian competent authority perspective, was in part to circumvent section 4(b) of the ITCIA and in part to clarify to the tax community that the CRA will allow the deduction of notional expenses for domestic tax purposes, in spite of its published comments on Cudd Pressure. Surprisingly, however, the Competent Authority Agreement is silent on the issue of notional expenses and the ITCIA. This may be intentional, as Canadian government officials may not have determined how the full AOA will, procedurally speaking, be integrated into Canada's treaty network.8 Thus, the CRA may consider a silent approach to be preferable in this instance. Regardless, the international tax community now awaits to see whether the Competent Authority Agreement will be the first of many such agreements, signed under the authority of the Mutual Agreement Procedure Article (MAP Article), to accept the full AOA. For example, it would appear that even if a new treaty or protocol incorporated the new Article 7 of the OECD Model into its text, a competent authority agreement would, presumably, still be necessary in order to override section 4(b) of the ITCIA and allow otherwise non-deductible notional amounts to be deducted in computing income attributable to a PE.
III. CANADIAN TAX PLANNING
Now that Canada and the U.S. have clarified that the 5th Protocol intended to ensure that both contracting states abide by the full AOA in regards to computing income attributable to a PE for purposes of Article VII of the Canada-U.S. Treaty, presumably including the fact that certain notional expenses may now be deductible in computing income attribution to a PE, there may be certain Canadian tax advantages to a U.S. resident in structuring a business operation in Canada as a PE. For example, where a U.S. resident sets up a branch rather than a subsidiary in Canada, not only do the rules in section 78 of the ITA dealing with unpaid amounts not apply in respect of a notional expense between a branch and its headquarters, there will also be no Part XIII withholding tax on such notional expenses. This Part XIII advantage is of no benefit in regards to notional interest since Canada is now generally at zero per cent for arm's length and non-arm's length interest paid to U.S. residents. However, there are still potential advantages for trade-marks and certain other royalties where Article XII of the Canada-U.S. Treaty has maintained source state taxing rights up to 10 per cent. These advantages may or may not be significant, depending on whether the Part XIII tax is an actual incremental tax that cannot be credited against U.S. taxes payable.
It should also be noted that a non-resident taxpayer carrying on business in Canada through a PE does not appear to be subject to Canada's transfer pricing penalty regime with respect to transactions between its Canadian branch and its resident country headquarters. For example, subsection 247(2) of the ITA seems to apply, in addition to traditional cross-border transactions, to intercompany transactions between a Canadian branch of a non-resident taxpayer and a separate legal entity that is a non-resident of Canada and with which the non-resident taxpayer does not deal at arm's length. However, under the current wording of subsection 247(2), it would appear that two legal entities must be party to the intercompany transaction.9 Accordingly, in the event a notional expense claimed by a U.S. resident taxpayer in computing the income attributable to its Canadian PE was not valued in accordance with arm's length principles, and the CRA denied all or a portion of the notional expense10, no penalties under subsection 247(3) should apply. In other words, even if the company's contemporaneous documentation is found to be lacking, assuming the non-resident taxpayer even maintained documentation, transfer pricing penalties should not apply. U.S. taxpayers may want to seek clarification from the CRA on this interpretive issue.
Finally, binding arbitration as introduced in the 5th Protocol applies to disputes involving the computation of income attributable to a PE. Accordingly, regardless of how aggressive a non-resident taxpayer is in calculating notional expenses, if a notional expense is challenged by the CRA and a deduction for the royalty expense is reduced or denied in its entirety, the matter should ultimately be resolved by the competent authorities or an arbitration board under the MAP Article of the Canada-U.S. Treaty. Ultimately, proper foreign tax credit relief should be given in the resident state.
In summary, there appears to be no real deterrence in the Canadian tax system to prevent overly aggressive tax strategies involving notional expenses. Where notional expenses are deducted in accordance with the full AOA in computing income attributable to a PE, which appears to have been approved by the Competent Authority Agreement, taxpayers and their tax advisers should be aware that Canada's transfer pricing system does not appear to apply to certain branch-to-headquarter notional transactions. Accordingly, as the current Canadian tax system simply may not possess adequate safeguards to deter overly aggressive tax planning regarding branch-to-headquarter notional transactions, one would expect this issue to be addressed by Canada's Department of Finance in the near future. Until such action is taken, taxpayers and tax practitioners may be tempted to take advantage of the situation. For instance, an aggressive tax strategy which shifts profits out of Canada and to the U.S. could be of benefit where the Canadian tax at the PE level is truly an incremental tax to the U.S. resident taxpayer and would not be creditable, immediately or in the future, against U.S. taxes. Generally, an aggressive allocation of notional expenses to a Canadian branch would be beneficial only where the U.S. corporation is not subject to immediate tax and cannot absorb the Canadian tax immediately as a foreign tax credit. Even though taxpayers would be well advised to take a principled approach to computing notional transactions, the economic analysis aspect of transfer pricing is so subjective that, unfortunately, there is potential for abuse.
1 Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital, (signed at Washington on September 26, 1980, as amended by the Protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997 and September 21, 2007).
2 On the date of signing of the Protocol, the U.S. and Canada exchanged two sets of diplomatic notes. The first note, the Arbitration Note, relates to the implementation of new paragraphs 6 and 7 of Article XXVI (Mutual Agreement Procedure), which provide for binding arbitration of certain disputes between the competent authorities. The second note, the General Note, relates more generally to issues of interpretation or application of various provisions of the Protocol.
3 Canada did not enter any reservations towards the new Article 7.
4 ( R.S.C. , 1985, c. I-4).
5 Paragraph 18(1)(a) of the ITA only allows a deduction in computing income from a business or property to the extent the payment is made or incurred for the purpose of producing income.
6 Paragraph 20(1)(c) requires that interest be "paid pursuant to a legal obligation."
7 Canadian jurisprudence such as Cudd Pressure Control Inc. v. The Queen, 98 DTC 6630 (FCA)would suggest, arguably, that notional amounts are not deductible in Canada. See the CRA's official position on this decision in Income Tax Technical News No. 18.
8 Other countries, such as the Netherlands, have eliminated some confusion by addressing the issue of notional expenses head-on. In January 2011, the Dutch State Secretary of Finance published a Decree on the attribution of profits to PEs in response to the OECD's work on the issue (PE Decree). The PE Decree confirms that where, based on the significant people functions, the economic ownership of the intellectual property can be allocated to a particular part of the enterprise, notional royalty payments are not prohibited.
9 The authors are not aware of any CRA document dealing with the interpretation of subsection 247(2) of the ITA in the context of a branch to headquarter intercompany transaction, however, the wording of the provision seems to clearly contemplate a two-person scenario only.
10 For example, under section 67 or paragraph 18(1)(a) of the ITA.
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.