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: Would the notional guarantee fee imputed by subsection 247(2) of the Act be exempt from Part XIII tax under paragraph 1 of Article XI of the Canada-U.S. Treaty or under paragraph 4 of Article XXII?
Position: Paragraph 4 of Article XXII of the Canada-U.S. Treaty would apply.
Reasons: Based on the intent of the parties to the Canada-U.S. Treaty, paragraph 4 of Article XXII was specifically added to apply to guarantee fees in order to harmonize the treatment of guarantee fees paid by residents of the United States and Canada.
December 13, 2011
Dear XXXXXXXXXX :
Re: Article XXII(4) of the Canada-U.S. Treaty
This is in response to your e-mail queries dated August 31, 2011 and October 20, 2011 inquiring about the interpretation of paragraph 4 of Article XXII of the Canada-U.S. Treaty (the "Treaty"), as revised by the Fifth Protocol.
You asked us to consider the following hypothetical fact pattern:
- Canco and USCo are sister companies;
- A third-party loan is made to Canco and a guarantee on the loan is provided by USCo for no consideration;
- Canco also receives a loan from its indirect Canadian parent company, and USCo also provides a guarantee on this loan for no consideration.
For the purposes of this discussion, we will also assume the following facts:
- The loans and guarantees are made in 2011;
- USCo is a regarded entity resident in the United States and is a qualifying person for the purposes of the Treaty;
- USCo does not have any permanent establishments in Canada;
- Canco is a regarded entity for U.S. tax purposes, and is resident in Canada;
- Any guarantee fees deemed to be interest will not be contingent interest. Contingent interest arising in Canada is determined by reference to the receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person; and
- The loans and guarantees are not made in respect to a real estate mortgage investment conduit.
Subsection 247(2) reflects the arm's length principle in the transfer pricing rules. It applies where a taxpayer and a non-resident person with whom the taxpayer does not deal at arm's length, participate in a transaction or a series of transactions and
(a) the terms or conditions of the transaction or series of transactions differ from arm's length terms and conditions, or
(b) the transaction or series of transactions would not have been entered into between arm's length parties and they can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.
If the conditions are met and subsection 247(2) applies, any amounts shall be adjusted to the quantum or nature of the amounts that would have been agreed to between parties dealing at arm's length.
Based on the hypothetical facts above, a notional guarantee fee may be imputed by subsection 247(2) to be paid from Canco to USCo for both loans. The issue arises as to whether the notional guarantee fee would be exempt from withholding tax under paragraph 4 of Article XXII of the Canada-U.S. Treaty ("Treaty") or paragraph 1 of Article XI of the Treaty.
When the notional guarantee fees are imputed by subsection 247(2) of the Act, paragraph 214(15)(a) of the Act is triggered to deem the amount paid or credited as consideration for the guarantee, to be a payment of interest. Accordingly, the deemed interest payment by Canco to USCo would be subject to withholding tax pursuant to paragraph 212(1)(b) of the Act.
The term interest, as reflected in paragraph 2 of Article XI of the Treaty, includes "income assimilated to income from money lent by the taxation laws of the Contracting State in which the income arises". As suggested in Associates Corp. of North America v. R.,  C.T.C. 80 (F.C.T.D.) at para. 9, aff'd  C.T.C. 215 (F.C.A.)., such language could well be broad enough to encompass "guarantee fees". Absent paragraph 4 of Article XXII of the Treaty, relief from Part XIII tax can therefore be provided by paragraph 1 of Article XI of the Treaty. Under this exemption, the deemed interest amount in this case would effectively only be subject to taxation in the U.S.
Paragraph 4 of Article XXII of the Treaty was added by the 2007 Protocol which provides that compensation derived by a resident of a Contracting State in respect of the provision of a guarantee of indebtedness shall be taxable only in that State. This will be the case unless the compensation is business profits attributable to a permanent establishment situated in the other Contracting State, in which case the provisions of Article VII (Business Profits) shall apply.
In determining which section of the Treaty should apply to provide the relief, the Supreme Court of Canada has pointed out that in interpreting a treaty, the paramount goal is to find the meaning of the words in question. This can be accomplished by examining the language used and the intentions of the parties (Crown Forest Industries Ltd. v. Canada,  2 C.T.C. 64 at para. 29). The court added in Crown Forest:
49. Reviewing the intention of the drafters of a taxation convention is a very important element in delineating the scope of the application of that treaty. As noted by Addy J. in Gladden Estate (J.N.) v. The Queen,  1 C.T.C. 163, 85 D.T.C. 5188 (F.C.T.D.), at pages 166-67 (D.T.C. 5191):
Contrary to an ordinary taxing statute a tax treaty or convention must be given a liberal interpretation with a view to implementing the true intentions of the parties. A literal or legalistic interpretation must be avoided when the basic object of the treaty might be defeated or frustrated in so far as the particular item under consideration is concerned. [Emphasis added.]
See David A. Ward, "Principles to be Applied in Interpreting Tax Treaties" (1977), 25 Can. Tax J. 264; see also the methodology used by this Court in Canada (A.G.) v. Ward,  2 S.C.R. 689, at pages 713-16 (albeit not within the context of taxation, but refugee determination). A similar position underpins American jurisprudence. In Bacardi Corp. of America v. Domenech, 311 U.S. 150 (1940), the Supreme Court of the U.S. held at page 163 that a treaty should generally be "... construe[d]...liberally...to give effect to the purpose which animates it". See also U.S. v. Stuart, 489 U.S. 353 (1989), at page 368, per Brennan J. (delivering the opinion of the Court).
While Article XI would provide relief in such a situation, the addition of paragraph 4 of Article XXII ensures reciprocity and that the resident-state only result would not be upset depending on which way the guarantee fee payments were flowing. The "Explanation of Proposed Protocol to the Income Tax Treaty between the United States and Canada" issued by the United States Joint Committee on Taxation (dated July 10, 2008), pointed out that the purpose of the addition of paragraph 4 of Article XXII:
was necessary to conform the treatment of guarantee fees by the United States and Canada. Absent the new paragraph, the United States would have been permitted to tax guarantee fees paid to a Canadian resident under Article XXII while Canada, which treats guarantee fees as interest, would have been obligated to provide relief from Canadian tax on payments made to U.S. residents under Article XI (Interest).
From this, we can see that the introduction of paragraph 4 of Article XXII was clearly intended to deal with guarantee fees over other Articles in the Treaty.
Based on the discussions above, it is our view that paragraph 4 of Article XXII applies to guarantee fees and not paragraph 1 of Article XI. As it applies to the hypothetical facts above, the notional guarantee fees imputed by subsection 247(2), would therefore be exempt from Part XIII tax as a result of paragraph 4 of Article XXII of the Treaty.
It is important to note that this view is restricted to the Canada-U.S. Treaty. In the context of other treaties, Article XI would generally apply.
We trust these comments will be of assistance.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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