20 February 2006 External T.I. 2006-0165421E5 - International Petroleum Taxation

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 pipeline constitutes a permanent establishment. Allocation of income and expenses from a single pipeline, which is laid from onshore to offshore, but within the Canadian jurisdiction.

Position: A pipeline may qualify as a permanent establishment. Canada's tax treaties generally follow the general principles described in the OECD Commentaries regarding the attribution of profits.

Reasons: Canada has reserved its right to insert a special article provision regarding the taxation of offshore hydrocarbon exploration and exploitation (see par.52 of the OECD Commentaries to Article 5) and has an offshore article in some of its treaties. In the absence of a special rule regarding the taxation of offshore activities, Canada generally follows the general principles described in the OECD Commentaries regarding the definition of permanent establishment and the allocation of profits.

								2006-016542
XXXXXXXXXX 							Isabeau Morrissette
(613) 957-2118
February 20, 2006

Dear XXXXXXXXXX:

Re: Pipelines- Allocation of Profits

We are writing in response to your letter dated December 8, 2005 wherein you asked us for general information regarding international petroleum taxation in Canada. Your main focus is on the issue of whether or not a pipeline constitutes a PE according to the Article 5 of the OECD Model Tax Convention. You request general information regarding the allocation of income and expenses (onshore vs offshore) for pipelines within Canada's jurisdiction.

Our Comments

Whether a Pipeline constitutes a Permanent Establishment

The variety of situations (including the various definitions of permanent establishment ("PE") in Canada's tax treaties) make it almost impossible to come up with general guidelines as each case must be considered on its own facts. However, we are prepared to offer the following general comments.

As you are aware, article 5 of the OECD Model does not contain any special provision with respect to offshore activities. In recognition of this, at paragraph 52 of the OECD Commentaries on article 5, Canada has reserved its right to insert a special article provision regarding the taxation of offshore hydrocarbon exploration and exploitation and related activities. Canada has acted on this reservation and has an offshore article in some of its treaties (such as Canada's treaties with Lithuania, Netherlands, Norway and the UK). The provisions of these offshore articles vary from one treaty to another and therefore, it is again difficult to come up with general guidelines. For example, the wording of the offshore article in our treaty with the UK allows for the taxation of income from all activities performed in Canada in connection with the exploitation and exploration of offshore resources and including all services performed in connection with such exploitation or exploration whether carried out onshore or offshore. Conversely, in the case of the Dutch treaty, in order for the activities of a Netherlands resident to be covered by the article, the activities must be performed offshore. While the activities performed onshore would not be subject to the offshore article in this case, the onshore activities could still be taxable in Canada if they can be attributed to a PE onshore in Canada.

We recognize there are particular difficulties in applying the concept of PE to offshore activities. Also, it seems that allocation problems could arise and separate computations from each particular source (i.e. onshore activities vs offshore activities) may have to be done especially where only one source is taxable in Canada.

When there is an offshore article in a particular treaty, this rule may deem the existence of a PE. However, in the absence of a specific rule, the PE article would determine if a pipeline constitutes a PE or not and all the profits attributable to a PE in Canada would be taxable in Canada, whether they arise onshore or offshore.

In order to qualify as a PE according to article 5 of Canada's tax treaties, a pipeline should meet the requirements of the basic PE definition. The conditions, as described in paragraph 2 of the OECD Commentaries on Article 5, are:

1) the existence of a "place of business": the term "place of business" covers any premises, facilities, installations or machinery or equipment used for carrying on the business of the enterprise;

2) this place of business must be "fixed": this condition requires that the place of business be established at a distinct place with a certain degree of permanence but it does not mean that the equipment constituting the place of business has to be actually fixed to the soil on which it stands: it is enough that the equipment remains on a particular site; and

3) the carrying on of the business of the enterprise through this fixed place of business.

In light of these conditions, it is our view that a pipeline generally qualifies as a PE under the so-called basic PE rule. It is also interesting to note that in a certain number of Canada's tax treaties (e.g. Lithuania) subparagraph 5(2)(f) of the PE Article is a bit broader than the OECD Model provision and reads as follow:

"(2) The term "permanent establishment" includes especially:

(...)

(f) a mine, an oil or gas well, a quarry or any other place relating to the exploration for or exploitation of natural resources".

In these cases, it is even more explicit that a pipeline would qualify as a PE. In this respect a recent decision of the Tax Court of Canada: Dunbar v. The Queen, 2005 TCC 769 concluded that the transporting of crude oil is in connection with the exploitation of petroleum resources.

Regarding the question of what criteria should be used in attributing profits or expenses to a PE in Canada, Canada's tax treaties generally follow the standard principles described in the OECD Commentaries for article 7. Therefore, the general principle underlying Canada's tax treaties is that the source country has a prior unlimited right to tax business profits earned by a non-resident to the extent that those profits are attributable to a PE situated in the source country. Canada's tax treaties are also in line with the separate entity and the arm's length principles. While Canada generally follows these general principles, it is worth mentioning certain "domestic specificities".

Most of Canada's treaties have a provision patterned on paragraph 3 of Article 7 of the OECD Model Convention (i.e. expenses deductibility provision). However, section 4 of the Income Tax Conventions Interpretation Act (Canada) provides that non-residents who carry on business through a permanent establishment are to determine their business profits attributable to that permanent establishment in accordance with the rules contained in the Income Tax Act (Canada) (the "Act") for the calculation of income from a business. One of the principal purposes of this provision is to ensure that such corresponding provisions in Canada's tax treaties are not to be construed as allowing a deduction for those expenses that would not, if incurred by a taxpayer resident in Canada, be deductible in calculating his business income. Therefore, a non-resident carrying on business through a Canadian permanent establishment will not be able to deduct expenses, such as eligible capital expenditures and the petroleum and gas revenue tax or resource royalties, except as specifically deductible for the purpose of the Act.

Also, paragraph 4 of Article 7 of the OECD Model is not applicable to Canada as the apportionment method is not used. Although Canada has no strong objection to including the paragraph in its treaties where the other Contracting State has requested that it be included, Canada does not use the apportionment method.

Allocation of Income in Canada: Offshore vs Onshore

The area outside the territorial sea of Canada ("offshore areas") is normally not considered to be in a province. As a result, income earned from offshore areas would fall only under federal jurisdiction in Canada in the absence of a specific rule providing otherwise.

Section 124 of the Act provides for a deduction from tax equal to 10% of a corporation's taxable income earned in the year in a province to allow for the fact that such income is generally also taxable under provincial tax legislation. Part IV of the Income Tax Regulations (Canada) (the "Regulations") provides for the allocation of the income among the provinces. For the purposes of these income allocations rules, subsection 124(4) of the Act holds that the term "province" includes the Newfoundland offshore area and the Nova Scotia offshore area. Accordingly, the 10% tax reduction is available. However, because these areas are not part of Newfoundland or Nova Scotia, those provinces cannot tax those activities. Instead, Canada signed a special Atlantic Accord in respect of Newfoundland and the Canada-Nova Scotia Accord in respect of Nova Scotia. Under the Atlantic Accord, for example, the federal government taxes the offshore activities using the Newfoundland Income Tax Act to determine the amount of tax. The tax is kept separate and is granted to the Newfoundland government by or through the Federal Department of Natural Resources (the Nova Scotia Accord works in a similar fashion). From the taxpayer's perspective, the offshore area is taxed as if the offshore area were in either Newfoundland or Nova Scotia, as the case may be, except the income is allocated and taxed as a separate province using Regulation 411 (which contains a special rule for the allocation of a corporation's income whose chief business is the operation of a pipeline).

Finally, for the purposes of the application of these income allocation rules to a corporation that is not a resident of Canada, Regulations 413 defines certain terms, such as "salaries and wages paid in the year", "taxable income" and "total gross revenue for the year", as generally not including what is reasonably attributable to a permanent establishment outside Canada.

We have attached a copy of the relevant provisions of the Act and of the Regulations for your information.

We trust our comments are of assistance.

Yours truly,

Olli Laurikainen, CA
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch