Date: 19981019
Docket: A-369-95
CORAM: STRAYER J.A.
ROBERTSON J.A.
McDONALD J.A.
BETWEEN:
CUDD PRESSURE CONTROL INC.,
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
Heard at Toronto, Ontario, on Tuesday, June 2, 1998
Judgment delivered at Ottawa, Ontario, on Monday, October 19, 1998
REASONS FOR JUDGMENT BY: ROBERTSON J.A.
CONCURRED IN BY: STRAYER J.A.
CONCURRING REASONS BY: McDONALD J.A.
Date: 19981019
Docket: A-369-95
CORAM: STRAYER J.A.
ROBERTSON J.A.
McDONALD J.A.
BETWEEN:
CUDD PRESSURE CONTROL INC.,
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
ROBERTSON J.A.
[1] The primary issue on appeal is whether Judge Sarchuk of the Tax Court of Canada erred in concluding that $2,516,690.00 of notional "rent" could not be deducted by Cudd Pressure Control Inc. in computing the net industrial and commercial profit attributable to its permanent establishment in Canada, as required by the Canada-United States Reciprocal Tax Convention ["the 1942 Convention"], for the taxation year ending June 30, 1985.
[2] After carefully summarizing the facts, the experts' testimony, and the parties' submissions, Judge Sarchuk concluded that Cudd could only have claimed a capital cost allowance for the use of the snubbing units against the income from its permanent establishment, based on paragraph 4(b) of the Income Tax Conventions Interpretation Act, because such an expense is allowed under Canada's internal law, namely the Income Tax Act. He added that paragraph 4(b) was intended to ensure that permanent establishments taxed on profits under the 1942 Convention could not deduct amounts which were unavailable to Canadian taxpayers in calculating their business income. Since, in his respectful opinion, Cudd had failed to meet the meaning of "expense" and "incurred" for the purposes of Canadian tax law, its notional "rent" was not deductible in computing its profit for the purposes of Article III of the 1942 Convention. In spite of his general finding that deductions of notional amounts are unsupported by the 1942 Convention, Judge Sarchuk noted that Article III of that Convention specifically requires that there be attributed to the permanent establishment the net industrial and commercial profit which it might be expected to derive if it were an independent enterprise "engaged in the same or similar activities under the same or similar conditions". Judge Sarchuk rejected the appellant's assertion that its permanent establishment, treated as an independent enterprise, would have rented the snubbing units from the head office. He found that Cudd was primarily a service company, whose "unmanned standby" charges were not equivalent to rental payments, and that it would not have acquired the Mobil contract if it had not been the sole owner of a snubbing unit with a pulling capacity of 600,000 pounds.
[3] My colleague Justice McDonald agrees with Judge Sarchuk that, in the circumstances of this case, Cudd could not deduct notional "rent" from the net profits derived from its permanent establishment in Canada, pursuant to the 1942 Convention. However, unlike Judge Sarchuk, Justice McDonald does not foreclose the possibility that notional "rent" could be deducted in an appropriate case. With respect, I do not find it necessary to deal with the issue of whether notional expenses are deductible as a matter of law in light of the factual findings made by Judge Sarchuk.
[4] The Tax Court Judge fully considered the factual and legal background surrounding Cudd's provision of the snubbing units to Mobil. It is trite law that an appellate court cannot substitute its own conclusions pertaining to factual matters for that of the trier of fact, unless a clear error appears on the record. Assuming, without deciding, that notional amounts may be deducted in computing the profits attributable to a permanent establishment for the purposes of Canadian taxation, pursuant to the 1942 Convention, I am of the opinion that Justice Sarchuk did not commit a reviewable error in refusing to allow Cudd to deduct an amount for notional rent in the circumstances of this case. In particular, I can find no basis for interfering with his finding of fact that the appellant's permanent establishment, treated as an independent enterprise, would have rented the snubbing units from the head office.
[5] I would dismiss the appeal with costs.
"J.T. Robertson"
J.A.
"I agree
B.L. Strayer J.A."
Date: 19981019
Docket: A-369-95
CORAM: STRAYER J.A.
ROBERTSON J.A.
McDONALD J.A.
BETWEEN:
CUDD PRESSURE CONTROL INC.
Appellant
-and-
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
McDONALD J.A.
[1] The issue to be decided in this case is whether a corporation incorporated outside of Canada but doing business in Canada can deduct an amount for notional rent pursuant to the Canada-U.S. Reciprocal Tax Convention (1942) (the "1942 Convention") when a corresponding deduction is disallowed under the Income Tax Act (the "Act") for a Canadian company doing the same or similar business in Canada.
Facts
[2] The appellant is incorporated in the United States and was at all material times a resident there for the purposes of the 1942 Convention. The appellant was never a resident in Canada for the purposes of the Income Tax Act. The appellant is a wholly owned subsidiary of R.P.C. Energy Services ("RPC"), a United States public corporation which provides a variety of services to the oil and gas industry. Similarly, the appellant's business consists of providing technical services to the oil industry, principally through the delivery of equipment and well control services on site.
[3] In September 1984 the appellant was contacted by Boots & Coots, a well control company based in Houston, Texas, with respect to an underground blowout in an exploratory gas well being drilled by Mobil Oil Canada Ltd ("Mobil") off the coast of Nova Scotia. The appellant sent representatives to Canada to assess the situation with a view to providing well control services to Mobil. The appellant and Mobil entered into an oral agreement for the appellant to provide snubbing services for a price of US $15,000 per day.
[4] The principal pieces of equipment sent from the United States by the appellant for the Mobil job were two snubbing units. A snubbing unit is a complicated piece of hydraulic equipment used to remove drill pipe casings or similar equipment from, or force them into, an oil or gas well. The two snubbing units used on this job had respective pulling capacities of 600,000 and 150,000 pounds (the "600 unit" and the "150 unit", respectively), and were owned by the appellant. In addition to these two snubbing units, Mobil was required to provide hydraulic chokes, blow-out preventer equipment and hydraulic tongs for use by the appellant on the Mobil job. This equipment was rented from third parties for the duration of the job at a daily rate that ranged from approximately one-half of one per cent to somewhat in excess of one per cent of the cost of equipment.
[5] According to the appellant, in its ordinary course of business, it frequently rents equipment to customers. Although other equipment is rented to be used or operated by its customers, snubbing equipment is provided on an 'unmanned standby' basis. In these situations, the services of employees of the appellant are not required for periods of time but it is not appropriate to remove the equipment from the site. The evidence of the appellant's witnesses is to the effect that snubbing units are not kept in stock by suppliers but are custom-made on an order basis from a manufacturer. During the relevant period of time, there were only two manufacturers of snubbing units, Hydrarig of Dallas and Otis Engineering of Dallas-Fort Worth. The minimum time for the manufacture and delivery of a snubbing unit from the date of order was six months for a 150 unit and one year for a 600 unit. The appellant also claims that there is no market for used snubbing units, that these units last indefinitely when properly maintained, and they do not depreciate from either obsolescence or wear and tear.
[6] In 1984-85 the appellant was the owner of the only 600 unit in the world. This unit had been used for only 30 to 40 days before the Mobil job and was used for approximately 120 days between the end of the Mobil job in 1985 and the start of trial. During the Mobil job the 600 unit was in use for most of the working time and the 150 unit was on standby for most of that time. In computing the industrial and commercial profits to be attributed to its permanent establishment in Canada for its taxation year ended June 30, 1985, the appellant:
| (i) included all amounts billed to Mobil as income; |
| (ii) deducted all direct labour costs multiplied by a factor, transportation, insurance and similar costs, certain additional labour costs and a portion of its general overhead expenses from its income; and |
| (iii) deducted a charge for the notional rent charged by the head office to the permanent establishment for use of the 600 unit and the 150 unit in the amount of $2,516,690. |
[7] The appellant initially derived the notional rent at issue in this case from the daily rental rates it quoted to its customers for unmanned, standby use of each piece of equipment, namely US $4,800 per day for the 600 unit and US $2,400 per day for the 150 unit. These amounts were adjusted to account for the degree of usage for each unit during the Mobil job. Accordingly, the amounts of notional rent claimed were US $5,000 and US $1,700 per day, for the 600 unit and the 150 unit respectively. The appellant claims that the adjustments were reasonable considering the use of the equipment, the danger of the situation and the emergency nature of the job. The daily rental charge represented 0.72% per day of the capital costs of the units.
[8] The appellant incurred losses from its operations both prior to, during and after 1984. The appellant's loss for its June 30, 1984 taxation year was US $10,564,577; for its June 30, 1985 year was US $8,031,822; for its June 30, 1986 year was US $7,493,414; and for its June 30, 1987 year was US $3,594,981.
[9] The Minister disallowed the deduction of $2,516,690 claimed as notional rent for the snubbing units and assessed tax thereon under Part I of the Act. The appellant appealed.
Decision of the Tax Court Judge
[10] The Tax Court Judge upheld the decision of the Minister disallowing the rental deduction on the ground that Article III(1) of the 1942 Convention should not be construed as permitting deductions to be taken of a nature or kind that would not be deductible in calculating business income by Canadian taxpayers under the Act. The Tax Court Judge also found that even if he had concluded that notional rent could be deducted under the 1942 Convention he still would have disallowed the deduction on two other grounds. First, the evidence did not demonstrate that the appellant was in the business of renting equipment. Second, the appellant's business is so unique that it would not have rented the equipment. The Tax Court Judge found that, in the circumstances, the more reasonable assumption would be that the branch purchased the snubbing units from the head office.
Analysis
[11] As will be detailed later, I am of the view that in an appropriate case, an amount for notional rent may be deducted by a corporation incorporated outside Canada in computing the industrial and commercial profits attributable to its permanent establishment in Canada, notwithstanding that a resident in Canada can not benefit from a similar deduction. However, on the facts of this case, a deduction for notional rent is not appropriate given that the evidence established that the amount of notional rent was never included as income at the appellant's head office. To allow the deduction in this circumstance would mean that the appellant has avoided being taxed on the rental amount in both Canada and the United States. The purpose of Canada's bilateral tax treaties is to avoid double taxation and to prevent tax evasion: see The Queen v. Crown Forest Industries, 95 D.T.C. 5389 (S.C.C.) at 5396-7. It follows that unless the amount of notional rent is included in the parent corporation's records a corresponding deduction can not be allowed.
[12] I am also of the view that the facts do not establish that in the normal course of business the snubbing equipment would have been rented to the appellant"s permanent establishment in Canada. Indeed, it is more likely that the head office would have been contacted directly to take on this contract given that it is the only one to have had equipment of this kind during the relevant period. An independent company in the position of the permanent establishment would not have entered into this type of relationship unless it had the necessary equipment to perform its duties under the contract. In this case, the appellant did not have the necessary equipment and would likely have declined the contract.
Interpreting the 1942 Convention
[13] The basic principles to be applied in interpreting the 1942 Convention or any bilateral tax treaty are those found in articles 31 & 32 of the Vienna Convention on the Law of Treaties. These articles provide:
| 1. A Treaty shall be interpreted in good faith and in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. |
| 2. The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes. |
| (a) any agreement relating to the treaty which was made between all the parties in connexion with the conclusion of the treaty; |
| (b) any instrument which was made by one or more parties in connexion with the conclusion of the treaty and accepted by the other parties in an instrument related to the treaty. |
| 3. There shall be taken into account, together with the context: |
| (a) any subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions; |
| (b) any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation; |
| (c) any relevant rules of international law applicable in the relations between the parties |
| 4. A special meaning shall be given to a term if it is established that the parties so intended. |
| Article 32 -- Supplementary Means of Interpretation |
| Recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of article 31, or to determine the meaning when the interpretation according to article 31: |
| (a) leaves the meaning ambiguous or obscure; or |
| (b) leads to a result which is manifestly absurd or unreasonable. |
[14] Article 3(2) of the OECD Convention (see discussion, infra, at para. 22) and section 3 of the Income Tax Convention Interpretation Act establish that where a term is not defined in a bilateral tax treaty, definitions from domestic income tax law should be applied unless the context indicates otherwise. In this case, the Tax Court Judge found that because the phrases 'net industrial and commercial profits' and 'all expenses wherever incurred' were not defined in the 1942 Convention, recourse was to be had to Canada's domestic tax law. Because the Income Tax Act prohibits the deduction of a notional expense, the Tax Court Judge found that the amount of notional rent claimed by the appellant could not be deducted under the 1942 Convention.
[15] While the Tax Court Judge applied the correct principles of interpretation for a double tax convention, nonetheless, I am of the view that the language of Article III (I) of the 1942 Convention does allow for the deduction of notional expenses. As a result, recourse to domestic Canadian Income Tax law principles is not essential.
