2 November 2009 Roundtable, 2009-0345881C6 - Article XXIX A(3) of the Canada-US tax treaty

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 safe harbour is part of the substantiality test under paragraph 3 of Article XXIX A of the Canada-US tax treaty. If not, can the CRA provide additional guidance on how it will interpret and apply the "substantiality" requirement?

Position: There is no safe harbour in the substantiality test. See below for additional guidance on how CRA will apply the substantiality requirement.

Reasons: A safe harbour is neither included in the text of the treaty nor referred to in the treaty's Technical Explanation.

November 2, 2009

2009 IFA Conference

Question: A safe harbour applies in certain U.S. income tax treaties for purposes of determining whether an active trade or business conducted in the residence country is "substantial" vis-à-vis the activities giving rise to income in the source state. In each of these treaties, as in the Canada-U.S. Tax Treaty ("the Treaty"), the determination of substantiality is based on all the facts and circumstances. However, in addition, in the foregoing U.S. treaties the trade or business will be deemed substantial if for the preceding year, or for the average of the three preceding years, the asset value, the gross income and the payroll expense that are related to the trade or business in the residence state equals at least 7.5% of the asset value, the gross income and the payroll expense, respectively, that are related to the activity that generated the income in the source state, and the average of the three ratios exceeds 10%. In determining whether an active trade or business conducted in the United States is "substantial" vis-à-vis the activities giving rise to income in Canada, would the CRA consider it relevant that the safe harbour described above (although not part of the Treaty) was met by the U.S. active trade or business? If not, can the CRA provide additional guidance on how it will interpret and apply the "substantiality" requirement?

CRA Response:

Paragraph 3 of Article XXIX A of the Treaty provides as follows:

Where a person is a resident of a Contracting State and is not a qualifying person, and that person, or a person related thereto, is engaged in the active conduct of a trade or business in that State (other than the business of making or managing investments, unless those activities are carried on with customers in the ordinary course of business by a bank, an insurance company, a registered securities dealer or a deposit-taking financial institution), the benefits of this Convention shall apply to that resident person with respect to income derived from the other Contracting State in connection with or incidental to that trade or business (including any such income derived directly or indirectly by that resident person through one or more other persons that are residents of that other State), but only if that trade or business is substantial in relation to the activity carried on in that other State giving rise to the income in respect of which benefits provided under this Convention by that other State are claimed.

The Technical Explanation ("TE") to the Fifth Protocol provides as follows (emphasis added):

As described above, income that is derived in connection with, or is incidental to, an active trade or business in a Contracting State, must pass the substantiality requirement to qualify for benefits under the Convention. The trade or business must be substantial in relation to the activity in the other Contracting State that gave rise to the income in respect of which benefits under the Convention are being claimed. To be considered substantial, it is not necessary that the trade or business be as large as the income-generating activity. The trade or business cannot, however, in terms of income, assets, or other similar measures, represent only a very small percentage of the size of the activity in the other State. The substantiality requirement is intended to prevent treaty shopping. For example, a third-country resident may want to acquire a U.S. company that manufactures television sets for worldwide markets; however, since its country of residence has no tax treaty with the United States, any dividends generated by the investment would be subject to a U.S. withholding tax of 30 percent. Absent a substantiality test, the investor could establish a Canadian corporation that would operate a small outlet in Canada to sell a few of the television sets manufactured by the U.S. company and earn a very small amount of income. That Canadian corporation could then acquire the U.S. manufacturer with capital provided by the third-country resident and produce a very large number of sets for sale in several countries, generating a much larger amount of income. It might attempt to argue that the U.S.-source income is generated from business activities in the United States related to the television sales activity of the Canadian parent and that the dividend income should be subject to U.S. tax at the 5 percent rate provided by Article X (Dividends) of the Convention. However, the substantiality test would not be met in this example, so the dividends would remain subject to withholding in the United States at a rate of 30 percent.

Neither the text of paragraph 3 of Article XXIX A nor the TE refer to a safe harbour in the interpretation and application of the term "substantial". The CRA does not consider it relevant that other tax treaties concluded by the United States may contain other means of testing the "substantial" requirement, since that approach does not appear in the Treaty.

CRA's view is that the guidance underlined above in the TE provides a basis for applying the "substantial" requirement. Taking this guidance into consideration, the CRA is of the view that, in applying the substantial requirement test:

• The size of the trade or business in the U.S. need not be "as large as" the income-generating activity in Canada; but it must be more than "a very small percentage" of the size of that activity.
• The phrase, "a very small percentage" imports a de minimis standard, one that is to be applied in the context of all the facts and circumstances of each particular case, with a view to preventing treaty shopping.
• In comparing the size of the trade or business in the U.S. and the size of the income-generating activity in Canada, the CRA will consider factors such as income, assets, payroll expense, the size and nature of relevant markets or other similar measures.