Income Tax Audit Manual Chapter 15

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This chapter was last updated in July 2018.

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Chapter 15.0 International audit issues - Under review

15.1.0 Introduction – Under review

This chapter deals with international audit issues as well as issues that affect international taxpayers.

15.2.0 Income of a non-resident – Under review

15.2.1 Overview

A non-resident person is subject to income tax under Part I of the Income Tax Act (ITA) where the non-resident person was:

employed in Canada;
carried on a business in Canada; or
disposed of taxable Canadian property at any time in the year or a previous year.

A brief discussion of the treatment of income from each of these sources follows.

15.2.2 Part XIII tax

A non-resident person is subject to income tax under Part XIII of the ITA on certain types of income arising in Canada, including dividends, interest, rents and royalties.

For more information, go to 15.3.0, Part XIII tax on income from Canada of non-resident persons.

15.2.3 Part XIV tax

Non-resident corporations that earn income from carrying on business in Canada are subject to tax under Part XIV of the ITA that is in addition to tax payable under Part I.

15.2.4 Income earned in Canada from an office or employment

Non-resident individuals that are regularly and continuously employed in Canada during the year are subject to tax under paragraph 2(3)(a) of the ITA on income earned in the year as described in subparagraph 115(1)(a)(i).

Subsection 115(2) applies in certain circumstances and deems certain types of non-resident persons to have been employed in Canada for the purposes of subsection 2(3).

A non-resident individual that has earned employment income during the year must calculate the amount and file an income tax return according to the same rules that apply to resident employees. Therefore, the non-resident's income includes the value of any benefits received or enjoyed in connection with employment in Canada. In addition, the individual must file an income tax return if, during a calendar year, employment income was earned in Canada resulting in income tax payable under Part I for that year.

Treaties do not generally override the statutory provisions referred to above; exceptions to the Canada-US treaty include exemption from Part I tax in Canada for any US resident that:

earns less than $10,000 in respect of an employment in Canada; and
is present in Canada for fewer than 184 days during the year and the remuneration is not expensed from Part I taxes in Canada.

15.2.5 Income from business carried on in Canada

Income earned by a non-resident from carrying on a business in Canada is:

included in taxable income under subparagraph 115(1)(a)(ii) of the ITA;
taxable under paragraph 2(3)(b) of the ITA; and
subject to withholdings in accordance with Section 105 of the Income Tax Regulations (Regulation 105).

Whether a business is being carried on in Canada is generally a question of fact based on common law factors connecting a business to a particular place and on the definition in section 253 of the ITA of "extended meaning of carrying on business" in Canada.

Where it is not obvious whether an individual is an employee subject to income tax under paragraph 2(3)(a) of the ITA or taxable as a contractor under paragraph 2(3)(b) as having "carried on a business in Canada," certain tests may be applied to make that determination.

For more information, go to 15.2.9, Agent or servant vs. independent contractor.

15.2.6 Common law factors connecting a business to a particular place

Common law has identified several factors that connect a business to a particular place. The place where profit-producing contracts (for example, sales contracts) are entered into is generally recognized as an important factor in determining where a business is carried on. However, the courts have frequently looked beyond the conclusion of sales contracts citing the fact that business income is attributable to the sum total of business activity not merely to the completion of the sale.

Accordingly, depending on the facts of a case, one or more of the following factors may be important in determining whether a non-resident person is carrying on business in Canada:

place of delivery of goods
place where services are rendered
place of payment for the goods or services
place where purchases are made in connection with goods or services
place of manufacture or production
place from which transactions are solicited
location of an inventory of goods
location of a bank account relating to the business
place where the non-resident's name and business are listed in a directory
location of a branch office
place where agents or employees of the non-resident are located

15.2.7 Carrying on business "with" vs. "in" Canada

Generally, non-resident corporations that export goods to Canadian customers are considered to be carrying on business "with" Canada, not "in" Canada if the place of delivery is the only factor that indicates that business activity is being carried on in Canada. For example, unless sales orders are procured through an agent in Canada, a corporation merely selling goods into Canada would not be considered to be carrying on business in Canada and is not subject to the T2 filing requirements or to income tax in Canada.

For more information, go to Tax Guide T4012, T2 Corporation – Income Tax Guide.

Where services are rendered to customers situated in Canada, such activity will normally be considered to be carrying on business in Canada only if work is performed in Canada.

15.2.8 Extended meaning of "Carrying on business in Canada"

Section 253 of the ITA deems a non-resident to be carrying on business in Canada regarding the activities and dispositions specified in the section. This extended meaning applies to a non-resident person and certain trusts whose beneficiaries are non-residents in a tax year that:

produce, grow, mine, create, manufacture, fabricate, improve, pack, preserve, or construct, in whole or in part, anything in Canada, whether or not for export;
solicit orders or offer anything for sale in Canada through an "agent or servant;" or
dispose of a Canadian resource property, timber resource property or real property that is not a capital property.

15.2.9 “Agent or servant” vs. “independent contractor”

In making a determination as to whether a Canadian resident is an "agent or servant" of a non-resident, as described in section 253 of the ITA, or is acting as an independent contractor, the courts consider the degree of legal and factual control exercised by the non-resident to be important. Identification of the following factors aids in this determination:

Agent or servant vs. independent contractor

Agent or servant	Independent contractor
The goods are sold in the name of the non-resident.	The goods are sold in the name of the contractor.
The goods are ordered from the non-resident when an order is received.	Inventory is maintained to fill orders.
Orders have to be approved by the non-resident.	The contractor approves own orders.
The non-resident sets the selling price of the goods.	The contractor sets the selling price.
The agent doesn't take title to the goods before the sale to the end user.	The contractor receives title to the goods upon receipt and bears the risk of ownership.
The agent pays for the goods after they are sold to the end-user.	The contractor pays for the goods received whether or not the goods are sold.
The agent holds the sales proceeds "in trust" for the non-resident.	The contractor does not account for transactions with the non-resident separately.

A non-resident person who renders services in Canada for a fee, commission, or similar consideration is also generally considered to be carrying on business in Canada.

15.2.10 Treaty-protected businesses

Non-resident persons that earn income from carrying on business in Canada during a year are subject to the same rules as residents regarding the filing of income tax returns. However, for tax years after 1998, non-resident corporations that carry on a "treaty-protected business" as defined in subsection 248(1) of the ITA, during a tax year are required to attach a completed Form T2SCH91, Schedule 91, Information Concerning Claims for Treaty-Based Exemptions, to their T2 Corporation Income Tax Return to support claims for treaty exemption.

Many of Canada's treaties contain a provision that exempts the profits from a business carried on in Canada by a non-resident of Canada from Canadian tax if such business is not carried on through a permanent establishment (PE) located in Canada. Such a business is considered to be a "treaty-protected" business.

Since any income derived from a treaty-protected business is exempt from income tax in Canada, it does not have to be included in the person's taxable income for the year, relieving the recipient of liability for Part I tax. In addition, under paragraph 150(1.1)(b), if the non-resident person is an individual, there is no obligation to file an income tax return unless the individual realized a taxable capital gain or disposed of a taxable Canadian property during the year.

Schedule 91

A corporation must file an income tax return if it carried on a treaty-protected business during the year. However, there is no requirement to report any income from that business on the T2 Corporation Income Tax Return. Instead, the corporation must support the claim for exemption by completing and submitting Form T2SCH91, Schedule 91, Information Concerning Claims for Treaty-Based Exemptions, as an attachment to the tax return.

15.2.11 Withholding of Part I tax – Income from carrying on a business in Canada

Regulation 105 and paragraph 153(1)(g) of the ITA require any person paying a non-resident person for services rendered in Canada (other than for regular and continuous employment services) to withhold 15% of the gross payment. However, most tax treaties between Canada and other countries provide for some relief from this requirement. The withholding does not represent a final tax and must be remitted by the 15th of the following month.

The non-resident must file an income tax return (T1 or T2) in Canada, regardless of whether a waiver has been received and pay income tax under Part I if applicable. Refunds may be issued if a business is carried on in Canada with no fixed base or PE if an exemption is provided under a tax treaty.

In accordance with subsection 227(8.4) of the ITA, where a person has failed to make a withholding under Regulation 105 from a payment to a non-resident recipient, such person becomes liable to pay the tax.

15.2.12 Disposition of taxable Canadian property by a non-resident

Taxable capital gains or other income arising from the disposition of taxable Canadian property by a non-resident are:

taxable under paragraph 2(3)(c) of the ITA;
included in taxable income under subparagraph 115(1)(a) (iii); and
subject to withholdings in accordance with section 116.

Withholding of income tax on dispositions of taxable Canadian property

Section 116 requires a non-resident person disposing of taxable Canadian property to notify the CRA of the dispositions and to make a payment or provide acceptable security on account of tax on any gain or income arising from the disposition.

Once this notification/payment has been confirmed, the CRA will issue a certificate to both parties to the transaction confirming that the non-resident has complied with the section 116 requirements. The certificate identifies the vendor, purchaser, and the property disposed of and confirms the amount of the certificate limit if it is a proposed disposition or the proceeds of disposition if it is an actual disposition.

For more information, go to Income Tax Information Circular IC72-17R6, Procedures Concerning the Disposition of Taxable Canadian Property by Non-Residents of Canada – Section 116.

However, if the final amount payable for the property exceeds the certificate limit, the purchaser must withhold and remit 25 %of the amount of the excess. In the case of properties the dispositions of which are generally accorded income rather than capital gains treatment, such as a Canadian resource property, timber resource or non-capital real property, the withholding rate for such excess is 50% (subsections 116(5.2) and 116(5.3)).

If the vendor does not notify the CRA, the purchaser is liable to remit to the Receiver General within 30 days after the end of the month in which the purchaser acquired the property, the tax on the amount payable by the purchaser calculated at the applicable rate. This requirement is waived if it can be demonstrated that, after reasonable inquiry, the purchaser had no reason to believe that the vendor was a non-resident. The purchaser acquiring the property may recover any such tax remitted by deducting it from any amount payable to the vendor.

In addition, the purchaser becomes liable for any related penalties and interest arising under subsections 227(9) and 227(9.3) for failure to remit.

15.2.13 Treaty-protected property

Non-residents are subject to Part I tax on income from the disposition of taxable Canadian property. However, Canada's tax treaties provide that while dispositions by non-residents of a real property or PE property situated in Canada are taxable in Canada, other taxable Canadian property is considered to be treaty-protected property. Any income or gain from the disposition of such property may be taxed only in the country of residence.

Schedule 91

A corporation must file an income tax return for the year if it disposed of a taxable Canadian property during the year. However, if the taxable Canadian property was a treaty-protected property, there is no requirement to include any gain or income from that disposition in the calculation of income earned in Canada. Instead, the corporation must support its claim for exemption by completing Form T2SCH91, Schedule 91, Information Concerning Claims for Treaty-Based Exemptions, and filing the schedule as an attachment to the return.

15.2.14 Waivers of withholding tax

If the CRA is satisfied that there is no tax liability or a lesser tax liability than provided for in the legislation, withholding tax may be waived on payments made to non-residents for the following:

non-resident employee remuneration
fees, commissions, or other amounts for services performed in Canada
business income in Canada (no Part XIII tax if taxable under Part I)
salary paid by an eligible employer to an employee working overseas at least six months (overseas employment tax credit)
payments under the Student Work Abroad Program (SWAP); foreign students studying full time and working in Canada may not be subject to withholding if the total income earned in the year is less than the non-refundable tax credit base amount
payments subject to treaty-based waivers – non-resident corporations that do not derive income from a PE in Canada, non-resident individuals that do not derive income from a fixed base regularly available in Canada, employment income in Canada less than the threshold amount ($10,000 for US residents)

15.2.15 Tax calculations

Individuals

A non-resident individual is liable for income tax at the rates set out in subsection 117(2) of the ITA that are the same rates applicable to an individual who is resident in Canada. A non-resident individual is also liable for Part I.1 surtax.

Section 118.94 stipulates that 90% of the total income of a non-resident must be included in computing taxable income earned in Canada for the non-resident to be entitled to deduct most of the non-refundable tax credits in computing income tax payable for the year.

Corporations

Non-resident corporations subject to income tax in Canada are taxed at the same rate as resident corporations. The normal rules for determining the amount of taxable income earned in a province by a corporation are modified by subsection 413(1) of the Income Tax Regulations applicable to non-resident corporations. In computing the taxable income earned in a province, a non-resident corporation that has a PE in a province, excludes salaries and gross revenue attributable to a PE outside Canada and includes only taxable income earned in Canada.

For purposes of determining the taxable income earned in a province, “permanent establishment” is defined in subsection 400(2) of the Income Tax Regulations as a fixed place of business, including an office, a branch, a mine, a workshop, and so on. However, it should be noted that this definition of “permanent establishment” differs from the one found in tax treaties.

A non-resident corporation may claim the same tax credits under Division E (computation of tax) as a resident corporation, except for the small business deduction in section 125 and the foreign tax deduction under section 126.

15.2.16 Audit considerations

Income from an office or employment in Canada

The verification of the propriety of payroll deductions and remittances is the responsibility of payroll auditors and is not normally addressed by business audit. However, during the audit of corporations carrying on business in Canada, the auditor may determine that certain non-resident employees are temporarily employed in Canada.

The auditor should verify that the employer has undertaken to account for the time that each employee was employed in Canada and has made reasonable salary allocations to Canada when preparing T4 slips for such employees.

In addition, non-resident employees may receive equalization payments to compensate them for relatively higher personal tax rates than payable in their resident country. Such equalization payments constitute employment remuneration and are subject to withholdings under section 102 of the Income Tax Regulations.

If the audit reveals that withholdings have not been made and T4 slips not prepared, all related documentation should be referred to the Trust Account Examination Section, Revenue Collections Division.

Services rendered in Canada by a non-resident

The review of disbursements by a non-resident corporation carrying on business in Canada may reveal non-payroll amounts paid to individuals for services rendered in Canada relating to that business. The nature of the relationship between the corporation and the individual should be reviewed to determine whether the individual is an employee or a sub-contractor. If the individual is providing regular and continuous service under the control of the corporation the matter should be referred to payroll audit. If it is determined that the individual is an independent contractor and is a non-resident, the application of Regulation 105 should be considered.

The auditor should be aware of the following examples of payments to individuals for non-employment services:

fees or other amounts paid to:
- entertainers – including actors and actresses
- athletes – including boxers, wrestlers, tennis players, golfers, and team players
- traveling theatrical groups, ballet, orchestras and variety shows, circuses and carnivals
- lecturers
- consultants
fees paid under service contracts relating to drilling operations in Canada, including offshore drilling
fees paid under service contracts for custom combining

Payments for services rendered in Canada by a non-resident in other than regular and continuous employment are subject to a withholding of 15%. This requirement to withhold tax applies regardless of any tax treaty between Canada and the recipient’s country of residence.

In addition, the auditor should:

Obtain the T4A-NR return and slips to reconcile applicable payments to non-residents.
Review the supplier master listing (including address details), if available, to identify potential non-resident payees that might be subject to withholding tax treatment (under either Part XIII or Regulation 105).
Where potential candidates for withholdings are identified, review the supplier file to determine the nature and dollar volume of the payments.
If possible, use audit software to isolate and summarize payments by supplier number and by account charged to quantify payments to specific suppliers and identify the nature of those payments.

Documentation, including copies of invoices, contracts and cancelled cheques relating to any questionable payments should be given to the International Tax Section at the tax services office (TSO) together with an explanatory memorandum.

The Non-Resident unit may initiate a concurrent joint audit of the Canadian resident payer based on the documentation provided and assess withholding taxes as required.

Dispositions of taxable Canadian property

During the audit of Canadian resident persons or non-resident persons carrying on business in Canada auditors should:

Review supporting documentation relating to significant purchases of property from non-residents.
Determine whether the property is taxable Canadian property subject to the requirements in section 116.
If the property is subject to section 116, establish whether the vendor has obtained a certificate of compliance (Form T2062 or T2062A) relating to the disposition. A copy of the certificate should be in the permanent document folder. A copy may also be obtained from the Dispositions Unit, International Tax Section at the applicable TSO or from the taxpayer.
Examine documentation relating to the transaction including any purchase agreement, correspondence, cancelled cheque, etc.
If the vendor was a non-resident and a certificate of compliance was not obtained, gather available evidence indicating that the purchaser should have been aware the vendor was a non-resident.

If a certificate relating to the disposition is unavailable and compliance cannot otherwise be verified, forward all documentation including records of taxpayer discussions concerning the transaction, together with an explanatory memorandum, to the International Tax Section at the TSO for issuance of a purchaser liability assessment if necessary.

15.2.17 Assessment procedures

Where potential assessments of residents for unremitted Part I withholdings are identified, refer the adjustments to the International Section of the applicable TSO for processing. Such referrals should be in the form of a written memorandum outlining the nature and the amount of the transactions requiring assessment and should be supported by copies of all applicable documentation. This procedure should also be followed for other potential Part I tax assessments of non-residents.

Where it is determined that a non-resident has earned income under section 115 during a tax year and has not filed an income tax return for that year, a memorandum outlining all relevant details should be referred to the Non-Filer/Non-Registrant Section of the International Tax Services Office.

All referrals should be noted in the Audit Report and cross-referenced to a copy of the applicable memorandum included in the audit working papers.

15.2.18 References

Income Tax Act

Sections 2, 115, and 116

Income Tax Regulations

Sections 102 and 105

Income Tax Information Circulars

Income Tax Interpretation Bulletins

Tax Guides

Communiqués

ITD-99-04, Regulation 105 Treaty-Based Waiver Guidelines
ITD-99-05, Non-Resident Athletes Employed in Canada – Signing Bonuses
ITD-05-06 , The Dudney Decision: Effects on Fixed Base or Permanent Establishment Audits and Regulation 105 Treaty-based Waiver Guidelines
ITD-02-02, International Waivers Program update on various issues

15.3.0 Part XIII tax on income from Canada of non-resident persons – Under review

15.3.1 Legislative authority

Subsection 212(1) of the ITA imposes income tax of 25% on certain amounts paid or credited (or deemed paid or credited) to non-residents by residents (or deemed residents) of Canada. The specific items on which tax is imposed are found in paragraphs 212(1)(a) through 212(1)(v) and subsection 212(2). Under section 215, the resident payer must withhold and remit this tax.

The statutory rate of withholding tax of 25% may be reduced by the relevant tax treaty between Canada and the country of residence of the non-resident.

15.3.2 Income taxed under Part XIII

The more common sources of income that are paid to non-residents, and from which Part XIII tax is withheld, include:

management fees;
interest;
rents;
royalties; and
dividends.

For more information, go to Income Tax Information Circular IC77-16R4, Non-Resident Income Tax.

15.3.3 Withholding and reporting obligations of the payer

In accordance with subsection 215(1) of the ITA, the resident payer, such as a tenant paying rent or a mortgagor or other debtor paying interest to a non-resident, must withhold non-resident tax at source from the amount paid or credited, and remit it to the Receiver General for Canada.

Under subsection 215(6), a person who fails to withhold and remit where required, is liable to pay the tax that should have been withheld. However, that person is entitled to withhold or otherwise recover from further payments to the non-resident any amount so paid as tax.

The payer must prepare an NR4 Summary annually. Accompanying information slips, including the full name and address of the payer and payee, the gross amount of income paid and the amount of non-resident tax withheld, must be submitted with the NR4 Summary. Copies 2 and 3 of the NR4 slips are to be delivered to the recipient by March 31 following the end of the calendar year. As the amount withheld represents a final tax, there is no requirement for filing of an income tax return by the non-resident income recipient.

15.3.4 Treaty reduction of Part XIII tax rate

The statutory Part XIII tax rate is 25% and is usually reduced by the relevant tax treaty between Canada and the non-resident's country of residence. Accordingly, it is recommended that auditors check with the International Tax Section of their TSO to confirm the applicable rate prior to processing a Part XIII assessment.

For more information, go to Income Tax Information Circular IC76-12R6, Applicable rate of part XIII tax on amounts paid or credited to persons in countries with which Canada has a tax convention, for a schedule of non-resident withholding tax rates for treaty countries.

This may be used as a guide to verify the correct rate for withholding of Part XIII tax from payments made to non-residents of Canada. However, as treaties are re-negotiated frequently and new treaties entered into, reference to the actual treaty texts is advisable.

15.3.5 Election by a non-resident to be taxed under Part I

Under sections 216 and 217 of the ITA, non-residents may obtain a tax benefit by electing to be taxed under Part I on certain types of income that would otherwise be subject to Part XIII tax.

Non-resident election to report rents and timber royalties as Part I income

A non-resident person that has received rent or timber royalty payments upon which Part XIII tax has been withheld may elect under subsection 216(1) to file a Canadian income tax return, (T1, T2, or T3 as applicable) and report the amounts in question as income subject to tax under Part I. In such a case, the person would calculate the tax under Part I based on the net rental or royalty income calculated as if a resident of Canada. As the net income from rental property in particular tends to be quite low, it is generally advantageous to the non-resident owner to file an election and report the net rental income (or loss) under Part I. The applicable return must be filed within two years after the end of the tax year during which the amount was received or credited.

Subsection 216(4) permits an agent or other person acting on behalf of the non-resident to elect to withhold tax based on the net amount of rents and royalties where the non-resident has filed an undertaking with the minister to do the following:

file Form NR6, Undertaking to File an Income Tax Return by a Non-Resident Receiving Rent from Real Property or Receiving a Timber Royalty, every year before the first rental payment is due for the year;
agree to file an income tax return and pay any Part I tax payable; and
file the return within six months after the end of the year.

The International Tax Services Office (ITSO) keeps a record of all approved NR6 applications. ITSO currently runs a default program that matches the NR6 undertakings with filed returns. When no return is filed, ITSO will usually issue an assessment under Part XIII based on the gross rental payments. The assessment is usually issued against the agent for failure to remit.

In certain circumstances, the Section 216 late-filing policy and/or the taxpayer relief provisions may be applied to allow a non-resident to late-file a section 216 return. Any requests to late-file such a return should be forwarded to the ITSO. The objective of the policy is to allow a one-time opportunity to re-enter the system as though they had filed on time, thus avoiding the onerous liability of the Part XIII tax. It is intended to promote voluntary compliance with Part XIII and to encourage non-residents to come forward and correct deficiencies to comply with their legal obligations.

For more information, go to Income Tax Interpretation Bulletin IT393R2, Election Re: Tax on Rents and Timber Royalties Non-Residents, or Communiqué ITD-02-03, Section 216 Late-Filing Policy.

Election respecting certain payments

Section 217 allows a non-resident who receives certain Canadian source income referred to in the section as "Canadian benefits" to elect not to be taxed under Part XIII on that income. The income is included in the computation of the non-resident's taxable income earned in Canada that is subject to Part I tax. The non-resident may decide to elect under section 217 if the Part XIII tax otherwise payable on the income is greater than the potential Part I tax liability. A non-resident person's "Canadian benefits" for a tax year include superannuation or pension benefits (CPP/QPP), death benefits, employment insurance (EI) benefits, retiring allowances, registered supplementary unemployment benefit plan payments, registered retirement savings plan (RRSP) payments, deferred profit sharing plan (DPSP) payments, and registered retirement income fund (RRIF) payments.

A return under Part I must be filed within six months after the end of the calendar year in which the income was received or credited. The person making the election is deemed to have been employed in Canada in the year, and is deemed to have taxable income earned in Canada equal to the greater of:

the amount described in subparagraph 217(3)(b) (i), that is essentially the amount that would be the non-resident person's taxable income earned in Canada if section 115 included "Canadian benefits;" and
the amount described in subparagraph 217(3)(b) (ii), that is the non-resident person's net income for the year, less any deductions in computing taxable income that are applicable to the person's Canadian-source Part I income excluding the "Canadian benefits."

For more information, go to Pamphlet T4145, Electing Under Section 217 of the Income Tax Act.

15.3.6 Non-resident beneficiaries of trusts

Part XIII tax is payable on Canadian-resident estate or trust income that is allocated to non-resident beneficiaries. The income is considered to have been allocated if it would have been included in the person's income under Part I had the person been resident in Canada. However, if such income is attributable to capital gains, it loses its source identity (and 50% inclusion rate) if it is paid or allocated to a non-resident beneficiary unless the trust is a mutual fund trust.

Payments thatflow through a trust, other than capital, are generally re-characterized and deemed to be trust income, and are therefore not entitled to any exemption from Part XIII that may have been applicable to the income prior to such re-characterization.

For a list of exceptions to this general rule and more information, see lesson 6 of learning product TD1115-000, Part XIII Non-Resident Tax – Legislation, or go to Income Tax Interpretation Bulletin IT465R, Non-Resident Beneficiaries of Trusts.

15.3.7 Audit considerations relating to Part XIII tax

When reviewing expense items during the audit of businesses carried on in Canada, the auditor should pay special attention to certain high-risk accounts including royalties, interest expense, dividend payments, and rent expense to determine the country of residence of income recipients. In this regard, the following records and documentation should be reviewed:

royalty agreements;
loan agreements;
share register; and
lease agreements relating to physical facilities and equipment.

Other audit steps

If available, review the master supplier list (including address details), to identify potential non-resident payees that might be subject to withholding tax under Part XIII or Regulation 105. Before doing this step, the auditor should be familiar with major suppliers of inventory so the review can be restricted to suppliers outside this category. Where potential candidates for withholdings are identified, the supplier file should be reviewed to determine the nature and amount of the payments.
Alternatively, audit software may be used to isolate and summarize payments by supplier number and by the account charged in order to quantify and determine the type of payments made to specific suppliers.
Auditors should access the NR4 return (internally or from the taxpayer) and reconcile audit findings to the NR slips.
Where discrepancies are found, the International section at the TSO should be consulted regarding adjustments that may be required.

When payments or credits to non-residents are discovered during an audit, the auditor must ensure that the correct amount of Part XIII tax is withheld and remitted.

When auditors discover a failure to withhold in connection with this type of transaction, they must discuss the file with the Non-Resident Section as quickly as possible to decide who will finalize this audit issue.

For more information, go to 10.11.13, Consultation and referrals on non-residents.

15.3.8 Other Inome Tax Interpretation Bulletins relating to Part XIII tax

15.4.0 Residency – Under review

15.4.1 Overview

Subsection 2(1) of the ITA requires that every person who is resident in Canada shall pay an income tax on taxable income for each tax year.

Subsection 2(3) stipulates that for a person who is not resident in Canada, income tax is payable on that person's "taxable income earned in Canada for the year" if that person at any time in the year or a previous year:

was employed in Canada;
carried on a business in Canada; or
disposed of a taxable Canadian property.

Since "resident" is not defined in the ITA, reference must be made to the applicable jurisprudence for guidance in this regard; the ITA includes the following deeming provisions applicable to specific situations:

Subsection 250(1) – applies mainly to individuals setting out situations where a person is deemed to be resident in Canada for income tax purposes.
Subsection 250(4) – describes situations where corporations are deemed to be resident in Canada for income tax purposes.
Subsection 250(5) – applies to corporations or individuals identifying situations where persons are deemed not to be resident in Canada for income tax purposes.
Under subsection 250(5.1), a corporation that obtains articles of continuance in Canada is deemed for Canadian income tax purposes to have been incorporated in Canada. In such a case, a corporation previously considered to be a non-resident of Canada under common law principles, may be deemed resident in Canada under subsection 250(4).

Specific rules are also provided in section 128.1 where a person has become a resident of Canada (immigrated) or ceased to be a resident of Canada (emigrated) during the year.

Residency of individuals

Jurisprudence indicates that a detailed review of an individual's personal circumstances may be required to determine residency. An individual will generally be considered a resident of Canada if the individual habitually lives in Canada as evidenced by the location of family, personal residence, holdings of financial and other properties, social ties, etc. Also, the permanence and purpose of stays abroad as well as the frequency and duration of visits to Canada are factors to be considered.

For more information, go to Income Tax Folio S5-F1-C1, Determining an Individual's Residence Status.

If requested, the International Tax Services Office (ITSO) will make a residency determination for a taxpayer, who will be asked to complete Form NR74, Determination of Residency Status (entering Canada), or Form NR73, Determination of Residency Status (leaving Canada).

Residency determinations are filed according to account number at the ITSO and copies can be obtained for specific individuals. Alternatively, if a determination has not been made, the auditor may use the NR74 or NR73 questionnaires as a guide to determine whether an individual is resident in Canada.

Individuals deemed resident

In addition to common law criteria, subsection 250(1) specifically deems a person to be a resident of Canada in certain circumstances including those persons (and their children and dependents) who were members of the Canadian forces, ambassadors, provincial agents-general or other diplomatic staff living abroad, Canadians working abroad under a prescribed international development assistance program, and more particularly, persons who sojourned in Canada for 183 days or more in the year.

An individual that sojourns, (that is, is temporarily present, for one or more periods in Canada totalling 183 days or more in any calendar year) is deemed to be resident in Canada for the entire year. For this to occur, the individual must also be a resident of another country during those same time periods. Consequently, a resident of Canada who becomes a non-resident in the last half of a calendar year cannot be considered a resident of Canada for the entire year.

However, if an individual emigrates to another country sometime during the first half of a calendar year, or in a previous year, but returns often enough to have "sojourned" in Canada for the required 183 days or more during the year and the individual was otherwise not a resident, the individual would be deemed to be resident in Canada for the entire year.

Individuals deemed to be non-resident by virtue of a treaty

Where both Canada and another country consider a person resident of their respective countries, the tax treaty, if any, with that country will usually provide a tiebreaker rule that determines, for purposes of the treaty, the country in which the person is resident.

To ensure that a person's status in Canada is consistent with the status accorded under the treaty, subsection 250(5) treats the person in such a case as a non-resident for all purposes of the ITA if that person is considered a resident of the other country under the treaty.

15.4.2 Residency of corporations

If a corporation is not incorporated in Canada, common law has generally established that a corporation is resident in the country in which its "central management and control" is exercised as evidenced by such factors as where the Board of Directors meets and holds its meetings, where the officers and directors reside etc.

By virtue of the deeming provisions in subsection 250(4) of the ITA, a corporation is generally deemed to be resident in Canada throughout a tax year if it was incorporated in Canada after April 26, 1965. In the case of corporations incorporated before that date, if they are otherwise incorporated in Canada and if they are otherwise resident under common law principles or carried on business in Canada are also deemed to be resident. Certain foreign business corporations incorporated before April 9, 1959 are also deemed resident in Canada under specific circumstances.

For more information, see paragraphs 15 and 16, "Corporate Residence," in Income Tax Interpretation Bulletin IT391R, Status of corporations.

15.4.3 Trusts

As stated in Income Tax Folio S6-F1-C1, Residence of a Trust or Estate, “The residence of a trust in Canada, or in a particular province or territory within Canada, is a question of fact to be determined according to the circumstances in each case. The Supreme Court of Canada (Fundy Settlement v. Canada, 2012 DTC 5063, 2012 SCC 14) has clarified that residence of a trust will be determined by the principle that for purposes of the Income Tax Act a trust resides where its real business is carried on, which is where the central management and control of the trust actually takes place. Usually the management and control of the trust rests with, and is exercised by, the trustee, executor, liquidator, administrator, heir or other legal representative of the trust.” “It is not uncommon for more than one trustee to be involved in exercising the central management and control over a trust. The trust will reside in the jurisdiction in which the more substantial central management and control actually takes place.”

15.4.4 Immigration – Becoming resident in Canada

Subsection 128.1(1) of the ITA provides rules that apply when a taxpayer becomes resident in Canada. The "particular time" at which residence occurs is very important as the events that are deemed under this subsection to take place are timed by reference to that moment. The events include the beginning and ending of an immigrating corporation's tax years and fiscal periods as well as dispositions and re-acquisitions of property owned by an immigrant.

Determining the particular time when a taxpayer became resident may be problematic if, for example:

An individual commuted between residences and worked in two jurisdictions for a period of time before gradually becoming rooted in one.
The management of a corporation is split between two jurisdictions both in terms of the location of meetings and the residence of management employees.

A review of jurisprudence may be helpful in both cases.

A corporation will generally be considered to have become resident in Canada if:

It was incorporated outside Canada and was managed from that outside jurisdiction but restructures its operations such that the central management and control is now exercised within Canada.
It obtains articles of continuance in Canada and is deemed for Canadian tax purposes under subsection 250(5.1) to have been incorporated in Canada.

In such a case, a corporation previously considered to be a non-resident of Canada under common law principles, may be deemed resident in Canada under subsection 250(4).

Income tax effects of becoming a resident in Canada

When a corporation or trust immigrates to Canada, paragraph 128.1(1)(a) deems its tax year to have ended immediately before the "particular time" of immigration and deems a new tax year to have begun at the "particular time" of immigration. The immigrating corporation or trust may select a new fiscal period at that time.

Immigrating corporations or trusts are deemed under paragraph 128.1(1)(b), to have disposed of each property owned immediately before the time of immigration for proceeds equal to the property's fair market value (FMV) and, under paragraph 128.1(1)(c), to have reacquired each such property at a cost equal to the proceeds of disposition.

The same rules apply to individuals becoming resident in Canada except that certain properties described in subparagraphs 128.1(1)(b) (i) through (v) are exempted from the provisions.

For income tax purposes, the deeming provisions give rise to a gain or loss that is considered to have been realized during the year that ended at the time of immigration. Accordingly, since the taxpayer is a non-resident throughout that year, section 115 applies and only gains on dispositions of taxable Canadian property will generally be subject to income tax.

In addition, the reacquisition of each previously owned property at FMV is reflected in the immigrating taxpayer's property valuations for purposes of capital cost allowance (CCA), inventory, and computation of capital gain or loss on future disposition.

A "paid-up capital adjustment" under subsection 128.1(2) may also be required to reflect the deemed acquisitions.

For more information, go to Pamphlet T4055, Newcomers to Canada.

15.4.5 Emigration – Ceasing to be resident in Canada

An individual will generally be considered as having ceased to be resident in Canada when that individual habitually lives in some other country as evidenced by the location of family, personal residence, holdings of financial and other properties, social ties etc.

A corporation may be considered to have emigrated from Canada if:

It restructures its operations such that the central management and control is no longer exercised within Canada and the corporation is not otherwise deemed to be resident in Canada under subsection 250(4) of the ITA.
It obtains articles of continuance in a foreign jurisdiction and under subsection 250(5.1), is deemed for Canadian income tax purposes to have been incorporated in that jurisdiction. In such a case, a corporation previously deemed resident in Canada under subsection 250(4), would no longer qualify.
It becomes a resident in another country and not resident in Canada under a tax treaty with the other country. Such a corporation is deemed not to be resident in Canada in accordance with subsection 250(5).
It is deemed to have ceased to be resident in Canada in accordance with subsection 128.2(2) by merging with another corporation to form a corporation not resident in Canada.

In addition, a person who is resident in Canada is deemed under subsection 250(5), to be a non-resident of Canada if such person is a resident of another country and not of Canada under a tax treaty with that country.

Income tax effects of ceasing to be a resident in Canada

When a corporation or trust emigrates from Canada, paragraph 128.1(4)(a) deems its tax year to have ended immediately before the particular time of emigration and deems a new tax year to have commenced at the particular time of emigration. The emigrating corporation or trust may select a new fiscal period.

A corporation or trust that ceases to be resident in Canada is deemed by paragraph 128.1(4)(b) to have disposed of all of its property at the time immediately before the deemed year end, for proceeds equal to the property's FMV. Where the taxpayer is an individual, subparagraphs 128.1(4)(b) (i) through (vi) exempt certain types of property from the deemed disposition. Generally, Canada has a continuing right to tax these properties upon their ultimate disposition. Properties include taxable Canadian property, inventory used in a Canadian business, rights to receive pension or similar payments and employee stock options that are subject to section 7.

In addition to any Part I tax that may result from the deemed disposition of property, section 219.1 imposes an additional 25% tax under Part XIV (commonly referred to as the "departure tax") when a corporation ceases to be resident in Canada. This tax is levied on the difference between the FMV of the corporation's property and the total of its paid-up capital and debts. Applicable tax treaty provisions may reduce the rate of tax.

Emigrant individuals, other than trusts, may elect under subparagraph 128.1(4)(b) (iv) not to be treated as having disposed of capital property provided that adequate security is given for the tax that would otherwise have been payable. Under paragraph 128.1(4) (e), such property is treated as taxable Canadian property until it is disposed of or the taxpayer once again becomes resident in Canada. Section 114 provides rules for computing the taxable income of an individual who is resident in Canada for a period or periods in a tax year, and who is non-resident for the rest of the year.

For more information, go to Tax Guide T4056, Emigrants and Income Tax.

15.4.6 For future use

15.4.7 Audit considerations

Residency of individuals

The term "resident" is not defined in the ITA. The Courts have held that an individual is resident in Canada for tax purposes if Canada is the place where, in the settled routine of life, the individual regularly, normally or customarily lives. In making this determination, all of the relevant facts in each case must be considered. In the case of individuals, useful documents for review include:

historical T1 filings;
vehicle registrations and insurance premium billings;
personal residence property tax bills;
personal residence utility bills;
health insurance premium statements or provincial health card;
credit card statements; and
lease agreements for vehicle or apartment.

In addition, the auditor should note the spouse or common law partner's place of employment and corroborate the information with T1 filings.

Where deemed residency under the 183-day sojourning rule is in question, the auditor may verify the time spent in Canada by reference to:

hotel bills paying particular attention to check-in/check-out dates;
airline tickets noting the dates of arrival and departure;
the rental period in automobile and apartment rental agreements; and
meeting and conference agendas, consulting agreements or other correspondence specifying the length of time.

15.5.0 Foreign-based information and documentation – Under review

15.5.1 Overview

Section 231.6 of the ITA came into effect on September 13, 1988. It was implemented as a result of difficulties encountered when information in the possession and control of non-residents, particularly those residing in countries where no treaty provisions for exchange of information apply, was not voluntarily provided by the Canadian taxpayer and was not obtainable by the minister. More specifically, the CRA was experiencing problems with taxpayer compliance where cross-border transactions and transfer pricing were involved.

The section was introduced to enable the minister to serve notice on any Canadian residents or non-residents carrying on business in Canada, to require that they provide foreign-based information or documentation that may be relevant to the administration or enforcement of the ITA. The section applies to information and documentation available or located in all foreign countries not only with respect to treaty partners.

Section 231.6 is an extension of the powers given to the minister under section 231.2 that requires any person to provide any information or document to specifically include information and documents located outside of Canada. There is no stipulation that section 231.6 is operative only after section 231.2 has failed. Situations may arise where certain foreign-based information is available in Canada (or copies thereof). In such situations, a decision will need to be made as to whether to issue a requirement under section 231.2 or 231.6. The ultimate decision will depend on the circumstances. It is advisable that TSO staff contact their regional international tax advisor to discuss the case.

The law is broad enough to allow service of a requirement on third parties such as with respect to information held abroad by an unrelated party. However, the CRA intends to use such powers only in exceptional circumstances; Headquarters, International Tax Directorate should be involved in any such request.

The authority to serve a requirement under section 231.6 has been delegated to the Directors of the TSO and to certain Assistant Directors and Managers. This delegation of authority is contained in the document, "Delegation of the Minister of National Revenue's Powers and Duties," that was signed on September 27, 1999. It supersedes the delegation of the minister's powers and duties under Section 900 of the Income Tax Regulations.

Where the requested information or document is located in a treaty country with which an Exchange of Information provision is available, the CRA has the option of proceeding by way of a specific request for information from that treaty partner. The circumstances of each case will dictate which route the CRA should take to obtain the information.

15.5.2 Potential conflict with foreign laws

The ITA does not include a specific reference to foreign non-disclosure laws. Including such a clause in the legislation could place a person in a conflict position where that person would have to break the foreign law to comply with Canadian law.

For example, in the 1985 Supreme Court of Canada case Spencer v The Queen, the issue was whether a Canadian resident and citizen, who had previously been a manager of a Bahamian branch of a Canadian bank, could be compelled to testify for the Crown in a prosecution under the ITA against a client of the bank. The appellant contended that to do so would make him liable for prosecution under a Bahamian statute and that this would be an infringement of his rights under section 7 of the Canadian Charter of Rights and Freedoms. The court held that section 7 of the Charter did not apply because the infringement of Mr. Spencer's liberty or security, if any, did not result from the operation of the Canadian law, but solely from the operation of a Bahamian law. To allow Mr. Spencer to refuse to give evidence would permit a foreign country to frustrate the administration of justice in Canada.

Although a foreign jurisdiction may forbid disclosure of certain information in that jurisdiction, this prohibition should not stop the CRA from issuing a requirement under section 231.2 of the ITA for that information in Canada and should not preclude the taxpayer involved from providing such information available in Canada for Canadian income tax purposes. Where the requirement is served on a resident who has to ask an employee of a non-resident affiliate to obtain and disclose the required information, the situation is much more difficult.

Situations are examined on a case-by-case basis.

15.5.3 Definition of "foreign-based information or document"

"Foreign-based information or document" is defined by subsection 231.6(1) of the ITA as being any information or document that is available or located outside Canada and that may be relevant to the administration or enforcement of the ITA including the collection of any amount payable under the ITA by any person.

The term "document" includes money, a security and a record. The term "record" is defined in section 248 to include an account, agreement, book, chart or table, diagram, form, image, invoice, letter, map, memorandum, plan, return, statement, telegram, voucher, and any other thing containing information, whether in writing or in any other form.

With respect to the application of the transfer pricing rules contained in section 247, the general principles on existing documentation in subsection 247(4) also apply to foreignbased documentation. This means that the taxpayer's documentation may include foreign-based information or documents to the extent that it is relevant in determining arm's length prices.

For example, in determining what constitutes a reasonable arm's length price for inter-company transactions, it may be necessary to obtain information concerning comparable uncontrolled prices, costs incurred to produce a product or supply a service, resale margins derived by a distributor, or profitability of a specific operation from a foreign jurisdiction. This information may be obtained from offshore studies that might have been undertaken and used in the determination of the transfer price.

The documentation requirements of subsection 247(4) are inclusive, but not prescriptive. The taxpayer is required to make a reasonable effort to provide information and penalty provisions are in place to ensure that complete and accurate information is maintained. Section 247 may be a strategic option to section 231.6 for transfer pricing.

15.5.4 Requirement to provide foreign-based information

Notwithstanding any other provision of the ITA, the minister may, by notice, serve requirements for foreign-based information or documents in person, by registered mail or certified mail on a person resident in Canada or a non-resident person carrying on business in Canada.

If there is a question as to whether a particular entity is carrying on business in Canada, the requirement may still be issued. The onus will be on the taxpayer to convince the court that the taxpayer is not carrying on business, and therefore not subject to the requirement.

Subsection 231.6(3) of the ITA sets out a list of what must be included in a notice/requirement referred to in subsection 231.6(2). The notice must contain:

a reasonable time period of at least 90 days for compliance. In all cases, a reasonable time period has to be given according to the type of documents requested and their location;
a clear description of the information or documentation being sought in order to ensure that the person served with the requirement can determine with reasonable certainty what must be provided. The description should include the type of document, for example “itemized invoice,” or describe the contents as precisely as possible. A description that is too general may allow the person served with the requirement to either selectively provide only the information or documents that are advantageous to the person’s case, or apply to have the requirement varied or set aside. This is also relevant when determining substantial compliance under subsection 231.6(8).
the consequences under subsection 231.6(8) for failure to comply.

It is advisable to add a reference as to where and to whom the information should be provided.

When preparing a requirement under section 231.6, it is advisable to contact the regional international tax advisor to discuss the case. To promote consistency a template is provided. For more information, go to Appendix A-10.1.19, Requirement for foreign-based information (Combined).

It is also strongly recommended that any officer preparing a requirement consult with Justice legal counsel to ensure that the requirement is complete and accurate in all respects and to avoid potential problems that could result in rendering the requirement invalid.

For example, errors have occurred in something as seemingly simple as the computation of the 90-day period. Note that subsection 27(1) of the Interpretation Act states that where there is a reference to “at least” a number of days between two events, the days on which the events occur are excluded from the calculation. With respect to serving a requirement, if the events include the date the requirement is served, and the date the documents are required to be provided, then a period of 92 days would be calculated as the time limit. If the requirement is worded to the effect that the taxpayer must comply before the ninety-first day following the day of the service of the requirement, then the requirement will not meet the provision of paragraph 231.6(3)(a) of the ITA and could be submitted by the taxpayer to a court for review.

15.5.5 Judicial review of foreign information requirement

Where a notice for foreign-based information is served, subsection 231.6(4) of the ITA permits the person served with the notice to apply to a judge for a review of the requirement. Application must be made within 90 days of the date the notice is served.

For purposes of this review, a judge includes a judge of a superior court having jurisdiction in the province where the matter arises or a judge of the Federal Court.

Subsection 231.6(5) sets out the powers of a judge on hearing an application for review under subsection 231.6(4). It is within a judge's jurisdiction to confirm or vary the requirement, or to set aside the requirement if it is considered to be unreasonable.

If, for example, the time period set forth in the notice was not reasonable in the circumstances, the judge could increase the time period, vary the description of the information or documents being sought, or set aside the requirement if the judge is satisfied that it is unreasonable.

Subsection 231.6(6) provides that for purposes of paragraph 231.6(5)(c), a requirement is not to be considered unreasonable where the foreign-based information or document being sought is under the control of, or available to, a related non-resident person, merely because that person is not controlled by the person served with the notice under subsection 231.6(2). This provision is intended to prevent a Canadian taxpayer from being excused from providing information simply by saying it does not have the power to force its parent or sister corporation to provide it. Apart from this specific limitation, the reasonableness of a requirement in any situation will depend on the particular circumstances.

A requirement could be held to be unreasonable where the information or document is under the control of or available to an unrelated non-resident person, such as a third party.

Subsection 231.6(7) provides that the time that elapses between a person's application for review of a requirement by a judge and its final disposition will not be included in computing the time permitted for production of the information or document as set out in the notice (that is, if the taxpayer applies for a review, the 90-day time limit stops until the application is decided).

In addition, the review will extend the statutory time limit (currently six or seven years under subparagraph 152(4)(b)(iii)) for making assessments or reassessments relating to crossborder transactions between a taxpayer and a non-arm's length non-resident person.

The six or seven-year limit applies only to the extent that the reassessment relates to the transaction with the non-resident person. The amendment to subsection 152(4) is effective for transactions entered into, payments made and reimbursements received after April 27, 1989.

15.5.6 Consequence of failure

Under subsection 231.6(8) of the ITA, failure to provide substantially all the documents or information covered by a notice allows the minister to bring a motion to prohibit the introduction into evidence of any such information or documentation in an appeal or other civil proceeding relating to the ITA. For example, if a person provides five out of ten documents required, that person may be prohibited from introducing into evidence any of the ten documents required, including those that were provided to the minister. Therefore, it is important to make the requirement as comprehensive and specific as possible in order to prevent taxpayers from selectively providing only the information or documents that are advantageous while refusing to provide the information or documents that could assist the minister in arriving at a proper assessment.

It is not the quantity of the documents supplied, but rather their relevance that should be taken into account in assessing whether there has been substantial compliance. The determination will ultimately be made at the court proceeding during which the person served with the notice wishes to introduce the documents as evidence.

Although not required by any provision of the ITA, in the appropriate circumstances the possibility of prosecution under section 238 could also be set out in the requirement. Any person failing to substantially comply with the requirement could be guilty of an offence under section 238 and liable to fines and/or imprisonment in addition to any penalty otherwise provided (that is, non-admissibility).

Subsection 238(1) deals with offences and provides that failure to comply with "any of sections 230 to 232" is an offence, subject on summary conviction to a fine from $1,000 to $25,000, or imprisonment for a term of up to 12 months, or both. Since the main objective of serving the requirement under subsection 231.6(2) is to obtain the foreign-based information and documents, rather than render them inadmissible, it may be more effective to use the provisions of section 238 and seek a fine and a compliance order under subsection 238(2). However, prosecution steps will not be automatic for non-compliance. In the rare circumstance that prosecution under section 238 is being contemplated by the TSO where the taxpayer has failed to substantially comply with the requirement, the Director of the TSO may wish to consult with Headquarters, International Advisory Services Section, International Tax Division, International and Large Business Directorate and with Justice counsel.

In addition, subsection 247(4) deems that taxpayers who do not assemble basic documentation by their filing date (documentation-due date) have not made reasonable efforts for purposes of the penalty provisions contained in subsection 247(3). Therefore, the provisions in section 247 that relate to contemporaneous documentation and penalties, although not the primary focus in relation to issuing requirements for foreign-based information, may be used as an alternative means of obtaining (foreign-based) information or documentation with respect to cross-border transactions between related parties.

15.5.7 Documentation submitted after the requirement due date

If a taxpayer submits sufficient documentation (such that the standard of substantial compliance contained in subsection 231.6(8) of the ITA is met), but it is submitted after the due date stipulated in the requirement, it may be advisable to accept the documentation, since the objective of issuing the requirement was to obtain such information.

If the documentation received after the due date is ignored, and in accordance with subsection 231.6(8) precluded from evidence, the judge may not support this position. In addition, the information may be provided to the Appeals Branch if the taxpayer appeals the reassessment or it may be presented by the other tax jurisdiction under the exchange of information provisions if the case goes to Competent Authority. Therefore, every available avenue (including for example, treaty requests) should be pursued to obtain information at the audit stage and documentation should be accepted even if it is submitted late. Each situation must be examined on a case-by-case basis.

For example, the taxpayer has made every effort to obtain the requested information, but due to circumstances beyond the taxpayer's control, the information is not obtained within the time limits set out in the requirement. When the information is subsequently obtained by the taxpayer and provided to the CRA, the minister should accept it, even if the due date has passed.

There may be circumstances where it is reasonable not to accept the documentation. For example, where the taxpayer is clearly not co-operating and two years have gone by with only minimal compliance, it may be reasonable not to accept information that is submitted after the due date. It is recommended that TSO staff contact their regional international tax advisor to discuss the case.

Although it may be contrary to the spirit of section 231.6, there are no explicit provisions contained in the section to prevent the taxpayer from providing any information/documentation to the Appeals Branch for examination, even if the taxpayer did not comply with the requirement at the audit stage. However, when the required information is provided after the due date, Appeals can bring a motion under subsection 231.6(8) to prohibit the taxpayer from using that, or any other information in court on the grounds that the taxpayer provided incomplete information and/or did not provide the information by the stipulated due date. While Appeals must examine the information, no matter if it is submitted past the due date, they are not obliged to take the information into account when determining whether or not to uphold the reassessment.

Section 231.6 is not limited to information available to related non-residents. However, if the requested information is available only to unrelated third parties and it is not provided within the time frame specified in the requirement, the question is whether the prohibition from using the information in court would apply if the taxpayer was initially unsuccessful in obtaining the documentation after exercising due diligence, but subsequently obtains the information. This will have to be determined on a case-by-case basis.

For example, this situation may be encountered when dealing with licensors, licensees, suppliers or customers. It is possible that a requirement could be held to be unreasonable where the information or document is under the control of or available to an unrelated non-resident person. If there is a possibility that a taxpayer could obtain the requested information in the future, or if failure to provide the information would result in being unable to substantially comply with a requirement that covers other important information, the taxpayer may be inclined to apply to a court for an order setting aside or varying the requirement, under the condition that they undertake to immediately provide the information to the CRA if or when they ever obtain it.

15.5.8 Jurisprudence

Merko v M.N.R., 90 DTC 6643, Federal Court – Trial Division

This was the first time that section 231.6 of the ITA was the subject of judicial consideration. The issue before the Court was whether the requirement to provide foreign-based information was an abuse of process provided by the ITA, and in the alternative, if the demand was too broad in its terms.

The applicant contended that the requirement was an abuse of process and should be set aside. He argued that the documents were not necessary for the minister to arrive at a proper assessment. The minister stated that there was no abuse of process as the requirement was an administrative matter under the minister's control, that the demand was reasonable and the onus was on the taxpayer to show that it was unreasonable.

The Court held that Parliament intended to give Revenue Canada (CRA) strong, comprehensive, and far-reaching powers under section 231.6 to obtain any information or document that is available or located outside Canada if the information was relevant to the administration and enforcement of the ITA.

The Court also held that there was no time period in section 231.6 within which the request for the information had to be made. The CRA was not limited to producing the requirement under section 231.6 during the course of assessing or reassessing the taxpayer, nor prior to the taxpayer's filing of a notice of objection to a notice of reassessment. The judge highlighted that the taxpayer is protected from abusive use of this provision through the power of a judge to review the requirement.

The Court ruled that the requirement was not an abuse of the process nor was the demand too broad to be reasonable.

The CRA considers that it can require the taxpayer or a third party to provide foreign-based information or documents, even after a taxpayer seeks relief in the courts, if it is able to maintain that the information or documents are necessary for the administration or enforcement of the ITA.

Crestbrook Forest Industries Ltd v the Queen, 93 DTC 5186, FCA

The issue in this case was whether the taxpayer, who was engaged in an international business arrangement with non-resident shareholders, was obliged to obtain from its non-resident controlling shareholders who were not parties to the action, answers to questions posed during examination for discovery that were relevant to the issues in dispute. The taxpayer sought answers from its non-resident shareholders but they refused to respond to the taxpayer's inquiries on a voluntary basis and suggested that the minister should make a formal order under section 231.6 of the ITA. The minister did not make a formal order. A motions judge in the Trial Division held that it was not open to the Court to compel a party to respond to a question, the answer to which was in the power of someone over whom that party had no control.

The Crown appealed to the Federal Court of Appeal. In allowing the Crown's appeal the Federal Court of Appeal stated that it would be unconscionable to allow non-resident corporations to structure their affairs so that they could be free to carry on a profitable business enterprise in Canada without also being obliged to fully comply with Canadian law in respect of the business they do here.

The Federal Court of Appeal also stated that while "fishing expeditions" are not to be permitted during discoveries, the corporate veil ought not to be permitted to inhibit the administration of justice in Canada. With respect to the suggestion by the non-resident shareholders that the Crown should have used section 231.6, the Federal Court of Appeal stated that since the remedy available under section 231.6 was prohibiting the introduction of the information, it was plainly not adequate in the circumstances where the information sought was very relevant to the minister's assessment. In other words, since the requested information was not favourable to the taxpayer, the sanction under subsection 231.6(8) of not being able to use it in court would not have been effective in compelling the taxpayer to provide it.

The Federal Court of Appeal directed Crestbrook to provide answers to the 22 questions within 90 days, failing which their statement of claim would be struck.

15.6.0 Permanent establishment – Under review

15.6.1 Permanent establishment for income tax purposes

Each of Canada's tax treaties contains a provision exempting corporations resident in the other country from Canadian tax on business profits earned in Canada unless such profits are attributable to a business carried on through a PE in Canada. This exemption applies to both income tax under Part I and to the Part XIV branch tax under section 219 of the ITA on business profits of non-resident corporations.

PE is defined for treaty purposes as a fixed place of business through which a resident of one country engages in business in the other country. The definition that follows is provided in the Model Tax Convention on Income and on Capital (the OECD model) developed by the Organization for Economic Cooperation and Development (OECD).

Legislative authority

When evaluating the treaty status of a non-resident's business profits earned in Canada, the definitions of PE contained in Article V of Canada's treaties prevail over those contained in the Income Tax Regulations.

If it is determined that such profits are not treaty-exempt, the PE definitions contained in subsections 400(2) and 2600(2) of the Income Tax Regulations, for corporations and individuals respectively, are used to allocate income to a province.

Determination of permanent establishment in Canada for income tax purposes

The definition in the OECD Model is used as a primary reference when determining the existence of a PE in Canada:

1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

2. The term "permanent establishment" includes especially:

a) a place of management;

b) a branch;

c) an office;

d) a factory;

e) a workshop, and

f) a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.

3. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.

4. Notwithstanding the preceding provisions of this Article, the term "permanent establishment" shall be deemed not to include:

a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;

b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;

c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise

d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;

e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

f) the maintenance of a fixed place of business solely for any combination of any activities mentioned in subparagraphs a) to e) provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person – other than an agent of an independent status to whom paragraph 6 applies – is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.

6. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

7. The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

Income Tax Interpretation Bulletin IT177R2-CONSOLID, Permanent Establishment of a Corporation in a Province, outlines the general principles used in determining whether or not a corporation has a PE in Canada. However, since the definition of PE may vary between treaties, reference should also be made to the relevant treaty in making a determination in any specific case.

Non-resident corporations carrying on business in Canada may claim treaty exemption from tax in Canada due to the absence of a PE in Canada but must nonetheless file Form T2 Corporation income tax return with Schedule 91 attached.

For more information, go to 15.2.0, Income of a non-resident.

15.6.2 For future use

15.6.3 Supplies between permanent establishments

A person carrying on business through a PE situated in Canada may deliver goods or services to another PE of the person outside Canada. Such activity is deemed to be a supply of the goods or service and the two PEs are deemed to be two persons dealing at arm's length.

15.6.4 Audit considerations

To determine whether a non-resident person has a PE in a Canada, it is necessary to apply the criteria listed in Article V of the applicable treaty to any facility used by the person to carry on business in Canada. This will often involve questions of fact that must be answered by the circumstances of each case. It should be noted that the term "carrying on business in Canada" is given an extended meaning by section 253 of the ITA for a corporation that is a non-resident of Canada. The following comments may assist in making the determination:

A fixed place of business may include a place, plant or natural resource used in the dayto-day business of the corporation. It does not mean that the place of business must exist for a long time or be located in a durable building. For example, a temporary field office on a construction site could in certain circumstances be a fixed place of business.
If a resident of the country maintains an agent in the other country who has, and regularly exercises, the authority to enter into contracts in that other country in the name of the resident, the resident agent will be deemed to constitute a PE in the other country with respect to the activities the agent undertakes.
The above rule does not apply where the contracting authority is limited to those activities such as storage, display, or delivery of merchandise that are excluded from the definition of “permanent establishment.” In addition, the CRA rule does not apply if the agent is a broker, general commission agent, or other agent of independent status provided that such persons are acting in the ordinary course of their business.
Where a fixed place of business is used solely for storing, displaying, or delivering merchandise belonging to the resident, the maintaining of a stock of goods belonging to the resident for storage, display, or delivery, or the maintaining of a stock of goods for processing by another person, that place of business does not constitute a PE.
Also exempted from PE status are activities such as the maintenance of a fixed place of business for the purchase of goods or merchandise, the collection of information, advertising, or scientific research or for any other preparatory or auxiliary activities for the resident.

