19 December 1985 Income Tax Severed Letter

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.

December 19, 1985

Department of National Revenue, Taxation Department of Provincial and International Relations 875 Heron Road Confederation Heights Ottawa, Ontario K1A 0L8 Att'n: Mr. Ed. Campbell

Dear Mr. Campbell:

Re: Canada-Brazil Tax Treaty

As discussed, I am writing to request confirmation of our interpretation of this treaty, which I expect will become effective on January 1, 1986. The area of particular concern relates to credit for Brazilian tax payable on interest.

Treaty Provisions

The treaty provides as follows:

A. Canada will allow credit for Brazilian tax where a resident of Canada derives income which "may be taxed in Brazil" under the terms of the treaty (Article 22, para. 2).

B. Within certain limits, the credit will be equal to "the income tax paid in Brazil". For this purpose "Brazilian tax shall always be considered as having been paid.... at the rate of 20 per cent of the gross amount of the income paid in Brazil in the case of interest to which paragraph 2 of Article 11 applies" (Article 22, para. 2 & 3).

C. Paragraph 2 of Article 11 refers to interest arising in Brazil that is paid to a beneficial owner that is a Canadian-resident company as long as the interest is not effectively connected to a permanent establishment in Brazil (Article 11, para. 5).

D. Interest is deemed to arise in Brazil when the payor is a resident of Brazil (Article 11, para. 7).

Analysis XXXX

1. Interest on certain loans is paid on a gross basis, i.e. payments to the Bank are not reduced by any Brazilian withholding tax applicable. Tax paid to the Brazilian government by the borrower is, however, considered to have been paid on the Bank's behalf and is regarded as additional interest revenue earned by the Bank. Such taxes paid are included in the Bank's taxable income and a corresponding foreign tax credit is claimed, subject to the limitations of section 126 of the Income Tax Act. The following example illustrates how the Brazilian withholding tax and the Bank's income are being calculated on these types of loans:

Assume: 
Amount of loan                                  $1MM 
Stated interest rate                                     10% 
Rate of Brazilian 
withholding tax applicable (non-treaty rate)   25%

Interest received by Bank 
$1MM @ 10%                                   100,000 

Brazilian tax paid by borrower                  33,333* 
Gross interest income                               $133,333

* Since interest paid to the Bank is considered to be net of withholding tax of 25%, gross interest subject to withholding is calculated as follows: $100,000 ÷ 0.75 = $133,333. Withholding tax payable thereon at 25% equals $33,333.

Under the treaty, the rate of Brazilian withholding tax will fall to 15% or 10% on certain loans. However, as noted above, Brazilian tax will be deemed to have been paid at the rate of 20% on "the gross amount of income paid in Brazil". It is our view that the gross amount of income paid in Brazil would be calculated in the same manner as it is to determine the amount of withholding tax payable in Brazil. Thus, using the same example as above, Brazilian tax paid on these loans would be calculated for treaty purposes as follows:

Interest received by Bank              $100,000 
Brazilian tax deemed paid =                        25,000*
Gross interest income                     $125,000

* $100,000 ÷ 0.8 =                 $125,000 
Tax at 20% of $125,000 =                  $25,000

2. The reduced rate of withholding tax does not apply to interest paid to a permanent establishment outside Brazil and Canada (Article 11, par. 6). Accordingly, interest received by the Bank in branches outside Canada will continue to be subject to the non-treaty rate, which is currently 25%. Since the purpose of the treaty is to reduce taxes and to eliminate double taxation, it is our view that Article 22 of the treaty cannot deem tax to have been paid at the rate of 20% when tax is actually paid at a higher rate.

3. Interest on certain loans to Brazilian borrowers is exempt from withholding tax under Brazilian domestic law. Nevertheless, such interest is income that, under the terms of Article 11 of the treaty, may be taxed in Brazil. The fact that it is not taxed in Brazil does not appear to preclude the application of paragraph 3 of Article 22, which deems Brazilian tax to have been paid at the rate of 20%. Therefore, we interpret these provisions as allowing the Bank to claim a credit for a deemed 20% Brazilian tax on interest received on loans that are in fact exempt from tax under Brazilian law.

I would appreciate an early response so that we can properly assess the impact of the treaty on our operations. If you wish to discuss the issues, please feel free to call me.

Yours truly, XXXX