2 January 1987 Income Tax Severed Letter 5-2683 - Liability to a non-resident lender incurred in purchasing the net assets of the lender—Canada-US 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.

This is in reply to your letter of January 2, 1987 concerning the effect of Article XI of the Canada-U.S. Income Tax Convention (1980) (the "Convention") in respect of a liability to a non-resident lender incurred in purchasing the net assets of the lender.

As we understand the facts, client, XXX. If this approach is followed it is your view that the exemption in clause 212(1)(b)(iii)(E) of the Income Tax Act (the "Act") will apply In respect of interest paid to the U.S. band. Depending upon the actual financing arrangements, you indicate that paragraph 212(1)(b)(vii) night also apply to exempt the interest payments from Part XIII withholding.

An alternative method to bank financing would be for XXX is not exempt under the Act from Part XIII tax. You state that the relevant interest expense is attributable to and borne by the U.S. branch of XXX and thus Article XI(6) of the Convention operates to source in the United States the interest payments made by XXX. Consequently, in your view, unless relief is available from Part XIII tax, XXX will be required to pay tax in both Canada and the United States in respect of the interest with no possibility of obtaining a foreign tax credit in either State.

On the other hand, if Article XI(6) could be ignored you believe Article XI(3)(d) would apply to exempt the interest from taxation in Canada. In your view Article XI(3)(d) should apply as long as the terms and conditions attached to the transaction are at arm's length (objectively determined) even though the parties are not at arm's length for purposes of the Act. You suggest that ignoring Article XI(6) in the circumstances of this case would give an equitable result in line with the spirit of the Convention. If Article 25(6) cannot be ignored, you inquire as to whether there is any provision in the Convention to alleviate USCo from double taxation.

Since the fact situation in your letter would appear to relate to a proposed transaction involving identifiable taxpayers we are unable to comment in specific reference thereto other than by way of an advanced income tax ruling request. However, in the alternative, we are prepared to provide the following general comments concerning Article XI of the Convention in relation to the issue of double taxation.

The first sentence of Article XI(6) of the Convention provided that where the payor of interest is a resident of a Contracting State that interest is deemed to arise in that State. The second sentence of Article XI(6) provides an exception to this rule are the following conditions are met:

• 1) The payor has a permanent establishment or fixed base in another State in connection with which the indebtedness was incurred which gave rise to the interest payments.
• 2) Such interest is borne by such permanent establishment or fixed base.

Where these conditions are met, the interest is deemed to arise in the State of the permanent establishment or fixed base and not in the State of which the payor is a resident. Whether or not the conditions stipulated in the second sentence of Article XI(6) are met is a question of fact in each case.

In those situations where the second sentence of article XI(6) applies, it is our view that Article XI(2) does not operate to permit the State of residency of the payor to impose a tax under that State's domestic law in respect of the subject interest paid to a resident of the other Contracting State. Where the other Contracting State is Canada, the subject interest is deemed not to be paid from Canada for purposes of Article XI and Article XI(2) would not apply to permit paragraph 212(1)(b) of the Act to impose a tax on this interest paid to a non-resident of Canada. Accordingly, in our view, there is no double taxation on this income.

In reference to the requirement XI article XI(6) that the interest must be borne by the permanent establishment or fixed base as discussed in 1) and 2) above, you indicate that this requirement is met. In our view, whether this requirement is met depends on whether the interest expense is allowed as a deduction in computing taxable income for U.S. tax purposes for the U.S. branch of XXX operating as a permanent establishment or fixed base. To the extent that a deduction is reduced or denied for U.S. tax purposes, the interest is not sourced in the U.S. pursuant to Article XI(6). The portion of the interest paid by XXX that is not sourced in the U.S. for purposes of Article XI may be taxed by Canada pursuant to Article 25(2). In that case, Article XXIV(1) of the Convention would appear to allow (subject to U.S. domestic law) a foreign tax credit to USCo against Part XIII tax paid to Canada.

We trust this will be of assistance.