2016-0642061C6 IFA 2016 Q.2: AOA & Notional Expenses

Principal Issues: Whether notional expenses determined under the AOA and attributable to a taxpayer’s permanent establishment in Canada can be deducted for Canadian tax purposes?

Position: Notional expenses are generally not deductible, except if there is an agreement entered into between the competent authorities of the parties to the particular tax convention in question and such agreement expressly provides for such deduction.

Reasons: See below.

Author: Roulier, Yannick
Section: 4(1)(b) ITCIA; Art. VII Canada-US Convention; Art. 7 Canada-UK Convention

2016 International Fiscal Association Conference
CRA Roundtable

Question 2 – Authorized OECD Approach to Profit Attribution

The possibility of deducting notional expenses in determining the profits attributable to a permanent establishment (“PE”) of a non-resident under Canada’s tax treaties was seemingly put to bed by the 1998 decision of the Federal Court of Appeal in Cudd Pressure (footnote 1) . However, the Organization for Economic Cooperation and Development’s (“OECD”) 2008 Report on the Attribution of Profits to Permanent Establishments has led to renewed interest in this issue in light of its development of the so-called “authorized OECD approach” (“AOA”). This report was revised in 2010 in order to be read harmoniously with the new wording of Article 7 of the OECD’s Model Tax Convention on Income and Capital (“Model Convention”) and its related commentary.

Canada did not enter any observation or reservation in respect of the AOA in the Model Convention’s commentary. As a result, many have wondered whether Canada’s position on notional expenses may have changed.

Can the CRA give us an update on its position in respect of notional expenses and the AOA?

CRA Response

Notional expenses are related to dealings resulting from interactions between different divisions of a single taxpayer, such as its headquarters and a branch it has in a different jurisdiction. In a nutshell, the AOA is a two-step process which generally applies the OECD Transfer Pricing Guidelines, by analogy, to determine the profits of a PE. The first step is a functional and factual analysis that requires the attribution of functions, risks and assets to the PE to hypothesize the PE as a separate entity. The second step involves the pricing of recognized dealings based on those OECD guidelines. This two-step process might, among other things, result in the recognition of notional dealings and, consequently, notional expenses.

In accordance with Cudd Pressure, the CRA maintains its long-standing view that notional expenses are generally not allowed in determining the profits attributable to PEs. This position is essentially based on our view that paragraph 4(b) of the Income Tax Conventions Interpretation Act (“ITCIA”) prevents such deductions. However, under the terms of that paragraph, this prohibition does not apply where an agreement is entered into between the competent authorities of the parties to the particular tax convention in question and such agreement expressly so provides.

To date, Canada has only one such competent authority agreement in place: the one entered into with the U.S. on June 26, 2012 (an extract of this agreement can be accessed on our website at the following address: http://www.cra-arc.gc.ca/tx/nnrsdnts/ntcs/cndntdstts-cmptntgrmt-2012-eng.html). This agreement generally applies to taxation years that begin on or after January 1, 2012, but taxpayers can elect to have it apply for taxation years beginning after December 31, 2008.

In respect of the Canada – United Kingdom Tax Convention, we would note that the new AOA-based Article 7 language was included in the convention by virtue of the protocol signed on July 21, 2014. However, pursuant to paragraph 4(b) of the ITCIA, it will be necessary to enter into a relevant competent authority agreement in order for notional expenses to be deductible under that convention.

Yannick Roulier
Dave Beaulne
2016-064206
May 26, 2016

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Cudd Pressure Control Inc. v The Queen (98 DTC 6630).

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