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: How will an "association of persons", carrying on business in Pakistan, be classified for purposes of the Act, as a corporation or as a partnership.
Position: A partnership.
Reasons: The characteristics of an association of persons are similar to the characteristics of a partnership under Canadian commercial law.
November 8, 2006
XXXXXXXXXX HEADQUARTERS
International Tax Advisor A. Seidel, CMA
International Tax (613) 957-2058
XXXXXXXXXX Tax Services Office
Attention: XXXXXXXXXX
XXXXXXXXXX Tax Services Office 2006-020318
Pakistan Association of Persons
We are writing in response to your August 11, 2006 memorandum in which you requested our comments concerning the income inclusion, pursuant to the provisions of the Income Tax Act (the "Act"), of amounts received by a resident of Canada from an "association of persons" ("AOP") formed and carrying on business in Pakistan.
Background
XXXXXXXXXX (hereinafter referred to as the "Original Owner") and her now deceased husband, XXXXXXXXXX (hereinafter referred to as the "2nd Original Owner"), began the XXXXXXXXXX business (the "Business") in XXXXXXXXXX (hereinafter referred to as the "New Owner") acquired his interest in the particular AOP (the "PAOP"), which carried on the Business, upon the death of the 2nd Original Owner. It is our understanding that no other persons have ever held an equity interest in the PAOP. The Original Owner is a resident of Pakistan for purposes of the Act. The New Owner immigrated to Canada on XXXXXXXXXX and was, for the XXXXXXXXXX taxation years, a resident of Canada for purposes of the Act.
In computing his income for Canadian income tax purposes, the New Owner included his share of the income from the Business for the XXXXXXXXXX fiscal periods of the Business ending in those taxation years. The New Owner claimed a foreign tax credit for the taxes paid by the PAOP on such income in Pakistan. The XXXXXXXXXX Taxation Centre (the "XXXXXXXXXX") requested support for the New Owner's XXXXXXXXXX claim for foreign tax credits. According to the XXXXXXXXXX, no supporting documentation was ever received and the XXXXXXXXXX disallowed the New Owner's claim for foreign tax credits.
The New Owner subsequently requested that the income from the Business previously included in his income should be deleted, as it was not taxable in Canada. The New Owner is claiming that the PAOP should be treated as a corporation for Canadian tax purposes such that only "dividend" type distributions from the PAOP are to be included in his income.
New Owner's Representative's Submissions
The Business is carried on as an AOP. For all intents and purposes, an AOP acts like a company in its corporate structure and activities rather than as a partnership. Its tax treatment in Pakistan is similar to that of a corporation in Canada in that the entity pays the income taxes, not its members.
The following provides evidence that the PAOP is a corporation, and not a partnership, for Pakistan and Canadian income tax purposes:
1. The income earned by the Business does not flow through to the owners of the PAOP. Since there is no sharing of profits, the PAOP cannot be a partnership.
2. The profits of the Business are taxed at the PAOP level, not at the member level. Therefore any Canadian members cannot use the tax paid by the PAOP for foreign tax credit purposes.
3. The New Owner is a full-time resident of Canada and therefore could not be actively carrying on the Business of the PAOP as a partner in a partnership.
4. Due to her age, the Original Owner could not be running a major business on her own in Pakistan.
5. The PAOP has professional managers and administrators running the Business and has a corporate organization chart structure. It is not a two-person show. The New Owner and the Original Owner are clearly not carrying on a business in common with a view to profit. They hold shareholdings in the venture, shareholdings that the New Owner received as a beneficiary of the 2nd Original Owner's estate.
6. Per the provisions of Article VII of the Canada-Pakistan Income Tax Convention, the income earned by the PAOP cannot be taxed in Canada, as the Business is not carried on in Canada.
The New Owner's representative also states that, after numerous discussions with renowned experts in Canadian and international taxation law, including chartered accountants, certified public accountants and tax lawyers based in Canada, Pakistan and the U.S.A., there is unanimous feedback and opinions received to support the conclusion that the CRA is ignoring the "conspicuously obvious and self-evident aspects of this case".
There is little in the way of statutory guidance on how to characterize a foreign business association for Canadian tax purposes. However, in our view, the appropriate approach to classifying an entity is, first, to determine the characteristics of the foreign business association under foreign commercial law, and then, compare these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories. This two-step approach has been adopted by Canadian courts and is also supported by the leading cases in the United Kingdom.
To decide whether or not the PAOP is a corporation, the CRA considers such matters as:
(I) Does the PAOP have a legal existence separate from that of the Original Owner and the New Owner?
(II) Does the PAOP issue share capital or something else which serves the same function as share capital?
(III) Do the Original Owner and the New Owner have an undivided interest in each property held by the PAOP or does the PAOP own the property used in the Business?
(IV) Are the Original Owner and the New Owner entitled to share in the PAOP's profits as they arise or does the amount of profits to which they are entitled depend on a decision of someone else to make a distribution of the PAOP's profits?
(V) Who is responsible for the debts incurred as a result of the carrying on of the business: the PAOP or the Original Owner and the New Owner?
(VI) Are there restrictions on the transferability of the ownership rights in the PAOP?
Under Pakistan law, the "Companies Ordinance (1984)" (the "Pakistan Companies Act"), a company is formed when two or more persons, associated for any lawful purpose, subscribe their names to a memorandum of association and register the company in accordance with the requirements of the Pakistan Companies Act. It is our understanding that the PAOP is not registered as a company under the Pakistan Companies Act and does not have a separate legal existence from its members.
There is no legislation, such as the Pakistan Companies Act, that is applicable to an AOP. It is our understanding that an AOP is a group of persons who have voluntarily joined together through a common agreement with a common purpose for a common enterprise. The members of an AOP may be individuals or any other legal persons or entities and an AOP is governed by the agreement entered into between the members that form the AOP. An AOP does not issue share capital. In this particular case, the PAOP was formed in 1977 by the Original Owner and the 2nd Original Owner. The New Owner acquired his interest in the PAOP upon the death of the 2nd Original Owner. The PAOP does not have, or issue, share capital or anything that serves the same function as "share capital".
The certificate issued by the Central Board of Revenue of Pakistan on XXXXXXXXXX confirms that the PAOP is an AOP for domestic tax purposes. Pursuant to section 80 of the Income Tax Ordinance, 2001 (the "Pakistan Tax Law"), some AOP's are treated as a separate person "for the purposes of this Ordinance". The Pakistan Tax Law provides the following inclusive definition for an AOP: "a firm, a Hindu undivided family, any artificial juridical person and any body of persons formed under a foreign law, but does not include a company". This definition includes entities that may be treated as corporations and entities that may be treated as partnerships for Canadian income tax purposes. The fact that an AOP is taxed as a separate person under the Pakistan Tax Law is not determinative of whether or not an AOP will be treated as a corporation for Canadian income tax purposes.
The New Owner's representative argues that the classification of the PAOP as a corporation for purposes of the Act would result in consistent treatment of the entity under Canadian tax law and under Pakistan Tax Law. However, where a particular AOP is a "professional" AOP (generally AOP's where all of the members are either accountants or lawyers), the income earned by such an AOP is taxed in the hands of the members. No tax is paid at the AOP level. Therefore, regardless of the position taken with regard to the classification of an AOP as a corporation or a partnership under the Act, there could always be inconsistencies between the treatment of an AOP under the Act and the treatment of an AOP under Pakistan Tax Law such that this argument by the New Owner's representative cannot be determinative of the issue.
A second argument that the New Owner's representative makes for the classification of the Business as a corporation rather than a partnership is tied into the arguments that: the Business is operated like a company in its corporate structure; the New Owner is a full time resident of Canada and therefore could not be carrying on the Business in Pakistan; the Original Owner, due to her age, is not able to carry on the Business in Pakistan on her own; and the Business is run by professional managers and administrators such that the Original Owner and the New Owner cannot be viewed as carrying on the Business in common with a view to profit.
The following would suggest that these assertions are not supported by the facts. Firstly, the "corporate structure" indicates that the Business is overseen by a "chief executive officer" ("CEO") and that the CEO reports directly to a chairperson. The website for the Business XXXXXXXXXX identifies the Original Owner as the chairperson and the New Owner as the CEO for the Business. Clearly both of these individuals, as the only members of the PAOP, are active in the carrying on of the Business. Secondly, the entire business employs approximately XXXXXXXXXX individuals. The "corporate structure" identifies XXXXXXXXXX "management" positions (including the CEO and the chairperson), including a general manager-marketing, a general manager-procurement and a "managing partner" for the XXXXXXXXXX division. All three of these positions "report" directly to the CEO, being the New Owner. When you consider all of these factors as a whole, it is reasonable to conclude that the Original Owner and the New Owner are the only members of the PAOP and that they actively carry on the Business of the PAOP with a view to earning a profit.
There is not sufficient information in the XXXXXXXXXX financial statements for the POAP to determine whom has ownership of the assets used in the Business (approximately $XXXXXXXXXX is shown as the undepreciated balance in the financial statements) nor do they specify who is responsible for the debts incurred by the Business (excluding bank advances which are also shown as an asset on the balance sheet, approximately XXXXXXXXXX% of the total liabilities relate to accounts payable and advances from customers).
The New Owner's representative has not provided the CRA with any specific copies/details of any of the opinions that he makes reference to in his submissions to the XXXXXXXXXX.
Conclusion
Based upon the fact that: the PAOP is not registered as a company under the Pakistan Company Act; the PAOP does not have a separate legal existence from the Original Owner and the New Owner; the Original Owner and the New Owner are entitled to receive the after-tax profits of the Business as they are earned; the PAOP does not have share capital or anything that resembles share capital; the Original Owner and the New Owner are the only members of the PAOP; and the Original Owner and the New Owner actively carry on the Business of the PAOP, it is our view that the PAOP would be a partnership for purposes of the Act.
A final argument of the New Owner's representative is that the provisions of Article VII of the Canada-Pakistan Income Tax Convention apply to an AOP, such that the income earned by the PAOP cannot be taxed in Canada as the Business is not carried on in Canada. However, section 6.2 of the Income Tax Conventions Interpretation Act states that "notwithstanding the provisions of a convention between Canada and another state or the Act giving it the force of law in Canada, it is hereby declared that the law of Canada is that, for the purposes of the application of the convention and the Income Tax Act to a person who is a resident of Canada, a partnership of which that person is a member is neither a resident nor an enterprise of that other state". Accordingly, it is our view that Article VII of the Canada-Pakistan Income Tax Convention does not apply in this situation such that the New Owner's share of the income from the PAOP is included in computing the New Owner's income for purposes of the Act.
Once the PAOP has paid the taxes applicable to its profits under the Pakistan Tax Law, the members of the PAOP are entitled to receive the after-tax profits on a tax-free basis under the Pakistan Tax Law. Treating the PAOP as a partnership for purposes of the Act would result in the New Owner being required to include, in computing his income for Canadian income tax purposes, his share of the income from the PAOP. Since the CRA would consider the tax paid by the PAOP to have been paid by the partners in proportion to their share of the profits of the PAOP such tax is a business-income tax for the purposes of subsection 126(2) of the Act and the New Owner would be entitled to claim foreign tax credits in respect of his share in the year for which the taxes are paid.
We hope that our comments are of assistance. If you wish to discuss any of the above, please contact the writer.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and 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. 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.
Olli Laurikainen, CA
for Director
International & Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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