2020-0872281I7 S.219 and Article X(6) of the Canada-US Treaty

Principal Issues: (1) Whether the position in 9408985 is still valid; (2) Whether the fact that a corporation applied a loss carry back under the Act to compute the amount of tax under Part XIV in any year affect its "earnings" under Article X(6) of the Treaty; (3) whether the Allowance for Investment Property in Canada claimed in the prior tax year constitutes "earnings" for the current year under Article X(6) of the Treaty.

Position: (1) Yes; (2) No; (3) No.

Reasons: (1) In accordance with the general principles of double tax conventions; (2) See response below (3) "Earnings" are computed on a cumulative basis and therefor Allowance for Investment Property in Canada claimed in the prior year would not be added back in the current year "earnings" computation.

Author: Tu, Grace
Section: s.219(1), Reg. 808, Article X(6) and Article XXIX(1) of the Canada-US Treaty

Derek Gledhill                                            HEADQUARTER 
T2 Legislation Team,                                 Income Tax Rulings Directorate
T2 Development Section
Corporation and Specialty Returns Division
Assessment, Benefit, and Service Branch              Grace Tu

                                                                                2020-087228

Section 219 of the Act and paragraph 6, Article X of the Canada-US Treaty

Dear Mr. Gledhill,

This memo is in reply to your request for a technical interpretation dated November 26, 2020 regarding certain interactions between the operations of subsection 219(1) of the Income Tax Act (the “Act”) and paragraph 6 of Article X (“Article X(6)”) of the Canada – US Income Tax Convention (the “Treaty”).

Unless otherwise noted, all statutory references herein are references to the Act.

Your specific questions are as follows:

1. Were there any changes made to Part XIV of the Act or the Treaty that would change the view expressed in technical interpretation 9408985 to compare two calculations, one under the Act and another under the Treaty, in the determination of the branch tax liability of a non-resident corporation?

2. Does the fact that a non-resident corporation applied a loss carry back under the Act to compute the amount of tax under Part XIV in any year affect its “earnings” under Article X(6) of the Treaty?

3. Does the Allowance for Investment in Property in Canada, claimed in the prior year under subsection 219(1), constitute “earnings” for the current year under Article X(6) of Treaty?

Our Comments

Under Part XIV of the Act, a tax (the “Part XIV branch tax”) of 25 percent is imposed on the taxable amount (the “branch tax base”) of any non-resident corporation, calculated based on the formula provided under subsection 219(1). In the case of an U.S. resident corporation carrying on business in Canada, Article X(6) of the Treaty sets the ceiling of this branch tax to be 5 percent of amount of “earnings”, defined and computed under that treaty provision, “which have not been subjected to such additional tax (i.e., the Part XIV branch tax) in previous taxation years”.

In providing guidance on the interaction between subsection 219(1) of the Act and Article X(6) of the Treaty, we stated in technical interpretation 9408985 that the Part XIV branch tax calculation for each year will involve a comparison of tax computed under subsection 219(1) and the limitation under Article X(6). The amount of tax computed under the Treaty serves as a ceiling of the Part XIV branch tax that Canada can impose in the particular year.

Question 1: Whether there were any changes made to Part XIV of the Act or to the Treaty that would change the view expressed in technical interpretation 9408985

Since the issuance of technical interpretation 9408985, some provisions under the Treaty were amended by the 1995 Protocol and the 2007 Protocol. Although certain amendments made by the 2007 Protocol have affected the application of Article X(6) with respect certain entities, there were no direct changes made to Article X(6) that would affect the computation of the ceiling to Part XIV branch tax under that paragraph, nor was there any other changes to the Treaty that, in our view, would change our general statements made in technical interpretation 9408985. Similarly, none of the amendments made to subsection 219(1) should affect our position as stated in technical interpretation 9408985.

In addition to a review of the amendments made to the specific provisions, it should be noted that our statement in technical interpretation 9408985 was based on two general principles of Canada’s income tax conventions, the first of which is that the treaties prevail over the provisions of the Act to the extent of any inconsistency and the second of which is that the treaties are exclusively relieving in nature and that they can do no more than restrict existing tax liabilities. These principles have not changed.

Question 2: Do losses carried back under the Act affect the computation of “earnings” under Article X(6)

In question 2, you asked us how the fact that a non-resident corporation applied a loss carry back to determine its taxable income earned in Canada under the Act in any given year affects its “earnings” under Article X(6).

Conceptually, and from a Canadian point of view, the computation of earnings starts with net profits (profits minus business losses) that are attributable to the Canadian permanent establishment (the pre-amble of Article X(6) and subparagraph (a)), and further reduces that amount by taxes payable (subparagraph (b)), by amounts re-invested in Canada (subparagraph (c)), and by $500,000 (subparagraph (d), the “tax-free amount”).

If one compares this computation of the “earnings” and the computation of branch tax base under subsection 219(1) of the Act, one sees that they are very similar. Specifically, the branch tax base formula starts in paragraph 219(1)(a) with the taxable income earned in Canada in the year. The computation of taxable income earned in Canada for a non-resident is found in subsection 115(1), which starts with the amount that would be the income for the year under section 3 computed as indicated in the paragraphs of that provision. By virtue of paragraph 115(1)(d), such taxable income earned in Canada takes into account the losses carried forward and back from other years by the corporation. Then, comparable to the computation of “earnings” under Article X(6), taxes are being deducted under paragraph 219(1)(h), and there is a computation of the amount re-invested or dis-invested in Canada in the current year by way of an interaction between paragraphs 219(1)(g) and 219(1)(j).

Although both the computation of “earnings” and the branch tax base under subsection 219(1) can generally be described as being based on profits minus losses, they differ from two perspectives.

On the one hand, taxable income earned in Canada only includes the profit of the taxation year whereas the “earnings” is a cumulative figure formed by the profits of the year and all previous years.

On the other hand, the way losses are treated under these formulas is different and such difference could cause timing differences. Specifically, under paragraph 219(1)(a) (and by extension subsection 115(1) and paragraph 115(1)(d)), the current year losses, prior years losses carried-forward, and future losses carried-back, could be taken into account. However, subparagraph (a) of the earnings definition only allows in the computation of “earnings” any “losses incurred in such year and previous years”. There is therefore a difference between the concepts with respect to the application of losses when the losses are carried back under the Act. More specifically, losses carried back to a prior year in the computation of taxable income earned in Canada under the Act would not alter the amount of “earnings” in that year for purposes of determining the maximum amount of Part XIV tax that Canada can impose on that year.

There exists another issue that may arise because of the different treatment of losses under subsection 219(1) and Article X(6), and this issue cause not timing, but real cash differences. Specifically, according to subparagraph (b) of the “earnings” definition under Article X(6), in computing the earnings, one needs to subtract “all taxes, other than the additional tax referred to in this paragraph, imposed on such profits”. Very generally, the taxes referred to in subparagraph (b), from the Canadian perspective, are Part I tax and Provincial taxes. Where losses are carried back under the Act in a previous year, the amount of those taxes would decrease, potentially resulting an increase in “earnings” computed, and thereby indirectly increase the amount of Part XIV tax that can be imposed by Canada in the year of the carryback, partly offsetting the amount of the Part I refund otherwise available. In this regard, it should be noted that it is our view that while a refund is not a “tax”, it should go into subparagraph (b) of the “earnings” definition and thereby reverse the amount of taxes previously subtracted.

It is not perfectly clear whether the impact of the loss year tax savings should be recorded in earnings in the year of the loss or the year to which the loss is carried back. The first approach should be taken for several reasons First, it accords with the apparent finality of the definition of “earnings”. If subsequent year losses do not affect prior years’ earnings directly, neither should they have an indirect impact. The concept of earnings closely parallels the accounting concept of retained earnings – relevant in the case of a corporation to the concept of distributable reserves – and for that concept, the income tax impact of losses is matched to the year which gave rise to the tax recovery. Second, it avoids a potentially perverse situation in which Part XIV tax payable could actually increase as a consequence of a loss carryback, which could occur if the impact on taxable income reduced the subsection 219(1) calculation to something near the former Article X(6) limit but the impact of the loss carryback on Part I and provincial taxes increased the treaty limit. Finally, there is the matter of practicality. If the tax recovery is recorded in the same year as the related taxable loss, there is only one year’s timing difference to be identified and tracked.

There is then the question of the potential difference in the timing of the refund under Part I and Part XIV as a result of a loss carryback. Under Part I of the Act, the carryback of a loss by a non-resident that carries on business in Canada through a permanent establishment reduces its taxable income earned in Canada for purposes of determining the amount of tax owing under Part I. Absent Article X(6) (which would be the case for most treaties applicable to the residents of countries other than the United States), the result would be the same under Part XIV to the Act and the taxpayer would receive the refund for both Part I and Part XIV taxes.

The difference for US residents where Article X(6) is applicable is that where the loss is carried back, the amount of tax owing under Part I will be reduced. However, the Part XIV tax would only be reduced by the carryback if the tax computed at a rate of 25% on the branch tax base (i.e., the adjusted amount giving effect to the impact of the loss carryback via its impact on the taxable income earned in Canada) is lower than the ceiling computed under Article X(6).

Interaction between the two branch tax calculations and the Interpretation of “amount of such earnings which have not been subject to such additional tax in previous taxation years” in Article X(6)

According to Article X(6), the ceiling of branch tax is “5 per cent of the amount of such earnings which have not been subject to such additional tax in previous taxation years.” This means that the increase in the cap is driven by the current year increase in earnings. In other words, earnings accumulated in prior years, effectively, have already been “subject to” the branch tax. As such, they are excluded from the computation of ceiling in Article X(6).

The phrase “such earnings which have not been subject to such additional tax in previous years” is to be interpreted bearing in mind that, first, the concept of branch tax base, based on which Part XIV tax under subsection 219(1) is computed, differs from the concept of earnings used to cap the amount of tax that Canada can collect under Part XIV, due to most importantly the treatment of losses. Second, sometimes the amount determined under subsection 219(1) could be less than the Article X(6) limit.

The difference in the treatment of losses carried back results from:

1) the definition of earnings taking into account all prior losses whereas the Act makes the deduction of losses carried forward elective (i.e. some past losses might not yet be claimed in a given year under the Act but would reduce the earnings under X(6));

2) loss carrybacks reducing taxable income earned in Canada in the year to which they are carried back but only reducing earnings in the year they are incurred and subsequent years.

Losses of a year will reduce the cumulative earnings of future year(s) and to that extent, will reduce the cap calculated under Article X(6) on the amount of Part XIV tax that Canada may collect in the future year(s) in which income is earned. Losses carried forward to a future year for purposes of Part I will reduce the amount of Part XIV tax computed under subsection 219(1) in the future year to which the loss is applied.

Losses carried back will never reduce the cap under Article X(6) for the carryback year, as the cumulative earnings in a given year that precedes the year in which the loss is incurred would be unaffected. However, such losses carried back will reduce the amount of Part XIV tax computed under subsection 219(1). In other words, for a year that precedes the year of the loss, there could be Part XIV tax room allowed under the Treaty but no tax payable using the computation under subsection 219(1).

The actual impact of a loss carryfoward or carryback on the amount of Part XIV tax owing in a given year will depend on its incidence on the amount of Part XIV tax computed under subsection 219(1) along with its incidence of the cap computed under Article X(6), which will depend upon the details of the particular year’s calculations. There is no simple heuristic to indicate what will happen.

Those elements suggest that the reference in Article X(6) to “earnings which have not been subject to such additional tax in previous taxation years” are not adjusted by reassessments as a result of loss carrybacks under the Act but rather refers to the amount of earnings that have not previously been used in determining the treaty cap for a prior taxation year. Those words are required in Article X(6) for the simple reason that “earnings” are computed on a cumulative basis, and therefore there is a need to avoid the double counting of historical profits or losses in a given year.

This interpretation of the words “subject to such additional tax in previous taxation years” can be illustrated through the following example.

For simplicity, the example ignores the tax-free $500,000 under subparagraph (d) of the “earnings” computation, and focuses only on the profits and losses of the years.

In the example, the non-resident taxpayer computes the following profits or losses in Years 1 to 6: a profit of $100 in Year 1, a profit of $200 in Year 2, a loss of $200 in Year 3, a profit of $400 in Year 4, a loss of $100 in Year 5, and a profit of $600 in Year 6.

The taxpayer would pay $5 and $10 of Part XIV tax respectively in Years 1 and 2 because the amount of tax would be capped by Article X(6). The taxpayer decides after the end of Year 3 to amend the tax returns for Year 1 and Year 2 since the impact on Part I tax is large.

For Year 1, the branch tax determined under Part XIV goes from $5 to nil (25% of zero) which is less than the unchanged $5 cap set by Article X(6) (5% times $100), and the taxpayer receives a refund due to the carryback.

For Year 2, the taxpayer would be liable for the lesser of $25 computed under Part XIV (25% on $100 since only $100 out of $200 has been offset) and the cap under Article X(6). The cumulative earnings in Year 2 are $300 ($100 + $200), from which $100 are carved out since $100 in respect of Year 1 has been subject to branch tax in previous taxation years. The cap of Article X(6) remains at $10 (5% of $200), so no refund is issued.

In Year 4, the amount of earnings as determined under the second segment of Article X(6) (accumulated “earnings”) would be equal to $500 ($100+$200-$200+400). The first segment of Article X(6) then indicates that, to determine the maximum amount of Part XIV payable, the 5% rate is to be applied to “earnings which have not been subject to such additional tax in previous taxation years”

In determining the amount of earnings which have already been subject to the branch tax, the amount of earnings (including both profits and losses) that has already been used in determining the maximum amount of tax that Canada can claim under Part XIV for a prior taxation year should be taken into account. It means that $100 ($100+200-200) has been “subject to” Part XIV tax in the previous taxation year. Therefore, the amount on which the 5% should be applied in the determination of the branch tax ceiling would be $400 ($500 - $100) and such ceiling would be $20.

In Year 6, the amount of earnings as determined under the second segment of Article X(6) (accumulated “earnings”) would be equal to $1,000 ($100+$200-$200+$400-$100+$600). Applying the same method described above, $400 has been “subject to” Part XIV tax in a prior taxation year. The amount on which the 5% should be applied in the determination of branch tax ceiling would be $600 ($1,000 - $400) and the ceiling would be $30.

This interpretation of “subject to tax” is consistent with the general interpretation of the words “subject to tax” in other contexts. According to the Glossary of Tax Terms of the Organisation for Economic Co-operation and Development (OECD), “income subject to tax” means “all sources of income liable to tax without taking account of tax allowances”...

That reading is consistent with one of the key differences between the computation of the branch tax under Part XIV and the computation of the amount of the cap introduced by Article X(6): the carryback of losses affects the former but not the latter. Finally, it is also consistent with Article X(6) providing for a separate computation of the taxation room available to Canada.

Question 3: Whether the Allowance for Investment in Property in Canada, claimed in the prior year, constitute “earnings” for the current year under Article X(6)

Under subsection 219(1), branch tax base is calculated on a year-by-year basis and that is why, the Allowance for Investment Property that was deducted in prior year was added back in the current year under paragraph 219(1)(g). The difference between the addition under paragraph 219(g) and the deduction under paragraph 219(1)(j) represents theoretically the amount that is invested (or dis-invested) in the current year.

On the other hand, under Article X(6), the calculation of “earnings” is cumulative, and therefore in our view, the “profit reinvested” in Canada as described in subparagraph (c) of that article should also be on a cumulative basis. At the same time, since subparagraph (c) under Article X(6) states explicitly that in the case of Canada, such allowance is to be determined by the existing domestic provisions at the time when the treaty provision was put in place, it would appear that such amount is to be calculated in accordance with the rules under Regulations 808 as long as the general principles of Regulation 808 remains consistent as it was in 1984, when Article X(6) was put in place.

Therefore, the amount of Allowance for Investment Property in Canada claimed in the prior year and that is being added back to the branch tax base under paragraph 219(1)(g) should not be added back in the same manner in computing “earnings” under Article X(6). Instead, the amount of Allowance for Investment Property in Canada for the current year, calculated under Regulation 808, would be deducted in the “earnings” calculation in accordance with subparagraph (c) of Article X(6).

For your information 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, following a 90-day waiting period (unless advised otherwise), 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 version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.

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

Yours truly,

Charles Taylor
Acting Manager
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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