27 October 1997 External T.I. 9704705 - FOREIGN AFFILIATES - RESIDENCY

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:

1) Whether a foreign affiliate which is resident in one designated treaty country under common law and resident of another designated treaty country for the purposes of an income tax convention qualifies as resident in a designated treaty country for the purposes of proposed section 5907 of the Regulations.

2) Whether a determination under section 5907 of the Regulations that a foreign affiliate resident in the United States for the purposes of the Convention has taxable surplus from active business carried on in designated treaty country, is overridden by Article XXIV(2)(b) of the U.S. Convention.

Position:

1) No. 2) No.

Reasons:

1) Subject to the deeming rule in proposed subsection 5907(11.2).

2) The treaty article is subject to the existing provisions of the laws of Canada and to any subsequent modification of those provisions.

970470
XXXXXXXXXX Olli Laurikainen
(613) 957-2116

Attention: XXXXXXXXXX

October 27, 1997

Dear Sirs:

Re: Foreign Affiliate-Residence in Designated Treaty Country

This is in response to your memorandum dated February 13, 1997.

You request our opinion with respect to the application of proposed subsection 5907(11.2) of the Regulations to the following hypothetical fact pattern.

1.A Canadian corporation ("Canco") owns 100% of the issued and outstanding shares of a Unites States corporation ("Usco").

2.Usco has an active distribution operation within the United States. It also has a manufacturing operation within Mexico. Usco operates in Mexico through a branch. Usco pays taxes in Mexico and has a permanent establishment in Mexico. The Mexican manufacturing operation is the main part of Usco's business. Both operations produce "income from an active business" for the purposes of subsection 95(1) of the Act.

3.Usco has three directors: one U.S. citizen and resident and two Mexican residents. The directors of Usco meet annually in Mexico to review operations and set policy.

4.Usco files U.S. income tax returns on its worldwide income and files Mexican tax returns on its profits attributable to the Mexican branch.

5.Usco is a Mexican resident for Canadian common law purposes.

You question whether under the above hypothetical set of facts, Usco would earn exempt or taxable surplus for the purposes of proposed section 5907 of the Regulations.

Our Comments

It is our view that in assessing the residency of a foreign affiliate for the purposes of the Regulations (including the proposed subsection 5907(11.2) of the Regulations), the common law test of residence is used. Once the country of residence has been determined under common law, proposed subsection 5907(11.2) of the Regulations provides that the affiliate may be deemed not to be a resident of that designated treaty country unless one of the conditions therein is met. In the above example, Usco is resident in Mexico for common law purposes. As it does not appear to be resident in Mexico for the purposes of the Canada - Mexico Income Tax Convention (the "Mexico Treaty"), proposed paragraph 5907(11.2)(a) of the Regulations is not applicable. Furthermore, since none of proposed paragraphs 5907(11.2)(b) through (d) are applicable, proposed subsection 5907(11.2) of the Regulations would deem Usco not to be resident in Mexico for the purposes of Part LIX of the Regulations. Therefore, notwithstanding that Usco is resident the United States for the purposes of the Canada - U.S. Income Tax Convention (the "U.S. Convention"), its earnings derived from an active business carried on in both Mexico and the United States would not be included in its exempt surplus vis-a-vis Canco.

You raise the issue of whether this interpretation is not in contravention of Article XXIV(2)(b) of the U.S. Convention which provides as follows:

"subject to the existing provisions of the law of Canada regarding the taxation of income from a foreign affiliate and to any subsequent modification of those provisions - which shall not affect the general principle hereof - for the purpose of computing Canadian tax, a company which is a resident of Canada shall be allowed to deduct in computing its taxable income any dividend received by it out of the exempt surplus of a foreign affiliate which is a resident of the United States..."

As the above treaty provision is subject to the existing provisions of the law of Canada regarding the taxation of income from a foreign affiliate and any subsequent modification of those provisions, it is our view that it will not provide for relief for Canco in the circumstances described above.

In a case such as the one described above, there does not appear to be anything preventing Usco from establishing residence in the United States under common law and if necessary, Canco may wish to explore the possibility that it is a dual resident of both Mexico and the United States under common law.

We hope the above will be of assistance to you.

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch