11 January 2001 Internal T.I. 2000-0001017 - Sourcing of income & foreign tax credit

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Determination of profits allocable to a Japanese branch of a Canadian

corporation for the purposes of the foreign tax credit calculation.

Position: Profits should be allocated between jurisdictions in a manner that reflects the contribution of the activities in each jurisdiction that gave rise to those profits.

Reasons: 1) jurisprudence
2) sourcing rules in Act
3) intent of foreign tax credit regime

		January 11, 2001

XXXXXXXXXX  Tax Services Office	International Section
J. Stalker
Attention:  XXXXXXXXXX 	957-2118
		Large File Case Manager
	2000-000101

XXXXXXXXXX Sourcing of Income and Foreign Tax Credit Calculation

We are writing in response to your memorandum dated December 30, 1999 concerning the computation of the profits earned by the Japanese branch of XXXXXXXXXX for Canadian tax purposes for the years XXXXXXXXXX. You also forwarded a letter from XXXXXXXXXX on this matter.

Facts

Our understanding of the facts is as follows:

1.

XXXXXXXXXX

2. XXXXXXXXXX.

3. For Japanese tax purposes, XXXXXXXXXX computed its income from carrying on business in Japan in accordance with the provisions of Article 7 of the Canada-Japan Income Tax Convention (the "Convention"). Paragraph 2 of Article 7 of the Convention requires that, "there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment." Accordingly, the computation of profits involved an adjustment to cost of sales in order to obtain a theoretical transfer price which took into account the relative contribution to profit from the functions performed in both Canada and Japan. The income reported for Japanese income tax purposes was the accounting profit reported in XXXXXXXXXX books.

4. For purposes of calculating the business foreign tax credit ("FTC") under subsection 126(2) of the Income Tax Act (Canada) (the "Act"), XXXXXXXXXX computed the profit earned on the sale of Canadian source XXXXXXXXXX in Japan by sourcing to Japan gross sales revenues in Japan from the Canadian source XXXXXXXXXX and related cost of goods sold, along with related selling and administrative expenses. As a result, for FTC purposes more income was sourced to the Japanese permanent establishment than was reported in Japan as directed by the Convention. The result was a foreign tax credit that exceeded the Canadian tax on income as reported for Japanese tax purposes.

Issue

The issue is the appropriate determination of the profits allocable to the Japanese branch for the purposes of the FTC determination in subsection 126(2) of the Act.

Our views

We agree with you that XXXXXXXXXX has computed its Japanese source income for FTC purposes incorrectly. That income should not reflect profits derived by the manufacturing and processing activities, which are Canadian source as established by case law, and Canada should not be giving an FTC on Canadian source income. Instead, only the profits attributable to business activities in Japan should be included in the numerator of the calculation in subsection 126(2.1) of the Act.

Our analysis below repeats many of the points which you made in your submission; however, we repeat them here for completeness.

Cudd Pressure

We agree that the case Cudd Pressure Control Inc. v. The Queen 1998 DTC 6630 (FCA) can be distinguished from the case at hand. (We also note that although XXXXXXXXXX insists that the treaty interpretation of allocation of income for permanent establishment purposes is not relevant to the case at hand, their argument for their method of income allocation is based on this case which is in fact dealing with the allocation of income to a PE for treaty purposes.) In that case the deduction of leasing costs was fictitious. We agree that notional expenses are not deductible under Canadian tax law. Furthermore, we note that any recognition of notional rent in the Cudd Pressure case would have resulted in a reallocation of income earned in Canada to outside Canada by the amount of such recognition.

The Cudd Pressure situation can be distinguished from the case at hand or any situation involving transfer pricing where certain income earning activities relating to a Canadian contract take place both inside and outside Canada, i.e. where a product is manufactured in Canada and then transferred to a foreign branch for distribution. In such a case it is appropriate to transfer the goods to the branch at fair market value as this will result in the quantum of income taxed in the foreign branch to be consistent with the value of the functions performed in the branch. The result is simply an allocation of net income to the country in which it is earned.

In XXXXXXXXXX situation, the use of a so-called notional cost of goods sold by the Japanese branch is just a reasonable method, as recommended by the OECD Model Convention, to allocate profits between jurisdictions. In order to determine the contribution to the profit by the production and processing activities carried out in Canada, one should estimate the profit that would have been earned from those activities by an arm's length person. Although the profit element is built into a notional cost of goods sold from the perspective of the Japanese branch, from the perspective of the Canadian branch the same amount is very real profits earned by their activities. This is not "notional" profit, but a reasonable allocation of recognized profit for the whole enterprise between the activities in Canada that gave rise to that and the activities in Japan that gave rise to that profit.

Instead of determining the profit allocation for Japan using fair market value of the Canadian source XXXXXXXXXX, the Japanese profit could arguably be allocated based on a "notional" arm's length sales commission to the Japanese branch.

Imperial Oil

We agree with you that the Imperial Oil case does not assist the taxpayer's arguments (MNR v. Imperial Oil Limited (SCC) 60 DTC 1219). The issue XXXXXXXXXX refers to is that the Supreme Court said the base for the purpose of the depletion allowance should not include unrealized profit. The profit could only be recognized when the product was sold. We agree.

In the case at hand, unrealized profit is not an issue. Instead, we are dealing with realized profit from XXXXXXXXXX that has been sold in Japan. The profit that the manufacturing division in Canada earned would be unrealized for Canadian tax purposes until the Canadian source XXXXXXXXXX was sold in Japan. After that sale we are dealing with recognized profit of one legal entity which must be allocated between the two sources, Japan and Canada, for FTC purposes. Although the cost of goods sold for Japanese tax purposes would reflect the prevailing market price at the time of shipment from Canada, we are dealing with recognized profits after the time of sale.

Cases dealing with allocation

We agree with you that International Harvester Company of Canada Ltd. v. Provincial Tax Commission of Saskatchewan, [1949] A.C. 36 and Provincial Treasurer of Manitoba v. William Wrigley Jr., Company Limited [1950] A.C. are on point in the XXXXXXXXXX situation. In both cases, the Privy Council considered the allocation of income of a company between its manufacturing and sales functions which were located in different jurisdictions. We do not understand why the taxpayer's representative rejects their applicability based on MNR v. Spruce Falls Power and Per company Limited, 53 DTC 1215 (SCC). In Spruce Falls, Rand, J. dismissed the rule of apportionment followed in International Harvester and Wrigley (and also approved in Commissioner of Taxation v. Kirk, (1900) A.C. 588, as the judge notes), not because those cases would not be relevant to apportionment for federal tax or any other territorial apportionment, but because apportionment is not the issue in Spruce Falls, so that those cases are irrelevant to Spruce Falls: "What he asks is that the plain language of the clause be complicated by the application of a rule designed for an entirely different purpose."

To underscore the application of International Harvester and Wrigley to cases of allocation between territories, we cite the following discussion from the CCH commentary at paragraph 17, 124 (discussing subsection 115(1):

Where a non-resident person extracts, manufactures or otherwise processes or produces goods in another country and sells those goods in Canada, it will be necessary to apportion the profits as between Canada and the other country. The same thing will be true if the goods are produced or manufactured in Canada and sold in the other country. The necessity of apportionment in these circumstances was established by the decisions in C. of T. v. Kirk, [1900] A.C. 588; International Harvester Company of Canada, Limited v. Provincial Tax Commission, [1949] A.C. 36; and Provincial Treasurer of Manitoba v. William Wrigley Jr. Company Limited, [1950] A.C. 1. In the Kirk case, a company extracted ore from the soil and converted the ore into a merchantable product in New South Wales. It then transported the product to Victoria and sold it there. It was held that in order to determine the income derived from a source in New South Wales it was necessary to apportion the company's profits between the two states. In delivering the judgment of the Privy Council, Lord Davey made the following statements at pages 592-3:

Their Lordships attach no special meaning to the word "derived", which they treat as synonymous with arising or accruing. It appears to their Lordships that there are four processes in the earning or production of this income (1.1) the extraction of the ore from the soil; (2.) the conversion of the crude ore into a merchantable product, which is a manufacturing process; (3.) the sale of the merchantable product; (4.) the receipt of the moneys arising from the sale. All these processes are necessary stages which terminate in money, and the income is the money resulting less the expenses attendant on all the states...

The fallacy of the judgement of the Supreme Court in this and in Tindal's case ... is in leaving out of sight the initial stages, and fastening their attention exclusively on the final stage in the production of the income.

In the International Harvester case a company which manufactured farm machinery in Ontario sold this machinery throughout Canada, some of the sales being in Saskatchewan. The Saskatchewan Commissioner of Income Tax determined that the company's net profit or gain arising from its business in Saskatchewan was the proportion of its total net income which gross sales in Saskatchewan bore to its total gross sales. In the Wrigley case, the company manufactured chewing gum in Ontario and sold it throughout Canada, including the Province of Manitoba. The Provincial Treasurer of Manitoba, in assessing the company, used the same formula as that which had been employed by the Saskatchewan Commissioner of Taxes in the International Harvester case. In both cases these assessments were appealed and the Privy Council decided that the formula adopted by the provincial authorities was not correct. In each case it was held that the profits attributable to sales in the province imposing the tax must be apportioned as between the manufacturing operations and the selling operation.

Place of contract

We disagree with the representative's statement in their September 20, 1999 letter that "the place of contract is the primary determinant of where business is carried on." As stated in IT-270R2, which is based on the jurisprudence to the date of its issuance:

26. A determination of the place where a particular business (or a part thereof) is carried on necessarily depends upon consideration of all the relevant facts, but has been stated in general terms to be the place where the operations in substance take place. In determining where a particular type of business is carried on, the Department usually relies on the following guidelines:....

(b) Merchandise trading - the place where the sales are habitually completed, but other factors such as the location of the stock, the place of payment or manufacture may be considered relevant in particular situations;...

This principle was also stated in the article by Richard G. Tremblay "Foreign Tax Credit Planning" in the 1993 CMTC at page 3:15, "The place of manufacture, processing, or packaging of goods may be found to be the source of income despite the fact that the taxpayer may also carry on business in another place where the contract is made. [Belfour v. Mace (1928), 13TC 539 (CA)]

Under Common Law principles, a business is generally considered to be carried on in the place where the operations from which the profits arise are located. The weight given to any particular factor to determine this place depends on the nature of the business. One factor is the place of manufacture or production. Another factor which is indicative of the location of a business is the place where the business' profit-producing contracts are made (based on old case law such as Grainger V. Bough (Surveyor of Taxes) (1896) A.C. 325(H.L.) and Firestone Tyre v. Lewellin (HM Inspector of Taxes) (1957), 37 TC 111)). For example, in Twentieth Century Fox Film Corporation 85 DTC 5513 (FCTD), the court did not put much weight on where the contracts were made. At page 5518, Addy, J. states (emphasis added):

The plaintiff produces films in the United States and, in order to do so, incurs all the related production costs for the express object and purposes of renting prints of the films to various outlets such as TV stations and cinemas. Its film distribution activities and the advertising activities and public relations promotions connected with them are the equivalent of the sales and the sales promotion activities of a manufacturer who produces goods for sale. The distribution of the product results in the generation of income and profits which of course is the ultimate goal of the entire undertaking. The revenue producing activities of the plaintiff's Canadian branch were substantially the same as the revenue producing activities which the four US Divisions the plaintiff carried out South of the border. Therefore, this is not the case of a US firm being engaged in business dealings in Canada, promoted, controlled and carried out entirely from the United States without a branch or organization in Canada. On the contrary, the Canadian business was promoted and carried on by and through the plaintiff's Canadian branch, although the company's US head office reserved the ultimate right to sign or approve distribution contracts and was in almost daily communication with its Canadian manager.

The court concluded that the branch was carrying on business in Canada.

Other jurisprudence that supports the principle that a business is generally considered to be carried on in the place where the operations from which the profits arise are located and not necessarily where the sales contracts are made include:

(a) F.L.Smidth & Co. v. F. Greenwood (1922), 8 TC 193 (HL) at page 203-4:

"There are indications in the case cited [Grainger v. Gough] and other cases that it is sufficient to consider only where it is that the sale contracts are made which result in a profit. It is obviously a very important element in the enquiry... But I am not prepared to hold that this test is decisive. I can imagine cases where the contract of re-sale is made abroad, and yet the manufacture of the goods, some negotiation of the terms, and complete execution of the contract take place here under such circumstances that the trade was in truth exercised here. I think that the question is, where do the operations take place from which the profits in substance arise?

(b) Firestone Tyre & Rubber Co., Ltd. V. Lewellin (HM Inspector of Taxes) (1957, 37 TC 111, at 142, "It follows then that the place of sale will not be the determining factor if there are other circumstances present that outweigh its importance or unless there are no other circumstances that can."

(c) Cutlers Guild Ltd. V. The Queen 81 DTC 5093(FCTD) at page 5095, "While income may be realized through sales, it may not arise entirely form that one activity or operation.

(d) See also The Queen v. Gurd's Products Company Limited 85 DTC 5314 (FCA), and In re Proctor and Gamble [1935-37] CTC 334 (Sask. KB).

This principle was discussed in an article by Dr. Jinyan Li, "Rethinking Canada's Source Rules in the Age of Electronic Commerce in the 1999 Canadian Tax Journal Vol. 47, no.5 at page 1077, which the taxpayer's representative asked that you forward to us. At page 1095, Dr. Li states:

The first test, the place where a contract is made, is often considered an important factor in determining the situs of a business, especially the trading of goods. English cases have held that "if the contracts are concluded in this country, that fact alone will be sufficient to constitute an exercise of trade here." The same rationale has been accepted by Canadian courts. However, the place where sales contracts are made is not always conclusive because it is easily manipulated and there are many factors that contribute to the profit-making process. Accordingly, the courts have frequently turned to the second test, which looks at a combination of factors such as the purchase of materials, the manufacture or production of goods, the location of inventory, the solicitation of orders, delivery and payment) to determine the place of operations from which the profits arise and hence the situs of business.

XXXXXXXXXX business is not just selling; it is also in the business of manufacturing the goods that are being sold. In this case the profits come both from the manufacturing process and the selling process and should be allocated accordingly to the locations where those activities take place.

The allocation on this basis where businesses are carried on partly in one place (Canada) and partly in another place (Japan) is consistent with the sourcing rules provided in paragraph 4(1)(b) of the Act. For greater certainty, subsection 4(3) of the Act clarifies that paragraph 4(1)(b) applies for the purposes of section 126 of the Act.

Reasonableness of method of allocation

XXXXXXXXXX contends that its approach to determining income is more reasonable that the CCRA's approach. However, it used the CCRA's approach both in determining its profits for the purposes of the Convention and for accounting purposes.

As stated in Canderel Limited 98 DTC 6100 (SCC) , at page 6110, which the representative quotes, "In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year." The court also quoted with approval the principle in West Kootenay Power and Light Co. v. the Queen 92 DTC 6023(at page 6028), "The approved principle is that whichever method presents the "truer picture of a taxpayer's revenue, which more fairly and accurately portrays income,..."

We believe that the OECD method is more reasonable and note that Canada has consented to the Commentary to Article 7 of the OECD Model Convention indicating its approval. The Commentary on paragraph 2 of Article 7 of the OECD Commentary states:

11. ... The paragraph incorporates the view, which is generally contained in bilateral conventions, that the profits to be attributed to a permanent establishment are those which that permanent establishment would have made if, instead of dealing with its head office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the "arm's length principle" discussed in the Commentary on Article 9. Normally, the profits so determined would be the same profits that one would expect to be determined by the ordinary processes of good business accountancy.

In addition, we refer to Toronto College Park 1998 2 CTC 78 (SCC) at page 85 (in which Iacobucci, J. cites the same principles from Canderel for profit computation that the taxpayer's representative has). The court states that the key is what method yields the more accurate picture of income (at page 86):

With respect, the accuracy of the income picture is the only issue to be considered, once it has been established that the method used by the taxpayer to arrive at this picture is consistent with the provisions of the Act, with the judicial interpretation thereof, and with the well-accepted business principles, including but not limited to G.A.A.P., which are found to be applicable in the particular case. While accounting evidence is not determinative of the legal question of profit, it is certainly relevant and may in many cases be highly persuasive.

Accordingly, we disagree that the taxpayer's method of income allocation for FTC purposes is the most accurate and indeed that it is reasonable at all. XXXXXXXXXX method was to source 100% of the profit on the Canadian source XXXXXXXXXX to Japan for FTC purposes. Instead, in our view, the method XXXXXXXXXX used both for treaty purposes and for accounting is the most accurate, is supported by the jurisprudence as discussed above and is consistent with the sourcing rules in the Act. Under that method a portion of the profit reflecting the business activities which resulted in that profit is sourced to the manufacturing activities in Canada.

No double taxation

Contrary to the statement made by the taxpayer's representative, there is no double taxation under the method proposed by you. Instead XXXXXXXXXX will simply pay the higher Japanese tax rate on the branch income with a credit only provided for the Canadian rate. This differential tax paid to Japan is not double taxation, but simply reflects Japan's higher tax rate. The carryforward mechanism for foreign taxes paid in excess of the foreign tax credit available addresses exactly this situation (among others).

In fact, if we were to allow XXXXXXXXXX calculation we would be giving Canadian tax credits against Canadian tax on Canadian source income. It is clearly unwarranted for Canada to give a credit in respect of income which was not taxed by Japan in the first place.

Intent of foreign tax credit

Paragraph 1 of Article 7 of the Convention states that XXXXXXXXXX profits are only taxable in Canada except that Japan may tax profits which are attributable to the permanent establishment in Japan. If Canada allows XXXXXXXXXX to use a different, larger Japanese profit base for the purposes of the FTC, then Canada will be granting a credit and effectively not taxing on some profits that are Canadian source. This approach does not recognize the commercial and economic realities of the situation and reduces the intent of the foreign tax credit provision to the absurd. Clearly, Canada wishes to retain its right to tax Canadian source profits.

In addition, the foreign tax credit regime of the Act (and our treaties) is intended to provide full or partial relief from double taxation on income that Canada and another country are taxing. In this case, Japan is not taxing the amount in question so the whole intent behind the foreign tax credit would be contradicted if we were to accept XXXXXXXXXX position.

Amendments to subsections 126(2) and 126(7)

The Notes to the February 1998 Budget on the definition "tax-exempt income" in subsection 126(7) state (emphasis added):

Generally speaking, under current rules a resident taxpayer is entitled to deduct from the taxpayer's Canadian tax the amount of foreign income tax paid in a country to the extent the foreign tax does not exceed that proportion of the taxpayer's Canadian tax otherwise payable that the taxpayer's income in that country bears to the taxpayer's total income. This formula reflects the notion that the FTC should only be available to reduce Canadian tax that is attributable to the foreign income. Given the effect of tax treaties, however, this formula in some cases applies too broadly.

Income of a Canadian resident from a source in a foreign country is sometimes made exempt from tax in that country by the terms of a tax treaty between Canada and that country. Under the current FTC formula, Canadian tax on the exempt foreign income is available for reduction by the credit even though no foreign tax is payable with respect to that income. To correct this anomaly, the budget proposes to amend the FTC limit so that such treaty-protected foreign income is excluded from foreign income in determining the ratio of income from that country to total income. Treaty-protected foreign income will continue to enter into the formula, however, if it is subject to an income or profits tax to which the treaty does not apply (such as a tax imposed by the government of a political subdivision of the foreign country).

We have stressed in the above quote that the amendments are addressed at tax-exempt foreign income. The income earned as a result of the manufacturing process of the Canadian source XXXXXXXXXX is not foreign income, but Canadian income. Accordingly, we disagree with the taxpayer's representative when he states that "tax-exempt income" as defined in subsection 126(7) "would exclude the portion of XXXXXXXXXX income from carrying on business in Japan which, because of the method of determination of income prescribed in Article VII of the Canada-Japan treaty, is exempt from tax in Japan." This is equivalent to saying that all of XXXXXXXXXX income outside the branch income is exempt from tax in Japan, which is patently not the intent of the definition of tax-exempt income. This income is not exempt from tax in Japan for the purposes of that definition; it is not in Japanese source income at all.

You have also asked for guidance on the application of the new amendments.

We confirm that your example illustrates the type of situation which the amendments were intended to address and adapt it in the following example. Consider a Canadian resident who earns income form two types of business carried on in a foreign country which has a tax treaty with Canada. Income from one of these businesses ("EI") is exempt from foreign tax under the tax treaty (e.g., because it is not connected to a permanent establishment in the foreign country) while income from the other business ("TI") is taxable in the foreign country. If the foreign tax rate on TI is greater than the Canadian rate of tax on such income, the excess foreign tax, which in tax policy terms should not be a creditable tax, could have been used to reduce Canadian tax on EI. The Amendments prevent the claiming of such a foreign tax credit by removing EI from the numerator of the formula for foreign tax credit purposes. The result is that the foreign tax credit is limited to the Canadian tax on TI.

The amendments to subsection 126(7) were also brought in to address the following situation. Consider the case where a person ceases to be resident in Canada in a particular year and takes up residence in Country A with which Canada has a tax treaty. Assume this part-year resident has income from Country A ("FSI-1") in the resident period, which Country A does not have the right to tax pursuant to the tax treaty. In addition, assume this person has income from Country A ("FSI-2") in the non-resident period which is taxable in Country A but is not included in computing his taxable income in Canada for that year. In such a case, Canada should be able to retain its tax on FSI-1. However, prior to the amendments to section 126, the tax paid to Country A on FSI-2 could have been claimed as a foreign tax credit even though FSI-2 was not included in computing his income in Canada for that year. The tax paid to Country A on FSI-2 is an income or profits tax for the purposes of the foreign tax credit rules in the Act and, prior to the Amendments, as FSI-1was income sourced to Country A for the purposes of the Act, it would have been included in the numerator of the formula described in subparagraph 126(1)(b)(I) of the Act for foreign tax credit purposes. The result, which was considered inappropriate, was that Canadian tax on FSI-1 could have been reduced or eliminated by Country A tax on FSI-2. The Amendments eliminate FSI-1 form the numerator of the formula and as there is no longer any income sourced to Country A for foreign tax credit purposes, there is no longer a foreign tax credit.

In reference to your question on how paragraph 4(1)(b) interacts with the amendments to section 126 of the Act, it is our view that the sourcing rule in paragraph 4(1)(b) must be followed in order to determine whether there is income from a source in a country for the definitions of "qualifying incomes" and "tax-exempt income" in subsection 126(7). Those definitions do not override the rule in paragraph 4(1)(b) because income remains foreign source even if it is not a qualifying income for the purpose of the section 126 FTC computation.

Summary

In summary, we agree with you that XXXXXXXXXX method of allocating profits to its Japanese branch profits for FTC purposes is not reasonable based on the jurisprudence and the sourcing rule in the Act. In addition, their method results in an under taxation of Canadian source profits, since their method results in Canada giving a credit against Canadian tax on Canadian source income. In order to accurately reflect the correct Japanese and Canadian source income for FTC purposes, profit should be allocated between the Japanese and Canadian activities which gave rise to the profits in a manner that reflects the contribution of the respective activities to those profits. In our view, allocating profits based on a method which estimates the Canadian profits by using a fair market value for the Canadian source XXXXXXXXXX inventory sold in Japan is a reasonable method.

We trust our comments will be of assistance. Please call the writer if you have any further questions.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 819-994-2898. The severed copy will be sent to you for delivery to the client.

for Director
Reorganizations and International Division
Income Tax Rulings Directorate
Policy and Legislation Branch