- Upstream Loans and Other Indebtedness to Foreign Affiliates
- CRA Guidance on Whether Canadian Captive Service Subsidiary Constitutes PE of Foreign Parent
- Court Upholds Capital Loss Recognition on Exercise of Exchangeable Share Rights
- Employee Profit Sharing Plans - Changes to Come?
- Change to Canada-US Tax Treaty Affecting Cross-Border Employees
- Back to the Future – British Columbia Votes to Restore Provincial Sales Tax
- Dernières nouvelles
John M. Campbell, Toronto
Draft legislation making significant changes to the foreign affiliate provisions of the Income Tax Act (Canada) (the “Act”) was released by the Department of Finance on August 19, 2011.
The new provisions deal with upstream loans from and other indebtedness owing to foreign affiliates, a new hybrid surplus account related to certain capital gains, foreign affiliate reorganizations, changes to the surplus distribution ordering rules, capital losses of foreign affiliates and stop-loss rules.
This article addresses only the new rules applicable to so-called “upstream loans”.
Prior to these changes, it was possible for a foreign affiliate with taxable surplus to make a loan to a Canadian resident corporate shareholder or a related Canadian resident corporation, instead of paying dividends, without adverse Canadian tax consequences. Loans could be an attractive alternative to dividends because a dividend from a foreign affiliate out of taxable surplus must be included in income and may not be completely offset by a deduction under subsection 113(1) of the Act in respect of underlying foreign taxes (if any) paid by the foreign affiliate. A loan may also have been preferred if dividends were not possible under foreign law or would be subject to an uneconomic level of withholding tax in the foreign jurisdiction. There were no rules requiring a loan from a foreign affiliate to be included in income if not repaid within a certain period of time. The primary target of the new rules regarding loans from and other indebtedness to foreign affiliates appears to be these “upstream loans”, however, the scope of the new rules is actually much broader.
The new upstream loan rules apply where a Canadian resident, any other person with whom the Canadian resident does not deal at arm’s length (other than controlled foreign affiliates within the meaning of section 17 of the Act) or certain partnerships is indebted to a foreign affiliate (“FAco”) of the Canadian resident. If the loan of other indebtedness is not repaid within two years after it arose, then, subject to certain exceptions described below, each Canadian resident taxpayer for whom FAco is a foreign affiliate must include a portion of the loan or other indebtedness in its income based on the taxpayer’s surplus entitlement percentage.
The income inclusion can be avoided if the loan or other indebtedness is fully repaid within two years after it arose (but the repayment cannot be part of a series of loans and repayments). For loan or other indebtedness owing to a foreign affiliate before August 19, 2011, the two year period for repayment commences on August 19, 2011. In other words, the loan or other indebtedness must be repaid on or before August 18, 2013 to avoid the application of the new rule.
Certain exceptions apply where the loan or other indebtedness arose in the ordinary course of the foreign affiliate’s business or is a loan made in the ordinary course of the foreign affiliate’s money lending business where bona fide arrangements were made at the time the indebtedness or loan arose for repayment within a reasonable time.
A striking feature of the new upstream loan rules is that a Canadian resident can be required to include an amount in its income even if the Canadian resident is not the person indebted to FAco. Where any person with whom a Canadian resident does not deal at arm’s length (except controlled foreign affiliates within the meaning of section 17 of the Act) becomes indebted to a foreign affiliate of the Canadian resident, then (subject to the ordinary course exception described above) the Canadian resident can have an income inclusion. Indebtedness of certain partnerships to the foreign affiliate can also trigger an income inclusion.
A Canadian resident can be required to include an amount in its income under the new upstream loan rules, even where the Canadian resident does not directly or indirectly benefit from the loan or other transaction giving rise to the indebtedness. This is illustrated in the following examples (which both assume the ordinary course exception does not apply).
The $1,000 loan to Canco 2 will require each of Canco1 and Canco 2 to include $500 in income unless the loan is repaid within two years (other than as part of a series of loans and repayments).
The $1,000 loan to Eurosub will require Canco to include $1,000 in income unless the loan is repaid within two years (other than as part of a series of loans and repayments).
If a Canadian resident individual becomes indebted to a foreign affiliate and the loan or other indebtedness is not repaid within one year after the end of the taxation year of the foreign affiliate, subsection 15(2) of the Act will generally require the amount of the loan or other indebtedness to be included in the individual’s income. The new upstream loan rules do not apply where subsection 15(2) applies and will therefore generally be more significant for corporations than for individuals. However, the upstream loan rules could apply to a Canadian resident individual in circumstances where subsection 15(2) would not. This is illustrated in the following example (which assumes the ordinary course exception does not apply).
The $1,000 loan to Canco will require Mr. X to include $500 in his income unless the loan is repaid within two years (other than as part of a series of loans and repayments).
The above examples show the broad scope of these new rules. The broad scope makes the “upstream loan” label given to these new rules by the Department of Finance dangerously misleading. It is not only loans that can give rise to mandatory income inclusions. Other indebtedness, e.g., unpaid purchase price, can have the same result. Also, transactions giving rise to indebtedness to a foreign affiliate which are not obviously “upstream” can trigger an income inclusion. A careful review of any loan or other indebtedness owing to a foreign affiliate of a Canadian resident taxpayer should be undertaken to identify situations that could result in income inclusions under the new rules.
If the loan owing or other indebtedness to the foreign affiliate is repaid after the two year period and a Canadian resident taxpayer had to include an amount in income in respect of the indebtedness, then the taxpayer is entitled to a deduction in the year of repayment. Where the loan or other indebtedness is only partially repaid, the deduction is prorated accordingly.
Where a Canadian resident taxpayer has an income inclusion as a result of a loan from or other indebtedness to a foreign affiliate, the taxpayer may claim a deduction under proposed subsection 90(6) of the Act for the portion of that amount that it could have received as an actual dividend without Canadian tax by reason of deductions claimed for exempt surplus, hybrid surplus and hybrid underlying tax (“HUT”) or underlying foreign tax in respect of taxable surplus of the foreign affiliate.
The deduction based on exempt surplus is only available if there is sufficient exempt surplus to cover a hypothetical dividend in an amount equal to the deduction claimed under proposed subsection 90(6) of the Act.
The deduction based on hybrid surplus is only available if there is sufficient hybrid surplus and HUT and if the foreign tax on the capital gains giving rise to hybrid surplus is at least equal to the Canadian tax rate applicable to capital gains realized by a corporation.
The deduction based on underlying foreign tax (“UFT”) related to taxable surplus is generally only available if the foreign affiliate has sufficient UFT such that the grossed-up UFT that could be designated in respect of a dividend out of taxable surplus is at least equal to the deduction claimed under proposed subsection 90(6).
These deductions based on hypothetical dividends are only available if no dividends are paid to the taxpayer or any other Canadian resident with whom the taxpayer does not deal at arm’s length by any foreign affiliate whose surplus accounts are relevant to the deductions claimed. At the Canadian Tax Foundation’s recent 2011 annual conference, a Department of Finance representative indicated that some relieving modifications are being considered regarding the restriction on payment of dividends while the loan or other indebtedness is outstanding.
The deductions based on hypothetical dividends are only available if the relevant surplus accounts have not been relied upon to support a deduction in respect of any loan or other indebtedness. The amount of the hypothetical dividend deduction must be included in income in the next year. The taxpayer may then claim a hypothetical dividend deduction in that next year based on the surplus accounts in the next year.
The draft legislation leaves some uncertainty as to which surplus accounts can be relied upon for the hypothetical dividend deduction. Clearly, the surplus accounts of the foreign affiliate to whom the loan or other indebtedness is owed are included. Clarification is desirable on whether the surplus accounts of subsidiaries of that foreign affiliate should also be included. It has been suggested that a Canadian resident taxpayer should be able to offset previously taxed FAPI from the relevant foreign affiliate against the income inclusion for loan or other indebtedness owing to that foreign affiliate. The Department of Finance appears to be sympathetic to these situations and suggestions.
It is likely that there will be changes to the proposed legislation before it is enacted to respond to submissions and to correct unintended consequences. Stay tuned.
Lyne M. Gaulin, Toronto
Canada Revenue Agency (“CRA”) has recently issued a favourable advance income tax ruling (“ATR”) to the effect that a company that is a non-resident of Canada (“Foreign Parent”) would not be considered to be carrying on business in Canada through a permanent establishment (“PE”) within the meaning of a tax treaty where it has a Canadian service subsidiary which performs services only for Foreign Parent (“Canadian Captive Service Subsidiary”). This ATR focuses on common Foreign Parent-Canadian Captive Service Subsidiary structures and provides CRA guidance on whether Canadian Captive Service Subsidiary could constitute a PE of Foreign Parent.
Foreign Parent is described in the ATR as a corporation formed under foreign laws and resident of a foreign country under a tax treaty between Canada and the particular foreign country. Foreign Parent has separate business divisions one of which consists of manufacturing, processing and distributing parts to manufacturers in Canada and in other foreign countries. Foreign Parent has entered into agreements for the supply of parts with a Canadian customer (“Supply Agreements”).
Foreign Parent has also entered into a service agreement with its wholly-owned Canadian subsidiary (“Canco”) pursuant to which Canco has agreed to assemble parts sold by Foreign Parent to the Canadian customer under the Supply Agreements (the “Service Agreement”). Canco performs such work through its own employees or the services of an employment agency. In this regard, the Service Agreement provides that Canco’s activities are limited to the assembly of parts, that is to say, Canco does not provide other services to Foreign Parent or any other customer.
Pursuant to the terms of the Service Agreement, the legal relationship between Canco and Foreign Parent is that of an independent contractor. Furthermore, the Service Agreement provides that Canco will not in any case carry out such activities as receiving orders, negotiating commercial issues with customers and/or concluding sales contracts on behalf of Foreign Parent and cannot otherwise bind Foreign Parent, assume or create any obligation, express or implied, on behalf of Foreign Parent or in the name of Foreign Parent , or any of its officers or employees, or in the name of Canco as a purported agent of Foreign Parent, or to commit Foreign Parent in any way to any obligation or contract.
Foreign Parent reimburses Canco for all expenses (including certain costs of materials and goods, administrative expenses, interest and taxes) incurred by Canco in performing its obligations under the Service Agreement. In addition, Foreign Parent pays Canco an amount equal to a percentage of total expenses incurred by Canco as compensation for services rendered by Canco.
Foreign Parent proposes to enter into a new service agreement with Canco whereby Canco would continue to perform the services under the Service Agreement but would provide additional services to Foreign Parent, including manufacturing of parts, engineering and quality assurance related to parts, and packaging and delivery of parts, which activities are currently being performed by Foreign Parent outside Canada under the terms of the Supply Agreements (“Proposed Service Agreement”). The main purpose of the Proposed Service Agreement is to achieve significant reduction of costs, such as shipping costs, by increasing the amount of manufacturing and assembling in Canada and procurement costs from suppliers by procuring tools, parts and materials directly. The Proposed Service Agreement includes provisions similar to those found in the current Service Agreement regarding the existence of an independent contractor relationship and Canco having no authority to conclude contracts on behalf of Foreign Parent or to bind Foreign Parent in any manner whatsoever.
There is disclosure in the ATR that Foreign Parent’s employees visited Canco’s facility from time to time for business meetings and to audit and monitor Canco’s performance in connection with the Service Agreement. It is expected that Foreign Parent’s employees will be present at the Canco facility in Canada for a period or periods not exceeding in the aggregate 90 days within any 12 month period to provide advice, inspect, supervise and/or expedite services required under the Proposed Service Agreement. In the event that any Foreign Parent employee is required to be present in Canada for a significant period, such employee will be seconded to work for Canco. However, no secondment of this nature is currently being contemplated by Foreign Parent in relation to the Proposed Service Agreement.
According to the ATR, Foreign Parent will not own or lease any space in Canada. Foreign Parent’s access to, and use of, Canco’s facility in Canada will be such that it will not create any degree of identification that could result in Canco’s facility being identified as Foreign Parent’s business location. Canco will make its Canadian facility available to Foreign Parent in the same manner as it will make such facility available to third party visitors.
The tax ruling given by CRA in this ATR appears to be consistent with the principles underlying the independent legal entity PE concept adopted for parent-controlled subsidiary relationships in Article 5(7) of the OECD Model Tax Convention on Income and Capital (“MTC”) and the dependent agent PE concept found in Article 5(5) of the MTC. These two PE concepts are generally included in the PE article in most of Canada’s tax treaties.
Any PE determination by CRA in the Foreign Parent-Canadian Captive Service Subsidiary context should generally be based on these two PE concepts. Under the first PE concept mentioned above, the Canadian Captive Service Subsidiary should be treated as an entity independent from Foreign Parent notwithstanding the fact that it is directly or indirectly controlled by Foreign Parent. Accordingly, Canadian Captive Service Subsidiary should not constitute a PE of Foreign Parent unless Canadian Captive Service Subsidiary is a dependent agent of Foreign Parent within the meaning of Article 5(5) of the MTC.
CRA has often focused on facts and circumstances surrounding the availability and use of the Canadian Captive Service Subsidiary’s facilities by Foreign Parent to determine whether Foreign Parent has a PE in Canada. In this situation, such a determination should be made in accordance with the principles underlying Article 5(5) of the MTC. Based on these principles, Canadian Captive Service Subsidiary should only constitute a PE of Foreign Parent if Canadian Captive Service Subsidiary is a dependent agent of Foreign Parent within the meaning of Article 5(5) of the MTC. Accordingly, CRA should not take the position that Canadian Captive Service Subsidiary should constitute a PE of Foreign Parent where Canadian Captive Service Subsidiary is not acting on behalf of Foreign Parent and does not habitually exercise an authority to conclude contracts in the name of Foreign Parent.
The ATR also provides guidance on the provisions that should be included in a service agreement between Foreign Parent and Canadian Captive Service Subsidiary in support of the position that the relationship between the parties is that of independent contractor rather than dependent agent. Such agreement will generally be reviewed by CRA in making a PE determination and may be useful in convincing CRA of the nature of the relationship if the provisions therein are consistent with the surrounding facts and circumstances and properly reflect Foreign Parent and Canadian Captive Service Subsidiary relationship under review.
Patrick Déziel, Toronto
Clifford Goldlist, Toronto
Exchangeable shares have long been used to effect tax-deferred share transactions involving Canadian resident vendors and foreign purchasers. Briefly, certain rollover provisions of the Act permitting tax-deferred share-for-share exchanges require that, where the shares being sold are shares of a Canadian corporation, the shares issued to a Canadian resident vendor must also be shares of a Canadian corporation.
To get around this limitation, the share-for-share exchange is generally structured in a manner such that Canadian resident vendors receive exchangeable shares of Canadian target (or other Canadian corporation owned directly or indirectly by foreign purchaser) in the course of a share sale to a foreign purchaser with the result that the taxation of any gain realized on the disposition of Canadian target shares is deferred until such shares are exchanged for shares of foreign purchaser. This type of planning provides a practical option where the consideration to be received by Canadian resident vendors on the sale of shares would include shares in the foreign purchaser. There are various possible structures involving the use of exchangeable shares, but the underlying principle is that the shares received by the Canadian resident vendor have an exchange right which entitles the holder thereof to exchange the shares of the Canadian target at some point in the future for shares of the foreign purchaser at a pre-determined ratio.
A typical structure involving exchangeable shares is as follows. The Canadian target will amend its articles to create a new class of exchangeable shares, as well as a new class of preferred shares. The exchangeable shares of Canadian target will generally be non-voting with a right of retraction at the option of the holder, subject to a call right by the foreign purchaser, which entitles the holder thereof to receive shares of foreign purchaser in exchange for shares of Canadian target. A number of voting rights of foreign purchaser equivalent to the number of issued and outstanding exchangeable shares of Canadian target are generally exercisable by a trustee for the benefit of all exchangeable Canadian resident vendors. The foreign purchaser receives one preferred share from the Canadian target in exchange for one common share of the foreign purchaser, and the Canadian shareholders then exchange their common shares of Canadian target for the exchangeable shares of Canadian target at negotiated ratios. Finally, the foreign purchaser exchanges its preferred share in the Canadian target for a common share of Canadian target.
Such structures have not historically been challenged by CRA, and indeed there have been suggestions in the Canadian federal budgets over the past decade that the rules governing tax-deferred share-for-share exchanges would eventually be extended to cross-border exchanges. Nonetheless, for the time being, exchangeable share transactions remain a valuable tool for effecting tax-deferred share purchase of Canadian targets by foreign purchasers.
In 10737 Newfoundland Ltd. v. R. (2011 D.T.C 1255) (“10737 Newfoundland”), the Tax Court of Canada recently addressed the issue of whether a Canadian resident taxpayer should be entitled to claim a capital loss realized on the exchange of Canadian target exchangeable shares for shares of foreign purchaser as a result of a subsequent decline in value. 3507271 Canada Inc. and 100935 Canada Inc. were Canadian resident shareholders of Newbridge Networks Corporation (“Newbridge”), which on February 23, 2000 entered into a merger agreement with Alcatel, a corporation resident in France. The merger was completed on May 25, 2000 pursuant to a court-approved plan of arrangement. Shareholders of Newbridge were given the option to receive either Alcatel American Depositary Shares (“Alcatel ADS”) or Newbridge exchangeable shares in consideration for their Newbridge common shares. The receipt of Alcatel ADS as consideration for Newbridge common shares was a taxable event for Canadian resident shareholders while the receipt of Newbridge exchangeable shares as consideration for Newbridge common shares was not a taxable event for such shareholders. The particular Canadian resident shareholders described above elected to receive Newbridge exchangeable shares.
The Newbridge exchangeable shares were intended to be economically equivalent to the Alcatel ADS, except that holders of Newbridge exchangeable shares were not entitled to attend or vote at meetings of Alcatel shareholders. The holders of Newbridge exchangeable shares were entitled at any time, subject to the exercise by Alcatel of its retraction call right, to require Newbridge to redeem their Newbridge exchangeable shares in exchange for Alcatel ADS.
Shortly after the merger became effective, 10737 Newfoundland Ltd. purchased the exchangeable shares from the two numbered companies mentioned above. More than two years later, after the Newbridge exchangeable shares had declined sharply in value, 10737 Newfoundland Ltd. exercised its retraction right to require Newbridge to redeem a portion of its Newbridge exchangeable shares in consideration for Alcatel ADS. 10737 Newfoundland Ltd. reported a significant capital loss on its disposition of the Newbridge exchangeable shares. The Minister of National Revenue (the “Minister”) reassessed 10737 Newfoundland Ltd. to disallow the capital loss on the basis of certain “stop-loss” rules under the Act.
The stop-loss rules in question are contained in subsections 40(3.3) and 40(3.4) of the Act and generally deem a capital loss realized on a disposition of property to be nil where all of the following conditions are met: (a) a corporation, trust or partnership (the “transferor”) disposes of a particular capital property (other than depreciable property of a prescribed class); (b) during the period that begins 30 days before and ends 30 days after such disposition, the transferor or a person affiliated with the transferor acquires a property (the “substituted property”); and (c) at the end of the period described in paragraph (b) the transferor or a person affiliated with the transferor owns the substituted property.
Finally, for the purposes of the aforementioned stop-loss rules, a right to acquire a property is deemed to be a property that is identical to the property itself pursuant to subsection 40(3.5) of the Act. Thus, the Minister reassessed 10737 Newfoundland Ltd. on the basis that the exchangeable shares were in effect merely a right to acquire Alcatel ADS, such that this right was deemed to be identical to the newly acquired Alcatel ADS with the result that no capital loss could be claimed until the eventual disposition of Alcatel ADS.
The Tax Court of Canada allowed the taxpayer’s appeal. Chief Justice Rip identified the question at issue as whether the property disposed of by 10737 Newfound Ltd. was properly identified as the Newbridge exchangeable shares themselves or as a right to acquire Alcatel ADS. Central to Chief Justice Rip’s decision was his determination that the exchange rights attached to the Newbridge exchangeable shares were part of the “bundle of rights” attached to the shares. Citing prior case law, the Court noted:
[…] a share should be looked at as a composite of different rights. By emphasizing the retraction right, the respondent arguably is proposing the existence of a distinct and separate property that the taxpayer did not own. The respondent is trying to parcel out piecemeal what suits its case. […] (at para. 39)
The appellant was a bona fide shareholder of Newbridge; it held Exchangeable Shares with all the rights and obligations attached to these shares. To say that the taxpayer disposed of "a right to acquire" Alcatel ADSs, ignoring that this right was attached to the Exchangeable Shares, would amount to a recharacterization of the legal relationship between the appellant as a shareholder of Newbridge and Newbridge itself. (at para. 42)
In essence, the Court held that particular rights attached to a share, in this case the right to exchange the Newbridge share, could not be separated from the overall bundle of rights attaching to the Newbridge share for the purposes of applying the above-noted stop-loss rules. The property disposed of by 10737 Newfoundland Ltd. was therefore Newbridge exchangeable shares which were different from the Alcatel ADS, and not merely rights to acquire Alcatel ADS which would have been deemed to be property identical to Alcatel ADS under the stop-loss rules. Thus, 10737 Newfoundland Ltd. was permitted to essentially crystallize the accrued capital loss in respect of its Newbridge exchangeable shares while retaining its interest in Alcatel ADS until such time as the Alcatel ADS are disposed of.
The decision in 10737 Newfoundland opens the door to the crystallization of capital losses where taxpayers have suffered a decrease in the fair market value of exchangeable shares received in similar transactions but wish to retain their economic interest in the foreign purchaser. One way of avoiding the application of the above-noted stop-loss rules would be for a taxpayer to wait 30 days after a particular disposition to reacquire identical property. Based on the findings in this decision, and subject to the application of the general anti-avoidance rule (“GAAR”) discussed below, it should not be necessary to resort to this more circuitous method to avoid the application of the stop-loss rules in the context of exchangeable shares.
It is noteworthy that the Crown did not raise GAAR in its argument against the crystallization of the capital loss. Taxpayers are left to speculate as to why GAAR was not raised at any stage in the proceeding, and whether in future cases GAAR may be invoked under similar circumstances involving loss crystallization where the taxpayer has arguably exchanged a right to acquire property for the property itself.
The circumstances in 10737 Newfoundland were unusual, in that they involved not only shares in a corporation which suffered a dramatic drop in value following an exchangeable share transaction, but also a shareholder who wished to retain the underlying shares of the foreign purchaser after crystallizing the capital loss in respect of the exchangeable shares. Nonetheless, the case is noteworthy for its support of the legal consequences of exchangeable share transactions in relation to their intended effect, as well as its more general implications for the interpretation of rights attaching to shares in a corporation and the application of the stop-loss rules. The Crown did not appeal the decision to the Federal Court of Appeal.
In the 2011 Federal Budget, the government announced its intention to review the rules regarding employee profit sharing plans ("EPSPs"). Further to this announcement, the Department of Finance issued a consultation paper on August 30, 2011 requesting feedback from stakeholders on the rules governing EPSPs.
In its consultation paper, the Department of Finance noted that the number of EPSPs has increased significantly between 2005 and 2009 mostly among small closely-held Canadian-controlled private corporations. According to the Department of Finance, there has been an increased proliferation of the use of EPSPs as a means for business owners to: (i) reduce their tax liability by splitting their income with family members; (ii) defer the payment of income tax; and (iii) avoid paying Employment Insurance premiums and Canada Pension Plan contributions.
The consultation paper is seeking feedback on the following four questions:
- Who should be allowed to participate as an employee (or beneficiary) in an EPSP? More specifically, should non?arm's length employees be able to participate in an EPSP?
- Should the so called "kiddie?tax" rules apply to allocations made from an EPSP to minor children?
- Should there be a limitation on the contributions an employer can make to an EPSP?
- Should the withholding requirements (including those relating to income taxes, Canada Pension Plan contributions and Employment Insurance premiums) with respect to salary paid to employees apply to allocations made from an EPSP to an employee (or beneficiary) of an EPSP?
It is quite evident from these questions that the Department of Finance is seriously looking to crack down on the use of an EPSP by small business owners as a means to income split, defer taxes and/or avoid paying Employment Insurance premiums and Canada Pension Plan contributions. The Department of Finance stated in the consultation paper that the intended purposes of EPSPs are to enable employers to share profits with employees, assist employees to save and better align the economic interests of management and labour. It appears that the Department of Finance is now looking at ways in which to curtail the current use of an EPSP such that future use of an EPSP will be more aligned with the intended purposes of these rules.
Given the fact that the Department of Finance is reviewing the rules with respect to EPSPs, it is important for employers who are considering implementing an EPSP to obtain legal and tax advice related thereto.
James A. Fraser, Toronto
Article XV(2) of the Canada-US Tax Treaty (the “Tax Treaty”) provides for an exemption from taxation of remuneration derived by an employee resident in a country (referred to herein as “residence state”) in respect of temporary employment exercised in the other country (referred to herein as the “source state”). Where certain conditions are met, such remuneration is exempt from taxation in the source state. Article XV(2) of the Tax Treaty was amended by the Fifth Protocol to provide for a change which appeared at first blush to be minor but is now causing unintended frustration for some employees temporarily working on the other side of the border.
Article XV(2) as amended by the Fifth Protocol provides that remuneration will be exempt from taxation in the source state if (i) the employee’s remuneration attributable to employment exercised in the source state does not exceed $10,000 in the currency of the source state; or (ii) the employee is present in the source state for a period or period not exceeding an aggregate of 183 days in any twelve-month period commencing or ending in the fiscal year concerned, and the remuneration is not paid by, or on behalf of a “person” who is a resident of the source state and is not borne by a permanent establishment in the source state. The minor change to Article XV(2) was to replace the word “employer” with the word “person”.
As the Technical Explanation to the Fifth Protocol explains, the minor change from “employer” to “person” was intended “only to clarify that both the United States and Canada understand that in certain abusive cases, substance over form principles may be applied to recharacterize an employment relationship.” According to CRA, this change is aimed at determining who is in fact exercising the functions of employer.
There has been recent indication that some Internal Revenue Service (“IRS”) auditors are taking a broad view of the implications of the change that goes beyond what was intended when the Fifth Protocol was negotiated. The result is that a change intended to clarify matters is now becoming a source of uncertainty. This is particularly relevant to intra-group services arrangements where Canadian employees are sent on a temporary basis to work in the United States.
This broad interpretation could catch arrangements where a Canadian parent sends a Canadian resident employee across the border on a temporary basis to assist a US subsidiary with its business operations. The Canadian resident employee maintains his or her employment with the Canadian parent and does not enter into a new or separate employment relationship with the US subsidiary with the result that the employee effectively engages in a contract of service while in the United States. The arrangement provides that the US subsidiary reimburses the Canadian parent in respect of the Canadian resident employee’s remuneration for services performed in the United States. Assuming the employee earns in excess of US$10,000, his or her presence in the US falls below the 183-day threshold and the Canadian parent does not have a permanent establishment in the US, Article XV(2) should apply straightforwardly and dispense with any US tax liability for the Canadian resident employee. However, the change in terminology leaves open the interpretation that the subsidiary was the “person” that bore the cost of the Canadian employee’s services exercised in the United States, thereby undermining the relief available to the employee under Article XV(2).
In practice, what this means is that Canadian employees working temporarily in the United States are being challenged on the availability of treaty relief, despite the fact that such challenge is inconsistent with the intention behind the change, the Technical Explanation and the expressed views of CRA. In order to assist their cross-border Canadian resident employees, Canadian employers should consider implementing cross-border arrangements with their US subsidiaries to properly document the purpose of the arrangement, where instructions are coming from and absence of any functions, benefits or risks being borne by the US subsidiary should the IRS come knocking on their employee’s door.
On August 26, 2011, Elections B.C. announced that British Columbians voted against the controversial Harmonized Sales Tax (“HST”). In a historic and binding mail-in referendum, approximately 1.6 million British Columbians representing 54.73% of the electorate voted to extinguish the HST. The former B.C. Provincial Sales Tax (“PST”) and Goods and Services Tax (“GST”) regimes will now be restored.
Finance Minister Kevin Falcon indicated it will take at least 18 months to transition back to the old PST and GST regimes. The Ministry of Finance has disclosed certain information regarding its action plan to ensure the timely and efficient transition back to the former PST and GST regimes. The 12% HST regime will remain in force during the period throughout which the mechanics of the transition are worked out. In general, the B.C. government plans to transition back to a system of separate tax regimes (7% PST and 5% GST). It intends to re-establish all of the previous exemptions to the PST and make administrative improvements to simplify the tax collection process.
Preparing for the PST
The B.C. Government’s action plan will involve, among other things, developing HST transitional rules at the federal and provincial level, drafting new PST legislation, and creating policies for the interpretation, administration and enforcement of the PST. The details of the new PST legislation and policies have not yet been released including when it will be levied, what exemptions will apply and how it will be collected.
