INTERNATIONAL TAXATIONIN CANADA

Principles and Practices

Jinyan LiOsgoode Hall Faculty of Law

Arthur CockfieldQueen's University Faculty of Law

J. Scott WilkieOsier, Hoskin & Harcourt LLP

LexisNexis*

B 358814

TABLE OF CONTENTS

About the Authors iiiPreface vTable of Cases xxi

Chapter 1: Introduction 1A. The Nature of International Taxation 1B. Major Themes 3C. Organization of This Book 4

PART I — FUNDAMENTALS OF INTERNATIONALTAXATION IN CANADA 7

Chapter 2: Concepts, Principles and System Design 9A. Introduction 9B. Canadian International Tax Law 9C. Basic Concepts, Principles and Policies 10

1. Concepts and Principles 102. Policy Concerns 12

(a) Equity 12(b) Neutrality 13(c) Administrative Efficiency 14

D. The System Design 141. Some Matters of Terminology 15

(a) Inbound Versus Outbound Transactions 15(b) Active Versus Passive Income 15(c) Direct Versus Indirect Investment 16

2. The Inbound Rules 173. The Outbound Rules 174. Rules Applicable to Inbound and Outbound

Transactions 18E. General Issues 19References 22

Chapter 3: Tax Treaties 23A. Introduction 23B. Legal Effects of Tax Treaties 23

1. Relationship with Domestic Law 232. Taxpayers' Reliance on Treaties 243. Legal Effects on Provinces 24

C. The Canadian Treaty Network 25

TABLE OF CONTENTS

1. Model Treaties 252. Purposes 263. Major Provisions 27

(a) Scope of Application 28(b) General Definitions 28(c) Allocating Tax Jurisdiction 29(d) Elimination of Double Taxation 33(e) Administrative Co-operation 35

D. Interpretation of Tax Treaties 361. Special Features of Treaty Interpretation 362. General Approach 373. Meaning of Terms 384. Object and Purpose of Treaties 415. Extrinsic Materials 42

(a) The OECD Model and Its Commentaries 42(b) Technical Explanation of the Canada-U.S.

Treaty 43(c) Foreign Jurisprudence 43

6. The Crown Forest Case 43E. Treaty Abuse 45

1. Benefits Limitation Provisions 452. Specific Treaty Anti-avoidance Rules 463. Domestic Anti-treaty Abuse Rules 464. Prevention of Tax Avoidance Through

Interpretation 46References 47

Chapter 4: Tax Jurisdiction 49A. Introduction 49B. Jurisdictional Principles 49C. "Residence" in Canada: Overview 51D. Residence of Individuals 52

1. Ordinary Residents 522. Sojourners 543. Dual Residence 55

E. Residence of Corporations 551. The Corporate "Person" 552. The Common Law Test: Place of Central

Management and Control 563. The Statutory Place of Incorporation Test 584. Dual Residence 59

F. Residence of Trusts and Partnerships 59G. Changing Residence 60H. Source of Income 62

1. Overview 62

TABLE OF CONTENTS xi

2. Place of Economic Activity 633. Place of Residence of the Payer 634. The Base-Erosion Test 64

References 65

PART II — INBOUND TAXATION 67

Chapter 5: Overview: Taxation of Non-residents EarningIncome from Canada 69

A. The Issues 69B. System Design 70C. Fundamental Principles 71D. Policy Concerns 72E. Part I Taxes 75

1. Taxable Activities 752. Tax Liability 75

(a) Net Income 76(b) Taxable Income 77(c) Tax Payable 77

F. Part XIII Taxes 78G. Relationship Between Part I and Part XIII 79References 79

Chapter 6: Non-residents "Employed in Canada" 81A. Canadian Tax Liability 81B. "Employment" 81C. "Employed in Canada" 83D. Income Attributable to Canadian Employment 85E. Treaty Relief 86References 86

Chapter 7: Non-residents "Carrying on Business in Canada" 89A. Core Issue in Inbound Taxation 89B. "Business" 89

1. General Meaning 892. "Business" Versus Passive Investing 90

C. "Carrying on Business in Canada" 911. Threshold for Canadian Taxation 912. Meaning of "Carrying on Business in Canada" 913. Productive Activities 934. Selling and Promotion Activities 935. Business Agents 956. Canadian Real Property and Resource Property 96

D. Attribution of Income to a Canadian Business 96E. Treaty Limitation 98

xii TABLE OF CONTENTS

1. General Principles 982. Meaning of "Permanent Establishment" and

"Fixed Base" 983. Attribution of Profits to Permanent

Establishment 1024. Artistes and Athletes 103

References 104

Chapter 8: Non-residents Disposing "Taxable CanadianProperty" 105

A. Overview 105B. "Taxable Canadian Property" 105

1. Real Property 1062. Shares , 1063. Equity Interest in Partnerships and Trusts 1084. Business Assets 108

C. Computation of Taxable Capital Gains 108D. Tax Compliance 109E. Treaty Limitation 109References 111

Chapter 9: Non-residents Receiving Payments from Canada 113A. Introduction 113B. Portfolio Versus Direct Investment in Canada 113C. Legislative Framework: Part XIII 114D. Dividends and Repatriation of Branch Profits 116

1. "Dividends" 1162. Canadian Source 1173. Portfolio Versus Direct Investors 1174. Branch Profits 118

E. Interest 1191. "Interest" : 1192. Canadian Source 1193. Portfolio Interest Exemptions 120

F. Direct Interest and Thin-Capitalization Rules 1211. Debt Versus Equity 1212. Non-arm's Length Shareholder/Lenders 1223. "Thin Capitalization" 1234. Back-to-Back Loans 1245. Interaction with Tax Treaty Provisions 125

G. Rents, Royalties and Similar Payments 1261. "Rents" and "Royalties" 1262. Similar Payments 1273. "Royalty" Defined in Treaties 1294. Canadian Source 131

TABLE OF CONTENTS xiii

5. Exemptions 132H. Management and Administration Fees 132I. Other Payments 134

1. Estate or Trust Income 1342. Pensions 1343. Retiring Allowances and Other Amounts 1354. Payment for Acting Services 135

J. Net Basis Elections 136References 136

PART III — OUTBOUND TAXATION 139

Chapter 10: Overview: Taxation of Residents Earning Incomefrom Foreign Countries 141

A. The Issues 141B. Basic Principles 142C. Policy Directions: Signposts to the Legislation 143

1. Capital Import Neutrality 1442. Capital Export Neutrality 1453. Passive Portfolio Income Versus Active Business

Income 146D. Transforming Policy into Legislative Framework 147E. Foreign Direct System 148

1. Foreign Business Income 1482. Foreign Passive Income 149

F. Foreign Indirect System 1491. Foreign Intermediaries 1492. Indirect Foreign Portfolio Income 150

(a) Non-resident Trusts 150(b) Controlled Foreign Affiliates 152(c) Foreign Investment Entities 153

3. Foreign Indirect Business Income 1554. The Architecture and General Concepts 157

References 158

Chapter 11: The Foreign Tax Credit 161A. Introduction 161B. Methods of Relieving Double Taxation 161C. Foreign Tax Credit: An Overview 165

1. Eligibility.... 1652. Creditable "Income or Profits Taxes" 1653. Source of Income 167

D. Computing the Credit 1711. Foreign Tax Paid 1722. "Canadian Tax Otherwise Payable" 173

xi v TABLE OF CONTENTS

3. Example 174E. Excess Credits 175

1. Causes 1752. Relief Measures 176

F. Foreign Tax Credit Trading 179G. Effect of Tax Treaties 182References 183

Chapter 12: Non-resident Trusts 185A. Outline 185B. Period of Legislative Transition 186C. The Former Rule 186

1. Policy Objective 1862. Conditions of Application 1873. Canadian Tax Consequences... 188

D. New Section 94 1901. Rational and Key Architectural Features 1902. The "Charging Rule" 1913. Application of New S. 94 192

(a) Resident Contributor 192(b) Resident Beneficiary 192(c) "Covered" Trusts 193(d) Indirect Transfers 193

4. Exclusions from Application of S. 94 194(a) "Arm's Length Transfers" 194(b) Other Exclusions 195

E. Conclusion 196References 197

Chapter 13: Foreign Affiliates 199A. Introduction 199B. Overview of the Foreign Affiliate System 199

1. Architecture 1992. Policy 2003. Key Concepts 202

(a) "Controlled Foreign Affiliate" and "ForeignAffiliate" 203

(b) "Foreign Accrual Property Income" (FAPI)and "Foreign Active Business Income" 204

(c) "Designated Treaty Country" 205(d) Surplus Accounting 205(e) Exempt Surplus and Exempt Dividends 205(f) Taxable Surplus and Taxable Dividends 206(g) Pre-acquisition Surplus 206

TABLE OF CONTENTS XV

C. The FAPI Regime 2071. The Charging Rule 2072. "Controlled Foreign Affiliates" Defined 208

(a) "Corporation" 208(b) "Equity" 209(c) "Control" 209

3. "Foreign Accrual Property Income" Defined 211(a) "Income from Property" 211(b) "Base Erosion" Rules 212(c) Services Income 214(d) Active Business Income and Notion of

"Corporate Group" 2154. Computation of FAPI 218

(a) General Inclusions and Exclusions 218(b) Capital Gains 219

5. Imputation of FAPI to Canadian Shareholders 220(a) General Rule 220(b) "Credit" for Foreign Tax 221(c) Adjustments to Cost Base of Shares and

Subsequent Dividends 222D. Dividends from Foreign Affiliates 222

1. General Comments 2222. Dividends out of Exempt Surplus 2243. Taxable Surplus Dividends 224

(a) Indirect Foreign Tax Credit 225(b) Foreign Withholding Tax 226

4. Pre-acquisition Surplus 2275. Constructive Disposition: Gains Treated as

Dividends 227E. Linking FAPI and Dividends Regimes 227F. Changes in the Ownership of Foreign Affiliates 228References 230

Chapter 14: Foreign Investment Entities 233A. Introduction 233B. Overview of Policy and Legislative Background 234

1. Policy Objectives 2342. Old S. 94.1 — Offshore Investment Fund Property

Rules 2353. Problems with Old S. 94.1 235

C. Application of the FIE Rules 2371. "Foreign Investment Entity" Defined 2372. Participating Interest 2383. Exclusions from the FIE Rules 239

xvi TABLE OF CONTENTS

D. Determination of Income from an FIE 2411. Prescribed Income Rate Approach 2412. The Mark-to-Market Approach 2423. Income Accrual Approach 2424. Avoiding Double Taxation 244

E. Other Considerations 244F. Conclusion 245References 246

PART IV — TAX AVOIDANCE AND ADMINISTRATION 249

Chapter 15: Transfer Pricing 251A. Overview: Tax Avoidance 251B. Transfer Pricing: The Problem and Principle 253

1. The Problem 2532. The Arm's Length Principle 255

C. Section 247 2551. Introduction 2552. Application of S. 247 2563. Transfer Pricing Adjustments 2564. Penalties and Documentation Requirements 2575. Interpretation of S. 247 260

(a) Administrative Guidelines and Their LegalEffects 260

(b) Textual, Contextual and PurposiveInterpretation 261

(c) Canadian Jurisprudence 262D. Transfer Pricing Methods 264

1. Overview 2642. CUP 2663. Resale Price Method , 2664. Cost-Pius Method 2685. Profit Split Method 2686. Transactional Net Margin Method 2717. Financial Arrangements 2728. Qualifying Cost Contribution Arrangements 273

E. The Elusiveness Of Arm's Length Prices and AdvancePricing Arrangements 274

F. Transfer Pricing and Tax Treaties 2751. Introduction 2752. Permanent Establishments 2763. Corresponding Adjustments 2764. Transfer Pricing Disputes Resolution 277

G. Formulary Allocation 277References 280

TABLE OF CONTENTS xvii

Chapter 16: The General Anti-avoidance Rule (GAAR) andInternational Transactions 283

A. Introduction 283B. Overview of the GAAR 284

1. Statutory Framework 2842. Interpretation and Application 286

(a) Tax Benefit 286(b) Avoidance Transaction 288(c) Misuse or Abuse 289

C. International Transactions 290D. Treaty-Based Transactions 291

1. GAAR arid Tax Treaties 2912. Tax Benefits from Treaty-Based Transactions 2933. Avoidance Transaction 2964. Abuse of Treaties 2965. Treaty Shopping 298

(a) Residence Definition 298(b) Beneficial Ownership 300(c) Limitation of Treaty Benefit 303(d) The GAAR 304

References 307

Chapter 17: International Tax Administration 309A. Introduction 309B. Federal Government Agencies 310

1. Canada Revenue Agency 3102. Department of Justice 3123. Department of Finance 313

C. Unilateral Tax Measures 3141. Enforcing Tax Liabilities of Residents Through

Enhanced Disclosure 3142. Enforcing Tax Liabilities of Non-resident

Taxpayers 315(a) Filing Tax Returns 315(b) Obligations to Withhold 316

D. Bilateral Co-operation 3171. Competent Authorities and Tax Treaties 3172. Special Canada-U.S. Treaty Matters 319

(a) Information Exchange 319(b) Reciprocal Enforcement of Tax Debts 321(c) Binding Arbitration 321

E. Multilateral Co-operation 3231. Global Tax Politics and the Tax Haven Problem 323

(a) Tax Sovereignty and the Absence of a WorldTax Organization 323

xviii TABLE OF CONTENTS

(b) International Tax Evasion and Tax Havens 324(c) International Tax Avoidance and Tax Havens... 325

2. OECD Harmful Tax Competition Project 3273. Convention on Mutual Administrative Assistance in

Tax Matters 3294. Multilateral Co-operation on Avoidance

Transactions 3305. Pacific Association of Tax Administrators 330

F. Conclusion 331References 332

Part V — OTHER ISSUES 335

Chapter 18: International Trade and Tax 337A. Introduction 337B. The Goods and Services Tax and International

Transactions '. 3371. Overview of GST Rules 3382. International Aspects of the GST 340

(a) Exporting and Importing Goods and Services... 340(b) Characterization and Place of Supply Rules 341(c) Non-residents Registration Obligations 342

3. GST Reform Efforts and Electronic Commerce 344C. NAFTA and Taxation 347

1. Tax Treatment of Goods 3482. Taxes on Services 3503. NAFTA and Tax Treaties 351

D. World Trade Organization Agreements and Taxes 3511. GATT and Cross-border Sales of Goods 3522. GATS and Cross-border Services 354

(a) General and Specific Obligations 354(b) Provisions Concerning Tax Measures 354

References 356

Chapter 19: Taxation of Electronic Commerce 359A. Overview 359B. Cross-border Business Profits and Server/Permanent

Establishments 3601. Background 3602. The New Server/Permanent Establishment Rules 361

C. Income Characterization of Cross-border E-commerceTransactions 3631. OECD Reform Efforts 3632. Characterization Example 364

D. Tax Residency and E-commerce 366

TABLE OF CONTENTS xix

E. Transfer Pricing and E-commerce Transactions 368F. Concluding Comments 370References 372

Chapter 20: International Taxation in Canada: an Epilogue 375

Appendix: Convention Between Canada and the United States ofAmerica With Respect to Taxes on Income and on Capital 379

Index 433