23 October 2012 External T.I. 2011-0431301E5 - Meaning of Substantial Operation

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: What is the meaning of the term "substantial operation" for the purposes of paragraph 2 of Article 8 of the Canada-Sweden Tax

Position: The Canada-Sweden Tax Convention does not clarify the meaning of the term "substantial operation". This term is also not defined in the Act. The term takes on its ordinary meaning under domestic law.

Reasons: Whether or not an enterprise has a "substantial operation" for the purposes of the treaty is essentially a question of fact. The CRA will review and evaluate a number of factors or criteria in making such a determination.

XXXXXXXXXX
2011-043130
K. Podor

October 23, 2012

Dear XXXXXXXXXX:

Re: Substantial Operation

We are writing in response to your email concerning the Canada Revenue Agency (CRA)'s interpretation of the term "substantial operation" as it applies to paragraph 2 of Article 8 of the Convention Between Canada and Sweden For The Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (the "treaty"). Specifically, you asked the Income Tax Rulings Directorate to provide guidance on the factors considered in making such a determination.

In addition, you asked our views regarding whether an operation that provides temporary services, for a period of less than six months, constitutes a "substantial operation" and whether the tax status of individuals involved in the operation will be reviewed in making our determination?

Our Comments

Meaning of the Term "Substantial Operation"

The question of whether a non-resident person has a "substantial operation" in Canada is essentially a question of fact, having regard to the applicable income tax convention or the domestic laws of the Contracting State. The treaty does not clarify the meaning of the term "substantial operation". Pursuant to section 3 of the Income Tax Conventions Interpretations Act (ITCIA), to the extent that a term in a double taxation convention is not defined in the convention, the term has the meaning that it has at that time under the Income Tax Act (the "Act"). In this case, the Act itself does not provide a definition for the word "substantial operation".

In the absence of a clear definition in the treaty or in the Act, treaty terms are to be given their ordinary meaning in their context and in light of the object and purpose of the treaty. This position is based on principles set out in the Vienna Convention on the Law of Treaties (Article 31).

The ordinary meaning of this term has been considered in Canadian domestic case law. In particular, Canadian courts considered the meaning of the term "substantial" in (SCC) Manning Timber Products Ltd. v MNR [52 DTC 1148]. Based on the facts of this case, the term "substantial" took on the meaning of "large quantity" and "important". However, the courts commented that the meaning of this term had a number of different senses, all depending on the context in which it is used. In (TCC) Taylor v the Queen [2001] 3 CTC 2126, a substantial operation was identified in terms of the factors of capital and time spent on the business.

The CRA has previously expressed its views on the factors considered in determining whether an active trade or business is "substantial" for the purposes of Article XXIX-A(3) of the Canada-United States Tax Convention. In comparing the size of the trade or business outside Canada and the income-generating activity within Canada, the CRA considered factors such as income, assets, payroll expense, the size and nature of relevant markets or other similar measures.

Whether the operation of a ship or aircraft is "substantial", as that term is used in paragraph 2 of Article 8 of the treaty, is a question of fact and must be determined in the context of all the facts and circumstances of each particular case. The CRA is not prepared to set arbitrary guidelines as to whether a specific method or basis is appropriate since in a particular fact pattern one method or basis may be more appropriate than in another situation.

Temporary Operation

Whether an operation that provides temporary services for a period of less than six months constitutes a "substantial operation" for the purposes of Article 8(2) of the treaty is again a question of fact.

The treaty does not provide specific time frames for determining the minimum period required to establish a "substantial operation" in a Contracting State. The treaty states that where a non-resident has a substantial operation in Canada for purposes of operating its ships or aircraft "during a taxation year" between places within Canada, Canada may tax the profits from such operation. The phrase "during a taxation year" suggests that there is no minimum period required in order to establish the existence of a substantial operation.

Regardless of which methodology or basis is used to determine whether an operation is "substantial", as that term is used in paragraph 2 of Article 8 of the treaty, that method or basis used should be reasonable in the circumstances and supportable.

We trust these comments are helpful.

Lita Krantz, CA
Assistant Director
International Division/ Division des opérations internationales
International Section III
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch