16 October 2007 Internal T.I. 2007-0224221I7 - Carrying on business in the US

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: (1) Is Canco carrying on business in the US? (2) If we consider that Canco is carrying on business in the US, how should the income be allocated to that business?

Position: (1) Yes (2) Subsection 4(1)(b), the Revised Commentaries on Article 7 of the OECD Model Tax Convention and the OECD Report on the Attribution of Profits to Permanent Establishments provide some guidance when determining how to allocate income as pertaining to a foreign jurisdiction.

Reasons: (1) There are a number of indicators that suggest Canco may be carrying on business in XXXXXXXXXX , such indicators include the facts that, the product is stored in XXXXXXXXXX , title and beneficial ownership transfer in XXXXXXXXXX , and Canco receives payment for the product in its US bank account. (2)

								October 16, 2007

Toronto Centre Tax Services Office
36 Adelaide St., 4th Floor				Isabeau Morrissette
Toronto ON  M5C 1J7					(514) 283-5259

Attention: Cynthia Rhodes, Group # 443-3-1
								2007-022422

Subject : Carrying on business in the United States (US)

This is in reply to your various emails regarding the above-mentioned file.

Summary of the facts

XXXXXXXXXX

FA1 has entered into a contract (the "FA1 Contract") to distribute Canco's XXXXXXXXXX to US based customers. When a US consumer orders XXXXXXXXXX from FA1, pursuant to the FA1 Contract, FA1 is entitled to obtain such XXXXXXXXXX from Canco's inventory at the FA1 warehouse for a purchase price predetermined by the terms of the FA1 Contract.

Canco also has another wholly-owned foreign affiliate in XXXXXXXXXX ("FA2") that has entered into a contract (the "FA2 Contract") with Canco which gives it the exclusive right to distribute Canco's XXXXXXXXXX in the US to other XXXXXXXXXX and large retail chains. FA2 employs sales representatives throughout the US to support US sales activities and when US customers order from FA2, the FA2 Contract entitles FA2 to obtain the XXXXXXXXXX from Canco's inventory at the FA1 warehouse for a predetermined purchase price. The sales terms for FA2 sales are generally "FOB" (free on board; i.e., without freight or insurance) destination and FA2 generally pays the delivery charges. FA1 mails packages directly to the consumers, and then encloses an invoice that includes charges for delivery. However, if the consumer does not receive the package, FA1 will resend another package at FA1's cost. Ultimately, FA1 is responsible for lost packages as well as any failure on the part of a customer to settle his account.

FA1 bills its customers directly but FA2's customers are billed through an arm's length corporation ("XXXXXXXXXX") from which FA2 receives monthly invoices. Pursuant to the FA1 Contract, FA1 agrees to pay Canco XXXXXXXXXX% of the fixed purchase price on all net sales in its territory. In addition, FA1 agrees to provide Canco royalty payments in respect of the XXXXXXXXXX.

Canco does not have any employees in the US and does not play any direct role in selling XXXXXXXXXX to XXXXXXXXXX based customers (Canco's only nexus to XXXXXXXXXX is its XXXXXXXXXX inventory stored in FA1's warehouse). All sales of XXXXXXXXXX made by Canco to FA1 and FA2 occur in the manner discussed above. Canco supports all the risks of the inventory until the inventory arrives at FA1's warehouse in XXXXXXXXXX. Once FA1 has custody and control of the inventory, FA1 assumes the risks of loss or damage up to the per unit manufacturing cost, and the risk of XXXXXXXXXX. The market risk remains with Canco while the XXXXXXXXXX are stored in FA1's warehouse.

Canco has two bank accounts in XXXXXXXXXX. The first is an operating account used to pay all US invoices, including invoices for the XXXXXXXXXX. The payments made by FA1 and FA2 for the XXXXXXXXXX purchases are also deposited into this account. The second US bank account is maintained by the corporate head office, to pay miscellaneous amounts, such as XXXXXXXXXX State tax installments and any miscellaneous invoices.

Canco is subject to XXXXXXXXXX franchise tax under the XXXXXXXXXX State Tax Code.

FA1 and FA2 are US "C" Corporations incorporated in XXXXXXXXXX.

Issues

(1) Is Canco carrying on business in the US?

(2) If Canco is carrying on business in the US, how should the income of Canco be allocated as between XXXXXXXXXX and Canada?

The answers to these questions will have an impact on the amounts that should be used for foreign business income in the calculation of the foreign tax credits under the provisions of subsection 126(2). It is an agreed fact that for US federal income tax and the Canada-US Tax Convention, Canco is not considered to be carrying on business in the US through a permanent establishment ("PE"). It is also an agreed fact (for analysis see ruling document #9919789) that the XXXXXXXXXX franchise tax is an income or profits tax and therefore a "business-income tax" within the meaning assigned by subsection 126(7) of the Act.

Analysis

Question 1- Is Canco carrying on business in the US?

Our approach to the determination of whether a person resident in Canada is carrying on business in another country is the same approach that we use in determining whether a non-resident is carrying on business in Canada.

1. We determine whether there is a "business", as defined in subsection 248(1) of the Act.

2. If there is a business, we determine whether it is carried on, which generally requires some continuity and regularity.

3. If a business is being carried on we determine whether the business is being carried on in Canada and/or outside Canada.

Subsection 248(1) of the Act defines a "business" as including "a profession, calling, trade, manufacture or undertaking of any kind whatever and...an adventure or concern in the nature of trade but does not include an office or employment." We are of the view that the XXXXXXXXXX clearly constitutes a business within the meaning of subsection 248(1) and these activities are performed regularly and with continuity. Therefore, we believe that Canco satisfies both 1) and 2) above, and that the essential issue is whether any part of the business is carried on in the US.

Following is a list of the criteria the courts consider relevant in making a determination of whether a person is carrying on a business in a particular place:

1. where the contract which is the basis of the transaction is made;

2. where the goods are delivered or payments are made;

3. where the business assets are located;

4. whether an agent or independent contractor is utilized;

5. where the operations take place from which the profits in substance arise (as opposed to where profits are realized);

6. the nature of the activities/transactions;

7. the establishment of a bank account, listed telephone number or address;

8. whether the reason for compliance with a jurisdiction's rules and relations is business - or legally - motivated;

9. whether the taxpayer intended to do business in Canada;

10. place where the assets used in the business are purchased;

11. the degree of supervisory or other activity in Canada;

12. the substance or object of the transaction;

13. the presence of a representative or resident expert;

14. whether activities in Canada are merely ancillary to the main business (e.g., the business of buying, storing, selling or manufacturing the product);

15. whether individuals in Canada assist (or are available to assist) the taxpayer in his endeavour;

16. the reason for the taxpayer's existence; and

17. where a reasonable person would consider the business to be carried on.

The jurisprudence stresses that each situation must be decided on its own facts. In each case, the essential question is where the business operations take place. In Cutlers Guild Limited v. Her Majesty The Queen, 81 DTC 5093 (FC-TD), Dubé J. made the following observation:

Whether or not a taxpayer is carrying on a business in another country is a question of fact to be determined in each case. Courts have ruled that the place where sales, or contracts of sale, are effected is of substantial importance. However, the place of sale may not be the determining factor if there are other circumstances present that outweigh its importance.

This principle, that there is no single conclusive test, is also found in Crookston Bros v. Furtado ((1910) 5 T.C. 602). At page 628, the Lord Justice Clerk stated:

The case of Grainger seems to point to this, that when it appears in any case to be laid down that the matter is to be determined by considering whether the contract is made in England it is not necessarily to be taken as conclusive, without such other element occur in the cases respectively. The place of delivery, and the mode in which payment is carried out are both important elements in the matter.

In our case, both the FA1 Contract and the FA2 Contract were concluded in Canada. However, those contracts provide that the title and beneficial ownership of the XXXXXXXXXX inventory at the warehouse in XXXXXXXXXX remains with Canco until such time as either FA1 or FA2 has received a purchase order from a customer. Therefore, ownership of the XXXXXXXXXX passes from Canco to FA1 and FA2 at a point in time when the XXXXXXXXXX are physically in XXXXXXXXXX The taxpayer argues that the sales by Canco to FA1 and FA2 are made in XXXXXXXXXX . We are not convinced that the place of contract would be XXXXXXXXXX but we agree that the issue is not free from doubt.

As discussed above, aside from the place where the contract is made, which is recognized by the courts as a significant factor, there are other factors to consider. For example, title passes from Canco to FA1 and FA2 at the warehouse in XXXXXXXXXX such that the place of delivery is in XXXXXXXXXX. Since Canco has an operating account in a bank in XXXXXXXXXX into which payments are made by FA1 and FA2 for purchases of XXXXXXXXXX, it would appear that the place of payment is also in XXXXXXXXXX. In addition, the fact that Canco stores inventory in a warehouse in XXXXXXXXXX is another indicator that it carries on business in XXXXXXXXXX. In our view, whether or not the contracts of sale are concluded in XXXXXXXXXX or Canada, the other indicators are sufficient to conclude that Canco carries on business in XXXXXXXXXX.

Question 2- How should Canco's income be allocated between Canada and the US?

Given our conclusion that Canco does indeed carry on business in the US, you will need to allocate a portion of Canco's income to the US. In this respect, there is not much guidance in either the Act or in case law. Indeed, the Act itself does not provide a detailed method of profit allocation to different territorial sources. Where a non-resident carries on a single business partly in and partly outside of Canada, the sourcing rules in paragraph 4(1)(b) serve to apportion the income from that business between Canada and each other country. Paragraph 4(1)(b) of the Act provides that where a taxpayer carries on a business partly in one place and partly in another place, the taxpayer's income or loss for the year from the business carried on in a particular place is the taxpayer's income or loss computed as if the taxpayer had no income or loss except from the part of the business that was carried on in that particular place and was allowed no deductions except as may reasonably be regarded as wholly applicable to that particular place. In effect, paragraph 4(1)(b) of the Act requires the profits of Canco to be allocated between Canada and XXXXXXXXXX in a manner that reflects the contribution of the activities in each jurisdiction that gave rise to those profits.

In previous interpretations we have relied on the OECD's Commentary to article 7 as well the 2004 revised draft discussion of the OECD relating to the attribution of profits to a PE to determine how much income should be sourced to a given location when no PE exists. Such principles have been recently revised and updated in the OECD's December 2006 "Report of the Attribution of Profits to Permanent Establishments" wherein it was determined that for the purposes of attributing income to a PE, the separate entity approach (the "OECD Approach") was the preferable approach.

While such an approach is not the only method of allocating profits to a source, it is our view that the analysis within the OECD Approach generally results in a reasonable allocation of income. Moreover, because the OECD Approach was developed with representatives from various member states it is our view that when dealing with other jurisdictions this approach would be acceptable to most member states.

Generally, the separate entity approach requires a determination of what profits would be attributed to an arm's length entity "if it were a legally distinct and separate enterprise performing the same or similar functions under the same or similar conditions."¹ This requires a two-step approach involving (1) a functional and factual analysis to determine the business activities, assets, risks and rights, keeping in mind how these activities, assets, risks and rights relate to the "entity's" people functions; and (2) an analysis of the arm's length pricing of the dealings between each entity.

To assist in determining how income should be allocated, it is helpful to look at the functions of a business and where those functions are performed. It is our understanding that Canco derives its income from² XXXXXXXXXX.

From the time that the XXXXXXXXXX leave the manufacturer's premises to the time that the XXXXXXXXXX are received at FA1's warehouse, Canco bears the risk that the XXXXXXXXXX may be damaged, lost or destroyed. Canco continues to bear the market risk, ie. XXXXXXXXXX.

In analyzing Canco's US activities it should be noted that the XXXXXXXXXX are not performed in XXXXXXXXXX. No employees from Canco's XXXXXXXXXX operations are used in this process. The XXXXXXXXXX belonging to Canco are then delivered from the manufacturer's premises to the warehouse of FA1. We have assumed that the delivery is done by an arm's length party and that no Canco employees in XXXXXXXXXX are used in this process, and, as such, this activity does not qualify as a people function in respect of Canco's XXXXXXXXXX operations.

The XXXXXXXXXX belonging to Canco are then stored at the warehouse of FA1 until such time as they are sold to FA1 and/or FA2. Canco does not pay a direct fee for the premises but upon reviewing the FA1 Contract it becomes apparent that the cost is imbedded in FA1's share of the eventual profits from the net sales.

When analyzing the risks attributable to Canco's XXXXXXXXXX operations we note that there are no significant people functions there, in fact, it appears there are no people functions (i.e., no employees) related to Canco's XXXXXXXXXX operations.

Under the OECD Approach it is also necessary to attribute "free" capital to the Canco's XXXXXXXXXX operations. Free capital is defined in the Report as "as an investment which does not give rise to an investment return in the nature of interest that is deductible for tax purposes under the rules of the host country of the PE". Free capital is to be allocated based on the capital that would be required for Canco to support its functions in XXXXXXXXXX, and any assets or risks that were attributed to it.

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The second step of the OECD Approach requires looking at the functions that Canco's XXXXXXXXXX operations perform, in light of their particular circumstances, to determine what is the appropriate price for such functions. The appropriate price is used to determine what profits should be attributed to Canco's XXXXXXXXXX operations. As noted above, Canco's XXXXXXXXXX operations are carried on by arm's length contractors. Accordingly, we would expect that the appropriate price would be reflected in the amount charged by these contractors, thus limiting the potential allocation of profit to the XXXXXXXXXX operation. In determining the appropriate price for the relevant functions, given the somewhat unique nature of Canco's XXXXXXXXXX operations, it may be that the traditional transactional methods of transfer pricing will not be appropriate.

It may be that there are other reasonable approaches to determine how the income should be sourced to Canco's business activities in XXXXXXXXXX. However, it is our view that the OECD Approach reflects both the application and policy of paragraph 4(1)(b) and is a good basis, in this scenario, for determining the allocation of income to foreign jurisdictions.

It should be noted that any additional facts you may be aware of, in respect of Canco's activities in XXXXXXXXXX , should be taken into consideration when you are ultimately determining a reasonable allocation. In addition, the significant difference between the price which Canco sells the XXXXXXXXXX to FA1 and FA2, and the fair market value of the XXXXXXXXXX when they are eventually sold to the consumer, should be reviewed to determine if a transfer-pricing adjustment is warranted.

Conclusion

The allocation of the profits of a business to a jurisdiction is not an exact science and it is necessary to look at all the facts to determine how such an allocation should reflect the actual functions of the business in that jurisdiction.

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We hope our comments are of assistance.

Yours truly,

For Director
International Tax and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

¹ Paragraph 79 of the Report on the Attribution of Profits to a Permanent Establishment.

² Canco may have other business activities but, to our knowledge, it is only the activities above that are relevant to the allocation of Canco's income to XXXXXXXXXX .