15.6.5 Examples

The following are examples of establishments that are not considered a PE:

A public warehouse that is used by a corporation, but that is neither owned by it nor under some measure of its control, does not constitute by itself a PE of that corporation.
An office that is maintained and controlled by an employee of the corporation at the employee's choice and expense or an office that is maintained solely to purchase merchandise is not in itself deemed to be a PE of the corporation.

15.6.6 Income tax references

Income Tax Regulations subsection 400(2) and subsection 2600(2)
Income Tax Interpretation Bulletin IT177R2-CONSOLID, Permanent Establishment of a Corporation in a Province
Communiqué ITD-05-06, The Dudney Decision: Effects on Fixed Base or Permanent Establishment Audits and Regulation 105 Treaty-based Waiver Guidelines

Treaties

Model Tax Convention on Income and on Capital, developed by the Organization for Economic Cooperation and Development (OECD)
Article V - (most) Canadian treaties

Jurisprudence

Joseph Fowler (Appellant) v The Minister of National Revenue (Respondent), 90 DTC 1834 (Court File No. 89-1061(IT))
William A. Dudney (Appellant) v Her Majesty the Queen (Respondent), 99 DTC 147 (Court File No. 97-1386(IT) G)

Training material

learning product TD1122-000, International Transactions - Tax Law

Topic: Taxation of Non-residents

learning product TD1127-000, International Transactions - Tax Treaties

Topic: Article V

15.7.0 Foreign reporting requirements – Under review

15.7.1 Overview

The foreign reporting rules in the ITA require Canadian residents to file an information return under four separate circumstances involving the ownership or interest in a foreign property or trust and the receipt of foreign investment income.

Under section 233.4 of the ITA, taxpayers resident in Canada of which a non-resident corporation is a foreign affiliate must file a return in prescribed form in respect of the affiliate. The taxpayer will file Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates.
Certain taxpayers resident in Canada and certain partnerships must file a return under section 233.3 in prescribed form with respect to their foreign property if the cost amount of such property exceeds $100,000. Form T1135, Foreign Income Verification Statement, is used for this purpose.
A Canadian resident who transfers or loans property to a foreign trust must file an information return under section 233.2 in prescribed form with respect to the trust. Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities, is the prescribed form.
Section 233.6 requires a Canadian resident who receives a distribution of property from, or is indebted to, a non-resident trust, to file a return in prescribed form for a tax year or fiscal period. The return that must be filed in this instance is Form T1142, Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust.

Reporting is required for tax years that begin after 1995 for non-resident trust and foreign affiliate reporting and for tax years that begin after 1997 for foreign investment property with a cost over $100,000.

In addition to the foreign reporting requirements, certain taxpayers are required to file Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents.

For an overview of Form T106, go to 15.8.0, Non-arm's length transactions with non-residents.

15.7.2 Rationale for the foreign reporting rules

The reporting requirements are intended to help combat and discourage income tax avoidance associated with the investment and transfer by Canadians of funds and other property outside Canada. Their purpose is to allow more efficient enforcement of the ITA by the CRA and they are expected to deter, in certain cases, arrangements designed predominantly for tax avoidance purposes.

The reporting requirements will make it clear that all investment income earned abroad is potentially subject to tax in Canada. As well, they discourage arrangements that are currently attractive because their existence does not need to be disclosed. The information obtained will facilitate the detection and the auditing of transactions that may result in tax avoidance.

15.7.3 Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates

Any taxpayer resident in Canada must file Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates, if it owned a controlled foreign affiliate or a foreign affiliate that is not controlled at any time in the year. The filing requirement does not apply if the taxpayer's income is exempt from tax under Part I of the ITA.

15.7.4 Required disclosures and related tax issues

1. Identification of the Reporting Taxpayer and the Foreign Affiliate

The information provided enables the selection of taxpayers with investments in known tax havens and in industry sectors potentially generating passive income that may be subject to foreign accrual property income (FAPI) legislation.

2. Disclosure of Capital Stock Held in Foreign Affiliates

The information provided enables the identification of direct and indirect ownership of foreign affiliates for the purpose of considering the application of FAPI legislation.

3. Other Information

This information provides:

changes in the equity percentage that may indicate taxable dispositions in shares of foreign affiliates or potential problems in a reporting entity's surplus calculations and/or FAPI calculations; or
possible audit issues under section 17 of the ITA related to indebtedness of the foreign affiliate to the reporting taxpayer.

4. Financial Information of the Foreign Affiliate

This information enables:

the determination of the potential taxable dividend distributions;
the evaluation of whether the income earned by the foreign affiliate is active or passive;
identification of income earned in known tax havens; and
gauging of audit potential based on the level of an affiliate's net income.

5. Surplus Account Information

This information enables:

the determination of the type of accounts (exempt, taxable, or pre-acquisition) from which dividends have been paid in order to determine the tax treatment of the distributions received by the reporting entity from foreign affiliates; and
determination of whether an election was made under subsection 93(1) of the ITA.

6. Corporate Grop Structure (Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates)

The information provided enables audit to:

Select taxpayers with direct and indirect investments in known tax havens and in industry sectors potentially generating passive income that may be subject to FAPI legislation.
Identify all members of a related group regarding potential transfer pricing issues.
Identify possible sources of information on the group through cooperation with our treaty partners.
Identify possible tax avoidance structures.
Identify the existence of first, second and subsequent tier investments that have consequences under foreign affiliate and FAPI legislation.

7. File Selection Criteria (Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates)

Potential file selection is based on:

FAPI earned, and reported in Canada;
income that would normally be FAPI, but is considered active by legislation;
income that would normally be active income, but is considered FAPI by legislation;
dividends paid from exempt surplus;
dividends paid from taxable surplus; and
income from an active business.

15.7.5 Penalties

Penalties are provided in subsection 162(7) of the ITA for failure to file an information return as and when required. Penalties are also provided in subsections 162(10) and 162(10.1) when such failure is done knowingly or under circumstances amounting to gross negligence. Penalties under subsection 163(2.4) apply to a person or partnership that knowingly or under circumstances amounting to gross negligence makes false statements or omissions in an information return.

Section 233.5 provides that the penalty for omissions in Form T1134 and Form T1141 is not applicable if there is a reasonable disclosure in the return of the unavailability of the information and the person or partnership exercised, before the day on which the return was filed, due diligence in attempting to obtain the omitted information.

For more information, go to International Programs Section – HQ Contacts.

15.7.6 Audit considerations for Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates

The following audit steps/procedures relate to Part III – Nature of income of “controlled” foreign affiliate (Sections 1 to 5) of the T1134 information return:

Review each section of the return and note any incomplete sections or information to follow up.
Check for completeness of required attachments.
Is there any correspondence from the taxpayer with the return requesting action?
Check Form T2SCH25, Schedule 25, and compare foreign affiliates listed with T1134s filed.
Compare with Form T2SCH9, Schedule 9, to see if T1134s were filed for related parties for which a T1134 should have been filed.
Check Form T2SCH1, Schedule 1, or T1 if an individual, for FAPI reported.
Review changes in structure.
Compare the total number of T1134s filed from year-to-year. Note changes in the number of foreign affiliates. Changes may indicate tax planning to shift income and reduce taxes that may impact on FAPI and transfer pricing, and have potential tax avoidance implications.
Review the organization chart or other written documentation with the required information. Note the potential impacts, if any, on equity percentage, partnerships, FAPI, and countries being used (for example, tax havens).
Check the information relating to the year in which a foreign affiliate is formed or dissolved. These events may trigger immigration and emigration tax rules (for example, disposition or acquisition of assets at FMV).
Review the principal activities of the foreign affiliate. Note whether the business is active or passive or whether the foreign affiliate is in a business sector that is problematic or high risk.
Information on country codes should be noted for potential FAPI, tax avoidance schemes, treaty shopping, and surplus pool manipulations (that is, must have a PE in a treaty country to be able to have exempt surplus).
Review the capital stock of the foreign affiliate owned by the reporting taxpayer. Note the types of shares purchased and the potential tax consequences relating to:
- preferred shares versus common shares;
- subsection 95(6) of the ITA;
- taxable dividend distributions;
- term preferred share rules (deeming dividends to be interest – section 258);
- possible Part IV tax on receipt of dividends from private corporations;
- surplus account and tax avoidance considerations; and
- cascading of money through foreign affiliates.
Review the "Other Information" section of the return for issues related to:
- the acquisition/disposition of shares;
- change in controlled/non-controlled status;
- proper dividend distribution;
- the amount of FAPI that should be reported;
- the purchase/disposition of shares in a foreign affiliate;
- the effectiveness of paragraph 95(2.2)(a) (that is, which taxpayers are now reporting as a result of this legislation);
- accuracy of the taxpayer's interpretation of legislation that excludes income from FAPI;
- offshore loans;
- potential section 17 issues – imputed income rules may apply if the foreign affiliate does not use the money in an active business; and
- potential surplus stripping to avoid Part XIII tax.
Review financial statements for such things as inter-company charges (pricing), tax avoidance situations, treaty shopping, and the shifting of profits out of Canada.
Surplus Accounts:
- Are the pre-conditions for exempt surplus including PE, treaty country and active business present?
- Check if an election relating to the disposition of shares in a foreign affiliate has been made under subsection 93(1). The election converts amounts from capital gains to dividends. The auditor must ensure that the proper amounts are in the surplus pools.
- If the reporting taxpayer indicated a "yes" to reorganization, amalgamation, issuance, reemption, acquisition, disposition of shares, etc., are summary descriptions attached?

Additional audit considerations:

Section 1 – Employees per business
- The form allows the reporting of up to four separate business lines for the foreign affiliate. The auditor/screener should examine each business separately in order to determine whether each business earns active business income.
- Where an investment business has been identified, if the foreign affiliate does not have more than five employees, the business income is deemed to be FAPI. Check to see whether the transactions are at arm's length, and if FAPI has been reported.
Section 2 – Composition of revenue
- Verify the information in this section against the information reported in Part III, section 3 of the return to determine if the reporting taxpayer should have reported FAPI.
Section 3 – Foreign accrual property income (FAPI)
- Has the foreign affiliate earned FAPI? If yes, was it reported?
Section 4 – Capital gains and losses
- Has there been a disposition of excluded property?
- Has there been a disposition of property that is not excluded property?
Section 5 – Income included in income from an active business
- Has the reporting taxpayer ticked "yes" under A or B? If yes, the taxpayer's interpretation of this legislation needs to be verified.
Part IV – Disclosure
- Has the reporting taxpayer indicated that any information was unavailable? If yes, when will it be filed? Has it been filed?
- Compare information on Form T1134 with that reported on the T106, Information return of non-arm's length transactions with non-residents.

15.7.7 Form T1135, Foreign Income Verification Statement

The T1135 return, Foreign Income Verification Statement, must be filed by any specified Canadian entity as defined in subsection 233.3(1) of the ITA if, at any time in the year, the total cost of foreign investment property exceeds $100,000. The filing requirement is effectively applicable to any individual, corporation or trust resident in Canada, as well as certain partnerships and applies for each tax year or fiscal period during which the $100,000 threshold was exceeded.

Required disclosures and related tax issues

1. Identification of the Reporting Taxpayer

The taxpayer is required to indicate the nature of the reporting entity (individual, corporation, trust or partnership) and to provide the applicable SIN, BN or trust account number.

2. Disclosure of foreign investment property owned

Investments by the taxpayer in each of the following types of assets must be disclosed including whether each respective investment exceeds thresholds of $0, $100,000, $300,000, $500,000, $700,000, and $1,000,000:
- funds held outside Canada;
- shares of non-resident corporations other than foreign affiliates;
- outstanding debt of non-residents;
- interests in non-resident trusts;
- real property outside Canada; and
- other property outside Canada.

In addition, the taxpayer is required to disclose the total income earned from the types of assets listed as reported on the taxpayer's tax return for the year. The intent of this requirement is to assist the auditor in verifying the accuracy and completeness of the taxpayer's reporting of income from offshore investments.

15.7.8 Audit considerations for Form T1135, Foreign Income Verification Statement

Normal audit procedures for the review of income from property are applicable to the review of these returns:

Dividend income from investments in shares is normally verified by reference to shareholder minutes (for private companies) and dividend register (for public companies).
Request financial statements for any share investments in order to rule out FAPI considerations.
Year-over-year reductions in share or real estate investments should be identified and the proceeds from any related dispositions should be traced to offshore reinvestment to determine if any income implications exist with respect to such reinvestment.
Interest income may be recalculated by reference to loan or other investment documents.
Net rental income is verifiable by reference to lease agreements and vouchers supporting related costs.
Documentation supporting other investments should be reviewed for income potential.

15.7.9 Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities, and Form T1142, Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust

Canadian resident individuals, corporations, and trusts that have transferred or loaned property to a non-arm's length non-resident trust that has a Canadian beneficiary must file Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities. Canadian residents must file this return to disclose information about the trust and details of the transfer or loan to the trust. This requirement applies if they have transferred or loaned property to a non-resident trust during the current year or if such a transfer or loan occurred in a prior year and remains outstanding at any time during the current year.

Filing of Form T1142, Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust, is required by Canadian resident individuals, corporations and trusts, as well as certain partnerships, where they have received a distribution from or are indebted to a non-resident trust in which they are beneficially interested in the year. Canadian residents must file this return to disclose information about the distribution received or the debt incurred during the year. The return must also be filed for the current year if such indebtedness arose in a prior year but remains outstanding at any time in the current year.

15.7.10 Audit considerations for Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities

Lesson 6 in learning product TD1118-000, Offshore Trust Audits, provides guidance in identifying whether an offshore trust exists as well as audit steps and procedures to be followed when auditing offshore trusts.

15.7.11 Non-resident trusts versus offshore trusts

The term "non-resident trust" includes all trusts residing outside Canada. Non-resident trusts are subject to Canadian tax on their Canadian income. Offshore trusts are non-resident trusts that are subject to the FAPI rules under section 94 of the ITA and/or the attribution rules under section 74.1, subsection 75(2), or subsection 56(4.1).

Prior to the introduction of the foreign reporting requirements it was extremely difficult to detect offshore trust arrangements for the following reasons:

Not all international arrangements include trusts.
Not all offshore trusts are required to file tax and disclosure returns.
Offshore trusts that should file in Canada frequently do not, for reasons such as:
- a different interpretation of the facts than the CRA;
- not being aware that returns are required; or
- a desire to keep an arrangement private.

It is anticipated that information that was previously difficult or impossible to obtain will now be available from the information returns. This should enable auditors to identify offshore trusts at an early stage in their audit and therefore enhance their audit results. It is also expected that the level of voluntary compliance will increase in the future.

15.7.12 Application of foreign accrual property income rules to trusts

It is important to identify offshore trusts because of the potential tax implications that flow principally from section 94 of the ITA. Trusts are deemed to be individuals for income tax purposes and inter vivos trusts are taxed at the highest marginal individual rate. For this reason, taxpayers beneficially interested in an offshore trust may attempt to avoid being caught under section 94, which applies if:

a non-resident trust has a beneficiary (paragraph 94(1)(a)) that is:
- a Canadian resident person;
- a corporation or trust not at arm's length with a person resident in Canada; or
- a controlled foreign affiliate of a person resident in Canada; and
the offshore trust {paragraph 94(1)(b)}:
- acquired property from a transferor who was related to the beneficiary; or
- the beneficiary obtained his interest by purchase or gift.

If section 94 applies, it is necessary to determine whether the trust is discretionary or non-discretionary. Under paragraph 94(1)(c) a discretionary trust, where the transferor maintains some type of control over the assets, is deemed to be a trust resident in Canada. The trust is subject to Part I tax on the total of Canadian source income (section 115) and FAPI including the FAPI of any controlled foreign affiliate of the trust.

A non-discretionary trust, where the transferor has no control over the assets is taxed in the same manner as a foreign affiliate. If the beneficiary has an interest of at least 10% or more of the FMV of the beneficial interests in the trust, paragraph 94(1)(d) deems the trust to be a non-resident corporation that is controlled by the beneficiary (that is, a controlled foreign affiliate).

15.7.13 Application of attribution rules to trusts

The ITA contains a number of attribution rules that are applicable to situations where property has been transferred to a trust in which a third party has a beneficial interest. In such instances, income and capital gains earned by the trust in respect of the transferred property are attributed to the transferor and taxed in the transferor's hands.

There are three main provisions in the ITA that govern attribution:

Subsection 75(2) applies to a settlor (or any other person) from whom a trust has received property. For subsection 75(2) to apply, the transferor must retain some type of control over the trust property. Subsection 75(2) ceases to apply when the transferor dies or ceases to be resident in Canada.
Sections 74.1 to 74.5 apply in situations where property has been transferred or loaned, directly or indirectly to or for the benefit of the transferor or lender's spouse or common-law partner or certain minors; or to a corporation or trust in which such spouse or common law partner or minors are directly or indirectly interested.
Subsection 56(4.1) applies to loans and indebtedness only. It applies when a particular individual, or a trust in which the particular individual is beneficially interested has received a loan or become indebted to a non-arm's length individual or a trust to which another non-arm's length individual resident in Canada has transferred property, provided the loan or indebtedness is non-interest-bearing or at a low rate of interest, and one of the main reasons for the loan is to reduce or avoid tax.

15.7.14 Audit steps to verify compliance with foreign reporting requirements

Auditors reviewing the tax returns of resident taxpayers should consider the following procedures as a means of uncovering the existence of investments in foreign affiliates and other offshore properties or trust relationships. Where these are encountered, the auditor should verify compliance with the foreign reporting rules.

Review T1 General, Income tax and benefit return

The auditor should look for indications of an interest in a foreign corporation that could be a foreign affiliate and for any indications of an interest in a non-resident trust:

Review the permanent file and returns for prior tax years.
Check Schedule 4 to determine if any dividends and interest were reported from a foreign corporation.
Check Schedule 3 for reporting of foreign capital gains and losses.
Check for rental income and review Form T776, Statement of real estate rentals. (Where is the rental property located? Were any rents received from a foreign corporation?)
Check for partnership income (Where is the partnership located? Does the partnership own any foreign property?).
Check for foreign tax credits claimed either as a tax credit or an income deduction.
Check for reporting of FAPI.
Determine if the taxpayer answered questions relating to foreign property on the bottom of page two of the T1 return.
If the taxpayer reports business income, review the financial statements. (Where is the business located? Does the business own any foreign property?)
Check for filing of T1134, T1135, T1141, and T1142 returns.
Review spouse or common law partner's return for indication of foreign income.
Question the taxpayer during the audit.

Review T3RET, T3 trust income tax and information return

The auditor should look for indications of an interest in a foreign corporation that could be a foreign affiliate and for indications of any interest in a non-resident trust:

Review the permanent file and returns for prior tax years.
Check page two for taxable capital gains and review Schedule 1, Dispositions of Capital Property, for dispositions of shares in foreign corporations and dispositions of bonds, debentures, promissory notes, and other properties that might relate to investments in foreign corporations.
Check page two of the return and Schedule 8 for foreign investment income.
Check for rental income and review Form T776. (Where is the rental property located? Were any rents received from a foreign corporation?)
Check for foreign tax credits claimed either as a tax credit or an income deduction.
Check for partnership income. (Where is the partnership located? Does the partnership own any foreign property?)
Check for reporting of FAPI.
Check for filing of T1134, T1135, T1141 and T1142 returns.
Question the trustee during the audit.

Review T2, Corporation income tax return

The auditor should look for indications of an interest in a foreign corporation that could be a foreign affiliate and indications of any interest in a non-resident trust:

Review the permanent file and returns for prior tax years.
Check the financial statements. (Are dividends or interest being received from a foreign corporation? Is there any investment in a foreign corporation? Are there any accounts receivable or payable from or to a foreign corporation?)
Check Form T2SCH1, Schedule 1, for deductions claimed under subsection 20(12) of the ITA and for inclusion of FAPI.
Check Form T2SCH3, Schedule 3, for dividends received. (Where are these corporations resident?)
Check Form T2SCH6, Schedule 6, for dispositions of capital property. (Are there any dispositions of shares of foreign corporations?)
Check Form T2SCH9, Schedule 9, for related corporations. (Where are these corporations resident?)
Check Form T2SCH22, Schedule 22, for beneficial interest in a non-resident discretionary trust.
Check Form T2SCH25, Schedule 25, for foreign affiliates.
Check Form T2SCH29, Schedule 29, for payments to non-residents such as royalties, management fees, interest, services, etc.
Check Form T5013, Statement of partnership income. (Is the corporation a member of a partnership? Where is the partnership located? Does the partnership own any foreign property?)
Check for foreign tax credits claimed.
Check for T106, T1134, T1135, T1141 and T1142 information returns that may have been filed.
Question the taxpayer during the initial audit meeting.
Review the organization chart and minute book for indications of, and decisions that relate to foreign affiliates.
Review accounting and legal invoices for payments to foreign affiliates.

15.7.15 Procedure for requesting foreign reporting returns

The Foreign Reporting Requirement (FRR) returns are stored at the T4-T5 Registry located at 2215 Gladwin Crescent, Ottawa, Ontario, by Processing Sequence Number (PSN). The PSN can be obtained from the database provided or from the hardcopy listing provided to audit. If unable to locate a client's PSN, contact the FRR team in Headquarters.

To charge-out a return, e-mail: T4-T5 REGISTRY (TAO).

15.7.16 Additional information

For more information, go to Foreign Reporting Audit Guide (including Database Guide) & Reference Manual Re: T1134(A) & (B); T1135; T1141 & T1142.

15.8.0 Non-arm's length transactions with non-residents – Under review

Subsection 233.1(2) of the ITA requires a "reporting person" to file, for each non-resident person with whom the reporting person does not deal at arm's length, an information return in prescribed form (Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents).

For more information, go to T106 Audit Guide (including Database Guide) & Reference Manual (HQ1073-000-R).

15.8.1 Form T106, Information Return of Non-Arm’s Length Transactions with Non-Residents, overview

This form was introduced in 1988 to combat abuses in transfer pricing and provide the CRA with information on non-arm's length transactions with non-residents. Form revisions were completed in 1996 and 1998. The 1996 revision added the transfer pricing methodology for each type of transaction and made a structural change to the form to reduce errors in the dollar amount of each transaction.

The 1998 revision added a $1,000,000 de minimis test and expanded reporting to trusts, individuals and certain partnerships. Prior to 1998, only corporations were required to file the T106. The legislation became effective for taxation years and fiscal periods that began after 1997.

A "reporting person" is a person who, at any time in the year, was a resident of Canada, or at any time was a non-resident and carried on a business (other than a business carried on as a member of a partnership) in Canada. The reporting person must file the T106 on or before the due date of the tax return for the year in which the person has a "reportable transaction." For a person resident in Canada, a reportable transaction is a transaction or series of transactions that relate in any manner whatever to a business carried on by a reporting person in the taxation year. Where the person is not resident in Canada at any time in the year, a reportable transaction is a transaction or series of transactions that relate in any manner whatever to a business carried on in Canada by the reporting person in the year or preceding year.

The requirement to file Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents, also extends to certain partnerships with reportable transactions. A "reporting partnership" is a partnership that has a member resident in Canada in the reporting period, or a partnership that carries on business in Canada in the reporting period. To determine the reporting obligation of a partnership, the relationships of the partnership as well as the relationships of each member of the partnership to non-resident persons must be examined. Reporting is required if the partnership or a member of the partnership does not deal at arm's length with a non-resident person, or does not deal at arm's length with a non-resident partnership of which such non-resident person is a member. The reporting partnership must file the information return on or before the date a partnership information return is required to be filed by the partnership under section 229 of the Regulations, or would have to be filed if that section applied to the reporting partnership.

The reporting requirement cannot be avoided by "stacking" partnerships. Subsection 233.1(5) provides that, for purposes of the reporting requirement, where a person is a member of a partnership, which in turn is a member of a second partnership, the person is considered to be a member of both the first and second partnership. As a result, we look through to the members of each partnership to determine non-arm's length relationships. Subsection 233.1(4) provides that Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents, is not required to be filed unless the total FMV of the property or services that relate to reportable transactions exceeds CAN $1 million.

15.8.2 Form T106 contents

The following is required to be reported on Form T106:

Identification of reporting person or partnership.

Summary information including:

tax year;
last year for which the form was filed;
total number of T106 Supplementary forms attached;
total dollar amount of transactions included on supplementary forms attached;
gross revenue of the reporting person or partnership;
main business activities of the reporting person or partnership;
whether competent authority requests affect the amounts reported;
whether any amounts reported are adjusted to reflect an assessment or proposed reassessment by a foreign tax administration;
whether any transfer pricing methodologies (TPM) used were based on an advanced pricing agreement or a similar arrangement with a foreign tax administration; and
whether the reporting person or partnership has to file Form NR4SUM, Return of Amounts Paid or Credited to Non-Residents of Canada, Form T4SUM, Summary of Remuneration Paid, or Form T4A-NRSUM, Summary of Fees, Commissions, or Other Amounts Paid to Non-Residents for Services Rendered in Canada, for the transactions reported; if yes, the primary account number must be provided;
whether there have been transactions for non-monetary or nil consideration;
identification of non-resident and relationship to reporting person or partnership;
main business activities and main countries for the reported transactions;
whether the TPM have changed since the previous report and whether the reporting person or partnership has contemporaneous documentation as described in subsection 247(4).

Monetary consideration or balances, as the case may be, and TPM where applicable, for the following types of transactions with non-arm's length non-residents:

tangible property, for example, stock in trade/raw materials;
rents, royalties and intangible property;
services;
financial, for example, interest, dividends;
other, for example, reimbursement of expenses;
loans, advances, investments and similar amounts; and
current accounts, that is, accounts payable and accounts receivable.

15.8.3 Form T106 as an audit tool

Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents, serves as a useful audit tool. Data on international transactions, including transfer pricing methodology, is available for screening and planning the audit before the actual review of the taxpayer's books and records starts. Using the T106 for risk assessment and screening should provide greater efficiencies in an audit. Screening objectives include:

Identify potential files for further review/audit/follow-up.
Identify international issues for large case files.
Identify weaknesses or deficiencies in the T106 form. For example, would additional information be useful? Are there recurring errors?
Determine level of compliance with reporting requirements. For example, are forms complete? Did the taxpayer identify information that was not available at time of filing and did the taxpayer subsequently file it?
Identify offshore structures/schemes.

15.8.4 Form T106 risk assessment

Review each section of the return and note any incomplete sections or information to follow up.
Check for completeness of any attachments.
Check Form T2SCH25, Schedule 25, and compare foreign affiliates listed with T106s filed.
Compare with Form T2SCH9, Schedule 9, to see if T106s were filed for related parties and determine whether other T106s should have been filed.
Review organization chart or other documentation for changes in corporate structure and foreign related parties.
Compare T106s filed from year-to-year. Note changes in the foreign related parties or unusual transactions. Changes may indicate tax planning to shift income and reduce taxes that may impact on FAPI and transfer pricing, and have potential tax avoidance implications.
Check the indication by the reporting person or partnership whether any transfer pricing methodologies have changed since the previous reporting period and whether contemporaneous documentation has been prepared or obtained.
Check information on the year in which foreign related parties were formed or dissolved; it may trigger immigration and emigration taxation rules if the foreign party is owned by a Canadian, for example, disposition of assets at FMV or acquisition at FMV.
Information on control codes and country codes should be noted for potential FAPI; transfer pricing issues; tax avoidance schemes; treaty shopping; and surplus pool manipulations, for example, note tax haven countries must have a PE in a treaty country to be able to have exempt surplus.
Note intangible transactions for Part XIII implications.
Review financial statements for such things as inter-company charges (pricing); tax avoidance situations; treaty shopping; and the shifting of profits out of Canada.
Has the reporting taxpayer indicated that any information was unavailable? If yes, when will it be filed? Has it been filed?
Compare information on the T1134 returns for foreign affiliates with that on the T106.

15.9.0 Transfer pricing – Under review

15.9.1 Overview

Transfer prices are the prices at which services, tangible property, and intangible property are traded across international borders between related parties. The transfer prices adopted by non-arm's length parties directly affect the profits to be reported by each of those parties in their respective countries, and consequently, the income tax paid to each country.

Canada's transfer pricing legislation, as contained in section 247 of the ITA:

embodies the arm's length principle; and
requires that, for tax purposes, the terms and conditions agreed to between non-arm's length parties in their commercial or financial relations be those that one would have expected had the parties been dealing with each other at arm's length.

This ensures that taxpayers who are non-arm's length members of a group and engage in transactions with other members of the group report substantially the same amount of income as they would if they had been dealing with each other at arm's length.

Canada, being a member of the Organization for Economic Co-operation and Development (OECD), endorses the arm's length principle as the basic rule governing the tax treatment of non-arm's length cross-border transactions.

15.9.2 The arm's length principle

The arm's length principle treats a group of parties not dealing at arm's length as if they operate as separate entities rather than as inseparable parts of a single unified business, and is generally based on a comparison of:

prices or margins between non-arm's length parties on cross-border transactions ("controlled transactions"); with
prices or margins on similar transactions between arm's length parties ("uncontrolled transactions").

Whether a taxpayer has adhered to the arm's length principle is a factual determination to be reviewed on a case-by-case basis.

To help taxpayers deal with transfer pricing issues, go to Income Tax Information Circular IC87-2R, International Transfer Pricing.

The OECD has also published OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. These guidelines may be consulted for general guidance on determining the transfer prices of related party transactions.

15.9.3 Taxpayers' responsibility

Under the ITA and the laws of most of Canada's treaty partners, taxpayers have a responsibility to appropriately document their transactions with non-arm's length non-residents. Without the proper documentation, competent authorities may be unable to resolve disputes expeditiously and double taxation can result.

15.9.4 Transfer pricing penalties - Reasonable effort

Subsection 247(3) of the ITA imposes a penalty equal to 10% of the net result of certain adjustments made under subsection 247(2), calculated as follows:

the total of the transfer pricing income and capital adjustments (upward adjustments, whether there are reasonable efforts or not);

minus:

the total of transfer pricing income and capital adjustments for which a taxpayer has made reasonable efforts to determine and use arm's length transfer prices or arm's length allocations (upward adjustments for which there are reasonable efforts); and
the total of transfer pricing income and capital setoff adjustments for which a taxpayer has made reasonable efforts to determine and use arm's length transfer prices or arm's length allocations (downward adjustments for which there are reasonable efforts).

If the taxpayer has not made reasonable efforts to determine and use arm's length prices or allocations, subsection 247(3) does not permit a reduction of the amount subject to the penalty. The penalty will only apply where the net amount calculated above exceeds the lesser of $5,000,000 and 10% of the taxpayer's gross revenue for the year.

Subsection 247(3) precludes applying the penalty unless the net amount of adjustments exceeds the specific threshold as described above. The penalty is intended to be a compliance penalty focusing on the efforts that a taxpayer makes to determine an arm's length price and not solely on the ultimate accuracy.

15.9.5 Advance pricing arrangements

The CRA's Advance Pricing Arrangement (APA) program assists taxpayers in determining acceptable transfer prices. An APA is an agreement or arrangement between the taxpayer and the CRA and stipulates a mutually acceptable transfer pricing method to be used on specified international transactions for a future period.

A bilateral APA under which a treaty partner also agrees to the same transfer pricing methodology provides assurance that potential double taxation will be avoided.

For more information, go to Income Tax Information Circular IC94-4R, International Transfer Pricing: Advance Pricing Arrangements (APAs).

15.10.0 Tax havens – Under review

Tax Havens pose a significant challenge because of their tax breaks and secrecy laws. In response, the CRA has established a multi-disciplined working group called the "Tax Haven Working Group" to share tax haven information internally. Externally, the CRA is a member of the "Seven Country Tax Haven Working Group," a sub-group of the Pacific Association of Tax Administrators (PATA), which collect information and discusses strategies to deal with Tax Havens. The CRA is also involved in numerous Organization for Economic Cooperation and Development (OECD) committees dealing with tax havens, exchange of information, transfer pricing and more. In short, the CRA considers tax havens to be a significant compliance concern.

General tax haven information can be found in a variety of sources. There are many interesting and useful books (which can be borrowed through the local TSO library; inter-library loans are available if the reference material is not on hand at the local library) and magazines from external sources, which provide insight into private sector perspectives on tax havens. There are also numerous industry and trade association publications, periodicals, trade journals and directories.

Suggested readings include: Diamonds' Tax Havens of the World (3 volumes, with periodic updates); Tax Notes International; Take Your Money and Run by Alex Doulis; My Blue Haven by Alex Doulis; Tax Haven Roadmap by Richard Czerlau; The Tax Haven Report by Adam Starchild; Offshore Finance Canada magazine.

Caution: While some of these publications may assist in identifying tax haven issues with respect to particular files, it should be kept in mind that the CRA does not necessarily agree with the conclusions reached by the authors as to the effectiveness of any particular arrangement or scheme.

15.10.1 Tax Haven Audit Guide

The Tax Haven Audit Guide is intended for general tax haven reference. The guide will provide an introduction to tax haven issues for auditors with no or minimal experience with such issues, particularly with the discussion and examples of particular types of schemes, and assist those with more experience in identifying potential tax haven issues in files currently under examination. This guide should assist non-resident, underground economy, large business, and small and medium enterprise auditors when faced with potential tax haven issues.

15.10.2 Tax haven grids

The CRA, in conjunction with the Seven Country Working Group on Tax Havens, has prepared information (grids) in regards to a number of countries that have been considered to be tax havens. The information provided includes not only information on the entities allowed under the country's laws, but also information on problems or schemes tied to this foreign country.

Go to An Offshore Open Source Tool – O-Zone for tax haven grids in regards to Andorra, Anguilla, Antigua and Barbuda, Aruba, Bahamas, Bahrain, Barbados, Belize, Bermuda, British Virgin Islands, Cayman Islands, Cook Islands, Costa Rica, Curacao, Dominica, Gibraltar, Guernsey, Hong Kong, Isle of Man, Jersey, Lebanon, Liberia, Liechtenstein, Luxembourg, Macau, Maldives, Malta, Marshall Islands, Mauritius, Monaco, Montserrat, Nauru, Niue, Panama, Samoa, San Marino, Seychelles, Singapore, Saint Kitts and Nevis, Saint Lucia, Saint Vincent and the Grenadines, Switzerland, Tonga, Turks and Caicos Islands, US Virgin Islands, and Vanuatu.

15.10.3 International tax alerts

The CRA, in conjunction with the Seven Country Working Group on Tax Havens, has prepared a number of International Tax Alerts. To date, Canada has only issued one alert. This alert deals with Health & Welfare trusts.

15.10.4 International Tax InfoZone site

ILBD Reference Material contains international tax related information such as: applications, bulletins, communiqués, conferences, external information, forms, guides, manuals, and more.

15.10.5 Auditing in a tax haven environment

With respect to auditing tax haven transactions, the goal is to "change the risk equation" by making it more difficult and costly for taxpayers to make use of tax havens for avoiding or evading Canadian income taxes. While it is recognized that tax haven audits can be complex due to multi-level ever changing structures, difficulties in obtaining information and other roadblocks, any additional audit effort is well worth the time invested as the rewards can be significant – there is great potential for large audit adjustments and non-compliance.

When conducting an audit that involves a tax haven, it is important to know what types of issues to look for, and to be on the lookout for new schemes. Although new schemes appear on a regular basis, the audit issues are the same whether the transactions take place in the US, UK, Netherlands, or Bermuda, etc. When a taxpayer is involved in establishing and maintaining an offshore presence, there are generally three main stages of activity. It is important to be on the lookout for triggers that might indicate that these activities are being undertaken by a particular taxpayer. The activities are:

1) Funds or property being moved offshore. It is important to recognize that, in a tax haven environment, the flow of funds is key. Examine transfers of funds to and from a tax haven. Appendix 7 of the Tax Haven Audit Guide discusses common methods of transferring funds offshore.

2) The taxpayer establishing and maintaining control over the offshore assets.

3) The taxpayer using or enjoying the offshore assets.

When potential offshore activities have been detected, gather as much information as possible during the regular course of conducting the audit and before interviewing the taxpayer. This will aid in developing relevant, probing questions and will improve any requests for additional (relevant) information that may be required. The taxpayer may be more willing to discuss the matter if they are faced with an auditor who has a clear picture of what has transpired and is well informed and prepared. Also, although most taxpayers are honest and will not withhold information or destroy documents, examining relevant documents and making copies prior to an interview reduces the possibility of information being lost should the taxpayer subsequently suppress or destroy the documents. If they have not already been contacted, international tax auditors should be consulted with and invited to attend the taxpayer interview. Where there are questionable offshore arrangements or transactions, the taxpayer should be invited to explain the non-tax reasons for them. The taxpayer should also be invited to provide any information that has not already been obtained, including when and by whom the offshore arrangements were set up.

Appendix 9 of the Tax Haven Audit Guide provides some suggested audit procedures. The existence of transfer pricing issues should be considered in files where there are no substantial activities being performed by the tax haven entity. Functional analysis is a key audit tool for examining the degree of "value added" in an offshore operation. In general, it may be reasonable to assume that a tax haven entity adds less value than the taxpayer will set out in their pricing practices. ITD has economists available as specialist resources to assist the field in conducting functional analyses, among other assistance.

Refer to TOM 10(14) for details on auditing specific industries. The T106 Audit Guide & Reference Manual and the Foreign Reporting Guide (FRR) Audit Guide also contain auditing procedures.

Remember when auditing in a tax haven environment, the flow of funds is key. The #1 audit procedure is to Follow the Cash.

15.10.6 Taxpayer-specific knowledge

Taxpayer-specific information is available from a number of sources, both internal and external to the CRA. A limited number of sources are listed below. A more detailed listing, including both internal and external sources, is provided in Appendix 4 of the Tax Haven Audit Guide.

15.10.7 T106 Audit Guide & Reference Manual

Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents, is a prescribed annual information return used for reporting non-arm's length transactions between Canadian taxpayers and non-resident persons. Canadian taxpayers are required to file one T106 summary form, as well as separate T106 supplementary forms, for each non-resident person with which it has engaged in non-arm's length transactions [see subsection 233.1(2)].

The T106 return, as well as its related database, are key audit screening and planning tools for tax haven issues. They can be used to identify specific companies that have transactions with related tax haven entities, as well as significant changes in reported tax haven transactions by all taxpayers. The information provided on the T106 can be analyzed on an individual or aggregate basis. For each taxpayer, the major details that the T106 will disclose, and that are relevant to tax haven issues, are: the type of reporting structure (corporation, partnership, trust, individual); the location of the related non-resident entity; the type of ownership of the non-resident entity; the types of transactions being reported; the dollar amount of transactions; the transfer price methodology, etc.

The T106 Management System database, which contains information for all of Canada, is now available online via a dedicated server located in Ottawa. T106 returns are viewable once they have been keypunched at the data centres. Access to the database is available to individuals who have obtained authorization from headquarters. Appendix 5 provides an example of how the T106 database can be used to find potential cases of management fees paid to a tax haven.

For a full discussion on how to use Form T106, go to T106 Audit Guide (including Database Guide) & Reference Manual (HQ1073-000-R).

15.10.8 Foreign Reporting (FRR) Guide Audit Guide

There are strong indications that significant amounts of foreign-sourced income earned for the benefit of Canadians is not reported for Canadian tax purposes. To address this "tax gap," a series of foreign reporting returns (FRR) were implemented to require disclosure and other details for a variety of foreign investments.

The FRRs include:

for corporations, Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates
for individuals, Form T1135, Foreign Income Verification Statement
for trusts, Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities, and
for trusts, Form T1142, Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust

Collectively, these returns represent the foreign reporting requirements. The purpose of FRRs is to ensure that foreign income taxable in Canada is reported by requiring disclosure of the offshore investments and by providing a reminder that all investment income earned abroad is potentially subject to tax in Canada. In addition, they assist with the detection of offshore investments and the audit of transactions that may result in tax avoidance or evasion.

The FRR Management System database, which contains information for all of Canada, is now available online via a dedicated server located in Ottawa. FRRs are viewable online to those authorized (visit your International Tax Team for more information).

For a full discussion on how to use the FRRs, go to Foreign Reporting Audit Guide (including Database Guide) & Reference Manual.

15.10.9 Form NR4, Statement of Amounts Paid or Credited to Non-Residents of Canada

Form NR4 is filed by residents or their agents in respect of amounts paid to non-residents that are liable for non-resident withholding (Part XIII) tax such as pensions, annuities, interest, dividends, royalties, rents, etc. (section 212). This form can be used to screen for the existence of dividends, intangibles, and royalties.

15.10.10 Section 116 – International Audit Guide and Reference Manual

This guide outlines the tax planning arrangements that the CRA is aware of and details the audit steps that will assist auditors in uncovering these arrangements.

Non-residents are subject to Canadian income tax on several sources of income including taxable capital gains on the disposition of taxable Canadian property, recaptured depreciation, the recovery of certain exploration and development expenses in connection with the disposition of Canadian resource properties, and income in respect of Canadian life insurance policies.

Section 116 of the ITA provides administrative procedures to ensure that non-residents comply with their obligations to report such transactions and pay tax in respect of such dispositions.

Section 116 requires non-resident vendors who dispose of taxable Canadian property in a taxation year, to file, no later than 10 days after the disposition, Form T2062, Request by a Non-Resident of Canada for a Certificate of Compliance Related to the Disposition of Taxable Canadian Property, detailing the particulars of the disposition.

The non-resident will be issued a certificate of compliance upon the receipt of either an amount to cover the withholding tax owing, or appropriate security for any gain the vendor may realize. The withholding requirement under section 116 is 25% for taxation years ending after October 17, 2000.

Failure to comply with the filing requirement will result in the purchaser becoming liable to pay 25% of the proceeds to the CRA on the 30th day of the month following the date of acquisition (for taxation years ending after October 17, 2000).

For more information, go to:

Section116 – International Audit Guide and Reference Manual
Income Tax Information Circular IC72-17R6, Procedures Concerning the Disposition of Taxable Canadian Property by Non-Residents of Canada – Section 116

15.10.11 Other tax administrations

Other tax administrations can serve as useful sources of information. For example, the Internal Revenue Service (IRS) has produced a document, Sources of Information from Abroad 2, which lists information that is readily available in foreign countries. The Exchange of Information section of ITD is providing, or has already provided, a copy of this document to each TSO.

15.11.0 Tax treaties – Under review

15.11.1 Overview

Canada has entered into numerous tax treaties with other countries partly because international trade is on the rise. To attract more foreign investment and allow our goods to compete around the world, Canada has entered into over 80 tax treaties in order to provide for a level playing field for Canadian business. As such, decisions, as much as possible, are tax neutral.

The Department of Finance negotiates all treaties and they can be viewed at Tax Treaties: In Force.

In its treaties, Canada has attempted to eliminate double taxation (tax on income in Canada and tax on the same monies in a foreign country) in order to encourage investment and allow Canadian companies to operate on an international basis. As mentioned, it appears evident that if international trade is to be increased, tax considerations should be minimized.

Tax conventions are a bridge between two independent taxing systems. Each taxing system is developed independently for internal legal purposes. In our case, the Income Tax Act was developed for Canadian tax purposes. A tax treaty is often referred to as a double taxation convention and, as mentioned, is entered into primarily to encourage trade and eliminate double taxation. The terms “tax treaty” and “tax convention” mean the same thing. A protocol is simply an addition to an existing treaty. For example, the latest USA Canada Protocol is simply an addendum to the Canada-USA income tax treaty.

A treaty (terms and conditions) is a negotiated agreement between two countries, where negotiators try to find a way to encourage investment by preventing double taxation, while allowing each country a fair share of the tax generated by the trade between the two countries, that is, the increased flow of capital, goods, and services.

15.11.2 The Income Tax Conventions Interpretation Act

Canada introduced this legislation in the early 1980's in order to set out guidelines to assist the interpretation of certain items in the tax conventions. The following extract indicates that as our Income Tax Act changes, or is amended, these changes also reflect on the tax treaties.

Notwithstanding the provisions of a convention or the Act giving the convention the force of law in Canada, it is hereby declared that the law of Canada is that, to the extent that a term in the convention is

(a) not defined in the convention.

(b) not fully defined in the convention, or

that term has, except to the extent that the context otherwise requires, the meaning it has for the purposes of the Income Tax Act, as amended from time to time, and not the meaning it had for the purposes of the Income Tax Act on the date the convention was entered into or given the force of law in Canada if after that date, its meaning for the purposes of the Income Tax Act has changed.

In interpreting a tax treaty, the goal is to find the meaning of the words in question. This process involves looking to the language used and the intentions of the parties. Contrary to an ordinary taxing statute, a tax treaty or convention should be given a liberal interpretation with a view to carrying out the true intentions of the parties. A literal or legalistic interpretation must be avoided when the basic object of the treaty might be defeated or frustrated insofar as the particular item under consideration is concerned.

15.11.3 General Anti-Avoidance Rule (GAAR)

The ITA contains a provision (section 245 – GAAR) that allows the CRA to reassess tax returns where the taxpayer has either eliminated or reduced income, taxable income or tax payable in some manner, which was not intended by the legislation. Many western countries have a similar provision.

The CRA takes the position (supported by legislation) that the GAAR, since its inception in 1988, applies not only to the ITA, but also to Canada's tax conventions.

15.11.4 Relief from double taxation

Canada grants Canadian taxpayers relief against double taxation under domestic law:

by preserving and limiting the tax credits and exemptions in treaties to the foreign tax credits provided under the ITA and the exemptions in the ITA relating to dividends paid out of exempt surplus (Section 113(1)(a));
by allowing for foreign tax credits in regards to withholding tax on dividends reported by Canadian taxpayers.

In regards to foreign investors, Canada has a number of tax rules and tax treaties that allow investors to be able to determine whether or not an amount will be subject to tax in Canada and if so, the rate of tax applicable.

For details on a number of withholding tax issues, go to Income Tax Information Circular IC76-12R6, Applicable rate of Part XIII tax on amounts paid or credited to persons in countries with which Canada has a tax convention.

15.11.5 If no treaty exists

In Canada, the ITA (sections 212 to 218) sets the rate of income tax on dividends, rents, royalties, interest, etc. (most common payments) to 25%, but this rate may be reduced by a tax treaty. However, payments into countries with which Canada does not have a tax treaty (or where a treaty is being used as a conduit) are subject to the full 25% withholding tax.

15.11.6 Permanent establishment

A PE in a province or territory is usually a fixed place of business of the corporation, which includes an office, branch, mine, oil well, farm, timberland, factory, workshop, or warehouse. If the corporation does not have a fixed place of business, the corporation's PE is the principal place in which the corporation's business is conducted.

If the corporation carries on business through an employee or an agent established in a particular place, it is considered to have a PE in that place if the employee or agent:

has general authority to contract for the corporation; or
has a stock of merchandise owned by the corporation from which the employee or agent regularly fills orders received.

Another interesting point deals with the fact that should a PE be found to exist, all other income earned in Canada by the non-resident can be deemed to relate to the PE. In summary, there are three main types of PEs:

asset type
activity type
agency type

For more information, go to Income Tax Interpretation Bulletin IT177R2-CONSOLID, Permanent Establishment of a Corporation in a Province.

15.11.7 Income from real property (or immovable property)

Immovable property includes such things as real property. Simply put, income earned from activities such as agriculture, forestry or other natural resources is taxable in Canada.

15.11.8 Business profits

The business profits of a resident of Canada shall be taxable only in Canada unless the Canadian resident also carries on business in another country, in which case the profits earned in the other country will generally only be taxed by that other country. In the case of a foreign company, they would be taxable in Canada on business profits earned in Canada. Once it has been established that the foreign company is carrying on business in Canada, they then have to calculate the profit relating to the Canadian business operations. Profit is generally determined according to Generally Accepted Accounting Principles and then adjusted for income tax purposes.

It should be noted that the CRA offers a number of services (fee-based services) that will allow a foreign company wishing to operate in Canada a certain level of comfort in regards to taxation related issues. These include Advance Pricing Arrangements, Advance Rulings in regards to technical issues or questions and pre-approval of certain Research and Development projects.

15.11.9 Capital gains

Canadian capital gain rules extend to tax non-residents of Canada on a large category of property described in the ITA as "Taxable Canadian Property" (see sections 248(1) and 115(1)). Capital gain may be exempt from tax where it arises from direct foreign investment in Canada through Canadian corporations and other entities, other than those whose value is principally attributable to immovable property (primarily real estate) situated in Canada. However, Canada retains the right to tax Taxable Canadian Property.

15.12.0 Other international tax services – Under review

15.12.1 Film Services Unit

Film Services Units (FSU) provide service to Canadians and non-residents in the film and television industry and administer or provide access to all the CRA programs dealing with film production in Canada. Its responsibilities include dealing with tax matters related to non-resident actors and behind-the-scenes personnel, and the federal tax-credit programs for Canadian and non-resident film productions. FSUs are located in the following Tax Service Offices: Vancouver, Toronto Centre, Montreal, Regina and Halifax.

15.12.2 Foreign accrual property income and foreign affiliates

FAPI legislation was introduced to tax the passive or investment income earned offshore by foreign affiliates of a Canadian taxpayer. In order to achieve foreign affiliate status, an affiliate must be a corporation resident outside of Canada and the Canadian taxpayer's equity percentage in the corporation must be at least 1% directly and 10% indirectly (that is, through related persons).

The FAPI and foreign affiliate rules were designed to tax the world income of Canadian reidents in way that would allow their businesses to compete internationally. Generally, the rules:

Provide for legitimate foreign business operations of Canadian taxpayers that are involved in active businesses,
Allow the profits of active businesses of foreign corporations operating in countries that have a tax treaty with Canada to be transferred back to Canadian corporate shareholders as tax-free dividends,
Prevent diversion of passive income to controlled foreign corporations,
Eliminate the tax advantage of offshoring investment income and income from property in controlled foreign affiliates that operate in tax haven jurisdictions.

When a Canadian resident owns a controlling interest in a foreign corporation that earns passive income (like interest, dividends, rents, or royalties) or income not deemed to be active income, that income is required under the FAPI rules to be included in the taxable income of the Canadian resident and taxed in Canada. The income is taxed even though no money may have been actually received by the Canadian taxpayer. The result is that the Canadian resident is taxed as if it earned the income directly.

In contrast, where a Canadian taxpayer invests in a foreign corporation that carries on an active business (that is, a manufacturing operation) or a qualified business (that is, a bank), the income earned by the foreign affiliate will not be FAPI and may be taxed only when repatriated to Canada. If the income is earned by a foreign affiliate in a country with which Canada has a bilateral tax treaty, then any dividends paid are free from Canadian tax. These non-taxable earnings are referred to as exempt surplus and the dividends as exempt surplus dividends. Earnings of an active business in a non-treaty country are taxable and as such are called taxable surplus.

The existence of a controlled foreign affiliate can have many tax implications. Not only must an analysis of the underlying sources of income be performed for the years under audit, an analysis of the surplus accounts must also be performed if dividends have been paid out. These analyses become increasingly complicated if the foreign affiliate has operations in other tax jurisdictions.

The CRA has specialists and training material to aid auditors with foreign affiliate issues including FAPI and surplus calculations. Contact the International Tax Section of your TSO for more information.

15.12.2.1 Questions relating to foreign affiliates

What country is the foreign affiliate a resident of? Does Canada have a tax treaty with this country?
Is the foreign affiliate taxable in Canada as a resident?
Is the foreign affiliate a controlled foreign affiliate?
Is there an active business?
Has the controlled foreign affiliate earned any FAPI income?
Has the Canadian taxpayer received and reported any dividends from the foreign affiliate?
Is the Canadian corporate taxpayer entitled to any Section 113 dividend deduction claimed?
What surplus account was the dividend paid from?
What business transactions has the Canadian shareholder conducted with the foreign affiliate? How were the transfer prices determined?
Are any of the related party transactions subject to Part XIII withholding tax?

15.12.3 Foreign investment entity

The legislation in regards to a foreign investment entity (FIE) has not received final legislative approval. However, FIEs deal with offshore investments and include such tax driven vehicles as offshore insurance, offshore investment funds, offshore mutual funds, etc. According to the Department of Finance, a FIE will be defined as a non-resident entity (other than a partnership) and it will exclude exempt foreign trusts (94(1)), discretionary personal trusts, entities with investment property with a carrying value less than 50% carrying value of all assets and a new exclusion has been added for an entity whose principal business is not an investment business.

15.12.4 Competent Authority Services Division

The Mutual Agreement Procedure article in Canadian tax treaties allows the competent authority to eliminate or minimize double taxation issues and concerns. In simple terms, the competent authority from each country (designated by the minister of national revenue in Canada) —generally designates one or more individuals to review requests or appeals from foreign tax jurisdictions and to determine whether or not the treaty provisions have been properly interpreted by the tax authorities of the country where the client is resident. Upon the taxpayer's request, if the CRA has issued reassessments or a foreign country has issued a tax reassessment, the competent authority will review the adjustments to make sure that they are properly documented and in accordance with the convention. The competent authorities of both countries then meet (or correspond) to discuss the issue in detail in order to prevent double taxation.

Under a tax treaty, an increase in tax in one country generally means a reduction in tax in the other country. Generally, the CRA issues an assessment to the taxpayer, who then files a notice of objection together with a request for review by the competent authority. If the taxpayer disagrees with the decision of the competent authorities, they may appeal the matter to the courts.

In addition, the Competent Authority Services Division is in charge of the APA (Advanced Pricing Agreements). These are similar to an advanced tax ruling in that the taxpayer will be able to receive surety in regards to the transfer pricing that will be used in regards to goods or services either imported or exported.

15.12.5 Exchange of information and simultaneous audit programs

As part of the Competent Authority Services Division, these programs provide assistance to TSOs and to foreign treaty partners through routine, spontaneous and specific exchanges, simultaneous audits and request for travel to perform limited audits. They are essential for international compliance and are part of the mandatory functions that the Competent Authority must perform under Canada's income tax agreements. This means that the provisions of the tax treaties govern exchanges of information.

For more information on these programs, go to Competent Authority Services Division.

15.12.6 TSO International tax team

For more information about any of the above programs or services, contact the International Tax Team members within your TSO.

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Date modified:: 2022-04-05

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Chapter 15.0 International audit issues - Under review

Table of Contents

15.1.0 Introduction – Under review

15.2.0 Income of a non-resident – Under review

15.2.1 Overview

15.2.2 Part XIII tax

15.2.3 Part XIV tax

15.2.4 Income earned in Canada from an office or employment

15.2.5 Income from business carried on in Canada

15.2.6 Common law factors connecting a business to a particular place

15.2.7 Carrying on business "with" vs. "in" Canada

15.2.8 Extended meaning of "Carrying on business in Canada"

15.2.9 “Agent or servant” vs. “independent contractor”

15.2.10 Treaty-protected businesses

15.2.11 Withholding of Part I tax – Income from carrying on a business in Canada

15.2.12 Disposition of taxable Canadian property by a non-resident

15.2.13 Treaty-protected property

15.2.14 Waivers of withholding tax

15.2.15 Tax calculations

15.2.16 Audit considerations

15.2.17 Assessment procedures

15.2.18 References

15.3.0 Part XIII tax on income from Canada of non-resident persons – Under review

15.3.1 Legislative authority

15.3.2 Income taxed under Part XIII

15.3.3 Withholding and reporting obligations of the payer

15.3.4 Treaty reduction of Part XIII tax rate

15.3.5 Election by a non-resident to be taxed under Part I

15.3.6 Non-resident beneficiaries of trusts

15.3.7 Audit considerations relating to Part XIII tax

15.3.8 Other Inome Tax Interpretation Bulletins relating to Part XIII tax

15.4.0 Residency – Under review

15.4.1 Overview

15.4.2 Residency of corporations

15.4.3 Trusts

15.4.4 Immigration – Becoming resident in Canada

15.4.5 Emigration – Ceasing to be resident in Canada

15.4.6 For future use

15.4.7 Audit considerations

15.5.0 Foreign-based information and documentation – Under review

15.5.1 Overview

15.5.2 Potential conflict with foreign laws

15.5.3 Definition of "foreign-based information or document"

15.5.4 Requirement to provide foreign-based information

15.5.5 Judicial review of foreign information requirement

15.5.6 Consequence of failure

15.5.7 Documentation submitted after the requirement due date

15.5.8 Jurisprudence

15.6.0 Permanent establishment – Under review

15.6.1 Permanent establishment for income tax purposes

15.6.2 For future use

15.6.3 Supplies between permanent establishments

15.6.4 Audit considerations

15.6.5 Examples

15.6.6 Income tax references

15.7.0 Foreign reporting requirements – Under review

15.7.1 Overview

15.7.2 Rationale for the foreign reporting rules

15.7.3 Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates

15.7.4 Required disclosures and related tax issues

15.7.5 Penalties

15.7.6 Audit considerations for Form T1134, Information Return Relating to Controlled and Not-Controlled Foreign Affiliates

15.7.7 Form T1135, Foreign Income Verification Statement

15.7.8 Audit considerations for Form T1135, Foreign Income Verification Statement

15.7.9 Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities, and Form T1142, Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust

15.7.10 Audit considerations for Form T1141, Information Return in Respect of Contributions to Non-Resident Trusts, Arrangements or Entities

15.7.11 Non-resident trusts versus offshore trusts

15.7.12 Application of foreign accrual property income rules to trusts

15.7.13 Application of attribution rules to trusts

15.7.14 Audit steps to verify compliance with foreign reporting requirements

15.7.15 Procedure for requesting foreign reporting returns