20 February 2007 Internal T.I. 2007-0221261I7 - Definition of "corporation" in subsection 248(1).

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.

                                          February 20, 2007

XXXXXXXXXX                                HEADQUARTERS
Appeals Division                          A. Seidel, CMA
XXXXXXXXXX  Tax Services Office           (613) 957-2058

                                          2007-022126

Pakistan Association of Persons

We are writing in response to your January 18, 2007 facsimile and the attached submission from XXXXXXXXXX (the "Submission") concerning the inclusion, pursuant to the provisions of the Income Tax Act (the "Act"), of income earned by a resident of Canada from an "association of persons" ("AOP") formed and carrying on business in Pakistan as discussed in our November 8, 2006 memorandum (file #2006-020318) (the "Memo").

The Submission does not provide any additional information with respect to the "Background" portion of our Memo.

Summary of the Submission

The business is carried on as an AOP. The AOP has a separate legal existence from its members. 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 Submission states that the following provides conclusive evidence that the AOP 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 AOP. The profits of the business are taxed at the AOP level, not at the member level. Furthermore, if the AOP is treated as a partnership, Canadian members would be unable to use the tax paid by the AOP for foreign tax credit purposes. For all of the above reasons, the AOP cannot be a partnership.

2. The taxpayer is a full-time resident of Canada and therefore could not be actively carrying on the business of the AOP as a partner in a partnership. Due to her age, the taxpayer's mother, the other partner in the business, could not be running a major business on her own in Pakistan. The AOP has professional managers and administrators running the business which also has a corporate organizational structure.

3. Per the provisions of Article VII of the Canada-Pakistan Income Tax Convention, the income earned by the AOP cannot be taxed in Canada, as the business is not carried on in Canada.

Our Comments

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 AOP is a corporation, the Canada Revenue Agency considers such matters as:

(I) Does the AOP issue share capital or something else which serves the same function as share capital?

(II) Are the members of the AOP entitled to share in the AOP'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 AOP's profits?

(III) Does the AOP have a legal existence separate from that of its members?

(IV) Do the members of the AOP have an undivided interest in each property held by the AOP or does the AOP own the property used in the business?

(V) Who is responsible for the debts incurred as a result of the carrying on of the business: the AOP or its members?

(VI) Are there restrictions on the transferability of the ownership rights in the AOP?

With respect to (I) above, the Submission confirms that the AOP does not issue share capital and does not have, or issue, anything that serves the same function as "share capital".

With respect to (II) and (III) above, the Submission states that the AOP must have a separate legal existence because it is subject to tax under Pakistan Tax Law at the entity level, not at the "members" level. The Submission focuses on where the profits of an AOP are taxed under Pakistan Tax Law and submits that this demonstrates the fact that the AOP has legal existence separate from its members. It is our view that this fact is neither determinative of separate legal existence of an AOP nor is it otherwise a factor relevant to the determination of whether an AOP will be treated as a corporation or a partnership for Canadian income tax purposes. Although certain AOP's are treated as a separate entity under Pakistan Tax Law, this does not create a separate legal person under commercial law. Pakistan, as a sovereign nation, can levy domestic taxes in any manner that it chooses and without regard to whether or not the entity being taxed has separate legal personality and existence under commercial law. Just as our Act has specific rules that apply to the taxation of income earned by a proprietorship, a partnership and a corporation, these rules do not determine the characteristics of the entity earning that income. The rules in the Act are only applied after the form of entity has been determined under commercial law. Similarly, under the Pakistan Tax Law, the rules relating to the taxation of an AOP/"professional" AOP are only relevant after it has been determined whether/what type of an AOP is actually in existence. As a result, the Canada Revenue Agency's determination of whether or not a particular AOP is a partnership for purposes of the Act is not influenced by the treatment of the AOP under Pakistan Tax Law.

With respect to (II) above, the Submission states that the AOP must have a separate legal existence because there are contracts and agreements in the name of the AOP. It is our view that this, in and by itself, does not give the AOP a separate legal existence from its members. Partnerships formed under Canadian commercial law are also permitted to use the name of the partnership in contracts and agreements. When determining separate legal existence of an entity, one must look at the legal affect of the contracts/agreements entered into by the parties. Where contracts/agreements are legally binding on all members of an AOP, regardless of which member entered into the contracts/agreements, it is reasonable to conclude that the AOP does not have a separate legal existence from its members whereas contracts/agreements that are only legally binding on the AOP (i.e. as opposed to its members) would support the conclusion that the AOP has a separate legal existence from its members. The Submission does not provide any additional information that would cause us to change our understanding that the AOP is a group of persons (originally the mother and father of the taxpayer and now the taxpayer and his mother) who have voluntarily joined together through a common agreement with a common purpose for a common enterprise, being the operation of the business carried on by the two of them. It is therefore our view that the AOP does not have a separate legal existence from its members.

The determination that the AOP is a partnership under Canadian commercial law is also supported by the Tax Court decision in Philip Backman v. Her Majesty the Queen, 97 DTC 1468, ("Backman") and the Supreme Court decision in Continental Bank Leasing Corporation v. Her Majesty the Queen, 98 DTC 6505 ("Continental Bank"). In Backman, the Tax Court was faced with the issue of whether a limited partnership formed under Texas law constituted a partnership under the Act. To do so, the Tax Court considered the meaning of a "partnership" for purposes of the Act. Since the Act does not define what a partnership is, the Tax Court reiterated that the courts look to the specific partnership legislation under which a Texas partnership is formed to determine whether or not a particular arrangement had the attributes of a Canadian partnership. The Tax Court expressed the view that, even in respect of foreign partnerships, the essential elements of a partnership that exists under Canadian law must be present for the purposes of section 96 of the Act. The Tax Court concluded that, in both common law and civil law, a partnership exists in Canada where the members of the partnership carry on an activity (or business) in combination (or common) with the intention of making a profit and that such a partnership would seem to be the type of partnership to which section 96 of the Act would apply. In Continental Bank, the Supreme Court concluded that a partnership is a contractual relation, an agreement between two or more persons, to run a business together in order to make a profit and that the existence of a partnership is determined by what the parties actually contracted to do, either by agreement or by their conduct.

In this particular case, the AOP was formed as a partnership between a husband and a wife and the taxpayer only became a member of the AOP upon the death of his father. Based upon the information provided to us, and the information available on the AOP's website, there is clear evidence that the business of the AOP is carried on by the taxpayer and his mother. The AOP has other employees, but only two owners, and it is these two owners that are directly entitled to all of the profits earned by the AOP. Although the Submission proposes that the income earned by the AOP be taxed in the hands of the partners when amounts are actually withdrawn by them, for Canadian income tax purposes the income earned by a partner from a partnership is included in computing the partner's income when the income is earned and not when amounts are actually withdrawn from the AOP.

With respect to (V) and (VI) above, the Submission does not deny the fact that the members of the AOP are responsible for the debts incurred as a result of the carrying on of the business, it simply states that there are none. The Submission confirms that there are restrictions on the transferability of the ownership rights in the AOP.

The Submission repeats the argument that the provisions of Article VII of the Canada-Pakistan Income Tax Convention apply to the AOP, such that the income earned by the AOP cannot be taxed in Canada as the business is not carried on in Canada. However, as pointed out in the Memo, section 6.2 of the Income Tax Conventions Interpretation Act provides 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 to deny Canada's right to tax a Canadian partner's share of the income of the AOP.

Conclusion

The Submission reiterates the arguments previously considered and raises numerous hypothetical questions. However, there is nothing substantive in the Submission that would cause us to change our previous conclusion that this AOP should be treated as a partnership for purposes of the Act. As stated in our Memo, our conclusion is supported by: the fact that the AOP is not a company under the commercial law of Pakistan and does not have share capital; the fact that the tax treatment under Pakistan Tax Law is not relevant to the determination of whether the AOP is a partnership or a corporation for purposes of the Act; the fact that the AOP does not have a separate legal existence from its owners; and the fact that it is the taxpayer and his mother, the two partners of the AOP, that are actively carrying on the business of the AOP and are entitled to all of the profits earned by the AOP.

Additional Comment

Treating the AOP as a partnership for purposes of the Act would result in the taxpayer being required to include, in computing his income for Canadian income tax purposes, his share of the income from the AOP. The Submission once again raises the issue of whether the taxpayer would be entitled to a foreign tax credit for the taxes paid by the AOP, not the member, under Pakistan Tax Law in respect of this income. As pointed out in the Memo, since the Canada Revenue Agency would consider the tax paid by the AOP to have been paid by the partners in proportion to their share of the profits of the AOP, such tax is a business-income tax, for the purposes of subsection 126(2) of the Act, and the taxpayer would be entitled to claim foreign tax credits in the year for which the taxes are paid.

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. 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