23 September 1998 Internal T.I. 9822230 - RESIDENCE UNDER AN INCOME TAX CONVENTION

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) Residence under an income tax convention.

Position: Question of fact.

Reasons: Decision must be made on a case by case basis.

The Queen v.Crown Forest

The Crown Forest decision confirmed the Department’s basic understanding of how residency is determined under the Canada-U.S. Income Tax Convention (1980) the (“Convention”) and under conventions with other jurisdictions which tax their residents on the basis of the residents’ worldwide income. 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 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 world-wide 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 world-wide 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 world-wide 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 world-wide 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. This principle must be applied with some caution in interpreting certain other conventions as some countries have adopted a territorial system of taxation and therefore do not tax residents on their world-wide income. In order to qualify as a resident contracting state which has territorial tax system, 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 interpretative aids. This principle has general application when interpreting all of Canada's income tax conventions.

Finally, the Supreme Court clearly preferred an interpretative 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.

Government, Pension Funds and Not-for-Profit Organizations

Prior to the Crown Forest decision and the 1995 3rd Protocol to the Convention, it was the understanding of the Department that the term “resident of a contracting state” for the purpose of paragraph 1 in the residence article of all of Canada’s income tax conventions included the following:

a) the government of either state or a political subdivision or local authority thereof or any agency or instrumentality of any such government, subdivision or authority, and

b) (i) a trust or organization that is operated exclusively to administer or provide pension, retirement or employee benefits; and

(ii) a not profit organization

that was constituted in either state and that is by reason of its nature as such, generally exempt from income taxation in that state.

The Crown Forest decision had no impact on the Department’s position.

It is our understanding that Canada’s treaty negotiators have brought up the issue of clarifying the residence article with many of our other treaty partners but that such treaty partners have declined on the basis that they generally feel that the residence of governments, pension funds and not-for -profit organizations is already sufficiently clear. This generally accepted practice is evidenced by the comments in the Technical Explanation to the 3rd Protocol to the Convention which clearly state that the amendments were made to clarify the residence article consistent with the prior practice of the contracting states. In addition there is an argument in some cases and in particular in the case of pension funds and charitable organizations that they would be liable to tax in the contracting state in which they were constituted if they were to fail to meet the criteria set out in the domestic legislation which entitle them to a specific exemption from tax.

Other Issues

U.S. S-Corps

The Department views U.S. S-Corps to be resident in the United States for the purposes of the Residence Article of the Convention. This view is based in the fact that they are “liable to tax” under the IRS Code like any other U.S. domestic corporation unless they make an election to be treated as a partnership. Furthermore, not withstanding the election, an S-corp. would be taxed in the United States on its world-wide income if certain conditions are not met.

The Department recognizes that the above position is arguably inconsistent with its view that U.S. LLCs are not resident in the U.S. for the purposes of the Convention. Possibly if the Department had had the knowledge and experience it now has in the area of residency determination when it formed its opinion regarding the residence of U.S. S-Corps, it may have reached a different conclusion regarding the residence of U.S. S-Corps.

U.S. LLCs

While the above position with respect to U.S. S-Corps may be subject to debate, the following position with respect to U.S. LLCs is clearly consistent with the Crown Forest decision. The Department continues to be of the view that a U.S. LLC 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 resident in the United States under the common law test of residency. Accordingly, such limited liability company does not qualify for reduced rates of Canadian tax on Canadian source income that may otherwise be provided for in the Convention.

In the context of the foreign affiliate legislation, a U.S. LLC which is treated as a partnership under the IRS Code and which is a foreign affiliate of a resident of Canada would qualify as resident in the United States (i.e. a designated treaty country) under paragraph 5907(11.2)(b) of the Regulations provided that such LLC was resident in the United States under the common law test of residency.

The common law test of residency provides that a corporation is resident where its mind, management and control resides. As a general rule, the mind, management and control of a corporation is situated in the jurisdiction in which the members of its board of directors meet. However, such would only be the case where it could be established that the foreign affiliate was in fact managed and controlled by the majority of its directors and those directors have the autonomy to make independent decisions at the meetings held in the particular jurisdiction. When mind, management and control resides in a particular place, the corporation is held to be resident in such place, but it does not follow that it cannot also be resident elsewhere. The mind management and control of a corporation may be divided and if so, it may have more than one residence. A LLC that is resident in Canada and another country would not qualify as a foreign affiliate and would be taxable in Canada on its worldwide income. As this issue requires detailed knowledge of the facts, it is the Department’s view that such determinations must be made at the audit stage.

Barbados Exempt Insurance Companies

The issue of concern here is whether a foreign affiliate of a corporation resident in Canada, and which is incorporated in Barbados and licensed under the Barbados Exempt Insurance Act 1983 (the “EIA”), will be considered resident in a designated treaty country in the context of sections 5907(11)-(11.2) of the Regulations. Once again the crux of the issue lies in whether such entity can be viewed as “liable to tax” in Barbados under the residence article of the Canada- Barbados Income Tax Agreement (the “Agreement”).

In 1995 amendments were enacted to the EIA which governs the operations of companies incorporated in Barbados which carry on the business of insuring risks outside Barbados in respect of which premiums originate from outside Barbados (“exempt insurance companies”). Prior to the 1995 amendments, exempt insurance companies enjoyed a total automatic exemption from Barbados taxation but were subject to an annual registration or license fee of Bds. $5,000. Pursuant to the EIA as amended, every licensee is now deemed to be managed and controlled in Barbados and is therefore resident there for Barbados tax purposes. Licensees will in the future be taxed at zero percent during the first 15 years and thereafter at two percent but only on the first Bds. $250,000 of taxable income (i.e. maximum of Bds. $5,000). The annual license fee will be waived in a year where a licensee is required to pay the two percent tax.

It is the Department’s view that an exempt insurance company licensed under the EIA would not be a resident of Barbados pursuant to paragraph 1 Article IV of the Agreement. Therefore, on the basis of Regulation 5907(11.2), an exempt insurance company will be deemed, for the purposes of Part LIX of the Income Tax Regulations, not to be resident in a country with which Canada has entered into a comprehensive agreement or convention for the elimination of double taxation on income.

In substance, the new requirement that, after 15 years, an exempt insurance company pay an income tax of two percent on the first Bds. $250,000 of its taxable income represents, for all intents and purposes, is nothing more than a continuing obligation to pay the annual license fee of Bds. $5,000. Given the reality that an exempt insurance company's main and, most likely, only source of income is effectively exempt from taxation in Barbados (i.e. zero percent) for a guaranteed period of 30 years (leaving aside what is essentially an annual license fee), it is our view that an exempt insurance company is not "liable to taxation" in Barbados, in the sense to be given to those words in paragraph 1 of Article IV of the Agreement, namely, that of full liability to tax, being the most comprehensive form of taxation of a person under the law of Barbados.

Remittance Basis Taxpayers

A number of countries employ a tax system which classifies individual taxpayers into three rather than two categories. In addition to making a distinction between non-residents and residents, a further breakdown is made between permanent or full-fledged residents and temporary or non-permanent residents. While an individual, who is considered for tax purposes to be a full-fledged resident of the country concerned is subject to tax on world income on a current basis, the so-called non-permanent resident is only subject to tax on a "remittance" basis. Under this latter system, the individual is liable to tax only on income derived from sources in the country concerned as well as on any foreign income to the extent that it is remitted to or received in that country. Two notable examples of countries using the remittance basis system are the United Kingdom and Japan.

The question is whether only individuals who are subject to tax in a country on their world-wide income, whether such remitted to that country or not, are to be considered as "liable to tax therein"and thereby meeting the definition of resident as defined in paragraph 1 of the residence article or are individuals taxed on the remittance basis to be considered as meeting the definition of resident as well? In other words, is the fact that these individuals would only be taxed on foreign source income when it is received or remitted sufficient to consider such individuals to be liable to tax on their worldwide income?

The Department takes the view that individuals who are subject to tax on a remittance basis are liable to tax on a world income basis. If the foreign source income is ultimately remitted to or received in the taxpayer's state of residence, the taxpayer will be liable to tax on that income at that time and, consequently, will effectively have been taxed on all his or her world income. Accordingly, persons who are liable to tax in a contracting state on a remittance basis, would not in our view, be precluded from being resident there for the purposes of paragraph 1 of the residence article of a convention. Of course, the determination of residence for the balance of a convention would be subject to the residence tie-breaker rule where applicable. The Department’s view applies equally to all income tax conventions regardless of whether remittance based taxation is addressed within the provisions of a particular convention.

Prepared by: Olli Laurikainen
September 23 1998
File 982223