8 March 2005 Internal T.I. 2003-0054281I7 - Designation of assets and the Canada-US tax treaty

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.

Principal Issues: Whether a designation of out-of-country assets by the Minister pursuant to paragraph 2400(1)(f) of the Regulations is contrary to Article VII of the Canada-US tax treaty.

Position: It depends. If the business profits attributable to a permanent establishment of a non-resident insurer as determined under Article VII of the Canada-US tax treaty are less than those determined under Canadian domestic law, the treaty will restrict Canada's right to tax to the amount determined under Article VII.

Reasons: The non-resident insurer needs to prepare a thorough functional and factual analysis to demonstrate that the business profits attributable to the permanent establishment as calculated under Article VII are less. The non-resident insurer cannot simply calculate its income under domestic law but without regard to paragraph 2400(1)(f) of the Regulations and use that amount as its business profits attributable to a permanent establishment under Article VII without any supporting functional and factual analysis.

 							March 8, 2005

	HEADQUARTERS						HEADQUARTERS
	John Crowley							Income Tax Rulings Directorate
	Manager, Income Tax Appeals					J. Leigh
									952-1505
	Attention:  John Kingston
2003-005428

XXXXXXXXXX

This is in response to your memorandum dated December 23, 2003 concerning the notices of objection filed by XXXXXXXXXX ("Insurer") with respect to income related to out-of-country assets designated by the Minister to fill the Canadian Investment Fund ("CIF") for the 1997 and 1998 taxation years of the Insurer. In this regard, you have requested our views as to whether such income is exempt from tax in Canada pursuant to Article VII of the Canada-U.S. Income Tax Convention ("Treaty") and the submission made in this regard by the taxpayer's representative in his memorandum dated August 18, 2003.

In order to best deal with the Treaty issue and the submission made by XXXXXXXXXX , our memorandum is segmented under the following headings:

? Authority for the Minister to Designate Assets Held Outside of Canada
? Part XIV - Branch Tax
? Article VII of the Treaty
? Functional and Factual Analysis
? Summary

Reference to provisions of the Income Tax Act ("Act") and the Income Tax Regulations ("Regulations") are to those provisions that were relevant to the 1997 and 1998 taxation years.

Authority for the Minister to Designate Assets Held Outside of Canada

Whether or not section 2400 of the Regulations constitutes a "model" used in the taxation of non-resident insurers under Part I of the Act, it is our understanding that the approach advocated by section 2400 of the Regulations was in response to the concern that it was difficult to attribute many of the investment assets of multi-national insurers to either the in-Canada and out-of-Canada insurance operations. A property that was designated, or deemed to be designated, under subsection 2400(1) of the Regulations was for purposes of subsection 138(12) of the Act property used or held by the non-resident insurer in the course of carrying on its insurance business in Canada. In other words, section 2400 of the Regulations determined which assets were used by a Canadian branch of a non-resident insurer in carrying on its insurance business in Canada.

While subsection 2400(5) of the Regulations prevented an insurer from designating assets that were held in the course of carrying its insurance business outside of Canada, paragraph 2400(1)(f) of the Regulations provided that where the insurer had failed to designate sufficient investment assets in a year to meet its CIF requirement, the Minister could designate sufficient assets owned by the insurer to fill its CIF, notwithstanding subsection 2400(5) of the Regulations. In this regard, we note that the only qualifications for designation were that the assets be investment assets and that they be owned by the insurer. There was no qualification that assets that could be designated were limited to those reported to the Office of the Superintendent of Financial Institutions ("OSFI") in Form P&C-2. XXXXXXXXXX suggests that the effect of Article VII of the Treaty was to provide for such a limitation in the Insurer's case. We will address this issue in our discussion of Article VII below.

Part XIV - Branch Tax

Although it appears that XXXXXXXXXX is of a different view, the general purpose of the branch tax is to equate the Canadian tax position of a non-resident carrying on business in Canada through a branch with that of a taxpayer carrying on business through a subsidiary. The branch tax is a proxy for the withholding tax that would be exigible on dividend distributions made by the subsidiary to its non-resident parent. While XXXXXXXXXX is correct in noting that no tax would be payable (because of the deduction under subsection 112(1) of the Act) where the Canadian subsidiary utilizes a Canadian holding company in the structure, this is simply a deferral until the holding company makes a distribution to its non-resident parent.

We recognize that Part XIV provides separate rules for non-resident insurers, which is necessary given, with reference to the CIF, that they are taxed in different manner than other branch operations under the Act. However, we see no basis to conclude, as XXXXXXXXXX apparently does, that the general principle underlying the branch tax regime, as noted above, should not apply to the Canadian branch operations of a non-resident insurer.

The provisions of Part XIV applicable to the branches of non-resident insurers are intended to provide for a deferral of tax and not the reduction of tax. The components of the "surplus funds derived from operations" ("SFFO") definition in subsection 138(12) of the Act result in a calculation that is similar to retained earnings. SFFO is also a component of the CIF calculation. The fact that the insurer did not hold sufficient assets in its Canadian branch to permit it to fill its CIF suggests that assets were repatriated through the Home Office Account. In this regard, subsection 219(4) of the Act permits an insurer to elect to reduce its CIF with the amount of the reduction being subject to branch tax. While this provision is elective, it does provide a mechanism for reducing the CIF by paying branch tax on earnings, which, in our view, is consistent with the purpose of Part XIV as noted above. It is also our view that it is consistent with the scheme of the Act that where a non-resident insurer chooses not to elect to reduce its CIF and pay the resultant branch tax, that assets be designated to fill the CIF without regard to the fact, or perhaps in recognition of the fact, that assets representing accumulated earnings have been removed from the Canadian branch on a tax free basis. While it is not necessary to repatriate assets to remove them from the Canadian tax base through an election under subsection 219(4) of the Act to reduce the CIF, the payment of branch tax is the intended cost of removing assets from the tax base under Part I.

Article VII of the Treaty

XXXXXXXXXX position is that the designation of out-of-country assets by the Minister is contrary to Article VII of the Treaty. He submits that the designated out-of-country assets were not assets of the Canadian branch and were not related to, and therefore not attributable to, the activities of the Canadian branch. XXXXXXXXXX presented the following facts as support for his views.

? The Canadian branch was not aware of the assets' existence.

? The assets were not available to either the Canadian regulator or the Insurer's Canadian chief agent.

? The assets were included in the Insurer's assets available to its US regulator and not OSFI.

? The income the assets produced was not made available to the Canadian branch in any way or form.

? The assets were designated some time after the taxation years in question and, in some cases, after they had been sold.

? The designations were made without any knowledge of the actual use to which such assets were put.

Based on paragraphs 2 and 7 of Article VII, XXXXXXXXXX contends that the income arising on these out-of-country assets are not subject to Canadian tax. XXXXXXXXXX also refers to the decision in North West Life Assurance Co. Canada, (107 T.C. No. 19) where the US Tax Court decided in the taxpayer's favour, holding that the specific provisions of the Internal Revenue Code (the "IRC") were contrary to the "separate entity" concept under Article VII of the Canada-US tax treaty.

In terms of determining the business profits attributable to the Canadian branch as contemplated by paragraphs 2 and 7 of Article VII, XXXXXXXXXX, based on his general understanding of the North West Life decision and the OECD Commentaries, submits that the annual report to OSFI, Form P&C-2, best represents the real facts of the Canadian branch. According to XXXXXXXXXX, the assets disclosed in Form P&C-2 are the only assets used by the Canadian branch. The designated out-of-Canada assets form no part of Form P&C-2's annual representation of the branch's affairs and are not factually assets of the branch. He is of the view that the Canadian branch accounts as presented to OSFI adequately disclose the profits attributable to its Canadian branch without the necessity of any adjustment. Essentially, his position is that the calculation of income under domestic law, absent the designation under paragraph 2400(1)(f) of the Regulations, results in the correct amount of profits attributable to the Canadian branch under Article VII.

Our comments

As you know, XXXXXXXXXX made reference to an earlier opinion (Document E2000-004916) we issued in connection with another non-resident insurer. In that opinion, we indicated that the designation of out-of-country assets to fill CIF is not contrary to Article VII of the Treaty. We take this opportunity to clarify that to the extent that there is a conflict, Article VII of the Treaty will override domestic law. In other words, if the profits attributable to a Canadian permanent establishment under Article VII of the Treaty are less than the profit of a non-resident insurer from business carried on in Canada as determined under our domestic law, then the Treaty will restrict Canada's right to tax to the amount determined under Article VII of the Treaty.

As noted by XXXXXXXXXX , the US Tax Court dealt with the application of Article VII of the Treaty in the North West Life case. North West Life was a Canadian insurance company that operated a branch in the US. Under US domestic tax law, it was subject to US tax on the higher of:

(1) its "effectively connected income" in the US as computed under section 842(a) of the IRC, and

(2) a minimum amount based on a formula computed under section 842(b) of the IRC.

North West Life argued that Article VII of the Treaty precluded the US from applying section 842(b) on the grounds that that section taxed "a fictional amount that is greater than their actual income derived from their business in the United States." The US Tax Court considered the meaning of "attributable to" within the context of paragraph 7 of Article VII and referred to a discussion in the OECD Commentaries that "...the general rule should always be that the profits attributed to a permanent establishment should be based on that establishment's accounts insofar as accounts are available which represent the real facts of the situation." The US Tax Court agreed with North West Life that section 842(b) attributed a fictional amount of income to the US branch that was not based on its own activities but rather on the investment performance achieved by domestic insurance companies and concluded that section 842(b) was contrary to and inconsistent with Article VII.

In our view, while some of the comments in the North West Life decision as to the calculation of the income attributable to a permanent establishment are relevant to the current case, there is no parallel to be drawn between section 842(b) of the IRC and the inclusion of income with respect to assets designated by the Minister under paragraph 2400(1)(f) of the Regulations. In the current case, there is no inclusion of fictitious income but rather an inclusion of actual income from the designated assets. It therefore comes down to whether the income attributed to the Canadian branch under Canadian domestic law exceeds the amount of income attributable to the branch calculated in accordance with Article VII.

As noted above, XXXXXXXXXX is arguing that Form P&C-2 is the best representation of the real facts of the Canadian branch. It is a question of fact whether a particular asset is an asset of the permanent establishment or related to the activities of the permanent establishment. In this regard, our view is that assets held outside Canada and not disclosed in Form P&C-2 could be attributable to a permanent establishment in Canada. We note that the US Tax Court in North West Life commented that income might be included in determining profits attributable to a permanent establishment under Article VII that would not be considered effectively connected for the purposes of the IRC.¹ Accordingly, while income from a particular investment may be excluded from attribution to the Canadian permanent establishment pursuant to Article VII, income not included under domestic law may be attributed to the Canadian permanent establishment under Article VII.

We further note that the US Tax Court considered whether the NAIC form 1A, the annual report to the US regulator and the equivalent of our Form P&C-2, should be used to determine all of the income attributed to a permanent establishment. The US Tax Court said:

We agree with respondent and respondent's expert that the NAIC form 1A is not the ideal means for reconciling and identifying all of the income attributable to a permanent establishment. It does not include a closed, self-contained book of accounts, reconciliation of any surplus, or information regarding capital gains or losses. The form is not designed to identify taxable income but rather to monitor compliance with State regulatory requirements on trusteed assets.

The US Tax Court concluded that based on the particular circumstances, it did not believe that North West Life underreported its actual net investment income despite whatever deficiencies may exist in NAIC form 1A. In this regard, we fully agree with the US Court's view that annual statements made to the regulatory authority of a state are not necessarily reliable documents for determining the profits attributable to the permanent establishment.

Based on our understanding of the OECD discussions to date on the attribution of profits to permanent establishments of insurance companies, it looks like many OECD countries may view the assets held within the state to cover the risks from the policies written under a licence to conduct insurance business in the state and shown on the balance sheet of the permanent establishment filed as required by the state regulator as only a starting point in determining the profits attributable to the permanent establishment.

In our view, XXXXXXXXXX has not adequately demonstrated that the profits attributable to the Canadian branch according to Article VII are less than those determined under the provisions of the Act. A thorough functional and factual analysis must be undertaken by the taxpayer to show that the Act is taxing profits greater than what are attributable to the Canadian branch. As we have indicated above, Form P&C-2 constitutes a starting point for determining the investment assets attributable to the permanent establishment.

Functional and Factual Analysis

For purposes of attributing profits to a permanent establishment in accordance with Article 7 of the OECD Model Convention or Article VII of the Canada-US treaty, it is necessary to determine the business profits of the permanent establishment which it 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 corporation of which it is a permanent establishment and with any other person related to the corporation (within the meaning of paragraph 2 of Article IX).

In this context, the authorized OECD approach is the functional and factual analysis used to delineating the permanent establishment as a hypothesised distinct and separate enterprise. The functional and factual analysis takes into account the assets used and risks assumed as a result of performing functions such as insured risks, product management, sales and marketing, underwriting insured risks, claims management, assets management or key entrepreneurial risk-taking.

Having appropriately determined the functions performed, the assets used and the risks assumed by the permanent establishment, the next question is how to reward those functions. For insurance, one component of the reward for performing the functions is the investment income from the financial assets representing the surplus and reserves. The authorized OECD approach requires that a permanent establishment of an insurance company be hypothesised as a distinct and separate enterprise from the company of which it is a part. There must then be attributed to the permanent establishment the surplus that it would have if it were a distinct and separate enterprise carrying on the same activities and incurring the same risks.

This attribution of surplus and the subsequent attribution of the income from the assets arising from the investment of the surplus should be carried out in accordance with the arm's length principle, to ensure that a fair and appropriate amount of profits is attributed to the permanent establishment. Under the arm's length principle, a permanent establishment of an insurance company, just like any other permanent establishment, should have sufficient surplus to support the functions it undertakes, the assets it uses in its business and, crucially, the insured risks it initially assumes and subsequently bears.

Summary

Pursuant to paragraph 2400(1)(f) of the Regulations, the Minister has the authority to designate any assets owned by the insurer to fill the CIF. This situation could have been avoided had the Insurer elected under subsection 219(4) of the Act to pay branch tax and reduce the CIF. However, since this is an elective provision, there was no requirement for the Insurer to do so. Relief under Article VII will be available to the Insurer provided that it can demonstrate that the income attributable to the Canadian branch determined in accordance with this article is less than the amount calculated under the Act. For reasons noted above, this is not as simple as simply excluding from the calculation of income under Canadian domestic law the income from the assets designated by the Minister under paragraph 2400(1)(f) of the Regulations. If the Insurer provides a thorough functional and factual analysis along the lines suggested above, we (likely Audit) would be prepared to consider it. As noted, this will require more than simply relying on the information reported in the OSFI annual return.

For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy 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
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch

ENDNOTES

¹ We note that the Technical Explanation on paragraph 2 of Article 7 of the US Model, which is identical to paragraph 2 of Article VII of the Canada-US treaty states:

The "attributable to" concept of paragraph 2 is analogous but not entirely equivalent to the "effectively connected" concept in Code section 864(c). The profits attributable to a permanent establishment may be from sources within or without a Contracting State.