5 February 2002 Internal T.I. 2000-0058637 - Interest Paid to Non-Resident

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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Various issues regarding sourcing of interest under Canada's tax treaties.

Position: see attached memo

Reasons: see attached memo

			February 5, 2002

	Toronto North TSO 	International Section
	Audit Directorate	Tim Kuss
	Industry Specialist Services	(613) 957-2117	

	Attention:  Doug Mitchell, Banking Specialist
			2000-005863

Canada-Australia Income Tax Convention

You have requested our views regarding the application of the Canada-Australia Income Tax Convention (the "Convention") in respect of interest paid by a foreign branch of a Canadian bank in the following situation.

A Canadian bank with a worldwide branch and agency network has a wholly owned foreign subsidiary incorporated in Australia and resident in Australia for purposes of the Income Tax Act (the "Act") and the Convention. The Australian subsidiary has placed surplus funds on deposit with the Australian branch of the Canadian bank as well as with other non-Australian branches of the Canadian bank. The subsidiary does not carry on business in Canada.

You have referred to Rulings opinion 7-4645 dated July 10, 1990, and asked whether our interpretation in that document remains the same. While we agree with the ultimate conclusions in that opinion (i.e., whether Canada has the right to tax such interest), we do not agree with the detailed analysis on how some of the treaties (including the Convention) would apply in situations where the branch of the Canadian bank is located in the same country as where the subsidiary of the Canadian bank is resident. Our comments, below, relating to treaty interpretation, while directed at the Convention, may be applicable to other treaties depending on the structure of the particular treaty.

Analysis and Discussion

In the above fact pattern, interest paid by a foreign branch of a Canadian bank to its subsidiary resident in Australia would be subject to 212(1)(b) of the Act and, because the bank and its subsidiary do not deal at arm's length, none of the exceptions in subparagraphs 212(1)(b)(iii), (vii) or (ix) would be applicable. Therefore, the issue becomes whether the Convention will exempt the interest from withholding tax in Canada.

The interest income of the subsidiary would generally be considered business profits; therefore, Article 7 of the Convention should be examined first in determining whether Canada may tax such interest. However, paragraph 6 of Article 7 states that business profits of an enterprise do not include items dealt with in, inter alia, Article 11 (Interest) of the Convention. Therefore, the possible application of Article 11 must be examined.

Article 11 of the Convention deals with interest arising in one of the Contracting States to which a resident of the other Contracting State is beneficially entitled. Paragraph 5 of Article 11 of the Convention determines where interest is considered to arise (note as well that paragraph 5 of Article 11 is of general application and its purpose is not limited to Article 11). Under the Convention, interest shall be deemed to arise in a Contracting State where the payer of the interest is a resident of that State for purposes of its tax. Where, however, the person paying the interest, whether he is a resident of one of the Contracting States or not, has in a State other than that of which he is a resident a permanent establishment in connection with which the indebtedness on which the interest is paid was incurred, and that interest is borne by that permanent establishment, then such interest shall be deemed to arise in the Contracting State in which the permanent establishment is situated (in our view, despite the somewhat confusing reference to "State" followed by a reference to "Contracting State", the intention is to override the "residence sourcing rule" only where the permanent establishment is situated in one of the Contracting States).

In the case where the interest paid is in connection with a permanent establishment that the Canadian bank has in Australia and such interest will be borne by that permanent establishment, the interest will be deemed to arise in Australia. As the interest arises in Australia and a resident of Australia is beneficially entitled to such interest, such interest is not dealt with in Article 11 of the Convention. Returning now to Article 7 (i.e., because the income is not dealt with in Article 11) the interest income may not be taxed in Canada because the subsidiary does not carry on business in Canada through a permanent establishment situated therein.

Paragraph 1 of Article 21 of the Convention only applies to items of income of a resident of a Contracting State not expressly mentioned in the foregoing Articles of the Convention. It is our view that such income was dealt with in Article 7 and, therefore, Article 21 is not applicable.

It should also be pointed out that even if the interest was not considered business profits (i.e., if an argument could be made that it was income from property) and therefore was not dealt with in Article 7, Article 21 of the Convention would exempt such income from tax in Canada as the income arises in Australia, not Canada. However, we repeat, we consider the better view is that the interest is dealt with in Article 7 of the Convention and Article 21 of the Convention is not applicable.

In the case where the interest is in connection with a permanent establishment of the Canadian bank situated in a third state, the default is to source the interest to the state in which the payer is resident. In this case, the interest is deemed to arise in Canada and is dealt with in Article 11 of the Convention. Canada may tax the interest within the limits described in paragraph 2 of Article 11 of the Convention.

In similar fact patterns where the Canada-U.S. Income Tax Convention (the "U.S. Convention") is involved (i.e., the interest is in connection with a permanent establishment that the Canadian bank has in the U.S., or a third state, and the interest is paid to one of the bank's U.S. subsidiaries), it is our view that Article XXII of the U.S. Convention would, in each case, apply to exempt the interest from Canadian withholding tax. Paragraph 6 of Article XI of the U.S. Convention sources interest to a third state where the interest is in connection with a permanent establishment the payer has in that state and the interest is borne by that permanent establishment. The comments in the Technical Explanation of the U.S. Convention (released by the U.S. Treasury Department and endorsed by the Canadian Minister of Finance) (the "Technical Explanation") relating to paragraph 6 of Article XI and paragraph 1 of Article XXII, indicates that such interest would be exempt from tax in Canada under article XXII of the U.S. Convention. It does not mention Article VII of the U.S. Convention. In our opinion, the comments in the Technical Explanation apply only for purposes of the U.S. Convention and do not apply for the purposes of interpreting other tax conventions to which Canada is a party.

We would like to point out that on January 23, 2002, a protocol to the Convention was signed in Canberra, Australia. We have reviewed the provisions of the protocol that are relevant to this memorandum and have concluded that they do not affect any of the comments that we have made.

Lastly, although not part of your opinion request, we want to make sure you are aware that in the situations described above, depending on the facts of the particular case, income derived by the foreign subsidiary from indebtedness of the Canadian bank may be included in computing the subsidiary's income from a business other than an active business pursuant to paragraph 95(2)(a.3) and thereby be included in computing the income of the bank under subsection 91(1). In such a case, any Canadian withholding tax that is paid in respect of the interest on such indebtedness would be considered "foreign accrual tax" pursuant to the definition in subsection 95(1).

We hope our comments are of assistance.

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