22 October 1998 External T.I. 9810555 - FOREIGN AFFILIATES - RESIDENCE TESTS

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: Residency of foreign affiliates in designated treaty countries.

Position: Question of fact. Must satisfy both mind, management and control test as well as 5907(11.2).

Reasons: Law

		981055
XXXXXXXXXX 	Olli Laurikainen
(613) 957-2116
Attention:  XXXXXXXXXX 

October 22, 1998

Dear Sirs:

Re: Foreign Affiliates - Subsection 5907(11.2) of the Regulations

This is in reply to your letters wherein you request our comments in reference to the application of the above provision.

You indicate that the residency determinations that must be made in order to ascertain whether a foreign affiliate’s earnings qualify for exempt surplus treatment under section 5907 of the Regulations to the Income Tax Act (the “Regulations”) give rise a great deal of uncertainty for Canadian corporations that own shares in foreign affiliates. This is due to the fact that a taxpayer must not only establish that the situs of the mind and management and control of a foreign affiliate rests in a particular designated treaty country under the common law test of residency but that the foreign affiliate would be resident there for the purposes of the income tax convention as well. You provide the following three examples.

Swiss Financing Affiliate

You describe a scenario involving a group financing affiliate incorporated in a particular European country (“Country X”) which carries on its lending business through a branch in Switzerland. The foreign affiliate has its board of directors meetings in Country X and two employees conducting lending activities in Switzerland. The Country X income tax regime, together with the treaty between Country X and Switzerland, offers a low tax or no tax regime applicable to income sourced to a Swiss branch. Under the Swiss domestic income tax regime, the financing affiliate is able negotiate a reduced rate of tax attributable to its Swiss branch profits on the basis that the income of the branch is derived from non-Swiss sources. The combined Country X, Swiss tax rate on financing income derived by the foreign affiliate and dividended to its Canadian shareholder is 9%.

You question whether in the above example ,the foreign affiliate would be a resident of Country X under the Canada - Country X comprehensive agreement or convention for the elimination of double taxation on income for the purposes of paragraph 5907(11.2)(a) of the Regulations.

LLC Financing Structure

Canco a corporation resident in Canada owns the shares of foreign affiliates which carry on active business in various different countries. Such foreign affiliates are financed by Canco by way of share capital and interest bearing loans. One of such affiliates is Usco, a corporation resident in the United States. Canco and Usco create a U.S. LLC with Canco having a 95% interest and Usco owning 5%. Canco then contributes the interest-bearing loans receivable to Usco. The United States treats the LLC as a partnership for tax purposes and taxes Usco’s share of the income of the LLC. The 95% portion flowing to Canco is not subject to U.S. tax. This is because for U.S. federal tax purposes, the income of LLC is non-U.S. source earned by a non-resident entity (i.e. Canco) and the income is not effectively connected with a U.S. trade or business.

In keeping with the minimal level of U.S. activity needed to administer the long-term loans, no U.S. based staff is needed in the LLC. The LLC retains support from Usco and pays a fair market value fee for this support. Annual board of directors meetings are conducted at the office which the LLC uses in the state of incorporation and bank accounts and related formalities are situated in that state.

You request our view whether in the above example LLC would be resident in the United States under the common law test of residence and would qualify as resident in the United States for the purposes of section 5907 of the Regulations by virtue of paragraph 5907(11.2)(b) thereof.

Ireland - European Commission Agreement

You provide a document indicating that European Commission has been successful in persuading Ireland to introduce a new universal 12.5% corporation tax regime applicable, subject to certain grandfathering provisions, to all trading income. It is our understanding that this tax would eventually apply to all corporations resident in Ireland. The document indicates that this tax will be fully compatible with the “Code of Conduct on business taxation” which was issued by the European Commission in December 1997. This Code is designed to curb harmful tax measures involving lower tax rates than the general rate of corporation tax in the European Economic Community country concerned. It does not aim to harmonize corporation tax rates in the Community and does not affect a general low rate of tax such as the proposed 12.5% rate.

You surmise that corporations resident elsewhere in the European Economic Community would now be able to establish subsidiaries to carry on activities in Ireland having tax certainty under the both the tax regime of the country in which the parent corporation is resident and in Ireland. You suggest that such tax certainty would be established without regard to the concerns such as those that Canadian corporations would still have under the Act in assessing whether Irish subsidiaries would be viewed as having their residence in Ireland under the Canada - Ireland Income Tax Agreement.

Our Comments

The determinations of the situs of a foreign affiliate’s mind management and control for the purposes of the Act, and a foreign affiliate’s residence for the purpose of a particular income tax convention requires detailed knowledge of the facts of a particular case. It is therefore impossible to reach any definitive conclusions based on the facts provided in the above examples. It is generally the Department’s view that it can only make these determinations at the audit stage.

We can appreciate that such complex determinations could in some instances create uncertainty for corporate taxpayers resident in Canada which have foreign affiliates. However, similar residence determinations under income tax conventions must be made to establish the tax result in situations not involving foreign affiliates. Also, the mind, management and control test is not confined to foreign affiliate matters and has been an important part of the Canadian tax system since its inception. Until the Department of Finance makes amendments to the foreign affiliate regime that do away with these determinations, Canadian taxpayers and Revenue Canada will be forced to make decisions on residency under the traditional rules based on their knowledge of the facts of each case.

Swiss Financing Affiliate

In the first example above, we would have the following concerns. Under the common law test of residence a corporation is resident where its mind management and control resides. Generally, this has been found to be the country in which its board of directors meet. However, the Department would on audit want to satisfy itself that the foreign affiliate in the above example, was in fact managed and controlled by the majority of its directors and that those directors have the autonomy to make independent decisions at the meetings held in the particular jurisdiction (i.e. Country X). When mind management and control resides in a particular place, the corporation is held to be resident there, but it does not follow that it cannot be resident elsewhere. If the mind, management and control of a corporation is divided, it may have more than one residence. A corporation that is resident in Canada and another country would not qualify as a foreign affiliate and would be taxable in Canada on its world-wide income.

If upon audit the Department were able to satisfy itself that the foreign affiliate in the first example above had its mind, management and control in country X, it would nevertheless be left the issue of whether it were resident in country X for the purposes of the Canada - Country X income tax convention (i.e. for the purposes of paragraph 5907(11.2)(a) of the Regulations). As you know, the Department follows the principle established in the Crown Forest case that a person must generally be liable to tax in the country on its world-wide income in order to be viewed as resident there for the purposes of the income tax convention between Canada and that country. In making such determination, an examination of the relevant foreign tax legislation and an understanding of how such tax law applies to the particular foreign affiliate and to other corporations resident in that country, is required. In the above example, the fact that the affiliate’s Swiss branch income was taxed at a reduced rate in County X may not necessarily cause the foreign affiliate to be deemed not resident in Country X by subsection 5907(11.2) of the Regulations. This would be the case if it could be established that in spite of the low rate of tax paid by the foreign affiliate in Country X, it could be considered to be subject to the most comprehensive tax of general application that Country X imposes. Such a fact pattern, in our view would generally satisfy the residence test of most of Canada’s income tax conventions.

LLC Financing Structure

In the case of the U.S. LLC financing structure above, it is our view that Department auditors would need to satisfy themselves that the directors meetings in the United States offices were in fact sufficient to establish that the situs of the mind, management and control of the LLC was in the United States and not in Canada. The fact that in the above case the lending activity takes place in Canada and the loans are merely contributed to the LLC as a capital contribution, is indicative that little, if any, direction could be given by directors meeting at the offices of the LLC. In such case, subject to a thorough examination of all of the relevant facts, it would appear that the LLC could be considered to be resident in Canada.

Ireland European Commission Agreement

In the case of Ireland, we are not in a position to comment on whether European Economic Community entities would be provided with greater tax certainty with regard to taxation in their country of residence outside Ireland as a result of amendments to the Irish tax regime. We would have thought that the tax laws of the particular country would play a large part in determining what impact changes to foreign tax law (i.e. Ireland) would play in clarifying the result under that law.

Nevertheless, if a particular designated treaty country had tax legislation which imposed a uniform tax on all the sources of income of every corporation resident in that country under that law, it is our view that any such corporation would generally be viewed as resident in that country for the purposes of the income tax convention between Canada and that country notwithstanding that the tax rate imposed under the foreign law may be relatively low in relation to Canadian corporate income tax rates. Therefore if our understanding of the Irish legislation is correct, it seems reasonably clear that a corporation created in Ireland which is subject to the new uniform 12.5% tax on its income from all sources would generally be resident there for the purposes of the Canada - Ireland Income Tax Agreement. This is so because the 12.5% tax is the most comprehensive tax imposed under Irish income tax law and such tax applies to virtually every corporation subject to certain grandfathering provisions. However, it is true that in the case of a foreign affiliate, the Department would nevertheless have to be able to satisfy itself that the situs of the mind management and control of such corporation is in Ireland and not in another country before it could be concluded that the corporation was in fact a foreign affiliate resident in Ireland for the purposes of the Act and its Regulations.

We trust this is the information you require.

Yours truly,

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