21 April 2011 Internal T.I. 2010-0388651I7 - Combined application of 124, 125, 126

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: Where a Canadian corporation is considered to have Nexus with a US State without having a PE under the Canada-US Convention:
1. For the purpose of subsection 126(2), would the Canadian corporation be considered to carry on business in the US?
2. For the purpose of paragraph 125(1)(a), can the Canadian corporation include, in income for the year from an active business carried on in Canada, its US business income?
3. For the purpose of section 124 and corresponding regulations, can the Canadian corporation's US business income be included in its "taxable income earned in the year in a province"?

Position: 1.Question of fact; 2. No; 3. Question of fact.

Reasons: Wording of the ITA and previous positions.

								April 21, 2011

Marie-Hélène Chouinard
Aggressive International Tax Planning 		Income Tax Rulings
Québec Tax Services Office				  Directorate
165 de la Pointe-aux-Lièvres Street			Yannick Roulier
Québec QC  G1K 7L3					(613) 957-2134

								2010-038865

Combined application of sections 124, 125 and 126 ITA

This is in reply to your e-mail of November 26, 2010, wherein you requested our comments with respect to the combined application of sections 124, 125 and 126 of the Income Tax Act to situations where a Canadian corporation reports business income from the United States ("US") without having a permanent establishment ("PE") in that country. Unless otherwise stated, all statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended ("ITA").

Background

You present the case of a Canadian corporation carrying on a business in the US during a given taxation year. You mention that the taxpayer did not have a PE in the US during that year under the terms of the Canada - United States Tax Convention ("Convention"). However, it did have a taxable presence ("Nexus") in different US States. In this respect, you have provided us with a document containing detailed calculations of the US State taxes payable by the taxpayer for the given year. You also bring to our attention a written opinion of the taxpayer's tax adviser commenting on the existence of a PE in the US.

According to your request, the file submitted is a typical case. You do not require from the Income Tax Rulings Directorate an opinion that is specific to your taxpayer. You prefer instead theoretical technical comments concerning the combined application of sections 124, 125 and 126 in similar situations. Hence, you ask the following questions in respect of a situation where a Canadian corporation is considered under US State law to have Nexus with that State (such that it is liable to tax in that state) without having a PE under the Convention:

1. For the purpose of the foreign tax credit stated in subsection 126(2), would the Canadian corporation be considered to carry on business in the US?

2. For the purpose of paragraph 125(1)(a), can the Canadian corporation include, in income for the year from an active business carried on in Canada, its US business income?

3. For the purpose of the provincial abatement rules stated in section 124 and its corresponding sections in the Income Tax Regulations ("ITR"), can the Canadian corporation's US business income be included in its "taxable income earned in the year in a province", as this expression is defined under subsection 124(4) ("Provincial taxable income")?

Discussion

1st question: subsection 126(2)

The fact that a Canadian corporation is considered under a US State law to have Nexus with that State would not necessarily imply that this taxpayer is carrying on business in the US for the purpose of a foreign tax credit claim under subsection 126(2).

Subsection 126(2) allows a taxpayer that is resident in Canada, and carries on business in a country other than Canada, to claim a foreign tax credit for "business-income tax" paid in that country, subject to certain limitations. It is always a question of fact whether a resident of Canada is carrying on business in a country other than Canada. Subsection 126(7) defines "business-income tax" as "the portion of any income or profits tax paid by the taxpayer for the year to the government of a country other than Canada that can reasonably be regarded as tax in respect of the income of the taxpayer from a business carried on by the taxpayer in the business country (...) ".

The approach to determine whether a Canadian resident is carrying on business in another country for the purposes of the ITA can generally be summarized as follows:

1. Does a "business" exist, as this term is defined in subsection 248(1)?
2. If so, is it carried on? This generally requires some continuity and regularity.
3. If a business is being carried on, is it being carried on in Canada and/or outside Canada?

Each situation must be decided on its own facts. Without intending to be exhaustive, the following is a list of relevant facts that have to be considered to determine whether a person is carrying on a business in a particular place for the purpose of the ITA:

• The place where a contract which is the basis of the transaction is made;
• The place where goods are delivered or payments made;
• The location where decisions to purchase and sell are made;
• The location of the business assets;
• The place where the goods are produced or the services performed;
• Whether an agent or independent contractor is utilized;
• The location of the profit making operations (as opposed to where the profits are realized);
• The nature of the activities/transactions;
• The establishment of a bank account, listed telephone number or address;
• Whether the taxpayer intended to do business in the jurisdiction;
• The degree of supervisory or other activity in the jurisdiction;
• The substance or object of the transaction;
• The presence of a representative or resident expert;
• Whether activities in the jurisdiction are merely ancillary to the main business (e.g., the business of buying, storing, selling or manufacturing the product);
• Whether individuals in the jurisdiction assist (or are available to assist) the taxpayer in his endeavour;
• The reason for the taxpayer's existence; and
• The place where a reasonable person would consider the business to be carried on.

Where a taxpayer carries on a business partly inside and partly outside of Canada, the sourcing rules in paragraph 4(1)(b) serve to apportion the income from that business between Canada and other countries, as the case may be. In this respect, the taxpayer's income or loss for the year from the business carried on in a particular place is the taxpayer's income or loss computed as if the taxpayer had no income or loss except from the part of the business that was carried on in that particular place and was allowed no deductions except as may reasonably be regarded as wholly applicable to that particular place.

Paragraph 4(1)(b) could literally be interpreted as requiring a taxpayer to separately calculate his income or loss for each business location. Instead, paragraph 4(1)(b) is generally accepted as only requiring (or allowing) a territorial allocation of his income or loss. As such, paragraph 4(1)(b) provides a territorial sourcing rule. In the present case, paragraph 4(1)(b) would require the profits of the taxpayer to be allocated between Canada and the US State in a manner that adequately reflects the business activities in each jurisdiction that gave rise to those profits. The ascertainment of the actual source of a given income is a practical, hard matter of fact, which requires considering the particular facts and circumstances of each case.

The allocation of the profits of a business to a jurisdiction is not an exact science. It is necessary to examine all the facts and circumstances to arrive at a reasonable allocation. The allocation should reflect the proportion of the actual income earning functions of the business conducted in that jurisdiction relative to the overall activities that comprise the business. The allocation should not be made according to a US State tax formulary apportionment method, or the method provided by the regulations adopted for the application of subsection 124(1), as those methods do not give a true picture of the income earned in the US by a taxpayer.
Nevertheless, if a Canadian corporation's activities carried on in a foreign jurisdiction are incidental to its main Canadian business, it might be reasonable to conclude that the taxpayer is not carrying on business in the foreign country. In this respect, as you mentioned in your request, paragraph 24 of Interpretation

Bulletin IT-270R3 - Foreign Tax Credit, published on November 25, 2004 (IT-270R3), states the followings:

"If, however, one activity of a business is clearly incidental to a predominant one, the incidental activity is not considered when determining in which country or countries the business is carried on. If a vendor of machinery, for example, provides to customers an engineer to supervise the installation of the machinery, this service would generally be considered to be incidental to the activity of selling the machinery; however, this type of service could in some cases be considered to be a significant activity on its own, depending on the machinery being sold, the nature of the installation service, and the terms of the contract with the customer."

Hence, a Canadian corporation that is liable to pay US State tax and that has no US source of income under the ITA, would not be allowed to claim any foreign tax credit pursuant to section 126. We agree with your statement that in those circumstances the taxpayer would generally have to rely on the subsection 20(12) deduction to recover a portion of the foreign taxes paid.

It is appropriate to note that the US State tax paid would have, among other things, to qualify as an "income or profit tax" to give rise to a foreign tax credit under section 126. In order for a foreign tax to qualify as an "income or profits tax", we have stated in paragraph 5 of the IT-270R3 that the basis of taxation must be substantially similar with that of the ITA. We are generally of the view that this requirement would be met if the foreign tax is levied on net income or profits. If a payment is not an "income or profits tax", it may be deductible from the income of the business under paragraph 18(1)(a) if it is incurred for the purpose of gaining or producing income from the business.

2nd question: section 125

For the purpose of section 125, we are of the view that the income from a business carried on in the US will generally not be included in the "income of the corporation for the year from an active business" carried on in Canada, as this expression is defined under paragraph 125(7) and used in paragraph 125(1)a).

3rd question: section 124

The existence of a PE for the purposes of section 124 and Part IV of the ITR is a question of fact that differs from the corresponding determination under the Convention. For the purposes of Part IV of the ITR, the meaning of PE is stated in subsection 401(2) ITR. In that context, the existence of a PE in Canada or in a foreign jurisdiction depends on the rules established under the ITR and is essentially a question of fact.

Subsection 402(1) ITR deals with situations where, in a taxation year, a Canadian corporation has a PE in a particular province and has no PE outside that province. In such circumstances, the entire taxable income of the Canadian corporation would be allocated to that given province. Hence, the taxpayer's US business income, if any, would be included in his Provincial taxable income.

In other respects, where a Canadian corporation has a PE in a particular province and a PE outside that province, whether in another province or in a foreign country, the Canadian corporation would generally be subject to rules that would allocate its taxable income to those jurisdictions based on prescribed factors. Under the general rule stated in subsection 402(3) ITR, the taxable income of the Canadian corporation would be allocated among the provinces based on a formulary method involving the proportion of gross revenue reasonably attributable to PEs in those provinces and salary and wages paid to employees of PEs in those provinces. Hence, the portion of the Canadian corporation's taxable income attributed to PEs located outside Canada by the applicable formulary apportionment method of the ITR would not be included in its Provincial taxable income.

We trust the above comments will be of some assistance.

Yours truly,

Alain Godin, Manager
for Director
International and trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch