Canada's permanent establishment rules threaten U.S. businesses - tax policy

Revenue Canada recently launched an initiative that aims to sweep a broad class of U.S. (and other non-Canadian) taxpayers who do business in Canada into the Canadian tax net. The effects of the policy could be felt even by taxpayers with only a minimal presence in Canada.

Revenue Canada's position is that U.S. (and other non-Canadian) residents are subject to Canadian tax on their Canadian profits if they have "space" (i.e., premises) in Canada at their disposal that is "able to support the conduct" of the business activities. For Revenue Canada's policy to apply, the U.S. resident need not own, lease, or otherwise have a legal right to use the relevant space, nor does the space have to be identified in any way (such as through letterhead, business card address, or telephone listing) with the nonresident. Such space can include space made available to the U.S. resident at a Canadian client's premises in Canada, even though the U.S. resident is not permitted to use the space for any purpose other than performing services for the client. Although Revenue Canada's policy applies to all types of businesses, it is critical that service businesses consider the issues, especially if they frequently render services in Canada at a client's premises.

Revenue Canada's position, which is based largely on its interpretation of the OECD's commentary (the "OECD Commentary") on the OECD Model Tax Convention on Income and on Capital (the "Model Convention"), is arguably inconsistent with current Canadian case law and is being challenged by affected U.S. taxpayers. This article discusses the relevant OECD Commentary, as well as Canadian and non-Canadian jurisprudence applicable to U.S. service businesses with clients in Canada. In addition, the article focuses on William A. Dudney v. The Queen, [1998] TCJ No. 985 (TCC), the first decision of a Canadian court at any level that specifically addresses Revenue Canada's new position. Finally, the article highlights the circumstances in which the issue typically arises for U.S. residents doing business in Canada and identifies practical concerns and decisions then faced by such businesses.

Legal Basis for Taxation of U.S.-Resident Businesses in Canada

Introduction

Generally, a U.S. taxpayer who is not resident in Canada will be subject to tax under Canada's Income Tax Act (the "Act") on profits derived from carrying on business in Canada. Where, however, the U.S. taxpayer qualifies as a resident of the United States for purposes of the Canada-United States Income Tax Convention (the "Treaty"), Canada is permitted to tax such profits only to the extent that they are attributable to a permanent establishment of the U.S. taxpayer in Canada.

For treaty purposes, the term "permanent establishment" means a "fixed place of business through which the business of [the U.S. resident] is wholly or partly carried on." As recently as 1996, Revenue Canada acknowledged in a technical interpretation that it is "essential" that the taxpayer have a "contractual or implied right to the `use of space'" in order for a permanent establishment to arise under that definition.(1) In other statements, however, and while not necessarily disavowing that position, Revenue Canada expressed an expansive view of the circumstances in which a U.S. resident may be considered to have an "implied" right of access to a place of business. Indeed, in a recently released technical interpretation,(2) Revenue Canada considered the situation of a U.S. management consulting company that entered into and performed a series of short-term contracts (say, two months) and longer term contracts (say, eleven months) with the same Canadian clients over several consecutive years. The consulting company had no premises (whether owned, leased, or otherwise controlled) in Canada; rather, its employees worked at its client's premises at various locations in Canada. With respect to the longer term contracts, Revenue Canada concluded that the company would be considered to have a permanent establishment in Canada. Moreover, Revenue Canada concluded that the short-term contracts could, depending on the circumstances, be viewed as part of a large and ongoing engagement, in which case they would be sufficient to constitute a permanent establishment as well.

In reaching its conclusion, Revenue Canada stated that "the activities carried out by [the] employees in Canada represented the essence of the business of [the taxpayer]. The space employed by [the taxpayer] in a client's premises was therefore clearly able to support the conduct of [the taxpayer's] business activities." Hence, in Revenue Canada's view, the availability of space in Canada that is able to support the conduct of the taxpayer's business activities for a sufficient period of time (eleven months or possibly less) may give rise to a permanent establishment, even though the taxpayer does not own, lease, rent, or otherwise control the premises.(3)

OECD Commentary

Revenue Canada's position is based largely on the following excerpt from the OECD Commentary on Article V of the Model Convention:

   The term "place of business" covers any premise, facilities, or
   installations used for carrying on the business of the enterprise whether
   or not they are used exclusively for that purpose. A place of business may
   also exist where no premises are available or required for carrying on the
   business of the enterprise and it simply has a certain amount of space at
   its disposal. It is immaterial whether the premises, facilities, or
   installations are owned or rented by or are otherwise at the disposal of
   the enterprise. A place of business may thus be constituted by a pitch in
   the marketplace, or by a certain permanently used area in a customs depot
   (e.g., for the storage of dutiable goods). Again, the place of business may
   be situated in the business facilities of another enterprise. This may be
   the case for instance where the foreign enterprise has at its constant
   disposal certain premises or a part thereof owned by the other enterprise.

It is unclear whether the OECD Commentary fully supports Revenue Canada's position. Indeed, while the OECD Commentary states that a place of business situated in the business facilities of another enterprise may constitute a permanent establishment regardless of whether the premises are owned or rented by the nonresident, the Commentary states that such premises may be a permanent establishment only if they are "at the disposal" of the nonresident. The phrase "at the disposal" is undefined in the Commentary and is ambiguous. It is unclear, for instance, whether premises should be considered to be at a nonresident's disposal where the nonresident's access to the premises is restricted -- such as where the nonresident obtains access to a client's premises only by invitation and under the supervision of client personnel. Examples in the OECD Commentary provide limited guidance and include a "permanently used area in a customs depot" and premises of another corporation that the nonresident has "at its constant disposal." (Emphasis added.)Although the terms "permanently" and "constant" address primarily the temporal character of the right of access, they also suggest that restricted access to premises is likely insufficient to create a permanent establishment.

European Case Law

Revenue Canada also relies on a number of European court decisions in which performing services at a client's premises was held to give rise to a permanent establishment. For instance, in Creole Production Services Inc. v. Stavanger Municipality (a Norwegian case dated April 14, 1981), Creole Production Services, a U.S. company, provided data analysis services to Phillips Petroleum Company of Norway, which operated a drilling platform off the continental shelf of Norway. Creole employees were permitted to use an office on the drilling platform. In that office, Creole's employees collected certain data and communicated it to Creole's Houston office for analysis. The Norwegian court decided that the collection and analysis of the data were essential business activities of Creole and concluded that the office on the platform constituted a permanent establishment in Norway.

Another important decision from Revenue Canada's perspective is Johanssen and Scannell v. Stavanger Municipality (decided by a lower Norwegian court in 1989 and upheld on appeal in 1991). Here, a Swedish company was hired as a consultant for an estimated period of 15 months in connection with the installation of a drilling platform on the Norwegian continental shelf. The taxpayer's sole employee, Mats Johanssen, was an engineer whose duties consisted of providing supervision and guidance at various stations on the platform. Johanssen had access to a room containing 25 desks that were also used by employees of other contractors. Key to the court's decision were factual determinations that the Swedish company's entire business activity was performed by Johanssen aboard the platform and that the company performed no other activities. The court concluded that the taxpayer had a permanent establishment in Norway.

These cases are very fact specific and, as with the OECD Commentary, arguably do not fully support Revenue Canada's position.(4) In particular, in Johannsen and Scannell, the nonresident company had only one employee and carried on no activities other than the contract with the particular client. As a result, the Norwegian court may have been concerned about preventing the taxpayer from claiming the benefits of the treaty protection accorded to business enterprises where the particular business relationship was more akin to an employment agreement. Consequently, this case is likely not relevant to corporations with many employees and multiple contracts and clients.

Canadian and U.S. Case Law

Until the decision in Dudney, there was no Canadian jurisprudence directly addressing Revenue Canada's new assessing position. Even before Dudney, however, Canadian case law seemingly did not support the proposition that a nonresident's performance of services at a client's premises is sufficient to constitute a permanent establishment. For instance, in Sunbeam Corporation (Canada) Ltd. v. MNR, 62 DTC 1390 (SCC), the taxpayer, an Ontario-based corporation that sold products to wholesalers throughout Canada, employed a sales representative and a number of junior salespeople in the province of Quebec. Although the taxpayer did not maintain an office in Quebec, the sales representative frequently used his personal residence to take orders, to train junior salesmen, and to keep a store of merchandise on hand for demonstration purposes. The company claimed that its operations in Quebec gave rise to a permanent establishment there,(5) which would entitle it to claim a provincial tax credit in respect of taxes paid to the province of Quebec. In deciding whether the sales representative's home office was sufficient to create a permanent establishment for the taxpayer, the Supreme Court of Canada stated that the word "establishment," as used in the Regulations, "contemplates a fixed place of business of the corporation, a local habitation of its own." (Emphasis added.) This implies that a taxpayer must have some right of access to premises (such as through ownership or by way of lease or rental) in order for the premises to qualify as a permanent establishment of the taxpayer.(6) The Supreme Court ultimately concluded that Sunbeam Canada did not have a permanent establishment in Quebec.

Similarly, in Hegeman-Harris Company of Canada Ltd. v. MNR, 79 DTC 886 (TRB), the taxpayer was a Canadian corporation with its head office located in Quebec. Approximately 10 percent of the taxpayer's income derived from real estate construction in Quebec, and the remaining 90 percent derived from providing management consulting services on real estate projects in the United States. The taxpayer had no business premises of its own in the United States and its management consulting employees spent their entire time on U.S. projects working at the clients' sites. In order to claim a larger tax credit in respect of income earned in Quebec, the taxpayer argued that it did not have a permanent establishment in the United States. The Tax Review Board agreed with the taxpayer's assertions.(7)

Finally, in Consolidated Premium Iron Ores Limited v. Commissioner of Internal Revenue,(8) the Court stated "[t]he term `permanent establishment' ... implies the existence of an office, staffed and capable of carrying on the day-to-day business of the corporation and its use for such purpose, or it suggests the existence of a plan or facilities equipped to carry on the ordinary routine of such business activity." (Emphasis added.)Although a U.S. case, Consolidated Premium Iron Ores has been cited with approval (including the quoted excerpt) in several Canadian cases, including Murray Fiebert v. MNR, 86 DTC 1017 (TCC) and No. 536 v. MNR, 58 DTC 417 (TAB).(9)

Dudney v. The Queen

Although Canadian and U.S. court decisions suggest that Revenue Canada's position is questionable, the decisions are not directly on point. The Dudney case, which was decided on October 30, 1998, afforded the Tax Court of Canada its first opportunity to consider Revenue Canada's new position on permanent establishments. William Dudney, a U.S. citizen and resident, was retained by Pan Canadian Petroleum Limited ("PanCan") to develop a new computer system and to train PanCan's personnel in its use. To that end, Mr. Dudney worked at PanCan's offices in Calgary, Alberta, for approximately 300 days in 1994 and for approximately 40 days in 1995. Other relevant facts included the following:

* Dudney had no dedicated space at the PanCan premises;

* The rooms in which he worked were shared with others;

* No other business was conducted out of the PanCan premises;

* Access to the PanCan building was controlled and restricted to business hours only; and

* Dudney had no letterhead, business cards, phone list, business license, or bank account in Canada.

Based on these facts, and after reviewing the Model Convention and the OECD Commentary, the Tax Court concluded that Dudney did not have a fixed base in Canada. Specifically, the Tax Court stated:

   The Appellant had no control over the premises in which he worked, nor was
   he identified with them in any way. This was not seriously challenged by
   the Respondent, whose case was simply that by working at a fixed location
   in Canada, albeit one dictated and totally controlled by PanCan, the
   Appellant became subject to taxation here. The Appellant had no freedom to
   come and go from the building where he worked except during normal business
   hours, and he could not do any work there, except that then under the
   contract for PanCan. Any other company wishing to use his services would
   not be able to find him there, as he was not identified anywhere as working
   at that location. He had no space in the building that was his exclusively,
   and in fact the location at which he did his work changed from time to time
   at the sole discretion of the PanCan personnel. He did not, in my opinion,
   have a fixed base regularly available to him.

Although Dudney was decided on the basis of whether the taxpayer had a "fixed base" -- as opposed to a "permanent establishment" -- in Canada, the Tax Court said "there is little, if any, real difference between the two expressions as used in the [Treaty]." The Tax Court's reasoning and decision should therefore be equally applicable to permanent establishments.

Unsurprisingly, Revenue Canada has appealed the Dudney decision to the Federal Court of Appeal. Nonetheless, the Dudney decision is consistent with the Canadian jurisprudence cited earlier and, if upheld, affords significant protection for nonresident taxpayers. Indeed, if affirmed, the case would severely limit -- if not eviscerate -- Revenue Canada's new policy.

Practical Considerations

As a practical matter, a U.S. resident service business's first encounter with Revenue Canada's new policy typically occurs when it is advised by Canadian customers that, as required under section 105 of the Regulations under the Act ("Regulation 105"), the customer will withhold and remit to Revenue Canada 15 percent of the fees paid in respect of services rendered in Canada. The amount withheld under Regulation 105 is not a final tax and a U.S. resident can apply for a refund by filing a Canadian income tax return for the year in question. To succeed in a refund claim, the taxpayer must establish to Revenue Canada's satisfaction that it either has no permanent establishment in Canada or no profits attributable to such a permanent establishment. Based on its new assessing policy, Revenue Canada is increasingly denying applications for refunds.

A U.S. resident may also apply for a waiver of Regulation 105 withholding. Under draft Guidelines for Treaty-Based Waivers of Regulation 105 Withholding (the "Guidelines") released on August 7, 1998, Revenue Canada sets forth the conditions under which it will likely grant or deny waivers of Regulation 105 withholding.(10) Subject to certain exceptions, the draft Guidelines contemplate that a waiver will be issued:

   (i) to nonresidents performing services in Canada for less than 120 days in
   the relevant "period,"(11) if their presence in Canada is not "recurring"
   and


   (ii) to nonresidents whose presence in Canada is recurring, provided the
   presence is less than 180 days during the relevant period and less than 90
   days during the current contract or engagement.

The Guidelines expressly state that a waiver will be denied in certain circumstances, including:

* multi-year engagements under a single contract that will occur at one or more sites over a number of years, and

* in respect of non-contractual or contractual services of a repetitive nature where services performed by the nonresident are relatively constant, and there is a history of presence in Canada to carry on those services in three or more previous years.

The grant of a waiver of withholding under the Guidelines does not mean that Revenue Canada concedes the lack of a permanent establishment; correspondingly, the denial of a waiver does not constitute a determination that a permanent establishment exists.(12)

Confronted with Revenue Canada's new policy on permanent establishments, some nonresidents have been tempted to forgo filing refund claims for amounts withheld under Regulation 105 in the belief that they can thereby avoid a protracted battle with Revenue Canada (and the possibility of an even greater tax liability) over the issue of whether the taxpayer has a permanent establishment in Canada. The Department of Finance, however, recently released amendments to the Act that will require nonresident corporations to file a Canadian income tax return regardless of whether a waiver is granted, where, for example, the corporation carries on business in Canada or Canadian tax would be payable by the corporation but for a tax treaty.(13)

Other nonresidents have been tempted to concede the existence of a permanent establishment and then seek to minimize Canadian tax exposure by allocating a portion of their overhead and the remuneration for employees who worked in Canada to reduce the profits of the Canadian operation. This approach, however, can produce unanticipated, adverse consequences. Indeed, while Revenue Canada may permit the expense allocation, it will then frequently assess the nonresident employees in respect of the portion of their remuneration earned in Canaday.(14) To spare their employees the likely increased tax burden and inconvenience of a Canadian income tax assessment, U.S. businesses should not be over-eager to concede the existence of a permanent establishment. Moreover, the Internal Revenue Service may disallow a claim for the corporation's foreign tax credits should it disagree that a permanent establishment exists in Canada.

Conclusion

Revenue Canada's position in respect of permanent establishments and the "use of space" is likely to take many U.S. businesses by surprise. The determination of whether a permanent establishment exists involves many complex factual and legal issues with important tax implications for both the nonresident business entity and its nonresident employees. Regrettably, many U.S. service businesses will face the issue for the first time only upon being informed by their Canadian customers that 15 percent of the invoiced fee is about to be withheld under Regulation 105. Without proper planning, there will likely be inadequate time for the U.S. business to address these issues in an informed and comprehensive fashion.(15) Finally, while many U.S. and other non-Canadian businesses are challenging Revenue Canada's assessing policy -- and the first round of the battle in the Dudney case decidedly favors taxpayers -- Revenue Canada continues to aggressively pursue its policy. U.S. companies doing business in Canada should watch for further developments in this area, especially a resolution of the issue by higher courts.

Notes

(1) Technical Interpretation No. 9638900, released November 22, 1996. Although the interpretation addressed the definition of "permanent establishment" in the Regulations (which is relevant to the allocation of a taxpayer's income between different provinces of Canada), the principles are similar to those that apply in the context of treaty interpretation.

(2) No. 9712976, released February 18, 1998.

(3) Revenue Canada expressed a similar position in a panel discussion of permanent establishment issues at the 1994 Annual Conference of the Canadian Tax Foundation and in Technical Interpretation No. 9638900, supra, note 1.

(4) The cases have some relevance for Canadian tax purposes because Canadian courts have held that foreign jurisprudence is persuasive, if not binding, in applying the provisions of international treaties under Canadian law. See No. 630 v. MNR, 59 DTC 300 (TAB), and Canadian Pacific Ltd. v. The Queen, 76 DTC 6120 (FCTD). Reliance on foreign cases in treaty interpretation has also gained some acceptance internationally. See, e.g., Klaus Vogel, Klaus Vogel on Double Taxation Conventions (Deventer, the Netherlands: Kluwer, 1991).

(5) Within the meaning of "permanent establishment" as defined in the Regulations under the Act.

(6) See also Shahmoon v. MNR, 75 DTC 275 (TRB).

(7) Although the Hegeman-Harris case addressed the meaning of "permanent establishment" under the Regulations, the relevant principles are similar to those under the Treaty.

(8) 28 T.C. 127 (1957), affirmed, 265 F.2d 320 (6th Cir. 1959).

(9) The Consolidated Premium Iron Ores case is relevant here only insofar as it has been cited several times in the Canadian case law and not because it is the only, or even the most relevant, case for U.S. tax purposes.

(10) The current Guidelines are being revised. Although the revised version of the Guidelines has not been released as of the date of the article, Revenue Canada officials were expected to decide in late April or early May 1999 whether to release the revised Guidelines for further public comment or to implement them.

(11) For these purposes, the relevant period includes the calendar year in which the transactions are proposed to occur, plus the three calendar years immediately before and immediately after that year.

(12) Revenue Canada's current practice, set forth in Information Circular IC75-6R, Required Withholding from Amounts Paid to Non-Resident Persons Performing Services in Canada, is to grant a waiver where the nonresident can adequately demonstrate, based on treaty protection or estimated income and expenses, that the withholding that would normally be required will exceed the nonresident's ultimate Canadian tax liability. Accordingly, Revenue Canada's current practice requires at least a preliminary determination that a permanent establishment does or does not exist. Information Circular IC75-6R remains relevant pending the final release of the new Guidelines.

(13) See Notice of Ways and Means Motion released by Canada's Department of Finance on December 10, 1998. The amendment applies to taxation years that begin after 1998.

(14) In fact, under subparagraph XV(2)(b) of the Treaty, Revenue Canada could assess an employee in respect of services rendered in Canada if the remuneration is borne by a permanent establishment of the employer in Canada, or the employee is present in Canada for a total of more than 183 days in the year, unless the remuneration does not exceed $10,000 in Canadian currency.

(15) The customer is required to remit the amount withheld under Regulation 105 by the 15th day of the month following the month in which the nonresident is paid.

PETER LEE practices tax law in the Toronto offices of Blake, Cassels & Graydon, primarily in the areas of corporate and partnership income taxation. He is involved in the planning of domestic and international acquisitions and reorganizations and the structuring of business ventures. Mr. Lee also provides tax planning advice to mutual fund trusts and other pooled fund entities, and his practice further includes advising clients in appeals under Canadian federal and provincial taxing legislation.

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