Canada's permanent establishment rules threaten U.S. businesses

Tax Executive, The, March, 1999 by Peter Lee

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: