2 July 2003 Internal T.I. 2003-0007967 - Proprietorship; treaty-protected business

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 CCRA.

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

Principal Issues: 1. If USco carries on business in Canada without a PE and there are losses attributable to that business and then USco carries on business in Canada through a PE, can USco use the losses from the non-PE years to offset the profits in the PE years?

2. If the US business is run through a proprietorship instead of a corporation, such that paragraph 81(1)(a) doesn't apply, does the "treaty-protected business" amendment to subsection 111(9) prevent the proprietorship from using the non-PE year losses in the year in which it has a PE?

Position: 1. No.

2. Yes.

Reasons: 1. See doc. # E 2002-0165077.

2. This follows from the definition of "treaty-protected business", together with paragraph 110(1)(f) and the clear policy set out by Finance when the "treaty-protected business" rules were introduced.

July 2, 2003

Mr. Robert Thomson Eliza Erskine

International Tax Division International Section I
Burnaby-Fraser Tax Services Office 952-1361
9737 King George Highway
5th Floor - Surrey Tower
Surrey BC
2003-000796

Carry-forward of Canadian Losses of US Businesses with no Permanent Establishment ("PE") in Canada: Corporations and Proprietorships

We are writing in reply to your email letter to Eliza Erskine of March 13, 2003, regarding the above-noted subject matter. Unless otherwise indicated, all references below to sections, subsections, paragraphs and subparagraphs are references to provisions of the Act.

Scenario

? A US business carries on business in Canada during 2000, 2001 and 2002.

? The US business does not have a PE in Canada in either 2000 or 2001 but it does have a PE in Canada in 2002.

? The US business has losses attributable to its Canadian operations in 2000 and 2001. The business has profits attributable to its Canadian operations in 2002. In fact, the business established the PE in Canada for the very reason that the Canadian operations had shown increased growth and profitability.

Issues

1. If the US business is a corporation (USCO), will the same reasoning apply in this scenario as in the scenario discussed in Rulings document # E 2002-0165077, such that USCO will be prevented from claiming the losses arising in the 2000 and 2001 taxation years to off-set the profits attributable to its Canadian PE in 2002?

2. If the US business is a proprietorship (USP), rather than a corporation, the reasoning applied in the scenario discussed in Rulings document # E 2002-0165077 will not apply because paragraph 81(1)(a) does not apply to the treaty exemptions of individuals. In this case, would the 1998 amendments to the Act incorporating the rules regarding "treaty-protected businesses" (the "1998 Amendments") be applicable so as to prevent the carry-forward of the 2000 and 2001 losses to the 2002 taxation year?

Discussion

Issue 1: Can USCO carry forward its 2000 and 2001 Canadian losses to the 2002 taxation year?

We agree with your comment in your letter to us that the analysis with respect to paragraphs 18(1)(c) and 81(1)(a) set out in our document referred to above will apply in the present situation such that USCO will have no losses from 2000 or 2001 to carry forward to its 2002 taxation year.

In brief, Article VII of the Canada-US Income Tax Convention (the "Convention") will apply such that USCO will be exempt from tax on its Canadian business income in 2000 and 2001. As USCO is a corporation, paragraph 81(1)(a) will provide this exemption for purposes of the Act. During the period that paragraph 81(1)(a) applies, any income earned in Canada by USCO will be "exempt income" as defined in subsection 248(1). As a result, paragraph 18(1)(c) will apply so as to deny any expenses incurred with respect to earning that "exempt income" and therefore USCO will not have any losses to carry forward to 2002.

We agree that the disallowance of the expenses under paragraph 18(1)(c), such that there are no losses to carry forward to 2002, achieves the result of preventing USCO from claiming what are loosely referred to as "treaty-exempt losses" independent of the 1998 Amendments.

Issue 2: Can USP carry forward its 2000 and 2001 Canadian losses to the 2002 taxation year?

When we considered the application of the 1998 Amendments in document # E 2002-0165077, we came to the conclusion that although our analysis of paragraphs 81(1)(a) and 18(1)(c) reduced the need for those amendments, our analysis did not render the amendments wholly superfluous. Our reasoning was that our analysis did not apply to individuals, as individuals would not be exempt pursuant to paragraph 81(1)(a). Thus, we concluded that the 1998 Amendments were required to prevent the carry-forward of "treaty-exempt losses" for individuals, such as in the case of a proprietorship. In a nutshell, issue 2 requires us to determine whether in fact the 1998 Amendments can apply to proprietorships as we supposed.

In our opinion, the better view is that the 1998 Amendments do apply to prevent the carry-forward of "treaty-exempt losses" by proprietorships. This view is based on our analysis of the relevant provisions of the Act and is strongly supported by the comments of the Department of Finance in the Technical Notes released at the time of the 1998 Amendments. In our view it is the only reasonable position in light of the clear policy rationale behind the 1998 Amendments.

The 1998 Amendments, in subsection 111(9) (and mirrored in subsection 115(1)), essentially provide that a non-resident taxpayer's non-capital loss for the year can only include losses from businesses other than treaty-protected businesses. A "treaty-protected business" at any time is defined in subsection 248(1) to mean:

"a business in respect of which any income of the taxpayer for a period that includes that time would, because of a tax treaty with another country, be exempt from tax under Part I".

The potential difficulty in applying this definition in the case of a proprietorship is that the Act does not provide an "exemption" such as the exemption under paragraph 81(1)(a) when providing treaty protections to individuals. Rather, subparagraph 110(1)(f)(i) allows an individual to deduct from his or her income "any amount that is ... an amount exempt from income tax in Canada because of a provision contained in a tax convention or agreement with another country that has the force of law in Canada." The question is whether this provision is sufficient as an "exemption" for purposes of the definition of "treaty-protected business", which requires that the relevant amount "must be exempt from tax under Part I".

There are two arguments that can be made to support the view that the treaty-protected income of an individual is "exempt from tax" under subparagraph 110(1)(f)(i) - that is, under Part I. The first argument is that the basic dictionary definition of "exempt" is "free from an obligation or liability imposed by others",¹ and, obviously, the treaty-protected income of an individual is free from the tax (i.e., the liability) imposed by the government of Canada because it never enters into taxable income on the basis of subparagraph 110(1)(f)(i).

In fact, this analysis demonstrates the significant distinction between the definition of "exempt income" (used in paragraph 18(1)(c)) and the definition of "treaty-protected business" (used in subsections 111(9) and 115(1)). Whereas the definition of "exempt income" only applies where amounts are excluded in computing an individual's income, the definition of "treaty-protected business" applies whenever income is excluded from tax liability, that is, excluded from an individual's taxable income. Subparagraph 110(1)(f)(i) is a Part I provision that excludes business income of an individual from the individual's taxable income on the basis that it is treaty-exempt.

The second argument, which strongly supports this interpretation of the nature of subparagraph 110(1)(f)(i) in relation to the definition of "treaty-protected business", is that the clear tax policy behind the 1998 Amendments is that the "treaty-protected business" definition should apply to all businesses whose income would be protected from Canadian taxation by a tax treaty. In this regard, the Technical Notes provided by the Department of Finance when the 1998 Amendments first appeared are of critical importance. These Technical Notes explain why the 1998 Amendments were necessary, and refer particularly to "losses from a source that is, because of a treaty, not subject to tax in Canada".

The losses of the USP in its non-PE taxation years are clearly losses from a source that is not subject to tax in Canada because of the Convention: a US business carried on in Canada is not taxable in Canada unless it has a PE in Canada. In particular, the Technical Notes accompanying the definition of "treaty-protected business" state as follows:

"It should be noted that a business may be a treaty-protected business even if it has generated no treaty-exempt income. For example, assume that a resident of a treaty country carries on two businesses in Canada: one through a permanent establishment (PE), and the other without a PE in Canada. Any income of the non-PE business would, under a typical tax treaty, be exempt from Part I tax. That business is therefore a treaty-protected business, whether or not it in fact generates any income."

In conclusion, there is a reasonable "literal" interpretation that a "treaty-protected business" can include a proprietorship, supported by a strong policy reason why it should.

As a final comment, we note that individuals were included in the paragraph 81(1)(a) exemption prior to 1982. As explained in our document # 9816346, based on the Technical Notes that amended paragraph 81(1)(a) and introduced the "inclusion-deduction" system, "[t]he income inclusion is principally relevant for purposes of determining whether the recipient qualifies as a dependant of another taxpayer for the purposes of a deduction under section 109. Any amount included in income by virtue of these amendments will be deductible in computing taxable income by virtue of the amendments to paragraph 110(1)(f)." In our view, this suggests that the amendments to paragraph 81(1)(a) that excluded individuals from the application of that provision were not intended to make those individuals any less "exempt" - that is, free from tax - with respect to their treaty-protected income.

We trust that our comments will be helpful to you. If you have any questions with respect to the issues discussed in this memorandum, please contact the officer noted above.

Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

ENDNOTES

¹ Canadian Oxford Dictionary
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