10 March 2011 External T.I. 2010-0390061E5 - Pakistani withholding tax - 126(2)

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: Whether Article XXII of the Convention entitles a Canadian taxpayer to claim a foreign tax credit for an amount of taxes withheld by a resident of Pakistan in a given case?

Position: Question of fact.

Reasons: Interpretation of the Act and the Convention

XXXXXXXXXX
		2010-039006
		Yannick Roulier

March 10, 2011

Mme:

Re: Availability of foreign tax credit for Pakistani withholding tax

This is further to your e-mail of December 13, 2010, requesting our comments regarding the possibility for a Canadian corporation to claim a foreign tax credit for Pakistani withholding tax in a given set of facts. 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").

Hypothetical situation submitted

We understand the facts of the hypothetical situation submitted to be as follows:

• A corporation resident of Canada ("Canco") enters into a service agreement with a resident of Pakistan ("Pakistanco") with whom it deals at arms' length.
• Under the service agreement, Canco renders engineering services exclusively in Canada during a given taxation year.
• Pakistanco withholds a 15 % Pakistani tax on payments for the services rendered by Canco during the given year.
• The Pakistani withholding tax is a tax covered by the Convention between Canada and the Islamic Republic of Pakistan for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income ("Convention") in accordance with its Article II.
• For the application of the Convention to the payments received by Canco during the given taxation year, the services are not considered to be rendered through a PE in Pakistan and Canco does not otherwise maintain any active permanent establishment ("PE") in Pakistan during the year.

You submitted that Canco would not be entitled to claim a refund of the tax withheld at source from the Pakistani tax authorities. Also, you are of the view that the payments received as consideration for the services would not be considered royalties within the meaning of paragraph 4 of Article XII of the Convention.

Question

You ask whether Article XXII of the Convention entitles Canco to claim a foreign tax credit for the amount of taxes withheld by Pakistanco.

Comments

The particular circumstances outlined in your letter seem to relate to a factual situation involving specific taxpayers. As explained in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, the Income Tax Rulings Directorate of the Canada Revenue Agency ("CRA") does not comment on transactions involving specific taxpayers except by way of an advance income tax ruling in respect of proposed transactions. When the situation involves a specific taxpayer and a completed transaction, the question should be directed to the appropriate Tax Services Office of the CRA for their views, along with all relevant facts and documentation. Nevertheless, we are prepared to offer the following general comments which may be of assistance. Our comments constitute technical interpretations. They are not income tax rulings and are not binding on the CRA.

In order to conclude that a foreign tax credit might be claimed by Canco for the Pakistani tax withheld in the hypothetical situation submitted, it is first required to establish whether the tax is levied in conformity with the terms of the Convention. In this respect, the application of Articles VII and XII of the Convention to the given hypothetical situation has to be considered.

In the first place, paragraph 1 of Article VII states the following:

"1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on or has carried on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them, as is attributable to

(a) that permanent establishment; or
(b) sales of goods or merchandise of the same or similar kind as those sold, or from other business activities of the same or similar kind as those effected, through that permanent establishment."

Subparagraph 1(b) provides for a rule based on a "force of attraction approach" according to which a contracting State is allowed to tax the business profits derived by a resident of the other contracting State without them being directly attributable to a PE. This rule applies to business activities or sales of goods or merchandise of the same or similar kind as those effected or sold through a PE. Whether a PE otherwise exists and whether the payments received by a taxpayer would be attributable to other business activities of the same or similar kind as those effected through its PE in Pakistan is a question that can only be determined following a review of all the facts relating to the taxpayer's particular circumstances. Considering that in the situation submitted Canco has no PE in Pakistan, it appears that the Pakistani tax authorities would not be allowed to rely on subparagraphs 1(a) or 1(b) to tax the payments received by Canco.

Secondly, payments not effectively connected with a PE that qualify as "royalties" may still be taxed by the source State in accordance with Article XII of the Convention. The term "royalties" is defined as follows in paragraph 4 of Article XII of the Convention:

"(a) payments of any kind received as a consideration for the use of, or the right to use, any copyright, patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment and includes payments of any kind in respect of motion picture films and works on film or videotape for use in connection with television;
(b) payments received as consideration for technical know how or information concerning industrial, commercial or scientific experience."

As previously stated, you are of the view that the payments received by Canco as consideration for the services would not be considered "royalties" within the meaning of paragraph 4 of Article XII of the Convention. It is however not clear to us if this statement is a conclusion drawn from the application of the Convention under a Canadian or a Pakistani perspective.

Assuming that your view is correct, it can reasonably be concluded that Canco should not be subjected to Pakistani tax in application of the Convention. Any amount of tax withheld at source and paid to the Pakistani tax authorities could then be seen as a "voluntary tax". As such, we would be of the view that the amount would not be considered to be an "income or profits tax" and no foreign tax credit would be allowed for it.

Notwithstanding the above, Pakistani tax withheld at source might qualify as an "income or profits tax" if Canco can establish that the tax has been levied by the Pakistani tax authorities in application of Pakistani law and the Convention. It is appropriate to underline that this conclusion of fact may differ from a conclusion of law that could be reached in a corresponding situation subject to the application of the Convention under Canadian law. For example, the Pakistani tax authorities might consider that a PE exists under their law, or that payments qualify as royalties, although such conclusions would not be sustainable under Canadian law.

In order to establish the legitimacy of the tax levied, we are generally of the view that Canco would have to have pursued all of the administrative avenues (e.g. objection, appeal, review) that it can regarding the tax assessed in contravention of a reasonable application of the Convention under Canadian law. Also, where Canco considers that the actions of Pakistan result or would result in taxation that is not in accordance with the Convention, Canco may address a written request to the Canadian Competent Authority presenting the grounds for a revision of such taxation in accordance with the Mutual Agreement Procedure stated in Article XXIV of the Convention.

Hence, if the facts support the conclusion that the Pakistani withholding tax is levied in conformity with the terms of the Convention and does not constitute a "voluntary tax", it would appear to us that Canco could be permitted to claim a foreign tax credit in application of Article XXII of the Convention, subject to the rules prevailing under the ITA for the application of paragraph 126(2).

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