17 July 2006 Internal T.I. 2006-0181911I7 - Determination of Foreign Source Business Income

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 formulary apportionment method that is used in computing U.S. state corporate business taxes is acceptable for determining qualifying income (i.e. U.S. source income) for Canadian foreign tax credit purposes?

Position: No.

Reasons: A separate accounting approach (traditional transaction method) is more consistent with the scheme of the Income Tax Act and supported by jurisprudence.

								July 17, 2006

	XXXXXXXXXX  Tax Services Office		HEADQUARTERS
	XXXXXXXXXX 						Income Tax Rulings
	Senior International Tax Auditor		Directorate
	Verification and Enforcement Division	S. Leung, CA
(613) 952-4666

								2006-018191

XXXXXXXXXX - Foreign Tax Credits ("FTC")

We are writing in reply to your Memorandum of April 12, 2006 in which you request our view as to whether your approach of computing net foreign business income for FTC purposes by marking up the amount paid to the U.S. sales agents by 5% to 7% is appropriate and is consistent with the position afforded to situations similar to the situation of XXXXXXXXXX. You indicate that the taxpayer has made the allocation using a formula based on U.S. state income tax law as described in paragraph 6 below. We acknowledge the additional information you provided in response to our email request of June 21, 2006.

The facts of the situation can be summarized as follows:

1. XXXXXXXXXX, a taxable Canadian corporation within the meaning assigned by subsection 89(1) of the Income Tax Act (the "Act"), manufactures XXXXXXXXXX exclusively in Canada for sale in Canada, the U.S. and other countries.

2. Sales to U.S. customers are arranged by independent agents located in the U.S. who are acting in the ordinary course of their business and who do not have the authority to conclude contracts on behalf of XXXXXXXXXX.

3. In XXXXXXXXXX sales to U.S. customers comprised XXXXXXXXXX% of total sales; sales to Canadian customers XXXXXXXXXX% and sales to customers of other countries XXXXXXXXXX%. Total sales in U.S. dollars for XXXXXXXXXX were US$XXXXXXXXXX and the total adjusted net income for Canadian FTC purposes was $XXXXXXXXXX.

4. XXXXXXXXXX is considered to be carrying on business in the U.S. but for the purposes of the Canada-United States Income Tax Convention (the "Convention"), XXXXXXXXXX does not have a permanent establishment in the U.S. by virtue of paragraph 6 of Article V of the Convention and the business profits are therefore not subject to U.S. federal taxation.

5. For XXXXXXXXXX, XXXXXXXXXX paid U.S. state taxes to XXXXXXXXXX U.S. states, namely XXXXXXXXXX.

6. XXXXXXXXXX computed its XXXXXXXXXX net foreign business income (qualifying income) for FTC purposes in accordance with the formula used by the U.S. states, such as XXXXXXXXXX, where such states imposed corporate business taxes on XXXXXXXXXX. The formula used by U.S. states to determine the amount of the U.S. income taxable in a particular state is to multiply the total net income of XXXXXXXXXX by a specified percentage applicable to that state. For example, the specified percentage applicable to XXXXXXXXXX is based on three factors: (i) the percentage of gross revenue derived from XXXXXXXXXX in proportion to total gross revenue; (ii) the percentage of payroll paid to employees in XXXXXXXXXX in proportion to gross payroll everywhere; and (iii) the percentage of real and tangible personal property located in XXXXXXXXXX in proportion to all real and tangible personal property everywhere. The percentage of gross revenue derived from XXXXXXXXXX is then multiplied by 2 before the other two percentages are added to arrive at a total percentage. This total percentage is then divided by 4 to arrive at the specified percentage applicable to XXXXXXXXXX. Under this formula, it should be noted that twice the weight is given to gross revenue as compared with the weight given to payroll or real and tangible personal property.

Issue

Whether the method of allocating income to the U.S. by using the U.S. state-adopted formula described above is acceptable in computing qualifying income for FTC purposes? Would a mark-up of 5% to 7% on the sale commission (or plus the selling expenses) present a truer picture of qualifying income for FTC purposes?

Our comments

In your email of June 21, 2006, you commented that you had accepted that XXXXXXXXXX is carrying on business in the U.S. through a "branch" (but with no permanent establishment in the U.S. for the purposes of the Convention). As a result, you do not need our comments on the issue of whether XXXXXXXXXX is carrying on a business in the U.S. It is also an agreed fact (see our Document #2003-0018905, dated June 20, 2003), that the XXXXXXXXXX corporate business tax is an income or profit tax and therefore a "business-income tax" within the meaning assigned by subsection 126(7) of the Act. We assume that all the other state business taxes paid by XXXXXXXXXX are levied in the same or similar manner and as a result are business-income taxes for FTC purposes. We will focus our attention on the issue of what is the best method for allocating income to a territorial source.

As you are aware, there is not much guidance in either the Act or in case law about how to allocate income to a source. In the last ten years, because of the emerging issues of e-commerce, several books and articles have surfaced to discuss and explore the issues of source taxation and the attribution of profits to a permanent establishment¹ . These books and articles all dealt with the allocation of profits to a permanent establishment of a multinational enterprise, not to a "branch" (with no permanent establishment) as in the case at hand, and they fell short of agreeing on an equitable method of profit allocation to a permanent establishment. The 2004 revised discussion draft of the OECD regarding the attribution of profits to a permanent establishment insists that the transfer pricing approach along with the arm's length principle should continue to be used in attributing profits to a permanent establishment. The participants to the Invitation Seminar² generally agreed that this approach, in theory and in principle, is the correct approach but mourned of the lack of a uniform approach to the interpretation and application of Article 7 of the OECD Model Convention. Some academics and practitioners suggested that the traditional transaction approach³ be abandoned in favour of the global profit split methodology.⁴ Hence, the allocation of profits to a permanent establishment is a difficult issue that has been debated for many years. In the case at hand, although the case does not involve (i) a permanent establishment as that term is defined in Article V of the Convention but only the carrying on of business by XXXXXXXXXX in the U.S. through independent agents or (ii) U.S. federal income tax covered by the Convention but only certain state business taxes which have nothing to do with the Convention, the same methodology as would be used in allocating profits to a permanent establishment would, in our view, be relevant in apportioning the income of a business to the various places the business is carried on.

As noted in our Document #2000-0001017, dated January 11, 2001, several Privy Council court cases⁵ have established the principle that income should be allocated to the province in which the goods were manufactured and processed in addition to the province in which the goods are sold as the manufacturing activities also contributed to the profits of the enterprise. However, these cases fell short of detailing how the profits are to be allocated. In the case at hand, this principle is upheld by XXXXXXXXXX as profits were allocated to both Canada and the U.S. The issue is whether the method of allocating profits to the U.S. "branch" for FTC purposes used by XXXXXXXXXX is acceptable. As noted above, XXXXXXXXXX uses the formulary apportionment method adopted by many U.S. states. This method applies to the income of a "unitary business". The three-factors formula (payroll, property and sales) adopted by the Uniform Division of Income for Tax Purposes Act (UDITPA) of the U.S. is used in many U.S. states. This formulary apportionment method has been offered as an alternative to the arm's length principle.⁶ By using this method for the year XXXXXXXXXX allocated about XXXXXXXXXX%⁷ of total net income to the states in the U.S. that levied corporate business tax on XXXXXXXXXX. Was such allocation of net income for FTC purposes reasonable in the circumstances?

The Act itself does not provide a detailed method of profit allocation to different territorial sources. Paragraph 4(1)(b) of the Act simply requires that income or loss from a business carried on in a particular place be computed separately from that carried on in another place. That paragraph reads in part as follows:

"where the business carried on by a taxpayer ... was carried on ... partly in one place and partly in another place, the taxpayer's income or loss for the taxation year from the business carried on ... in the particular place is the taxpayer's income or loss ... computed in accordance with this Act on the assumption that the taxpayer had during the taxation year no income or loss except from the part of the business that was carried on in that particular place ..., and was allowed no deductions in computing the taxpayer's income for the taxation year except such deductions as may reasonably be regarded as wholly applicable to that part of the business ..., and except such part of any other deductions as may reasonably be regarded as applicable thereto."

When a property (inventory, depreciable property, eligible capital property and capital property) begins or ceases to be used in a business, certain provisions of the Act such as subsections 10(12) and 10(13), paragraphs 13(7)(a) and 13(7)(b) and subsections 13(9), 14(14), 14(15) and 45(1) require that the property be acquired or disposed of at fair market value. Other than the above, the Act does not provide any statutory provisions for allocating income and expenses to a particular source.

Other than those cases noted in footnote 5, we have only a handful of court cases dealing with source taxation or the attribution of profits to a permanent establishment⁸ , but none of these has any direct bearing on the issue at hand.

The CRA publications on this issue are also limited. The most relevant ones are Documents #2000-0001017 and Document #9235160. Document #2000-0001017 dealt with a situation where for FTC purposes the Canadian corporate taxpayer who was the manufacturer of goods sold in Japan allocated to its permanent establishment in Japan all the profits from the sale of goods in Japan, even though for the purposes of the Canada-Japan Income Tax Convention (the "Japanese Treaty") the taxpayer followed the requirements of Article 7 to compute a notional cost of sales based on an arm's length value of the goods "sold" by the manufacturing division in Canada. As a result, the method used by the taxpayer for computing net foreign business income under the Japanese Treaty is different from that for FTC purposes. The CRA opined that for FTC purposes the taxpayer should follow the same method it used to compute its net foreign business income under the Japanese Treaty as it gave a truer picture of the profits earned in Japan by the permanent establishment. Another document, #9235160, was written in response to a question at the 1992 Tax Executives Institute Roundtable in a situation where a non-resident corporation sold goods in Canada through its parent company which had the authority to conclude sales contracts in the name of the non-resident corporation. In the response CRA indicated that a notional cost of sales representing the fair market value of the goods manufactured or processed as determined by arm's length sales of these goods under comparable conditions was the appropriate method for computing income from a business carried on in Canada by the non-resident corporation.⁹

As to whether XXXXXXXXXX's method of allocating profits to the U.S. based on a formulary apportionment method adopted by many U.S. states is acceptable for FTC purposes, it should be noted that the Act and the Regulations thereto contain formulary apportionments for certain purposes, such as under the thin capitalization rule in subsection 18(4) and for the allocation of taxable income of a corporation earned in a province under Regulations 402.¹⁰ The two-factors formula (gross revenue and payroll) used in the latter is particularly generous in that if it were to apply in the situation at hand for the year XXXXXXXXXX, approximately one-half of XXXXXXXXXX% (or XXXXXXXXXX%) of the profits from all sales of XXXXXXXXXX (because U.S. sales representing XXXXXXXXXX% of all sales of XXXXXXXXXX in XXXXXXXXXX) would have been allocated to the U.S. as U.S. source income for FTC purposes.

However, there is no statutory formulary apportionment provision in the Act or the Regulations relating to the determination of qualifying income for FTC purposes as there is for the allocation of taxable income of a corporation earned in a province. Although the Act and the Regulations contain certain formulary apportionment provisions, it does not mean that in all circumstances a formulary apportionment method is acceptable. Formulary apportionment methods provide a greater degree of certainty and simplicity but they are also arbitrary. They may not reflect the true contributions made by various segments of an enterprise for the earning of profits. In the case at hand, we feel that where all the XXXXXXXXXX were manufactured in Canada and all the sales were concluded in Canada, even though much of the XXXXXXXXXX were sold in the U.S. through independent agents, it does not warrant the allocation of XXXXXXXXXX% of the profits to the U.S. for FTC purposes for the year XXXXXXXXXX.¹¹

Notwithstanding that for the purposes of the Convention XXXXXXXXXX does not have a permanent establishment in the U.S., we feel that for FTC purposes the activities carried on by the independent agents in the U.S. could be analogized as activities carried on by a permanent establishment in the U.S. As such, a method similar to that provided in Article 7(2) of the OECD Model Convention (i.e., separate entity concept and arm's length principle) should be used to allocate profits to different territorial sources for FTC purposes. As was mentioned above, the majority of the OECD member countries as well as many tax administrators continue to opt for the separate entity approach and the arm's length principle of transfer pricing instead of the formulary apportionment method even though it appears that the European Union (EU) is contemplating to use the formulary apportionment method to some extent.

The transfer pricing methods approved by OECD and Canada include the comparable uncontrolled price method ("CUP"), the resale-price method, the cost-plus method, the profit split method, and the transactional net margin method ("TNMM").¹² The CUP method and the cost-plus method could be used to estimate the notional selling price of the XXXXXXXXXX to the U.S. "branch". Accordingly, the profits allocated to the U.S. "branch" could be determined by subtracting from the selling price to U.S. customers the notional cost of sales and selling expenses (including remunerations and commissions paid to the independent agents).

If for some reason the CUP method or the cost-plus method is not readily available, the resale-price method could be used by determining the percentage of gross margin that would normally be provided to the independent agents as commissions and selling expenses in that industry. Depending on the industry information this method could support your proposal of a mark-up of 5% to 7% on the commissions paid to the independent agents.¹³

We feel that in the case at hand, the separate accounting approach (i.e., separate entity concept and arm's length principle) is far better than the formulary apportionment method used by XXXXXXXXXX to compute qualifying income for FTC purposes for the following reasons:

(a) The OECD approves and insists on using the separate accounting approach to allocate profits to a permanent establishment in accordance with Article 7 of the OECD Model Convention. The separate accounting approach (i.e., transfer pricing approach along with the arm's length principle) has over 70 years of history;

(b) The CRA's position as stated in Document #2000-0001017 indicated that the separate accounting approach is a fairer method offering a truer picture of the profits of a permanent establishment, especially when it is applied to a relatively uncomplicated organization like XXXXXXXXXX;

(c) The formulary apportionment method is arbitrary;

(d) Using sales factor in a formulary apportionment method is rather weak as noted in footnote 11;

(e) FTC should not be granted on Canadian source income. In this case it appears the formulary apportionment method used by the taxpayer allocates Canadian source income to a foreign branch;

(f) Even though double taxation may occur where the determination of income from a territorial source is different between Canada and the U.S. states in issue, Canadian taxation of foreign source income should not be dictated by a U.S. state-adopted formula; and

(g) Separate accounting approach is consistent with the scheme of the Act in light of subsections 10(12) and 10(13) and other similar provisions referred to above.

Conclusion

In our view the separate accounting approach (the traditional transaction method) is the best approach for allocate profits (qualifying income) to the U.S. "branch" in the case at hand. This is consistent with CRA's position as expressed in Documents #2000-0001017 and #9235160. Your approach of determining U.S. source income of XXXXXXXXXX by marking up the commissions of U.S. sales agents by a certain percentage, depending on the facts, may or may not, produce a reasonable allocation. We reject the formulary apportionment method used by XXXXXXXXXX for the allocation of net income to a particular U.S. state (such as XXXXXXXXXX) based on the state's corporate business tax return and we find that such method appears in the case at hand to allocate Canadian source income the U.S. Accordingly, such allocation should not be used for the purposes of computing qualifying income under subsection 126(2.1) of the Act.

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 copy severed using the Privacy Act criteria which does not remove client identity. Request for this latter version should be made by you to Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Yours truly,

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

ENDNOTES

¹ See, for example, "The Attribution of Profits to Permanent Establishments - The taxation of intra-company dealings", edited by Raffaele Russo, IBFD; "The Taxation of Business Profits Under Tax Treaties" by Brian Arnold, Jacques Sasseville, and Eric M. Zolt, Eds. (Canadian Tax Foundation); "International Taxation in the Age of Electronic Commerce: A Comparative Study" by Jinyan Li, (Canadian Tax Foundation); The OECD Discussion Draft on the Attribution of Profits to Permanent Establishment - Part I (General Consideration) (Paris, OECD, August 2004); "Subject II: The Attribution of Profits to Permanent Establishments" (Canadian Branch Report) by Marc Darmo and Carrie Smit, IFA Congress 2006 Amsterdam; "Global Profit Split: An Evolutionary Approach to International Income Allocation" by Jinyan Li, (2002, vol. 50, no.3 Canadian Tax Journal, 823-867); "Rethinking Canada's Source Rules in the Age of Electronic Commerce: Part 1", by Jinyan Li (1999, vol. 47, no. 5 Canadian Tax Journal, 1077-1125); "Rethinking Canada's Source Rules in the Age of Electronic Commerce: Part 2", by Jinyan Li, (1999, vol. 47, no.6 Canadian Tax Journal, 1411-1478); "Summary of Proceedings of an Invitational Seminar on the Attribution of Profits to Permanent Establishments" by Brian Arnold and Marc Darmo, (2001, vol. 49, no. 3, Canadian Tax Journal, 525-552); "The OECD Project: Transfer Pricing Meets Permanent Establishment", by Robert Couzin, (2005, vol.53, no. 2 Canadian Tax Journal, 401-408); and "Transfer Pricing and Attribution of Income to Permanent Establishments: The Case for Systematic Global Profit Splits (Just Don't Say Formulary Apportionment)", by Francois Vincent, (2005, vol. 53, no. 2 Canadian Tax Journal, 409-416).

² Supra, footnote 1.

³ This approach is based on transactions such as using the traditional comparable uncontrolled price method (CUP), resale-price method and cost-plus method of transfer pricing

⁴ For example, Jinyan Li and Francois Vincent; see their respective articles referred to in note 1.

⁵ 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. 3. Also see Commissioners of Taxation v. Kirk, [1900] A.C. 588.

⁶ See footnote 74 in "International Taxation in the Age of Electronic Commerce: a Comparative Study", supra footnote 1.

⁷ Total net income allocated to the states that applied corporate business tax to XXXXXXXXXX for XXXXXXXXXX of $XXXXXXXXXX divided by total adjusted net income for FTC purposes on T2 return of $XXXXXXXXXX and multiplied by 100 equals to XXXXXXXXXX%.

⁸ Such as Imperial Oil Ltd., [1960] CTC 275 (SCC); Interprovincial Pipelines Co., ]1968] CTC 156 (SCC); Twentieth Century Fox Film Corp., [1985] 2 CTC 328 (FCTD); Wuslich, [1991] 1 CTC 2473 (TCC); and Cudd Pressure Control Inc., [1999] 1 CTC (FCA); [1995] 2 CTC 2382 (TCC).

⁹ See also Documents #2003-0044127, #2002-0064665 and #9505676 for allocation of profits to a branch, between provinces, and on global trading, although they are not particularly on point to the issue at hand.

¹⁰ Other formulary apportionments include provisions regarding income of financial institutions and branch tax.

¹¹ Brian Arnold, Jacques Sasseville and Eric Zolt in their book "The Taxation of Business Profits Under Tax Treaties", page 230, stated, "If the aim is to devise a formula that replicates the distribution of profits under separate accounting, without the need to calculate transfer prices, the justification for including a sales factor is rather weak. Under separate accounting, a jurisdiction in which there are only sales would receive little or no tax revenue. A sales elements in a formula could therefore function to over-allocate profits to that jurisdiction compared to separate accounting. This assumes that the existence of sales within a state suffices to facilitate a claim to share in the profits generated by the enterprise. Even if a greater nexus, such as a PE, is required to attract a share of profits, that nexus does not legitimize the use of branch sales to attribute profits. The inclusion in the formula of the labour and property employed in the state through the establishment should adequately replicate the share of profits that the state could have expected under separate accounting from the distribution of products within the state (assuming that no manipulation of transfer prices under separate accounting occurs).

¹² See IC 87-R2 International Transfer Pricing for more details. See also "International Tax Primer", by Brian Arnold and Michael McIntyre, 2nd ed. 61-68 and "International Taxation in the Age of Electronic Commerce: A Comparative Study", by Jinyan Li, Canadian Tax Foundation, 109-114.

¹³ If a 5% or 7% mark-up is used, the profits allocated to the U.S. for the year XXXXXXXXXX would be from $XXXXXXXXXX to $XXXXXXXXXX if only remuneration paid to the independent agents are taken into account, or from $XXXXXXXXXX to $XXXXXXXXXX if selling expenses are also taken into account in addition to remuneration. There is a big difference from the amount of $XXXXXXXXXX arrived at using the U.S. state-adopted formulary apportionment method for that year.