22 March 2001 Internal T.I. 2000-0049167 - NON RESIDENT INSURER CIF

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:

1. Is a Reserve for Unregistered Reinsurance ("RFUR")included in computing CIF for a non-resident non-life insurer?

2. Does the Branch have a RFUR?

3. Does Canadian tax law provide for the designation, by the Minister of assets of a non-resident insurer that are not reported in the annual report to OSFI?

4. Is such a designation described in (3) contrary to Article VII of the Canada-US Income Tax Treaty?

Position:

1. Yes
2. Yes, based on the facts
3. Yes
4. No

Reasons: Please refer to the analysis in the document

							March 22, 2001

	INTERNATIONAL TAX DIRECTORATE		HEADQUARTERS
	Transfer Pricing & 			Alison Campbell
	Competent Authority

	Attention:  Tam Nguyen
							2000-004916

XXXXXXXXXX
Canadian Investment Fund - Unregistered Reinsurance Reserve
XXXXXXXXXX Taxation Years (Your File XXXXXXXXXX)

This is in reply to your memorandum of September 25, 2000, regarding the XXXXXXXXXX and its Canadian branch, hereinafter referred to as USCo and the Branch, respectively. In particular, your requested our comments on two points:

1) Should the Branch have included a reserve for unregistered reinsurance ("RFUR") in its computation of the Canadian Investment Fund ("CIF") as defined in subsection 2405(3) of the Regulations for the years in question?

2) In our view, would the designation by the Minister of USCo's assets not held in Canada, in order to fill the requirements of the CIF designations, be contrary to paragraphs 1 and 7 of Article VII of the Canada - US Income Tax Convention (1980) (the "Convention")?

Facts

The relevant facts in this case, as we understand them, are as follows:

1. USCo is a United States insurance company, which carries on a property and casualty business in Canada through its Canadian branch.

2. The Branch is principally engaged in the writing of XXXXXXXXXX insurance in Canada and is authorized to carry on this business in Canada under the Insurance Companies Act, which came into force in 1992, (previously under the Foreign Insurance Companies Act).

3. The Office of the Superintendent of Financial Institutions ("OSFI") administers the Insurance Companies Act.

4. During the period under review, the Branch had reinsured some of its risks under its Canadian policies with insurers not resident in Canada and not registered to carry on an insurance or reinsurance business in Canada (the "Unregistered Reinsurers").

5. In accordance with the Insurance Companies Act (the "ICA"), the Branch is required to maintain assets in Canada that are adequate to cover the reserves reinsured to the Unregistered Reinsurers. This RFUR, is generally required to be reported in the "Head Office Account and Reserves" section of the P&C-2 Annual Return (the "P&C-2). Every foreign insurer carrying on a property and casualty insurance business in Canada must file a P&C-2 with OSFI each year.

6. OSFI approved an arrangement whereby the Branch deposited assets with a Canadian trust company (the "Trustee") (the "Trust") that would be accessible to OSFI in the event of default by the Unregistered Reinsurers with respect to obligations under the Canadian policies that they have reinsured. OSFI permitted the Branch to reduce the RFUR that it otherwise would have been required to report on its balance sheet in the P&C-2 to the extent of the fair market value of the assets in the Trust.

7. In schedules that form part of the P&C-2, the Branch details the amount of the reserves that relate to the policies ceded to the Unregistered Reinsurers. XXXXXXXXXX

8. In computing its CIF for the years in question the Branch included only the amount of any RFUR reported on its balance sheet. The Branch's position would seem to be that because of the assets held in the Trust, which they state is under OSFI's control, the Branch does not have any RFUR, to the extent of the value of the assets in the Trust.

9. In designating assets to fill the CIF for the years in question, the Branch did designate assets held in the Trust, and believe that they may do so because the assets held in the Trust are still the Branch's assets.

10. The Minister has proposed to reassess the Branch for the taxation years in question, to increase the CIF for each year with respect to the amount of the RFUR reflected on XXXXXXXXXX of the P&C-2 annual statement, before deducting the value of the Trust assets for each year. This proposed reassessment is being made on the basis that the Branch still has a RFUR, and the RFUR is a reserve for purposes of the CIF computation even though it is reported in the schedules to the P&C-2 and not on the face of the balance sheet.

11. If the additional amount is added to CIF in respect of the RFUR, additional assets will need to be designated in the Branch's return, in order to fill the CIF. The Minister is of the view that it may designate assets not reported in the P&C-2, and which are held outside of Canada by USCo., in order to fill CIF for the Branch.

12. The taxpayer has argued, with respect to the designation of assets not reported in the P&C-2, that to designate these assets and thereby cause the income from these assets to be included in the income of the Branch for Canadian income tax purposes, would result in the income from these assets being taxed in both Canada and the US and that this would be contrary to paragraphs 1 and 7 of Article VII of the Convention.

Analysis

Reserve for Unregistered Reinsurance

In general, when an insurer reinsures Canadian risks with unregistered reinsurers, OSFI requires the ceding company to maintain assets in Canada that are sufficient to cover the ceded risks. OSFI requires that the assets be maintained in Canada because it has no control over the unregistered reinsurers to ensure that the Canadian policyholders whose policies have been reinsured are protected. These assets reflect a reserve that the ceding insurer is establishing in respect of unregistered reinsurance and therefore the reserve is commonly referred to as the RFUR. OSFI requires that these additional assets be reported in the annual report that the ceding insurer files with OSFI.

The definition of CIF is found in subsection 2405(3) of the regulations. Paragraph (iv) of that definition provides that included in the CIF of a non-resident non-life insurer is,"a liability (other than a debt [incurred or assumed to acquire investment property and that is still outstanding]) or a reserve (other than the insurer's investment valuation reserve) as reported by the insurer in its annual report for the year to the relevant authority..., that was incurred or provided for in the course of carrying on the insurer's property and casualty insurance business in Canada."

Therefore, an insurer will have to include in the computation of CIF, an amount that has the following characteristics:

a) it represents a liability or a reserve (but not an investment valuation reserve),

b) it is reported in the annual report filed with OSFI (ie. the relevant authority),

c) it was incurred or provided for in the course of carrying on the insurer's property and casualty business in Canada.

Given the general description of a RFUR set out above, it would seem that a RFUR would satisfy the conditions for inclusion in CIF and therefore, would generally be included in the computation of CIF.

The position that a RFUR, where it exists, be included in the computation of CIF is also supported by the Tax Court of Canada's findings in Victory Reinsurance Company Limited v.MNR (1992 DTC 1869). The Victory case actually dealt with the issue of whether a reserve for unregistered reinsurance should be included in the computation of the company's Canadian Reserve Liabilities ("CRL").

Subsection 2405(3) of the regulations, defines CRL as "the aggregate amount of the insurer's liabilities and reserves ... in respect of its insurance policies in Canada, as determined for the purposes of the relevant authority at the end of the year...". The court held that a RFUR was a reserve for the purposes of computing CRL. When the CRL definition is compared with the wording in the CIF definition, the words in the CIF definition would seem at least as broad and would therefore support a finding that a RFUR is a reserve for the purposes of computing CIF.

Given that a RFUR, where it exists, is included in the computation of CIF, it is important to determine whether the Branch in this particular instance has a RFUR. In referring to XXXXXXXXXX of the P&C-2 filed by the Branch with OSFI for the years in question, one notes that the Branch has listed the amount of reserve that OSFI requires it to carry in respect of reinsurance it has undertaken with various Unregistered Reinsurers. XXXXXXXXXX In our view, this schedule effectively reports the amount of the Branch's RFUR to OSFI, as well as the assets which are being used to support the RFUR. The Branch has reported a RFUR to OSFI; XXXXXXXXXX The reporting of the RFUR in an off-balance sheet manner does not, in our view, negate the fact that a RFUR exists and was reported to OSFI. The reporting on this schedule in the P&C-2, also supports our view that there is a direct relationship between the Branch's Canadian property and casualty business and the creation of the Trust, given that the reason for the Trust is to provide OSFI with security that the Canadian policyholders of the Branch, whose policies were reinsured with unregistered reinsurers, are protected.

The only issue remaining is whether the Trust represents a "reserve" for the purposes of Part I taxation. "Reserve" is not defined in the Act, for the purposes of Part I. Black's Law Dictionary ("Black's"), defines "reserve" to be "[s]ums of money an insurer is required to set aside as a fund for the liquidation of future unaccrued and contingent claims, and claims accrued, but contingent and indefinite as to amount." In this particular case, the Branch has placed assets in the Trust, which the Trust Agreement clearly indicates have been placed in trust to provide for contingent liabilities that may result from policy liabilities that have been ceded to unregistered reinsurers. Under a reinsurance arrangement, the ceding company (the Branch in this case) remains ultimately liable to the policyholders and therefore if the reinsurer does not cover a reinsured claim, the ceding company must still be in a position to satisfy the claim of the policyholder. This is the purpose for which the Branch established the Trust.

Based on the foregoing analysis, it is our view that the Trust represents a reserve of the Branch in respect of its reinsurance with unregistered reinsurers and should be included in the computation of the Branch's CIF.

Designation of Non-Branch Assets and the Canada-US Treaty

Based on the information provided, if it were determined that the Branch's RFUR as disclosed in the schedules to its annual report filed with OSFI, should be included in computing the CIF of the Branch for the taxation years in question, there will be insufficient assets held in Canada to fill the designation requirement. This means that it would be necessary to designate assets that are held, and perhaps also used in, USCo's insurance business outside of Canada. The taxpayer has raised the concern that if such assets are designated, USCo will be subjected to double taxation on the income from these assets. No specific details have been provided that support that USCo would be subject to double taxation as a consequence of having to designate additional assets. You have asked for our views on the designation of assets outside of Canada for purposes of Canadian income taxes and whether this would be contrary to Article VII of the Canada-US Income Tax Convention (the "Treaty").

General Background on the Scheme of the Act for Taxation of Non-Resident
Insurers

In general, the scheme of the Act for the taxation of non-resident insurers carrying on business in Canada is to tax the Canadian permanent establishment in a manner that equates with how the operations would be taxed if the permanent establishment were an incorporated entity carrying on an insurance business in Canada. A resident Canadian insurer would have to carry assets that would be equal to the sum of the corporation's reserves, liabilities, capital and retained earnings and would have to pay Part I tax on the income from that amount of assets. The amount of assets, and therefore the amount of investment income being taxed, can be reduced through a dividend distribution from the retained earnings of the corporation. The amount of the dividend would be taxed in Canada as dividend income to the recipient shareholder.

The rules for the Canadian taxation of investment income of a non-resident non-life insurer carrying on business in Canada through a branch, provides that the non-resident is taxed on the income from assets, the value of which equals the sum of (1) the reserves and policy liabilities of the Canadian business, and (2) the greater of the surplus funds from operations ("SFFO") or attributed surplus. The SFFO is the amount of the branch's cumulative earnings for Canadian tax purposes, net of Canadian income and branch tax taxes paid and is essentially a tax equivalent of retained earnings. Where a non-resident insurer's SFFO exceeds its attributed surplus, the non-resident can reduce the amount of assets it must designate as being used in the Canadian business by electing to reduce its SFFO. When the non-resident reduces its SFFO, it will be subject to a branch tax under Part XIV on the amount of the reduction which, is conceptually similar to the tax on dividends from retained earnings paid to the parent corporation of a Canadian resident insurer. When the non-resident ceases to carry on its insurance business in Canada, it will generally pay Part XIV branch tax on the full amount of its SFFO at that time. Again this is similar to the manner in which a Canadian insurer's retained earnings would be taxed as a dividend in the hands of its shareholders at the time the Canadian insurer's operations were wound-up.

It is possible, that a non-resident insurer's activities in Canada will reach a point where the assets that they are required to physically maintain in Canada to meet OSFI's requirements will be less than the assets required to fill CIF. However, where the taxpayer has not chosen to reduce SFFO and pay Part XIV tax, for tax purposes it must still pay tax on the income from assets, the value of which are equal to the CIF. The regulations in the Act which deal with the investment assets that must be designated by non-resident insurers to fill CIF ensure that, even where a non-resident insurer has sufficient assets to meet OSFI requirements but not to meet CIF requirements, the non-resident must still pay tax on assets with a value equal to CIF, until the non-resident pays the branch tax and reduces its SFFO and therefore its CIF to a level where it has sufficient assets in Canada to fill CIF.

Subsection 2400(5) of the regulations provides that for the purpose of the asset designation rules, the insurer may not designate investment property owned by it at any time in the year, that was used or held by the insurer in the course of carrying on an insurance business outside Canada in the year, unless the property was designated in the prior year in respect of the Canadian business. Subsection 2400(5) would therefore prohibit the Branch itself from designating home office assets used by USCo in carrying on business outside Canada, except for assets it had designated in respect of the Canadian business the previous year. Paragraph 2400(1)(f) however, provides that where an insurer has failed to designate sufficient assets in a year to meet its CIF requirement, the Minister may designate assets to fill CIF, notwithstanding subsection 2400(5). The "notwithstanding" reference seems to make it clear that parliament intended that the Minister could designate assets of the insurer that were not required to be reported to OSFI, in order to satisfy the CIF requirement. It would seem that these particular subsections of the regulations are the mechanism in the Act for ensuring that non-resident insurer's cannot avoid the payment of branch taxes by simply removing any assets not required for OSFI's purposes from the Canadian branch.

XXXXXXXXXX Accordingly it follows that such assets are held in respect of the Canadian business and as noted above it is our view that such assets that are disclosed in the annual report to, and required to be held by OSFI, constitute a reserve. Apart from the RFUR the Branch has included the other reserves reported to OSFI and the SFFO in the calculation of the CIF. There appears to be no dispute in this regard that assets must be designated to cover these amounts. The Branch has designated assets held in the Trust to cover off this requirement, which is clearly inappropriate since such assets XXXXXXXXXX In effect the Branch is attempting to use the Trust assets twice; once to support is RFUR and a second time to cover off the assets it is required to report to cover off its SFFO.

The Treaty

Based on the above, the Canadian tax laws clearly support the designation by the Minister of a non-resident insurer's assets in amounts sufficient to fill CIF for the year, even though those assets may not be reported in the annual report USCo files with OSFI. The assets may be used by the non-resident insurer in support of its insurance liabilities outside of Canada, or may simply be assets it holds in excess of its requirements to cover its global insurance liabilities. It is a question of fact, whether or not any particular asset of an insurer is held in support of an insurance business carried on outside of Canada. Having determined the Canadian tax law as it applies to this situation, we then considered your question as to whether we believe this domestic rule is in contravention of Article VII of the Treaty.

Paragraph 1 of Article VII, provides that where a resident of the United States ("US") carries on business in Canada through a permanent establishment situated in Canada, the business profits of the US resident may be taxed in Canada but only so much of them as is attributable to that permanent establishment. Paragraph 2 provides that where a resident of the US carries on business in Canada through a permanent establishment, there shall be attributed to that permanent establishment, by each country, the business profits that the permanent establishment might be expected to make if it were a distinct and separate person engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the resident.

Based on paragraph 2, it would seem that the business profits of the Branch, that Canada is entitled to tax, would be the profit that would be computed if the Branch had been a Canadian resident insurer that entered into reinsurance with unregistered reinsurers and used its own assets to settle a Trust. If a Canadian resident insurer entered into such transactions, it would effectively be taxed on assets sufficient to cover is non-reinsured risks and the amount of the RFUR, as the trust income would be taxable in the Canadian resident insurer's hands, even if not distributed by the Trust, pursuant to subsection 75(2). We are of the view that a key argument in favour of including the RFUR in the Branch's CIF and the Minister designating home office assets, is that in doing so, the Branch will not be subjected to any more tax than a Canadian resident insurer in a similar situation.

When paragraph 2 is considered in the context of the Branch tax scheme under the Canadian Act, it also seems reasonable from a conceptual standpoint, to be able to designate home office assets where branch assets are insufficient to fill CIF. As explained above, the SFFO is included in computing CIF as a reflection of cumulative earnings of the branch that have not yet been taxed on repatriation. The model for taxing non-resident insurers treats SFFO as retained earnings of a resident corporation and presumes sufficient assets to cover earnings not yet distributed by way of dividends or repatriation. If Canada were unable to tax income on assets needed to fill CIF because the assets are held outside the Canadian branch, then non-resident insurers will be taxed on income from fewer assets than would be the case if they were resident in Canada. Based on the foregoing, we believe that the designation of home office assets to fill CIF is not contrary to, and is in fact consistent with paragraphs 1 and 2 of Article VII.

The taxpayer has argued that paragraph 7, of Article VII should apply to prevent the inclusion of assets not reported to OSFI in the designations. Paragraph 7, provides that the business profits attributable to a permanent establishment, shall include only those profits derived from the assets or activities of the permanent establishment. The taxpayer argues that the home office assets were not used in support of the Canadian insurance business, the income from the assets was therefore not derived from assets of the permanent establishment and Canada has no right to tax the income under the Treaty. We are not aware of any arguments that the taxpayer made with respect to the income from the designated assets not be related to the "activities" of the permanent establishment. It is our view that the model under which the CIF rule was developed for taxing non-resident insurers was to determine the quantum of assets that for tax purposes, are considered to be attributable to the Canadian permanent establishment's "activities". The Technical Explanation to paragraph 7, Article VII provides that paragraph 7 does not preclude Canada or the US from using appropriate domestic tax law rules of attribution. Accordingly, it would seem that the Canadian model used to tax non-resident insurers is not precluded by paragraph 7 of Article VII.

We have considered the US Court decisions in National Westminster Bank, PLC v. United States of America and North West Life Assurance Company of Canada v. Commissioner of Internal Revenue, which you provided to us, in connection with the current case. The former case dealt with Article VII of the US-UK tax treaty as it applied to the issue of interest deductibility by a US branch of a UK bank, and whether the IRS Code formula for the computation of deductible interest was contrary to the "separate entity" concept under Article VII. The latter case dealt with the imputation under the IRS Code of investment income to the US branch of a Canadian insurance company, and whether this formula in the Code was contrary to Article VII of the Canada-US Treaty. In both cases the courts found in favour of the taxpayer and held that the relevant provisions of the IRS Code were contrary to the "separate entity" concept under the relevant treaties.

While we believe that these cases should be given some consideration, given that they deal with the use of models/formulas under domestic law and the "separate entity" concept under Article VII of the relevant treaties, we do not believe they should be taken as decisive of the issue currently under consideration. In the National Westminster case, the relevant section of the IRS Code was a formula that computed interest deductible by the branch based on an allocation of the world-wide interest of the non-resident, without reference to the actual debt reported in the accounts of the branch and the rates of interest actually charged on those debts. In the North West Life case, the relevant section of the IRS Code was a formula for imputing "fictitious" assets and income thereon to the permanent establishment for US taxes purposes. In both of the cases, the courts believed that the accounts of the branch should be given significant consideration in determining the assets, liabilities and income attributable to the permanent establishment. The application of the IRS Code in these cases would result in amounts being added to the permanent establishment, which were not reflected in the accounts of the branches, and it was found that the accounts were reasonably reliable as a reflection of the branch debt and assets as a "separate entity".

In the current case, the inclusion of the RFUR in the CIF of the Branch does not constitute the inclusion of an amount of liabilities and assets that are not reflected in the accounts of the Branch. The Trust assets, while not disclosed on the balance sheet, are clearly reflected in the annual report to OSFI and constitute part of the accounts of the Branch. While it is true that the home office assets that the Minister would designate to fill CIF are not reported anywhere in the annual report that the Branch files with OSFI, it is clearly provided for in the Canadian Income Tax Act that income from assets equal to the SFFO, inter alia, is subject to tax in Canada whether or not such assets are reflected in the branch accounts reported to OSFI. As noted earlier, if such amount is to be excluded from the Canadian taxation, a non-resident insurer is required to make an elect and pay the required branch tax. The fact that a taxpayer may remove assets from its branch statements by repatriating them through the Home Office account in our view, neither negates our authority to tax the income from such assets (or an equivalent amount of assets) where branch tax has not been paid, nor is it contrary to the Treaty. This is consistent with the comments of the justice in National Westminster Bank where he stated, "Time and again throughout the Commentary on Article 7, OECD Document at 78-89, one finds affirmation of the concept that where the books of account of a permanent establishment are, with adjustments, adequate to determine the profits (gross revenues less expenses) of the permanent establishment as a separate entity, then those books should be used (and presumably not some substituted formula)."

Finally, we would differentiate the current situation from those in these two cases on the basis that the IRS Code sections that were considered by the court, could effectively result in a permanent establishment of a foreign company being subject to more tax in the US than would a US resident corporation carrying on identical activities. This supported a finding by the courts that the IRS Code sections were contrary to the view that the permanent establishment should be taxed as though it were a separate entity. The Canadian model for the taxation of non-resident insurers carrying on the insurance business in Canada through a branch, results in the taxation of the permanent establishment in the same manner that it would be taxed if it were a Canadian resident corporation. That is, it will pay Part I tax on the income from assets that are sufficient to cover its liabilities, reserves and undistributed earnings, and Part XIV tax on distributions to home office just as a resident would pay tax on the income from the assets on its balance sheet (which equate to its liabilities, reserves, capital and retained earnings), and the shareholder would pay tax on the distribution of profits in the form of dividends.

Conclusions

Based on the foregoing analysis, we have the following conclusions:

1) The Branch has a RFUR that is supported by the assets held in the Trust.

2) The amount of the RFUR should be included in computing the CIF of the Branch.

3) The Minister may designate assets not held in Canada, where the assets held in Canada are insufficient to fill CIF.

4) If the taxpayer wanted to reduce the amount of assets it required to fill CIF and therefore the amount of Canadian tax paid in respect of the Branch operations, it could have done so by reducing its SFFO and paying the Part XIV branch tax on the amount of the reduction.

5) The Canadian model for the taxation of non-resident non-life insurer's carrying on business in Canada through a Branch is not inconsistent with Article VII of the Treaty. The model results in no more taxation on the permanent establishment than it would be subject to, if it were a Canadian resident corporation carrying on identical activities. This would seem to fit squarely within the "separate entity" approach to be taken under the Treaty for the allocation of profits to a permanent establishment.

The application of the Treaty is only relevant to the extent the taxpayer is being subjected to taxation in both Canada and another jurisdiction with respect to the income on its assets, and the other jurisdiction is not providing credits in respect of the Canadian taxes paid on the income from the assets. As noted, no evidence has been provided that USCo, is in fact being subjected to double taxation in respect of its assets, and that the United States has not, or will not, provide relief in respect of the Canadian taxes. In order to sustain such an argument it is our view that the entire operation of USCo must be taken into account. The fact that it can be show that assets specifically designated by the Minister are held in support of insurance liabilities from business outside of Canada is not in itself conclusive, as USCo may hold other assets that are not designated in support of any insurance liabilities anywhere that USCo carries on its business.

If it is determined that the taxpayer is in fact being subjected to double taxation if the Minister designates home office assets, then the issue should be pursued by competent authority, on the basis that the taxation under the Canadian tax model is consistent with Article VII of the Treaty, and therefore, Canada has the right to tax the income from these home office assets designated to fill CIF.

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 Mrs. Jackie Page at (819)994-2898. A copy will be sent to you for delivery to the client.

We trust that our comments will be of assistance to you.

F. Lee Workman
Manager
Financial Institutions Section
Income Tax Rulings Directorate
Policy and Legislation Brach