On January 1, 2010, the new service provision of the 5th Protocol to the Canada-US tax Convention (the "Convention") will come into force.
New paragraph V(9) of the Convention reads as follows:
Subject to paragraph 3, where an enterprise of a Contracting State provides services in the other Contracting State, if that enterprise is found not to have a permanent establishment in that other State by virtue of the preceding paragraphs of this Article, that enterprise shall be deemed to provide those services through a permanent establishment in that other State if and only if:
(a) Those services are performed in that other State by an individual who is present in that other State for a period or periods aggregating 183 days or more in any twelve-month period, and, during that period or periods, more than 50 percent of the gross active business revenues of the enterprise consists of income derived from the services performed in that other State by that individual; or
(b) The services are provided in that other State for an aggregate of 183 days or more in any twelve-month period with respect to the same or connected project for customers who are either residents of that other State or who maintain a permanent establishment in that other State and the services are provided in respect of that permanent establishment.
Subparagraph V(9)(a) targets enterprises that earn their income through the personal services provided by a small number of individuals. It requires the presence of only a single individual in the other Contracting State for a total of 183 days or more during the same 12-month period. In order to meet this test, the enterprise must also derive at least a minimum of 50% of its gross active revenues from the activities of that individual in the other Contracting State.
Subparagraph V(9)(b) is aimed at the overall activities of an enterprise with regards to the same or connected project. For the purpose of this subparagraph, the threshold to be met is the presence of any employees for a minimum of 183 working days in aggregate in the same 12-month period (non-working days such as weekends or holidays do not count in the test as long as no services are actually being provided on these days). For the purpose of meeting the time threshold, time will be computed on a calendar-day basis, independent of the number of employees working in the other Contracting State. This means that even if a resident of a Contracting State sends many individuals simultaneously to provide services in the other State, their collective presence during one calendar day will count for only one day of the company’s presence in that State.
The introduction of this "service PE" provision seems clearly to be a reaction to the Dudney 1 case, in which a computer expert based in the U.S., who stayed in Canada for 300 days to perform his work, was found not to have a permanent establishment in Canada on the basis that his ties with Canada where not sufficiently fixed and permanent to meet the permanent establishment threshold under the Convention.
Similar wording to paragraph V(9) has recently been included in the OECD’s Commentaries on the Articles of the Model Convention ("OECD Commentaries"). Arguably this addition was made in an effort to satisfy countries reluctant to adopt the fixed and permanent place of business test with respect to services performed in their territory.
It is interesting to note that this provision is not included in the current version of the OECD’s Model Convention (the "OECD Model") nor in the United States Model Income Tax Convention (the "US Model").
The Technical Explanation of the 5th Protocol (the "TE") prepared by the United States Department of Treasury and subscribed to by the Government of Canada states that (emphasis added):
Paragraph 9 applies only to the provision of services, and only to services provided by an enterprise to third parties. Thus, the provision does not have the effect of deeming an enterprise to have a permanent establishment merely because services are provided to that enterprise.
In a recent publication2, the Canada Revenue Agency ("CRA") concluded that the term "third party" should be given a liberal interpretation and that it should include any person other than the person operating the enterprise. Moreover, the CRA concluded that a related person in reference to a particular person is considered a "third party" for purposed of paragraph V(9) of the Convention.
This may lead to situations where a related party which is a member of a multinational group may be considered a "third party" for that purpose. As a consequence, a U.S. subsidiary of a multinational group providing services in Canada to a related Canadian subsidiary of the same group could be considered to have a permanent establishment in Canada.
One may question whether this CRA position correctly reflects the intention of the parties to the Convention and the language used in new paragraph V(9) and in the TE.
Ambiguity in the application of new paragraph V(9) results mostly from the following comments from the United States Joint Committee on Taxation in its explanation of the 5th Protocol (emphasis added):
According to the [TE], paragraph 9 applies only to services provided by the enterprise to third parties, and not to services provided to that enterprise (i.e. intercompany services).
Many practitioners consider these comments to be in total contradiction with CRA’s view. This position seems to be based on the assumption that the term "enterprise" should be given a wide meaning and should therefore be understood to mean the "enterprise" of a multinational group as a whole. This position appears to be reinforced by the importunate use of new and undefined terms in both the Convention and the TE which appear to be referring to dealings with unrelated parties (such as references to "third parties" and "customers").
At the other end of the spectrum, some argue that "intercompany", as referred to by the U.S. Joint Committee, was meant to mean within the same company or entity or, in other words, "intra-company". They also suggest the terms "enterprise" and "enterprise of a contracting state" should be given a narrow meaning and, therefore, be limited to the business activities of a resident of a Contracting State on a stand-alone basis only.
On the last point, it should be noted that the terms "enterprise" and "enterprise of a contracting state" are defined under the US Model and match the exact wording of the OECD Model. The term "enterprise" is defined to apply to the carrying on of any business. While the term "enterprise of a Contracting State" mean an enterprise carried on by a resident of a Contracting State. Interestingly, the US Model specifies that "the terms also include an enterprise carried on by a resident of a Contracting State through an entity that is treated as fiscally transparent in that Contracting State."
Should a wide meaning to the term "enterprise" had been intended, one could question why such specification would have been required since the enterprise of such a fiscally transparent entity would have been viewed as the same enterprise as its owner in any case under a wide-meaning approach anyway.
Where Do We Stand?
Without doubt, new paragraph V(9) raises important interpretative concerns as it introduces new and undefined terminology to the Convention. The use of the terms "enterprise", "enterprise of a Contracting State" and "customers" in these contexts is new to the Convention and no definition of such terms have been added to the Convention.
The ambiguity created by this new language has been expanded by the conflicting views described above. With CRA recently affirming its aggressiveness on the issue, the Canadian judicial system will probably be called to settle this ambiguity. In the meantime, multinational groups must be aware of the risk of Canadian taxation associated with a deemed permanent establishment in Canada and should plan the allocation of their human resources accordingly.