3 November 1997 9524971 - DETERMINATION OF RESIDENCY - GENERAL

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Various issues connected to the determination of residency under an income tax convention, the Canada - U.S. Convention in particular.

Position:

Please see memorandum attached.

Reasons:

RESIDENCY UNDER CANADA'S INCOME TAX CONVENTIONS

The determination of the residency of a taxpayer for the purposes of one of Canada's income tax conventions is the foundation on which the balance of the provisions of the particular convention are applied. In particular, unless a taxpayer is found to be resident in one of the contracting states, he is not entitled to the relieving provisions provided for in the convention. On June 22, 1995 the Department's basic understanding of how that residency should be determined was confirmed by the Supreme Court of Canada when it handed down its decision in the case of Her Majesty the Queen v. Crown Forest Industries Limited ("Crown Forest"). The Department views Crown Forest as a landmark case because not only did it uphold certain fundamental principles dealing specifically with the interpretation Article IV of the Canada - U.S. Income Tax Convention (1980) (the "Convention"), but in addition set down broad guidelines for the interpretation of income tax conventions in general. Nevertheless, it should be recognized that the determination of residency for the purposes of an income tax convention remains a question of fact, and each case should be decided on its own facts. The determination is made on the foundation of certain fundamental principles, but there is no set of hard and fast rules that apply to all cases. In this regard, the Crown Forest decision can be viewed as a decision based on the facts and circumstances of that particular case.

The Crown Forest Case

Crown Forest Industries Limited was a corporation resident in Canada which paid rent to Norsk Pacific Steamship Company ("Norsk") a related company for the lease of several maritime barges. The issue in the case was whether Norsk was a "resident of a contracting state" for the purposes of the Convention and was therefore eligible thereunder for the benefit of a reduced rate of Canadian withholding tax.

Norsk was incorporated in the Bahamas. Therefore Norsk was a foreign corporation for the purposes of the U.S. Internal Revenue Code and as such was only taxable in the United States on U.S. source income (e.g. income from a business carried on in the United States). It carried on an international shipping business and its only office and place of business was in the United States. While Norsk was generally subject to tax on any income that was attributable (effectively connected) to an office or other fixed place of business within in the United States, its income from the international operation of ships qualified for a special exemption under U.S. tax law.

The Minister took the view that Norsk could not be viewed as a resident of the United States in the above circumstances. The Minister's position was based on the view that in order for Norsk to be considered to be a resident of the United States for the purposes of the Convention, it had to be liable to tax in the United States not only on income from U.S. sources but its worldwide income and such liability for tax must arise by reason of one of the criteria listed in Article IV. In the Minister's view Norsk did not meet either of the requirements of this two pronged test.

The Supreme Court accepted both contentions of the Minister and allowed his appeal. More particularly, the Court concluded that Norsk was not liable to tax in the United States "by reason of" one of the enumerated criteria (i.e. place of management). The finding that Norsk's place of management is a prime factor in determining its liability to tax in the United States (i.e. in determining that it is engaged in a business in the United States) does not mean that its U.S. tax liability arises by reason of its place of management. Moreover, the basis that formed Norsk's liability for U.S. tax was found not to be a "criterion of a similar nature" because all the other tests listed in Article IV of the Convention were grounds for worldwide taxation. The Court accordingly accepted the view that in order for one to be a resident of a contracting state under the Convention; it had to be liable to tax in that state on its worldwide income and that being liable to tax in a state only on income sourced to that state was not enough to earn residency status.

The Department views the decision of the Supreme Court to be of particular importance for several reasons.

First, the Court accepted the fundamental principle that to be a resident of a contracting state under the Convention, a person must be liable to tax in the contracting state on its worldwide income. A decision to the contrary would have allowed treaty benefits to accrue to those who had quite modest connections with the United States. This, of course, would undermine the integrity of the Convention and it could have led to increased treaty shopping. It is important to note however, that this principle must be applied with some caution in interpreting certain other conventions as some countries have adopted a territorial principle in their taxation and therefore do not tax residents on their worldwide income. In order to qualify as a resident a contracting state that follows the territorial principle, a taxpayer will generally have to be subject to as comprehensive a tax liability as is imposed by the particular state.

Second, the decision of the Supreme Court is significant in that it states that conventions must be interpreted not simply by looking at the plain meaning of the words but by reference to the purpose of income tax conventions generally and the intention of the parties to the convention in particular.

Third, the Court made extensive use of extrinsic materials in interpreting the Convention. Undoubtedly, the most significant advancement in this regard is the affirmation by the Court of the role of the O.E.C.D. and U.N. Model conventions and related Commentaries as interpretive aids. This principle has general application when interpreting all of Canada's income tax conventions.

Finally, the Supreme Court clearly preferred an interpretive approach which discouraged treaty shopping to one that did not. The Department believes that the Court's rejection of an interpretation which could lead to potential tax avoidance is encouraging and will assist the Minister in cases where tax avoidance is effected through the use of income tax conventions.

Critical Commentary

Certain aspects of the reasons for judgement in Crown Forest have been criticised by commentators in papers published in the Canadian Tax Journal ("CTJ") of the Canadian Tax Foundation. In 1996 CTJ Volume 2, David Ward points out that missing from the reasons for judgement is any reference to the fact that both Canada and the United States apply the Convention to entities that are not generally subject to tax although they possess one of the criteria (place of incorporation or place of management) that would give rise to comprehensive tax liability in the absence of domestic relieving provisions. Such entities include charities, pension plans, US subchapter "S" corporations, and federal, provincial, state and local governments. David Ward concludes that if a person's connecting characteristics with the state are the same as those of persons who are fully liable and actually subject to tax, that the person can be said to be liable for tax for the purposes of Article IV paragraph 1 of the Convention, even though the person is not subject to tax on part or all of his income by virtue of special provisions in the domestic legislation of the state of his residence.

We would agree that the analysis in the Crown Forest case may be incomplete without some comment why the above entities qualify for the benefits of the Convention despite their non-taxable status, however we would disagree with the inferences drawn from that fact by Mr. Ward. While a thorough analysis of the issue is beyond the scope of this paper, suffice it to say that the primary support for the view that the above entities qualify for the benefits of the Convention is based in the fact that the Convention contains provisions which deal specifically with each of those entities. To take the view that they do not qualify as resident in a contracting state, would render those provisions meaningless. General principles of statutory interpretation provide that such an interpretation is to be avoided if at all possible, not to mention that such view would be in direct opposition to the intent of the parties to the Convention. In addition, as each case must be decided on the basis of its own facts and circumstances, it is our view that the Crown Forest decision and the reasons given would not have been different even if the Supreme Court had considered the situations outlined by Mr. Ward.

In another article in 1996 CTJ Volume 1, Francois Vincent concludes that "Crown Forest clearly places the OECD model tax convention and commentary in a prominent position in the landscape of materials available to practioners to assist in the interpretation of tax treaties". A conclusion with which we agree. However, in the body of his paper, he is critical of the court in Crown Forest for not recognizing inconsistency in Revenue Canada's arguments concerning inferences that can be drawn from differences between the residence articles in the Convention and the OECD Model convention. Mr. Vincent makes the claim that on the one hand Revenue Canada argues that a certain sentence found in the residence article in the OECD model convention was deleted from the residence article of the Canada - U.S. Convention as it was meaningless in the Canada - U.S. context. On the other hand Revenue Canada gives no explanation why the words such as "domicile" and "place of management" (which were critical to case at hand) were retained if they also do not have any significance in the Canada - U.S. context.

The retention of what may appear as meaningless words is a product of negotiating treaties using a model (e.g. OECD and individual contracting states' models) where all the words are used. Often the model is only altered to reflect additional criteria which must be listed (e.g. place of incorporation in the case of the United States) to take into account the legislation of a particular contracting state. Analysis of most of Canada's income tax conventions will reveal the retention of the so called meaningless words in paragraph 1 of Article IV. Had this point been brought to the attention of the court in Crown Forest, it is our view that it is unlikely that it would have had any impact on the decision rendered.

Article 3 of the New Canada - U.S. Protocol

Article 3 of the new protocol to the Convention introduces several changes to the Residence Article of the Convention. It is important to appreciate that these changes were merely for greater certainty. For example, paragraphs 1(a) and (b) of the amended Residence Article refers to the government of a contracting state or a political subdivision, a trust, organization or other arrangement that is operated exclusively to administer or provide pension benefits, retirement or employee benefits and a not-for-profit organization, provided that any such entity was constituted in a contracting state and is by reason of its nature generally exempt from taxation in that state. These entities were generally viewed by the Department as resident of Canada or the United States for the purposes of the Convention, as the case may be, notwithstanding their tax exempt status. In our opinion, this result was clearly intended as evidenced by the existence and wording of paragraph 1 of Article XXI of the Convention. The same interpretation would apply to Canada's other income tax conventions. Accordingly, it should be noted that the clarifying amendments should not be interpreted as implying that similar entities in other countries must specifically be referred to in the residence article of the relevant income tax convention in order to qualify for benefits under that convention. It is our understanding that with respect to such entities, Canada's treaty partners have the same interpretation.

A specific reference to include a person who is subject to tax in a contracting state by reason of his citizenship has been added. The amendment is only applicable to U.S. citizens as Canada does not tax on the basis of citizenship. The amendment clarifies that U.S. citizens and "green-card" holders are to be considered as residents of the United States for the purposes of the Convention only if the individual has a substantial presence, permanent home or habitual abode in the United States, and that individual's personal and economic relations are closer to the United States than to any third State. It is notable that the above amendment only confirms the manner in which the Department applied the Convention to U.S. citizens from the time it came into force.

A new sentence is added to Paragraph 3 of the Article IV to address the residence of certain dual resident corporations. The new sentence states that corporation will be resident of the state into which it is continued. Prior to the addition of the new sentence, a dual resident corporation would have been resident in the contracting state in which it was created (i.e. incorporated) notwithstanding that such corporation may have been continued into the other contracting state. This amendment permits the Convention to interact properly with subsection 250(5.1) of the Act.

Other Comment

Finally the Department continues to be of the view that a U.S. limited liability company that is treated under U.S. tax law as a partnership and which is therefore not liable to tax in the United States, is not a resident of the United States for the purposes of Article IV of the Convention notwithstanding that such company may be treated as a corporation resident in the United States for the purposes of the Act. Accordingly, such limited liability company does not qualify for reduced rates on Canadian tax that may otherwise be provided for in the Convention.

Olli Laurikainen

November 3, 1997

File: 952497