CRA Guidance on Whether Canadian Captive Service Subsidiary Constitutes PE of Foreign Parent

December 19, 2011

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 ofidentification 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.

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