It is useful to consider some of the previous exemptions from the PST in order to get a sense of what the new PST legislation may look like. If the B.C. government plans to restore the previous exemptions to the PST then businesses can identify those exemptions with a view to minimizing the tax cost of planned purchases. For example, the timing of certain sales transactions might be accelerated or delayed before the PST is restored, depending upon the circumstances.
PST Exemptions and Non-Taxable Services
Under the former PST regime, a number of specific goods and services were not taxable either because the goods were specifically exempted from the PST or because the services were considered non-taxable. These exempt goods and non-taxable services included:
- Food products for human consumption
- Prescribed drugs and medicines
- Children’s clothing and footwear
- Specified safety equipment
- Goods purchased for resale
- Haircuts, medical services and other personal services
- Services in respect of items that are exempt from tax
- Services in respect of software, such as installation, configuration, repair or restoration
- Services provided by way of diagnosis, test, safety inspection or estimate
- Services relating to real property including services to construct, adjust, repair, renovate, restore or maintain real property
This list provides some guidance on the type of goods or services that may be exempt or non-taxable under the new PST legislation.
While transitional rules have yet to be implemented, businesses should plan to deal with the positive and negative impacts of going back to the PST. For instance, one may consider whether or not to delay plans to hire contractors to perform renovations or to build new properties. The tax cost associated with these services may be lower when the PST is restored. Consumer spending in certain areas may be impacted. Consider, for example, restaurant meals, which were not subject to PST, but which are subject to HST. Of particular concern is the fact that businesses will have to plan and budget for the implementation of systems and processes to again account for PST.
The B.C. Business Council and other organizations have asked the B.C. government to focus its attention on the short-term impacts of the transition from the HST regime to PST and GST regimes. Some have voiced concerns regarding how the return to the PST will impact the competitiveness of B.C. businesses. At the present time, businesses should keep informed of developments and seek specific planning advice to take advantage of potential tax-savings opportunities.
David W. Chodikoff of our Toronto office co-chaired the 7th Basics of International Tax and Transfer Pricing Course for Federated Press on November 7 and 8, 2011 in Toronto. David also lectured on the topic of The Competent Authority and Dispute Resolution.
Wendi P. Crowe of our Edmonton office presented a Webinar on "Business Succession" for Merit Contractors Association on September 28, 2011. Wendi also conducted seminars on "Business Succession" for Merit Contractors Association in Edmonton and Calgary in November 2011.
William J. Fowlis of our Calgary office instructed courses for the Institute of Chartered Accountants of Alberta in Calgary entitled "Taxation of Family Trusts - Basic" on November 1, 2011 and "Taxation of Family Trusts - Advanced" on November 9, 2011 in Calgary. William also presented on "Tax Planning with respect to the Ownership of US Real Property by Canadians" to the Rotary Club of Calgary on November 8, 2011.
Bryant D. Frydberg of our Calgary office presented on various corporate tax matters at the Video Tax News Calgary Seminar on September 29, 2011.
Clifford Goldlist and James A. Fraser of our Toronto office presented at the Federated Press: 2nd Annual Tax Planning for the Sale of a Business Seminar hosted by Federated Press on November 21, 2011.
James Hutchinson of our Toronto office chaired the Tax Administration Panel at the 2011 Ontario Tax Conference on October 24-25, 2011.
James Rhodes of our Waterloo office presented on Subsection 163(1) ITA Penalties and Employee vs. Independent Contractor to the Association of Professional Accounting and Tax Consultants on October 22, 2011.
David W. Chodikoff of our Toronto office authored two articles for the September issue of it’s Personal, a Carswell publication: the first article focused on the distinction between a worker's status as either an employee or independent contractor and the second article concerns offshore tax crimes and the risks to Canadian taxpayers.
Wendi P. Crowe of our Edmonton office authored "Business Succession Planning - Where Do I Start" for Merit Contractors Association.
We are proud to announce the upcoming release of Miller Thomson on Estate Planning. The book provides comprehensive analysis of estate planning and administration issues from our team of experienced lawyers from across the firm. The Editor-in-Chief is Martin J. Rochwerg, Miller Thomson’s National Chair of the Private Client Services Group.
We are also proud to announce that David W. Chodikoff of our Toronto office is the Chair of the Executive of the Taxation Law Section of the Ontario Bar Association for 2011-2012.
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