Regulation 402 - General Rules

In the first scenario, a Canadian resident purchases a good (or service) from a non-resident at an amount in excess of an arm’s length price, and a transfer pricing adjustment is made to reduce the excess expenditure. In the second scenario, a Canadian resident sells a good (or provides a service) to a non-resident at an amount less than an arm’s length price and a transfer pricing adjustment is made to increase the amount considered to be received. Do such adjustments increase the Canadian resident’s gross revenue, as defined in s. 248(1)?

After noting the relevance of gross revenue to allocations under Reg. 402(3), CRA stated respecting Scenario 1:

Since the primary adjustment changes an amount paid, there is no amount that is received or receivable. Thus, an adjustment… would not be included in gross revenue for provincial income allocation purposes.

Respecting Scenario 2:

Upward adjustments made as per 247(2) essentially deem the sale price…to be what it would have otherwise been had the parties been dealing at arm’s length. Therefore, the amount of the increase should be included in gross revenue for the year… .

…[A]ny adjustment to gross revenue would be attributable…to whichever permanent establishment was reasonably attributed the gross revenue from the sale that was subject to the transfer pricing adjustment.

Should amounts received or receivable as volume discounts should be included in a corporation's "gross revenue" for purposes of Reg. 402(3)? After noting "that taxpayers tend to treat gross revenue to mean revenue for financial statement purposes" and "that, for financial statement purposes, rebates and volume discounts are deducted from the cost of purchase," stating that the "truer picture" doctrine in West Kootenay Power, 92 DTC 6023 and Canderel, 98 DTC 6100 was "not determinative of the issue because gross revenue is specifically defined in the Act, whereas profit and loss are not," and noting that "using financial statement revenue would potentially render paragraph (b) of the definition of gross revenue meaningless," CRA stated that "gross revenue for the purposes of Part IV of the Regulations includes all amounts received or receivable by a taxpayer, other than on account of capital, but does not include amounts received in respect of expenditures of the taxpayer." Respecting the latter exclusion, CRA referred specifically to:

• "amounts received or receivable on account of a taxpayer's expenditures, such as volume rebates, received by the taxpayer because these are adjustments to amounts of expenditures as opposed to receipts in respect of income-earning activities;
• financial assistance received by the taxpayer from a government in respect of expenditures incurred or to be incurred by the taxpayer;"

This represents a "change in position on the meaning of gross revenue for purposes of provincial income allocation from that taken in our letter F2010-0382161I7."

Are joint venture participants permitted, for purposes of provincial income allocation, to include their pro-rata share of the wages and salaries incurred by the operator of the joint venture in their individual provincial income allocation calculations? The Directorate stated:

Where the participants agree to share legal responsibility for the salaries and wages of the employees of the joint venture, the participants would include in their respective provincial income allocation calculations their pro-rata share of the salary and wages. …Additionally, where there is a nominee corporation paying the employees of a joint venture and the legal responsibility is not shared among the joint venturers, the central pay master rules in section 402.1 of the Regulations may apply to attribute the salary and wages to the joint venturers.

Respecting the application of the definition of "salary or wages" in s. 248(1), CRA stated that "subsection 402(3) of the Regulations contemplates only the salaries and wages paid by the corporation to the employees, which precludes consideration of the deductions available to an employee under section 8."

In confirming that the calculation of "salaries and wages" in Reg. 402(3) includes employment income of a non-resident employees, performing employment duties at a permanent establishment of a Canadian corporation in Canada (including, in turn, "employment benefits (e.g., stock option benefits and deferred amounts under salary deferral arrangements), living and personal allowances, and director's fees, to the extent that these amounts are attributable to services rendered in Canada"), CRA stated that "the definition of ‘salary or wages' in subsection 248(1)… is not limited to those individuals who earn income from office or employment who are resident in Canada."

In further confirming that the employment income of a non-resident employee paid by a corporation resident in Canada and attached to a permanent establishment of the corporation outside of Canada is included in the calculation of "salary or wages" for the purposes of the income allocation rules in Reg. 402(3), CRA indicated that the restricted interpretation of "taxpayer" in Oceanspan (87 DTC 5102) does not "not extend to the meaning of the term "salaries and wages" in Part IV of the Regulations," as confirmed, for example, by the exclusion in Regs. 402(4.1)(e) and 413 of salaries and wages of employees of permanent establishments outside of Canada in specified limited circumstances.

A corporation engaged in a franchising business which had a permanent establishment only in Quebec and which derived royalties from franchisees in all the provinces, took over for the time being the franchise operations of an Ontario franchisee (in order to preserve the business reputation), thereby acquiring an Ontario permanent establishment. After quoting Reg. 402(3)(a) and making a "question of fact" disclaimer, CRA stated (TaxInterpretations translation):

[I]t would appear that the income which is reasonably attributable to the Ontario permanent establishment is that which is derived from the carrying on of the acquired franchise business. The other Ontario income, namely the royalties derived from other franchisees exploiting franchises in that province, would reasonably be attributed to the permanent establishment situate in Quebec from which the franchisor business is carried on.

The corporate Taxpayer, which had an October 16 taxation year had only a permanent establishment in Quebec excepting a partnership (the "Partnership") which had permanent establishments in several provinces from which it derived business income and which had an October 31 taxation year, but which, on October 16, 2005, disposed of all its assets located outside Quebec to a person with whom the Taxpayer was not dealing at arm's length. The Taxpayer took the position that the taxable income of the Taxpayer for its taxation year ending on October 31, 2006 should be allocated on the basis that it had a permanent establishment only in Quebec. In disagreeing, the Directorate stated:

[S]ince the income a corporation earns through a partnership in a particular taxation year is deemed to come from the same sources in the same provinces in which the partnership's income was earned, the corporate partner must allocate its taxable income for a particular taxation year to the provinces in which the corporation had a permanent establishment in the taxation year including the provinces in which the partnership had permanent establishments in its taxation year that ended in the particular taxation year.

Interest arising under s. 164(3) due to a refund of an overpayment resulting from a court-ordered reassessment, would not qualify as "gross revenue".

Recapture of depreciation does not constitute "gross revenue" for purposes of Regulation 402(3).

Where an oil and gas company does not have inventory readily available at a specific location and, in order to avoid transportation costs, borrows that product from another company as part of an exchange agreement, the swap under the Law of Bailments will be characterized as a sale and, therefore, will also give rise to a sale for purposes of ss.402(3) and (4) of the Regulations and the definition of "gross revenue".

A capital gain from the disposition of property would not be included in a taxpayer's "gross revenue" whose definition in s. 248(1) specifically excludes amounts as or on account of capital.

Description of criteria applied in determining the destination of a shipment of merchandise for purposes of Regulation 402(4)(a).

Where a corporation having a permanent establishment in two provinces ships a product that is manufactured at its permanent establishment in the first province to its shipping offices in the second province to be shipped to a foreign customer with no Canadian offices, the fact that title to the product passes to the foreign customer in the second province does not alter the conclusion that the destination of the shipment is the foreign jurisdiction (assuming that the vendor knew with some reasonable degree of certainty that the product would be ultimately consumed or re-sold by the foreign customer in its foreign jurisdiction).

Discussion of Regulation 402(4)(d). For Regulation 402(4)(d) to apply, there is no requirement that there be a transfer of the title to the "some other person" by the customer.

The Legislative Policy Directorate had addressed a situation where a taxpayer with permanent establishments in a province and in a country other than Canada sold non-manufactured goods to a customer in the other country, with the sale not being taxed in that other country. The Rulings Directorate agreed with the LPD that because of the application of subsection 402(4.1), there were no longer any specific rules that applied to this sale to determine where the gross revenue should be allocated. Accordingly the taxpayer would then allocate the gross revenue on this sale on the basis of where it was reasonably attributable as required by subparagraph 402(3)(a)(i). The Rulings Directorate also noted that

subsection 402(4.1) would apply to shipments of merchandise regardless of whether that merchandise is manufactured or produced by the corporation.

The central paymaster rules in Reg. 402.1 of the Regulations allocate the salaries and wages paid by an employer for services provided to a non-arm’s-length benefiting corporation. Given that Reg. 402.1(5) deems a partnership to be a corporation for the purposes of these rules, the paymaster rules will apply such that the salary or wages earned by an employee of a partnership for the performance of services in a particular province for a benefiting corporation are deemed to be salary or wages paid by non-arm’s length benefiting corporation to an employee of its permanent establishment(s) (if it has them) in the province.

Given that Reg. 402.1(3) provides that the salaries and wages paid by a partnership that are thus deemed to be paid by the benefiting corporation, are deducted from the partnership employer’s salaries and wages paid in the taxation year, such salaries and wages are not included in the salaries and wages that are allocated under Reg. 402(6) to the members of the partnership for their own allocation purposes .

CRA stated that Reg. 402(6):

...provides that a corporation's proportionate share of a SIFT partnership's gross revenue and salaries and wages is to be included in the corporation's gross revenue and salaries and wages in subsection 402(3) of the Regulations notwithstanding the fact that some or all of the SIFT income might be subject to Part IX.1 tax.

The corporate Taxpayer had an October 16 taxation year and had only a permanent establishment in Quebec excepting the Partnership, which had an October 31 taxation year and had permanent establishments in several provinces but which, on October 16, 2005, disposed of all its assets located outside Quebec. After finding that the Taxpayer was required to allocate income for its taxation year ending on October 31, 2006 on the basis that it had permanent establishments in those other provinces, the Directorate went on to address the reverse situation, stating:

[A] corporation with a permanent establishment only in Quebec becomes a partner in a new partnership in a particular taxation year. Suppose that the first fiscal period of the new partnership will end after the particular taxation year and that the new partnership has only a permanent establishment in Ontario. In this example, although the corporation would have a permanent establishment in Ontario through the partnership during its particular taxation year, since the partnership's income is included only in the corporation's income in the taxation year following the particular taxation year, no portion of the corporation's taxable income for the particular taxation year will be allocated to the province of Ontario under subsection 402(6) of the Regulations.

Respecting a query as to a corporation which has a permanent establishment in a province and is also a limited partner in a limited partnership operating in another province, CRA stated:

[E]ach member of a partnership has a permanent establishment in the province where the partnership has a permanent establishment. This applies to both general and limited partners....For the purposes of allocating the corporation's income to various provinces, the gross revenue and salaries and wages of the partnership will be allocated to the province where the partnership has a permanent establishment.

A partnership (P1), whose sole permanent establishment is in Province 1, is a member of two partnerships (P2 and P3) whose sole permanent establishment is in Province 2 and 3, respectively. P2 and P3 pay fees to a manager in their respective province for services which were normally performed by their employees. It is not possible to obtain a breakdown of what expenses were incurred by the manager.

After making the simplifying assumption that the partners of P1 were corporations rather than individuals (so that Part IV rather than XXVI of the Regulations applied), CRA noted that a pro rata portion of the salaries and wages of P2 and P3 were attributed to P1, and by P1 to its partners. CRA stated (TaxInterpretations translation) respecting the "normally" test in Reg. 402(7) that "the required conditions for management fees paid to a third party to enter into the numerator as ‘salaries or wages' attributable to a permanent establishment situated in a province" are:

1. The service or function performed by the service provider must be a service which previously was performed by an employee of the partnership. ...[S]ubsection 402(7)... does not apply where the partnership has no employee.
2. The task accomplished by the service provider to perform a particular service or function is a short-term one.

As to the portion of the fee "that may reasonably be regarded as payment in respect of [the] services," this was a question of fact. Any profit margin or commission would be excluded under Reg. 402(8) (or 2603(8).)

Regulation 402(7) may apply to fees paid to independent truckers.