IFA Seminar, May 10, 2004

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CONTENTS

Competent Authority Services Division
International Tax Operations Division
Income Tax Rulings Directorate

Chair: Brian Schneiderman , Borden Ladner Gervais LLP
Panelists: Pierre Bourgeois, PricewaterhousCoopers LLP
Marcel Racicot, Hart Saint-Pierre
Bruce Messenger , Chief Economist, Competent Authority Services Division, International Tax Directorare
Mara Praulins , Director, International Tax Operations Division, International Tax Directorate
Jim Wilson , Manager, International Section, Income Tax Rulings Directorate

COMPETENT AUTHORITY SERVICES DIVISION
Bruce Messenger
Chief Economist, Competent Authority Services Division, International Tax Directorate

Question #1

What is the status of the consultative process with respect to Draft IC 71-17R5, Requests for Competent Authority Assistance under Canada ‘s Income Tax Conventions? – as a result of this process, could you indicate what revisions are being considered at this time.

Status

Primary reasons for update:

At this point we are still reviewing a number of our policies, such as:

Some policies have been finalized, these include:

Question #2

We understand that the Agency has developed another means of starting the process for an APA, the “First Step Meeting”. Could the Agency indicate what the nature of these meetings is and how can they best be used by taxpayers and their advisors

In February we announced a new APA service called “First Step”
The purpose of this service is to make the APA Program more accessible to prospective clients and to do so in an informal manner.
Stated simply, APA First Step makes myself, or a delegate, available by phone or videoconference to a prospective client to answer any question about the APA Program.

Prior to APA First Step, initial contact for a taxpayer with the APA Program was usually done through a Pre-Filing Meeting. However, our experience has been that most clients who come in for a pre-file meeting are usually committed to the process.

Therefore, we recognized the need to make ourselves available early in the process – such as when taxpayers and their advisors may be discussing the appropriate course of action when faced with an international audit.

APA First Step is free, can be done anonymously, and is non-committal. It is the ideal service for clients who are unsure about an APA and what advantages it can bring.
Phone number (613-941-7801) was noted on the slide.

Question #3

Many small and medium sized businesses (SMB) have similar issues to MNC’s with respect to transfer pricing. There is a perception that APA’s are not a viable alternative for a SMB. We understand that the Agency is looking to put in place a different process for SMB. Could the Agnecy outline the criteria for SMB APA’s, and the differences with the traditional APA process that it is considering?

First of all, let me dispel the notion that APAs are not viable for small and medium-sized businesses. Although the main users of this service have historically been large multinationals, we have had a significant number of small and mid-sized clients.

Having said this, we have nonetheless prepared a discussion paper of how to better address the needs of small business taxpayers. This paper was presented last year to the International Tax Advisory Committee. We also sought feedback from a number of individuals in public practice.

Although a formal program has yet to be launched (perhaps by the end of his fiscal year), this is the current thinking in terms of eligibility:

A couple of differences between this and the traditional APA process:

Question #4

In draft Information Circular, IC 71-17 R 5, Requests for Competent Authority Assistance under Canada Income Tax Conventions, paragraphs 4 to 7 deal with situations involving typical requests for assistance from the Canadian competent authority under the Mutual Agreement Procedure (MAP) article of Canadian tax conventions.

INTERNATIONAL TAX OPERATIONS DIVISION
Mara Praulins
Director, International Tax Operations Division, International Tax Directorate

Question #1

What is the relationship among the International Tax Operations Division, the Competent Authority Services Division and the tax services offices of the Canada Revenue Agency?

The International Tax Operations Division of the International Tax Directorate
provides expertise, guidance and advice to international audit staff and managers in field offices. For transfer pricing, the division:

· Develops transfer pricing specialists for specific industries and issues.

· Develops expertise and compliance strategies in complex international tax issues including foreign affiliates, foreign accrual property income, offshore trusts, financial instruments and tax haven related issues.

· Provides expert economic advice to field offices on complex transfer pricing cases.

Within the tax services offices, the Large File Case Manager normally uses resources from other specialized areas, including the International Audit Section, which consists of transfer pricing auditors and non-resident auditors to conduct their audits.

The Large File Case Manager develops an audit plan in advance of the audit. The International Auditor participates in the selection of the audit issues.

The Large File Case Manager then holds a pre-audit meeting with the corporation to discuss the audit plan. The International Auditor normally attends this meeting.

The International Auditor communicates his findings to the audit team for consideration. The International Auditor attends all meetings convened with the corporation to discuss any aspects relating to international issues. The International Auditor is an expert in his field.

The Competent Authority Services Division functions include participation in double taxation cases, exchanges of information, simultaneous audits and execution of miscellaneous special arrangements. The division also administers the Advance Pricing Arrangements service to multinationals.

Question #2

What is the status of proposed Communiqué on secret comparables? Under what circumstances will the Agency use such comparables?

The communiqué on use of secret comparables as a basis of reassessment is entitled Third-Party Information. The new communiqué was posted to CRA’s external website on April 2, 2004 . 

The CRA will continue to use confidential third-party information as an audit tool for screening purposes and for secondary support, i.e. so-called “sanity checks”. However, auditors should only use the information as a last resort to form the basis of any reassessment. Every effort will be made to develop an assessing position based on publicly available information. This will facilitate negotiations with the taxpayer as well as reduce the likelihood of double taxation.

Auditors who want to use third-party information as the basis of an assessment for transfer pricing must refer the file to the International Tax Operations Division before they send a proposal letter to the taxpayer.

The Field Advisory Services sections of the International Tax Operations Division will review the third-party information and evaluate the auditor’s effort to locate and use publicly available information. The International Tax Operations Division will either approve the use of third-party information or help develop an assessing position based on publicly available information.

Question #3

Provide an update on the number of cases and issues considered by the Transfer Pricing Review Committee. How many cases have been referred and what types of issues are being referred? Have penalties been applied to date?

To date four cases have been referred to the Transfer Pricing Review Committee. All of the cases dealt with the determination of “reasonable efforts”. The committee has recommended a penalty in one case.

Question #4

With respect to the procedure for contemporaneous documentation request, how many have been made and how many have taxpayers complied with? Recent requests cover the years under audit as well as subsequent years – is this the practice to request information with respect to years that are not under audit? What guidelines has the Agency developed with respect to the taxpayer have made a reasonable effort?

Question #5

We understand that tax services offices are being directed to impose penalties when taxpayers do not complete T106s correctly. Do such penalties apply with respect to clerical errors or does the taxpayer have to have intentionally omitted information or answered incorrectly?

The penalty under subsection 163(2.4) of the Income Tax Act applies to a person or partnership who knowingly or under circumstances amounting to gross negligence makes false statements or omissions in an information return, including the T106 Information Return of Non-Arm’s Length Transactions with Non-Residents. The penalty is $24,000.

The penalty under subsection 163(2.4) requires that the taxpayer made a false statement or omission knowingly or under circumstances amounting to gross negligence. It is not sufficient for the Agency to demonstrate only that non-compliance occurred. The Agency must also establish a set of facts which demonstrates that the taxpayer knew or ought to have known of the false statement or omission and that it was not the result of a simple misunderstanding of the law or clerical error. 

Question #6

What can the Agency tell us about its current position with respect to section 231.6 requests for information?

The International Tax Directorate has recommended that requirements should be used to obtain requested documentation not provided by the taxpayer where the auditor believes the taxpayer has or ought to have such documentation.

Section 231.6 came into effect in 1988. This provision was implemented as a result of difficulties encountered when information in the possession and control of non-residents was not voluntarily provided by the Canadian taxpayer and was not obtainable by the Agency.

The section requires that foreign-based information or documentation, which may be relevant to the administration or enforcement of the Act, be provided to the Canada Revenue Agency.

Therefore, the CRA is using the tools available to it, to gather the information in a timely manner, and hopefully facilitate a more timely completion of audits.

