The fifth protocol to the Canada-US Tax Convention, 1980 (the "Treaty") revised Article V(9) and deleted Article XIV.1 These treaty changes essentially treat income derived from cross-border independent personal services and other services of a commercial or industrial nature as business profits covered by Articles V and VII. Article V(9), which contains two separate and distinct tests, provides a deeming rule that broadens the scope of the permanent establishment concept to cover certain services provided in Canada by an enterprise of the US, as generally described in the article by Bryan Bailey and Jeffrey Shafer of Blake, Cassels & Graydon LLP published in a previous issue of this publication.
Article V(9)(a) generally covers independent personal services and applies to an enterprise of the US that provides services in Canada through an individual, where the individual meets a physical presence test and the enterprise meets a gross revenue test. The physical presence test requires the individual to be present (not necessarily working) in Canada for a period or periods aggregating 183 days or more in any twelve-month period. The gross revenue test requires that, during the period of the individual’s presence in Canada, more than 50 percent of the gross active business revenues of the enterprise of the US must consist of income derived from the services performed in Canada by that individual. This provision provides bright line tests that are clearer and likely easier to apply than the fixed base test formerly applicable to independent personal services under Article XIV.
Article V(9)(b) is potentially of broader application because its presence test aggregates the working days of any number of persons (including a single individual) and it does not contain a gross revenue test. More specifically, Article V(9)(b) applies to an enterprise of the US that provides services in Canada through any number of persons, where those persons provide services in Canada for an aggregate of 183 or more working days in any twelve-month period with respect to the same or connected project for customers who are either residents of Canada or who maintain a permanent establishment in Canada and the services are provided in respect of that permanent establishment.
The treaty changes reflect updates to the commentary to the OECD Model Convention and Canada’s intent to assert source country taxing jurisdiction over cross-border services performed in Canada after the Crown’s loss in the Dudney case.2
While the protocol entered into force on December 15, 2008, Article V(9) does not take effect immediately. It takes effect as of the third taxable year of an enterprise of the US that ends after December 15, 2008 but, under Article 27(3)(c) of the fifth protocol, in applying the provision, any days of presence, services rendered or gross active business revenues that occur or arise before January 1, 2010 are to be ignored.
Scheme of Article V
Article V(9) deems a permanent establishment to exist where one would not otherwise arise under the other provisions of Article V, subject to two exceptions. Pursuant to the preamble of Article V(9), it applies "subject to [Article V(3)]." This means that Article V(9) does not apply to services performed on a building site or in respect of a construction or installation project. Further, as a result of amendments contained in the fifth protocol, Article V(6) overrides Article V(9) where a fixed place of business is used solely for the listed preparatory and auxiliary activities. The technical explanation to the Treaty clarifies that Article V(9) does not apply to deem services to be provided through a permanent establishment if the services are limited to those activities described in Article V(6).
There are a number of interpretive issues that arise under Article V(9). We discuss below only some of these interpretive issues, which were considered by the Canada Revenue Agency (the "CRA") in a recent technical interpretation (the "TI").3
Meaning of "Enterprise"
The preamble of Article V(9) specifies that it applies to an "enterprise of a Contracting State," which is an undefined term in the Treaty. In the TI, the CRA noted that a number of extrinsic sources would be valuable resources to use in construing Article V(9), including the commentary to the OECD Model Convention, the commentary to the US Model Convention and the technical explanation to the Treaty.
Unless the context otherwise requires, Article 3(1)(d) of the OECD Model Convention defines "enterprise of a Contracting State" as "an enterprise carried on by a resident of a Contracting State," and Article 3(1)(c) of the OECD Model Convention provides that "enterprise" applies to the carrying on of any business. Under the concept endorsed by the OECD, "enterprise of a Contracting State" means any business carried on by a person who satisfies the residence tests in Article 4 of the OECD Model Convention.
In the TI, the CRA accepted this concept of "enterprise" and stated as follows:
Our view is that the term "enterprise" refers, to a resident of a contracting state but only in reference to a particular line of business carried on by such resident. Therefore where a resident of a contracting state carries on two lines of business, that resident may have a permanent establishment in the other contracting state by reference to one of such lines of business but not the other.
Thus, under this interpretation, a single person resident in the US may operate multiple "enterprises" for purposes of Article V(9). One consequence is that a US resident carrying on more than one business could in certain circumstances be deemed to have a permanent establishment in Canada under Article V(9) by providing services in Canada to itself across business divisions. Another consequence for a US resident that carries on more than one business and provides services in Canada through a single individual is an increased potential for being found to have a permanent establishment in Canada under Article V(9)(a). The reason is that the gross revenue test in Article V(9)(a) will apply to each business separately, such that the US resident cannot rely on revenues from other businesses to fail the gross revenue test in respect of a particular business.
Another issue is whether the activities of agents should be attributed to the "enterprise" for purposes of applying the presence test in Article V(9)(b). In this regard, the commentary to the OECD Model Convention states that the term "enterprise" includes personnel in an employment relationship with the enterprise and also dependent agents receiving instructions from the enterprise. While the technical explanation to the Treaty is silent on this issue, the CRA accepted this approach in the TI by endorsing certain examples of the application of Article V(9). The examples indicate that activities of persons "under the supervision, direction or control" of the particular person operating the enterprise in question should be attributed to that enterprise for purposes of applying the presence tests in Article V(9).
Meaning of "Third Parties" for purposes of Article V(9)(b)
Article V(9)(b) deems a permanent establishment to arise where an enterprise of the US provides services in Canada "for customers." The technical explanation to the Treaty states that Article V(9) applies only to services provided by the enterprise to "third parties" and, further, that it does not deem an enterprise to have a permanent establishment merely because services are provided "to that enterprise."
In its technical explanation to the Treaty, the Joint Committee on Taxation, a non-partisan joint committee of the House of Representatives and the Senate of the US Congress, interpreted this statement as follows: "According to the Technical Explanation, [Article V(9)] applies only to services provided by the enterprise to third parties, and not to services provided to that enterprise (i.e., intercompany services)."4 If the US adopts this interpretation of Article V(9), it would likely take the position with Canada that a US resident should not be deemed to have a permanent establishment in Canada under Article V(9) by providing services in Canada to its Canadian affiliate.
In the TI, the CRA applied the concept of "enterprise" set out above to construe the meaning of the term "third party" in the technical explanation to Article V(9)(b) of the Treaty. In this context, the CRA stated that the term "third party" means "any person other than the person operating the enterprise in question," and that a related person constitutes a "third party." The CRA’s administrative position means that Canada may assert that a permanent establishment could be deemed to arise under Article V(9)(b) in respect of the provision of services between related companies within a multinational group.
If these apparently conflicting positions on the consequences of the provision of cross-border intercompany services persist, resolution may have to be obtained by binding arbitration under the mutual agreement procedure pursuant to Article XXVI(6)(b)(i)(A). Since Article V is listed in the preamble to Annex A to the Treaty, such a case would be eligible for binding arbitration.
One commentator5 expressed concern over the CRA’s departure from the interpretation apparently endorsed by the drafters6 of the technical explanation to the Treaty and invited the CRA to revisit its administrative position in this regard. The CRA should provide additional guidance on the application of the presence test in Article V(9) in respect of the provision of services between entities within a multinational group, which seems to be outside the mischief at which the provision is aimed.
Same or Connected Project
In applying the presence test in Article V(9)(b), the number of days worked "with respect to the same or connected project" must be aggregated. Paragraph 2 of Annex B to the Treaty clarifies that, in this context, projects will be considered to be "connected" if they constitute a coherent whole, commercially and geographically. In this regard, the technical explanation to the Treaty states that the determination of whether projects are connected should be considered from the point of view of the enterprise, not the customer, and noted that the following three factors are relevant in determining the existence of commercial coherence: (1) whether the projects would, in the absence of tax planning considerations, have been concluded pursuant to a single contract; (2) whether the nature of the work involved under different projects is the same; and (3) whether the same individuals are providing the services under the different projects. The technical explanation to the Treaty also states that whether the work provided is covered by one or multiple contracts may be relevant, but not determinative, in finding that projects are commercially coherent.
In the TI, the CRA noted that what constitutes the "same or connected project" is a question of fact, determined on a case-by-case basis. The CRA provided a number of examples that illustrate the application of the three factors in determining what constitutes the "same or connected project." Foremost among these is the following example taken from the commentary to the OECD Model Convention (modified herein to apply to the Treaty specifically):
A US-resident corporation ("USco") outsourced to a Canadian-resident corporation ("Canco") technical support services provided by telephone to USco’s clients. Canco operates call centres for a number of other customers similar to USco. During the twelve-month period in 2010, employees of Canco provided technical support to various clients of USco. Since the employees of Canco are not under USco’s supervision, direction or control, USco is not considered to perform services in Canada through Canco’s employees. Further, while the services performed by Canco’s employees to the various clients of USco are similar, they are provided under different contracts concluded by USco with unrelated clients and, thus, cannot be considered to be rendered for the same or connected projects.
Reg. 105 Withholding
Other interesting issues arise in connection with Article V(9), including withholding obligation considerations.
Under paragraph 153(1)(g) of the Income Tax Act (Canada) and section 105 of the Income Tax Regulations (Canada), every person paying to a non-resident person a fee, commission or other amount in respect of services rendered in Canada, of any nature whatever, must deduct or withhold 15 percent of such payment. The CRA may waive the withholding obligation where the non-resident person demonstrates an entitlement to treaty relief under Article VII by virtue of a lack of a permanent establishment in Canada. Upon the entry-into-force of Article V(9), it is expected that obtaining such a waiver will be difficult because it will often be impossible to know ex ante whether or not a permanent establishment will be deemed to arise.
The competent authorities of Canada and the US have indicated that they will issue further guidance in this regard, which may delineate specific safe harbours for these purposes.
The text of Article V(9) admits some ambiguity and so it raises interesting interpretative issues. Thus, the CRA’s administrative guidance will continue to be a valuable resource to assist practitioners in advising clients as to the proper interpretation of the provision.