2013-0496401I7 XXIX-A(3) - Active Trade or Business Exception

Principal Issues: 1) In applying par. XXIX-A(3) of the Canada-US Tax Convention to an interest payment, whether the requirement that the income be derived “from the other Contracting State (Canada) in connection with (…) that (US) trade or business” might be met based on a “funding approach”? 2) In making the determination mentioned in 1), whether the requirement can only be met in respect of Canadian-sourced income?

Position: 1) Possibly, depending on the facts. 2) Yes.

Reasons: Interpretation of the Canada-US Tax Convention.

Author: Roulier, Yannick
Section: Par. XXIX-A(3) of the Canada-US Tax Convention

                                                                              November 5, 2015

XXXXXXXXXX, International Tax Auditor             HEADQUARTERS
XXXXXXXXXX Tax Services Office                      Income Tax Rulings
XXXXXXXXXX                                                      Directorate
                                                                              Yannick Roulier

                                                                              2013-049640

Canada - U.S. Tax Convention – Limitation On Benefits, Active Trade or Business Exception

This letter is in reply to correspondence dated XXXXXXXXXX from your office wherein our assistance was requested in respect of the application of the “active trade or business exception” set out in paragraph 3 of Article XXIX-A of the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital (“Convention”) in the context of a given set of facts. We apologize for the delay in responding.

Facts

Our understanding of the pertinent facts is as follows:

1.    Canco, a Canadian corporation XXXXXXXXXX, is resident in Canada for the purposes of the Income Tax Act (“Act”) and the Convention.

2.    XXXXXXXXXX

3.    In XXXXXXXXXX (“US-Opco2”), a non-resident corporation that is resident in the US for the purposes of the Convention.

4.    XXXXXXXXXX (“Parent”) is a non-resident XXXXXXXXXX that directly and indirectly owns all of the shares of the capital stock of a non-resident corporation XXXXXXXXXX (“US-Holdco1”).

5.    US-Holdco1 is a corporation incorporated under the law of the State of XXXXXXXXXX that is resident in the US for the purposes of the Convention. It is not a “qualifying person” for the purposes of paragraph XXIX-A(1) of the Convention. 

6.    XXXXXXXXXX

7.    XXXXXXXXXX
XXXXXXXX Canco owns all of the issued and outstanding shares of XXXXXXXXXX (“US-Holdco3”), a non-resident corporation resident in the US.

8.    In XXXXXXXXXX, Canco set out to indirectly acquire all of the issued and outstanding shares of XXXXXXXXXX (“NR-Target”), a XXXXXXXXXX non-resident corporation resident in XXXXXXXXXX, for US$ XXXXXXXXXX. NR-Target has operations in XXXXXXXXXX.

9.    In XXXXXXXXXX, Canco and US-Holdco3 formed XXXXXXXXXX (“NR-Holdco3”), a non-resident corporation that is resident in XXXXXXXXXX. In turn, NR-Holdco3 formed XXXXXXXXXX (“NR-Holdco4”), another non-resident corporation resident in XXXXXXXXXX.

10.   XXXXXXXXXX

11.   In XXXXXXXXXX, US-Holdco1 used US$ XXXXXXXXXX to make the following investments:

a.    Subscribe for US$ XXXXXXXXXX of Canco’s XXXXXXXXXX shares; and

b.    Loan US$ XXXXXXXXXX to Canco (“Loan2”).

12.   In XXXXXXXXXX, Canco used US$ XXXXXXXXXX, funded by XXXXXXXXXX and the liquidity obtained through the above share subscription and loan, to make the following investments:

a.    Capital contribution of US$ XXXXXXXXXX to NR-Holdco3; and

b.    Non-interest bearing loan of US$ XXXXXXXXXX to NR-Holdco4.

13.   XXXXXXXXXX, in turn, NR-Holdco3 made a capital contribution of US$ XXXXXXXXXX to NR-Holdco4.

14.   XXXXXXXXXX, NR-Holdco4 acquired all of the issued and outstanding shares of NR-Target for US$ XXXXXXXXXX.

15.   XXXXXXXXXX

16.   XXXXXXXXXX

17.   XXXXXXXXXX

18.   XXXXXXXXXX

19.   XXXXXXXXXX

20.   XXXXXXXXXX

21.   US-Opco2 primarily markets and distributes XXXXXXXXXX products in the US XXXXXXXXXX.

22.   XXXXXXXXXX.

23.   In XXXXXXXXXX and XXXXXXXXXX, Canco made interest payments on Loan2 to US-Holdco1 (“Interest Payments”). Those payments were made out of cash generated from sales to US-Opco2 of XXXXXXXXXX products manufactured in Canada.

XXXXXXXXXX

Questions

We have been asked to comment on the application of the “active trade or business exception” set out in paragraph XXIX-A(3) of the Convention to the Interest Payments. More specifically, the main issues are as follows:

1)    In applying paragraph XXIX-A(3) of the Convention to the Interest Payments, whether the requirement that the income be derived “from the other Contracting State (Canada) in connection with (…) that (US) trade or business” might be met based on a “funding approach”?

2)    In making the determination mentioned in 1), whether the requirement can only be met in respect of Canadian-sourced income?

Comments

The situation submitted involves essentially interest payments made by a Canadian payer to a US resident in respect of borrowed funds used to acquire shares of a corporation resident in a third country, where the interest payments were funded out of cash generated from sales of products it manufactured in Canada.

In general terms, Article XXIX-A of the Convention states that a person that is a resident of a Contracting State and that is not a “qualifying person” may nonetheless be entitled to the benefits of the Convention if one of three exceptions applies. Paragraph XXIX-A(3) of the Convention provides for one of these exceptions. It is generally applicable in respect of an item of income derived by a person resident in a Contracting State (in this instance, the US) from the other Contracting State (Canada) if the following conditions are met:

*     That person (US person), or a person related to that person, is engaged in the active conduct of a trade or business in the residence state (US), other than certain businesses of making or managing investments (“Active Conduct Test”);

*     The item of income is derived from the source state (Canada) in connection with or incidental to that (US) trade or business (including any such income derived directly or indirectly by that resident person (US person) through one or more other persons that are residents of the source state (Canada)) (“Connected Test”); and

*     The trade or business in the residence state (US) is substantial in relation to the activity carried on in the source state (Canada) giving rise to the income in respect of which treaty benefits are sought (“Substantiality Test”).

We are assuming here that the first and third conditions are met and our focus is on the second. In respect of the Connected Test, the question of whether income is “derived in connection with or incidental to a trade or business” is a question of fact that can only be ascertained after a review of all the facts of a particular situation. As per the Technical Explanation of the 2007 Fifth Protocol, the “incidental standard” is generally restricted to income derived from short-term investments of working capital. Concerning the “connection standard”, Canadian case law, albeit not specifically dealing with the interpretation of paragraph XXIX-A(3), suggests that the expression “in connection with” has a broad connotation, although not as wide as the expression “in respect of”.

We are of the view that in order for an item of income to meet the “connection standard”, there should be a strong connection between it and the US active trade or business. In this respect, we are of the general view that interest paid or credited by a Canadian resident to a US person might be considered “derived in connection with” a US active business in the following circumstances:

1.    the interest is paid or credited in respect of an account payable issued by the US person in the course of carrying on its US active business,

2.    the interest payments are in respect of borrowed money used for the purpose of earning income from a business carried on in Canada that is upstream, downstream or parallel to the US active business (“Canadian-Connected Business”), or

3.    the interest payments are funded out of the cash flow from such a Canadian-Connected Business.

The last two assertions rely on an interpretation of the “connection standard” that allows it to be met based on either a “use test” or a “funding approach”. However, in the case where reliance on a “funding approach” is sought, we are of the view that it would only be met to the extent it can be demonstrated that the Canadian-Connected Business generated sufficient net cash flows to fund the payments of interest for which treaty benefits are sought.

Based on the facts submitted, it is clear that the taxpayer cannot rely on the “use test” as the borrowed money was used to acquire shares of non-resident corporations. As for the “funding approach”, it is not clear to what extent that requirement is met as we do not know whether the Canadian-Connected Business generated sufficient net cash flow in the relevant periods. To the extent of any shortfall in net cash flow of the Canadian-Connected Business, where, for example, the Interest Payments might be partially funded from foreign affiliate dividends, we are of the view that no relief would be available under paragraph XXIX-A(3) of the Convention.

However, a person resident in a Contracting State (US) that is not otherwise entitled to the benefits of the Convention may obtain relief by applying to the competent authority of the other Contracting State (Canada) under paragraph XXIX-A(6) of the Convention. Thus, you may want to suggest to the taxpayer to initiate a request for the grant of treaty benefits under this provision if the “active trade or business exception” set out in paragraph XXIX-A(3) of the Convention cannot be relied on by the taxpayer to obtain full relief in respect of the Interest Payments. We refer you to the following webpage for guidelines in this respect: http://www.cra-arc.gc.ca/tx/nnrsdnts/rtcl29-eng.html.

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust that these comments will be of assistance, and thank you for your enquiry.

Yours truly,

Dave Beaulne, CPA, CA
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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