5.3 Explanation & Interpretation of Article V under U.S. Law (Canada U.S. Tax Treaty)

5.3.1[a] U.S. Taxation of Foreign Persons

The U.S. tax treatment of foreign persons and foreign-related transactions depends primarily on three criteria:

1 – Whether the income earned is active or passive;

2 – Whether the income is deemed to be earned from a U.S. or foreign source;

3 – The implications of any applicable U.S. income tax treaties.

A foreign person earning certain U.S. source periodic or investment income, such as interest, rents, royalties, dividends, and other fixed or determinable annual or periodic income (FDAP), is taxed on a gross basis at a 30 percent rate.

If the foreign person conducts a U.S. trade or business (USTB), income that is effectively connected (ECI) with such trade or business is taxed on a net basis at graduated rates.

If a foreign corporation determines that it is engaged in a USTB, it next must determine whether it has any ECI under U.S. internal law. Even though a foreign corporation may have a USTB and ECI under U.S. domestic law, such ECI may be exempt from U.S. tax under an applicable U.S. income tax treaty if the foreign corporation does not have a U.S. permanent establishment or if its business profits are not attributable to the permanent establishment under the terms of the Treaty.

5.3.1[b] Engaging in a U.S. Trade or Business

Certain common factors for foreign corporations starting operations in the U.S. influence the determination of whether they have a USTB, including the following:

1 – Whether administrative activities constitute a trade or business;

2 – The circumstances under which the purchase and / or sale of goods in the U.S. constitute a USTB;

• Whether the foreign corporation engages in real estate investment activities;
• The applicability of certain Treasury and IRS guidance in determining a USTB; and
• When and whether activities of agents can be imputed to the foreign corporation.

Administrative and clerical functions that constitute “ministerial” activities generally do not give rise to a USTB.

Purely administrative activities, such as record-keeping and payroll functions should not alone constitute a USTB.

Purchasing goods does not, by itself, generate profits, but the sale of goods does. Thus, if a foreign corporation purchases goods in the U.S. and does not engage in sales activities there, it should not be viewed as engaged in a USTB.

Section 897, which overrides U.S Treaty obligations, treats gain or loss from the disposition of U.S. Real Property Interest as ECI.

A Canadian corporation under the jurisdiction of the IRS Large Business and International Division that wishes to have certainty on whether or not it is engaged in a USTB may obtain a closing agreement under the IRS pre-filing program.

According to IRS guidelines, issues that are likely to be suitable subjects for a pre filing agreement include whether the taxpayer is engaging in a USTB, the amount of gross income that is ECI, and whether the taxpayer has a PE in the United States.

Activities of persons subject to a high degree of control by the corporation, such as employees and agents acting exclusively or almost exclusively for the corporation, may be imputed to the corporation.

In general, the actions of independent agents, acting in the ordinary course of their business, generally do ot create USTB for the principal.

Under the regulations, an “independent agent” is a general commission agent, broker, or other agent of independent status acting in the ordinary course of his business in that capacity.

The regulations note that a wholly owned domestic subsidiary of a foreign corporation, which acts as an agent for the foreign parent may be treated as acting in the capacity of an independent agent for the foreign parent.

5.3.1[c] Effectively Connected Income

U.S domestic law treats three types of income as ECI.

1 – U.S source business income;

2 – Certain U.S source FDAP;

3 – Certain foreign source business income.

If a foreign corporation is engaged in a USTB, all of its income effectively connected with the conduct of that trade or business is subject to U.S. net basis income tax.

Once a foreign corporation is engaging in one type of USTB, all of its other U.S. source business income for the taxable year also will be treated as ECI. Thus, if a foreign entity has a USTB, all of its U.S source active business income, even if derived from a completely different business line or activities, would be taxed as ECI.

A foreign corporation is subject to U.S. tax on foreign source ECI only if it is engaged in a USTB at some time during the taxable year and the foreign taxpayer has an office or fixed place of business within the U.S. to which the foreign source income is attributable.

5.3.2 U.S. Interpretation of the Treaty

5.3.2 (a) Overview

If a foreign corporation is a resident of a country that has entered into an income tax treaty with the U.S., an additional condition must be satisfied before the income connected with its USTB (i.e., ECI) may be subject to U.S. net basis tax. Generally, the United States may impose its net basis tax only on the foreign corporation’s ECI attributed to its U.S. permanent establishment (PE).

For a PE to exist, the following three conditions (the “three factor test”) must be met:

1 – There must be a link between the place of business and a specific geographical point;

2 – The taxpayer must have the right to use the place of business; and

3 – The use of the place of business must last for a certain period of time (though it does not have to be used exclusively for carrying on the business of the foreign corporation.)

A PE can be deemed to exist only if the place of business has a certain degree of permanency.

5.3.2 (b) Provisions of the Canada – U.S. Tax Treaty Currently in Force

Generally, a Canadian corporation must be engaged in a USTB under U.S. internal law, and so through a “fixed place of business” to be considered to have a PE. In essence, a Canadian corporation must determine, based on all of the facts and circumstances, whether it is engaged in a USTB through its own activities or the activities of an agent. Then it must determine whether the activities are conducted through situs located in the United States.

5.3.2 [c] The PE list and the Exempt List

The PE list in Article V(2) of the Treaty provides that the term PE specifically includes:

• A place of management, a branch, an office;
• A factory or a workshop;
• A mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

The exempt list in Article V(6) of the Treaty specifically exempts from the definition of a PE:

• Using facilities for storing, displaying or delivering goods or merchandise belonging to the resident;
• Maintaining a stock of goods or merchandise belonging to the resident for the purpose of storage, display or delivery;
• Maintaining a stock of goods or merchandise belonging to the resident for the purpose of processing by another person;
• Purchasing goods or merchandise, or collecting information, for the resident; and
• Advertising, the supply of information, scientific research or similar activities which have a preparatory or auxiliary character, for the resident.

A foreign corporation performing “promotional and administrative” activities that included direct mailing, sales promotional plans with other entities (e.g. department stores or businesses), and placing advertising in magazines and trade journals was not engaged in USTB according to IRS.

5.3.2 [d] Agency PEs

Under the treaty, a dependent agent of a Canadian corporation (Whether or not an employee) may create a PE for the corporation if the agent is authorized to conclude contracts on behalf of the corporation.

The treaty specifically provides that a Canadian corporation shall not be deemed to have a PE in the U.S. because the Canadian corporation carries on business in the U.S. through an independent agent, such as a broker or a general commission agent, provided the agent is acting in the ordinary course of its business.

A Canadian corporation that sells goods in the United States through an agent may avoid having a PE by entering into bona fide buy-sell arrangement.

5.3.2 [e] Miscellaneous Rules

Article V(4) of the Treaty provides an exception from the PE definition for installations or drilling rigs or ships that are used to explore for or exploit natural resources, if “such use” lasts 3 months or less in any 12 – month period. Preparatory activities, which could take place onshore, are included in Article V(4).

It is generally accepted that the existence of a subsidiary company does not, by itself, constitute a PE of its parent company. This reasoning follows from the principle that, for taxation purposes, the subsidiary constitutes an independent legal entity. Even the fact that the trade or business carried on by the subsidiary is managed by the parent company does not make the subsidiary a PE of its parent. There must be an agency contract or evidence that the subsidiary was organized or acted as the agent of the parent corporation in business dealings between the two entities.

5.3.2 [f] E-commerce

The internet website does not constitute a PE because an internet site id composed of software and data, not tangible property, and therefore it should not be considered “a fixed place of business”.

A computer server may create a PE because it is tangible property requiring physical location. The server’s location can be a “fixed place of business”, regardless of whether the server is owned or leased.

If the server is not at the disposal of the taxpayer or if the e-commerce operation carried on through the server is restricted to preparatory or auxiliary activities, the server would not constitute a PE.

A taxpayer is not generally considered to have a PE where its website is hosted by an ISP on ISP’s equipment, because the ISP is typically not authorized to contract on behalf of a business operating through its network. Thus, the ISP should not constitute an independent agent.

References: 

Advisor’s Guide to Canada – U.S. Tax Treaty

By:  Vitaly Timokhov, Raymond Montero, David Kerzner

Published by: Thomson Carswell