INCOME TAX RULINGS DIRECTORATE
Jim Wilson
Manager, International Section, Income Tax Rulings Directorate

Question #1 Tower Structure

We understand that the Agency has recently considered some issues with respect to a tower structure in which a partnership had a debt owing to non-residents that did not qualify for the subparagraph 212(1)(b)(vii) exception. Could the Agency explain the situation it considered and the position that it developed?

In a recent advance income tax ruling request, the Canada Revenue Agency (the “CRA”) was asked to rule that Part XIII tax was not exigible on certain interest payments made by a partnership. The general fact scenario is as follows:

Two taxable Canadian corporations formed a partnership (the “Partnership”) in the U.S. The Partnership borrowed money (the “Loan”) from a U.S. financial institution and used the borrowed money to acquire an interest in a U.S. limited liability company (“LLC”). LLC used the funds to make a loan to a related U.S. operating company. LLC was a disregarded entity for U.S. tax purposes while the Partnership checked the box to be treated as a corporation for U.S. tax purposes. The Partnership, in accordance with the partnership agreement, elected not to be a separate legal person under the law of the jurisdiction in which the Partnership was formed. The terms and conditions of the Loan were such that the interest on the Loan was not exempt from Part XIII tax pursuant to subparagraph 212(1)(b)(vii) of the Income Tax Act (the “Act”).

The CRA concluded that provided that the Partnership did not earn any income from sources in Canada , paragraph 212(13.1)(a) of the Act would not apply to deem the Partnership to be a person resident in Canada . However, this did not mean that withholding taxes under Part XIII of the Act would not be exigible in respect of the interest paid by the Partnership on the Loan to the U.S. financial institution.

Based on the facts of the situation described in the ruling request, taking into consideration the foreign law under which the Partnership was formed, the provisions of the partnership agreement and the terms and conditions of the loan agreement between the Partnership and the U.S. lender, the CRA came to the conclusion that the partners of the Partnership were considered to be the payers of the interest on the Loan. In other words, depending on the facts of a particular situation, one can look through a partnership to the partners as the persons who legally owe the debts of the partnership and pay the interest on such debts. In other scenarios with different facts, the facts and circumstances of each particular case have to be examined to determine whether Part XIII tax is exigible and if it is, whether such tax is exempt under the provisions of the applicable Canadian tax convention.

Furthermore, where the facts of a particular situation support a look-through approach so that a Canadian resident partner is considered to have paid the interest, the first sentence of paragraph 6 of Article XI of the Canada-United States Income Tax Convention applies so that such interest is deemed to arise in Canada for purposes of Article XI. Generally, under these circumstances, the CRA is of the view that the second sentence of paragraph 6 of Article XI would not apply to re-source such interest to the U.S. unless the CRA is convinced that (i) investing in the interest in a wholly-owned subsidiary (i.e., LLC in this case) of the Partnership constitutes a business carried on by the Partnership through a permanent establishment in the U.S. (which is not normally the case where the Partnership is merely holding shares or interests in a wholly-owned subsidiary), (ii) the Loan was incurred in connection with such permanent establishment, and (iii) the interest paid on the Loan was borne by such permanent establishment. All these are fact-related issues that need to be examined on a case-by-case basis.

Question #2 Partnerships and Tax Treaties

In a recent technical interpretation, the Agency noted that its position with respect to partnerships and treaties was not consistent with recent pronouncements of the OECD (2003-00390515). Could the Agency outline the nature of its concerns with respect to partnerships and treaties?

The issue that we are revisiting with respect to partnerships and treaties is whether Canada should continue to give treaty benefits to partners resident in a treaty country (for purposes of the applicable treaty), where the partnership is formed in Canada and is transparent for Canadian tax purposes, but is considered to be a foreign corporation for purposes of the treaty country’s tax system and the partners are not actually taxable on the partnership income in the treaty country. The typical situation involves a partnership established in Canada by two U.S. companies who have elected to have the partnership treated as a foreign corporation for purposes of the Internal Revenue Code. We note that our current position, that the partners are entitled to treaty benefits in this situation, continues to apply on a “business-as-usual” basis. Also, we are not revisiting our general position that treaty benefits flow through to partners where both Canada and the other country view the partnership as a transparent vehicle.

Paragraph 6.2 was added to the OECD Commentary on Article 1 in 2000. It was part of a set of additions to the Commentary arising from a lengthy report on partnership and treaty issues put together by the OECD. Applied to transactions involving Canada as a source state, this paragraph provides that partners of a partnership set up in Canada cannot claim the benefits of a tax treaty between the partners’ state of residence and Canada if the partnership is a non-transparent entity for purposes of the tax laws of the partners’ state of residence. In other words, treaty benefits are denied if the partnership is treated as a foreign corporation for tax purposes in the other state such that the partners are not taxable on the partnership income in the other state at the same time that they are taxable on such income in Canada . The Agency’s current position as described above is clearly contrary to this part of the OECD Commentary.

The Agency has three general concerns with maintaining the current position. The first is that maintaining the position may be inconsistent with Agency practice in other areas; the Agency has followed or relied on OECD Commentary with respect to treaty interpretation for a number of other issues. While the weight to be given to Commentary on any particular subject will always depend in part on the overall Canadian tax context, the Agency should be consistent to the greatest extent possible on how Commentary is used in establishing interpretative positions. The second concern is with Canadian tax policy. Canada has not entered an Observation with respect to the particular OECD Commentary in question, which may indicate that Canada agrees with the OECD that treaty benefits should not be given to partners of a partnership where the partnership is treated as a transparent entity in the source state and as a separate legal entity by the partner’s state of residence. Our third concern is that Canadian courts are taking notice of and applying OECD Commentary in a growing number of situations. At the same time, we recognize that the weight to be given to OECD Commentary remains in issue, especially where the Commentary in question has been adopted after Canada has entered into the relevant tax treaty. However, the Introduction to the OECD Commentary states that new Commentary should be taken into account when interpreting an existing tax treaty as long as the new Commentary is merely clarifying in nature. It is our understanding that new paragraphs 2-6 and 6.1 et seq. of the Article 1 Commentary are intended to be merely clarifying in nature, that is, these new comments were simply intended to say explicitly what had been understood implicitly before.

In summary, we are revisiting the issue of whether a partner resident in a treaty country should receive the benefits of a tax treaty between Canada and that treaty country where the partner is not liable for tax on the particular income in the treaty country because the partnership is treated as a separate taxable entity by that country. Our review will focus specifically on this issue and not on general partnership issues. Our main concern is that our current position is directly contrary to specific, applicable OECD Commentary on which Canada has not entered an Observation. The results of our review will be announced in a future Income Tax Technical News. Comments on this matter should be forwarded to Eliza Erskine of the Income Tax Rulings Directorate by email at Eliza.Erskine@ccra-adrc.gc.ca or by phone at (613) 952-1361. Written comments on this particular issue are appreciated, however, inquiries not directly connected to this issue will be dealt with as ordinary technical interpretation requests.

Question #3 Partnerships and Treaty Rate for Dividends

The Agency has taken the view in the past that dividends paid to a partnership do not benefit from the lower withholding rate under a treaty as the shares are owned by the partnership and not the partners. In a recent ruling ( 2003-0032923), the situation involved shares of a Canadian corporation that were held by a partnership governed under the Delaware Revised Uniform Partnership Act. In this ruling, the corporate partners subscribed for preferred shares giving them the requisite 10% ownership to benefit from the 5% withholding rate under the Canada-US Income Tax Convention. The Agency also ruled favourably with respect to the application of the General Anti-Avoidance Rule. Could the Agency indicate that it would rule favourably in situations where the partners are resident for treaty purposes and whose economic interest via the partnership represents at least 10% ownership?

It has been a longstanding position of the CRA that a partner does not own a specific percentage of the shares of a corporation held by the partnership (see Question 1 of the 1991 CTF Revenue Canada Round Table). In Ruling 2003-0032923, this position was avoided where the corporation issued sufficient voting preferred shares directly to each partner in order to comply with the formal requirement in the Canada-U.S. Convention, Article 10, paragraph 2(a), that the beneficial owner of the dividend must own at least 10% of the voting stock of the corporation paying the dividend. We also ruled that the General Anti-Avoidance Rule (“GAAR”) did not apply to the issuance of the preferred shares in this case. However, we make such GAAR determinations only on a case-by-case basis.

The CRA is prepared to revisit the position but it may be difficult to overturn because the issue is directly relevant to certain provisions in the Income Tax Act. The CRA will publish its views in reference to this matter along with details of its findings in connection with the issues raised in Questions 2 and 5 of the IFA Roundtable in an Income Tax Technical News article when our review is complete. In the meantime, our current position that the corporate partners are not entitled to the lower withholding rate under a treaty continues to apply.

Question #4 Denomination of Foreign Affiliate Surplus Accounts

Recently a number of countries have amended their tax legislation to allow taxpayers to choose a functional currency for tax return purposes that differs from the local currency. This is the case notably in Australia and the Netherlands . Assume that in the past, the surplus accounts of a foreign affiliate (FA) resident and carrying on business in Australia were kept in Australian dollars and that the FA decides to use the US Dollar as its functional currency for financial statement and tax return purposes. From an economic and policy perspective, keeping the surplus accounts in US dollars would be appropriate on a go-forward basis. Applying such an approach is not fundamentally different from the one that was used for European companies which moved from their respective legacy currencies to the Euro. Due to the requirement in Regulation 5907(6) that consistency be maintained, it is not clear that the functional currency of FA can be changed from the Australian dollar to the US dollar.

Where the business of FA is transacted in a foreign currency other than the currency of the country in which FA is resident and in which the business is carried on, and such foreign currency is used by FA for financial statement and tax return purposes in that foreign country, it would in our view be reasonable in those circumstances that FA’s surplus accounts be maintained in that same foreign currency. Therefore, provided that the adoption of the new foreign currency for financial statement and tax return purposes is carried out when such option first becomes available under the foreign tax law, the CRA would generally consider a conversion of FA’s surplus accounts to the new foreign currency to be in compliance with Regulation 5907(6). Conversions carried out at another time would be considered on a case-by-case basis.

Question #5 Section 93.1

Absent the provisions of section 93.1, where a Canadian partnership owns all the shares of a non-resident corporation, such corporation could not qualify as a foreign affiliate of the partners of the partnership. Section 93.1 was introduced into the Act in order to deal with partnerships in foreign affiliate structures and change this result by deeming shares owned by a partnership to be owned by corporate partners in proportion to the fair market value of such partners’ respective interests in the partnership. However, subsection 93.1 applies only “for the purpose of determining whether a non-resident corporation is a foreign affiliate of a corporation resident in Canada for the purposes of …sections 93 and 113…(and any regulations made for the purposes of those provisions), section 95 (to the extent that that section is applied for the purposes of those provisions)…”.

Where a Canadian partnership with Canadian resident corporate partners acquires all the shares in a non-resident corporation during a taxation year of that corporation and such non-resident corporation has income from property described in subparagraphs 95(2)(a)(i) to (iv), will section 93.1 apply for the purposes of subsection 95(2.2) and paragraph 95(2)(a) to create the result that the throughout the taxation year test is met with respect to the related and qualifying interest tests in the year that the foreign corporation becomes a foreign affiliate of the partners of the Canadian partnership for the purposes described in 93.1? Please consider the question in the context of the following example.

We are of the view that in the above circumstances the result of the non-application of subsection 95(2.2) for the purposes described in subsection 93.1(1) would be anomalous. However more time is required to complete our review. The CRA will publish its views in reference to this matter along with details of its findings in connection with the issues raised in Questions 2 and 3 of the IFA Roundtable in an Income Tax Technical News Article when our review is complete.