[16] Article I of the 1942 Convention provides:
An enterprise of one of the contracting states is not subject to taxation by the other contracting state in respect of its industrial and commercial profits except in respect of such profits allocable in accordance with the articles of this Convention to its permanent establishment in the latter State. [emphasis added]
In computing profits, Article III sets out the rule that a permanent establishment is to be treated as a separate entity for income tax purposes:
| 1. If an enterprise of one of the contracting states has a permanent establishment in the other state, there shall be attributed to such permanent establishment the net industrial and commercial profit which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions. Such net profit will, in principle, be determined on the basis of the separate accounts pertaining to such establishment. |
In the determination of the net industrial and commercial profits of the permanent establishment there shall be allowed as deductions all expenses, wherever incurred, reasonably allocable to the permanent establishment including executive and general administrative expenses so allocable. [emphasis added]
[17] Thus, Article III(1) sets out the fiction that a permanent establishment is to calculate its profits as if it were an independent enterprise. It further allows for the deduction of expenses, which may also be fictional, that are reasonably allocable to the permanent establishment. It follows that a deduction for notional rent may be allowed because if the permanent establishment is an independent enterprise, it would be necessary to rent or purchase the equipment in question. As Ian Roxan states in "Judicial Overrides of Double Tax Conventions: The Case of a Permanent Establishment" (1997) 25 Intertax 367 at 371:
If the permanent establishment had been an independent enterprise, then it could have rented the snubbing units from the head office (also a separate enterprise under the assumption) ... The permanent establishment would then have incurred an obligation to pay the rent. So the rental expense would have been an expense incurred within the meaning that the Crown argued the term had under the Act.
Roxan continues, stating
... if we calculate the profit of the permanent establishment as if it were an independent enterprise, that is using the notion of treating it as an independent enterprise, it is entirely consistent to treat the permanent establishment as if it had incurred the rental expense... The expense is no more notional than the idea of treating the permanent establishment as an independent enterprise, which is required by the Convention. [emphasis added]
[18] Albert A. Ehrenzweig and F.E. Koch provide further support for the concept that the two enterprises should be treated separately, i.e. as if they were third parties contracting with each other. This, in turn, supports the idea that a deduction for notional expenses should be allowed. In their commentary on the 1942 Convention, Ehrenzweig and Koch state:
The allocation rule of the Convention is in substance based on the 'profit convention for the Allocation of Business Income between States for the Purpose of Taxation (except for the rephrasing of the 'arms length element').' The rule is designed to subject to taxation by the country of establishment that part of the income which is produced in its territory, without regard to the total result of the business of the foreign enterprise maintaining the establishment. In view of its generality, this rule has always been implemented in various ways.
To facilitate a favourable apportionment, the establishment should, in its accounts treat its transactions as if made with an outsider... The book entries should be based on terms of similar transactions between the enterprise (or similar foreign enterprises) and third persons in the taxing country; or on customary prices or rates of commission prevailing between third parties for similar transactions in that country; or on the quotations in an independent market.
See Albert A. Ehrenzweig and F.E. Koch, Income Tax Treaties (New York: CCH, 1949) at 106 [emphasis added].
[19] The Commentaries to tax conventions and other extrinsic evidence regarding the intention of the drafters of tax treaties form a part of the legal context surrounding international taxation: see Crown Forest, supra at 5396. Accordingly, it is clear that Commentaries to tax conventions and other evidence are to be used as an aid in the interpretation of tax treaty provisions.
[20] The most relevant commentary and other travaux préparatoires relating to Articles I and III of the 1942 Convention are found in the records of the deliberations of the Fiscal Committee of the League of Nations (the "Fiscal Committee") during the 1930s and early 1940s which dealt with Convention provisions concerning the calculation of the profits of a permanent establishment. Of additional significance is Mitchell B. Carrol's report which was delivered to and endorsed by that committee. The Carrol report as well as the Reports of the Fiscal Committee endorse the concept of the separate accounts accounting procedure. As Carrol states:
To summarise, the regime of allocation for enterprises operating in several countries in which they have permanent establishments consists (1) in separating the various items of income and allocating them to their respective sources; (2) if income is derived from the joint operations (of one or more classes) of two or more establishments in different countries, the income is to be allocated or apportioned in accordance with what each establishment would derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions. Thus, if an independent enterprise would make a profit or receive certain remunerations for the given activity, such profit should be reflected in the separate accounts of the given establishment.
See M.B. Caroll, "Allocation of Business Income: The Draft Convention of the League of Nations" (1934) 34 Col L.Rev. 472 at 485-86.
[21] Thus, the separate accounts principle found in Article III(I) which requires the enterprise and the permanent establishment to be treated at arms-length -- as separate entities contracting or interacting with one another -- provides the basis for a deduction for notional rent. In Utah Mines Ltd. v. The Queen, 92 D.T.C. 6194, this Court held that under the terms of the implementing legislation, the provisions of the Convention prevail over domestic legislation in the event of an inconsistency. Accordingly, the fact that a similar deduction is not provided for Canadian businesses is not relevant because the provisions of the 1942 Convention apply. Having found that the 1942 Convention allows for a deduction of a notional expense for rent, the question then becomes, when is such a deduction for this expense appropriate?
[22] Canada is a member of the Organization for Economic Co-operation & Development ("OECD") which adopted a Model Tax Convention on Income & Capital (the "OECD Convention") in 1977. The main purpose of the OECD Convention is to provide a means of uniformly settling the most common problems which arise in the field of international juridical double taxation: see Krishna, The Fundamentals of Canadian Income Tax (Scarborough: Carswell, 1995) at 79. All signatories to the OECD Convention, including Canada, are to follow the OECD Convention as closely as possible in drafting their own bi-lateral treaties.
[23] The relevant commentaries on the OECD Convention were drafted after the 1942 Convention and therefore their relevance becomes somewhat suspect. In particular, they cannot be used to determine the intent of the drafters of the 1942 Convention. However, although the wording and arrangement of the provisions are significantly different in the two conventions, the 1942 Convention follows the same general principles as the OECD model. The OECD Commentaries, therefore, can provide some assistance in discerning the "legal context" surrounding double taxation conventions at international law, and in particular in ascertaining when it is appropriate to allow a deduction for a notional expense.
[24] Article 7(3) of the OECD Convention is similar in effect to the second paragraph of Article III(1) of the 1942 Convention. Article 7(3) provides:
In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the state in which the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.
Thus, both the 1942 Convention and the OECD Convention allow for the deduction of expenses which are attributable to the permanent establishment. In particular, this provision allows for the deduction of expenses actually incurred by the head office against the profits incurred by the permanent establishment where such expenses are "reasonably allocable to" (1942 Convention) or "incurred for the purposes of" (OECD Convention) the permanent establishment.
[25] The Commentaries to the OECD Convention elaborate on the meaning of this provision. Paragraph 16 of the Commentary states that the purpose of Article 7(3) is to clarify the general directive in relation to the expenses of a permanent establishment that is contained in Article 7(2) -- the OECD equivalent to the "separate enterprise" provision contained in the first paragraph of Article III(1) in the 1942 Convention. The Commentary goes on to state:
... [Article 7(3)] specifically recognizes that in calculating the profits of a permanent establishment allowance is to be made for expenses, wherever incurred, that were incurred for the purposes of the permanent establishment. Clearly in some cases it will be necessary to estimate or to calculate by conventional means the amount of expenses to be taken into account. In the case, for example, of general administrative expenses incurred at the head office of the enterprise, it may be appropriate to take into account a proportionate part based on the ratio that the permanent establishment's turnover (or perhaps gross profits) bears to that of the enterprise as a whole. Subject to this, it is considered that the amount of expenses to be taken into account as incurred for the purposes of the permanent establishment should be the actual amount so incurred. The deduction allowable to the permanent establishment for any of the expenses of the enterprise attributed to it does not depend upon the actual reimbursement of such expenses by the permanent establishment. [emphasis added]
[26] Paragraph 17.1 of the Commentary is also particularly helpful in this case as it provides a test to determine when it is appropriate to allow a deduction for expenses. Paragraph 17.1 states:
In applying these principles to the practical determination of the profits of a permanent establishment, the question may arise as to whether a particular cost incurred by an enterprise can truly be considered as an expense incurred for the purposes of the permanent establishment, keeping in mind the separate and independent enterprise principles of paragraph 2. Whilst in general independent enterprises with each other will seek to realise a profit and, when transferring property or providing services to each other, will charge such prices as the open market would bear, nevertheless, there are also circumstances where it cannot be considered that a particular property or service would have been obtainable from an independent enterprise or when independent enterprises may agree to share between them the costs of some activity which is pursued in common for their mutual benefit. In these particular circumstances, it may be appropriate to treat any relevant costs incurred by the enterprise as an expense incurred for the permanent establishment. The difficulty arises in making a distinction between these circumstances and the cases where a cost incurred by an enterprise should not be considered as an expense of the permanent establishment and the relevant property or service should be considered, on the basis of the separate and independent enterprises principle to have been transferred between the head office and the permanent establishment at a price including an element of profit. The question must be whether the internal transfer of property and services, be it temporary or final, is of the same kind as those which the enterprise, in the normal course of its business, would have charged to a third party at an arm's length price i.e. by normally including in the sale price an appropriate profit. [emphasis added]
[27] In other words, the test proposed in paragraph 17.1 of the Commentary is whether the internal transfer of property or services between the foreign corporation and its permanent establishment in Canada is of the same nature as a transaction in which the companies, in the normal course of business, would have charged a third party a price which included an appropriate profit. Paragraph 17.2 of the Commentary attempts to explain when the answer to that question will be affirmative and when it will be negative:
On the one hand, the answer to that question will be in the affirmative if the expense is initially incurred in performing a function the direct purpose of which is to make a sales of a specific good or service and to realise a profit through a permanent establishment. On the other hand, the answer will be in the negative if, on the basis of the facts and circumstances of the specific case, it appears that the expense is initially incurred in performing a function the essential purpose of which is to rationalise the overall costs of the enterprise or to increase in a general way its sales.
[28] Another approach to determining whether an expense should be deducted for a permanent establishment was offered by Caroll. He suggests that the correct approach is to inquire where the risk of ownership lies: with the head office or the permanent establishment. In most cases, the risks of profit and loss are principally borne by the parent company. To account for this, Caroll suggests that the permanent establishment be allowed to deduct from its income an amount to account for the "services rendered" to it, by the head office, i.e. a notional commission or fee which accounts for the risk borne by the head office. This notional fee can be adjusted downward to account for any risks borne by the independent enterprise, just as a fee charged to a third party for services rendered would reflect the risks borne by that party: see M.B. Caroll, Taxation of Foreign and National Enterprises: Methods of Allocating Taxable Income , (1933) 4 League of Nations, (Ser. L.o.N.P.: Geneva, 1933.II.A20). See also Roxan, Judicial Overrides, supra at 373-74.
[29] Having reviewed the evidence, I am satisfied that either under the test provided in the OECD Commentary or under Carrol's methodology, the deduction would not be allowed in the circumstances of this case. The 1942 Convention requires that one consider what an "independent enterprise engaged in the same or similar conditions would do." Given the unique nature of the business conducted by the appellant"s head office (i.e. it owned the only 600 unit in the world), it is highly unlikely that an independent enterprise would have rented the 600 unit from the head office, particularly in light of the high rental costs, and then have used it to provide snubbing services to another company, in this case Mobil. Instead, given the nature of the business and the type of equipment at issue, the head office would have been contracted directly to take on the project in question. It is not reasonable to believe that an independent third party would have contemplated entering into this type of contract given it did not have the required equipment and would have incurred exorbitant expense if it chose to rent the equipment. A reasonable third party would have declined the contract all together, or, as noted by the Tax Court Judge, would have purchased the equipment in question. However, this latter option is highly unlikely in light of the facts that a one year lead time was required for the manufacture of a 600 unit and the Mobil job was an emergency situation.
[30] I would also dismiss the appeal on the ground that the purpose of the 1942 Convention is to prevent double taxation and to prevent tax evasion. The preamble to the 1942 Convention states that one of the purposes of these bi-lateral treaties is to prevent tax evasion:
The government of Canada and the Government of the United States of America, being desirous of further promoting the flow of commerce between the two countries, of avoiding double taxation and of preventing fiscal evasion in the case of income taxes, have decided to conclude a Convention... [emphasis added]
[31] The Supreme Court of Canada has addressed the issue of tax avoidance in the context of bilateral tax treaties in Crown Forest Industries, supra. It made the following comments at 5397:
In the case at bar, I underscore that there is no need to prevent double taxation because the U.S. has declined to tax Norsk's revenue. Although this does not affect Norsk's tax liability, the effect is still that Norsk is not required to pay any tax in the United States by virtue of the s.883(1) exemption, this exemption arising by virtue of a reciprocal arrangement between the U.S. and the Bahamas, where Norsk is incorporated. Further, it is unclear whether the specific rental income at issue is, even independent of the exemption, subject to taxation in the U.S., because, pursuant to s.864(c)(4) of the Internal Revenue Code, it might not be considered to be effectively connected with the conduct of Norsk's American trade or business. Allowing Norsk to benefit from the Convention in this case would actually lead to the avoidance of tax on the rental income because the liability for tax asserted by the Canadian authorities would be reduced notwithstanding that the United States chooses not to impose any tax thereon or does not even have the jurisdiction therefor. [emphasis added]
[32] The evidence of Ms Herron, the Chief Financial Officer of the appellant and its parent corporation, RPC, is that the amount of notional rent claimed by the appellant was not included as income in the parent company's tax return. In cross-examination she was asked the following question:
Q. The amount of $2,942.316 which was set up as notional rent, is, I take it, not included anywhere here in the revenues which are reported in this return?
A. It's an elimination. This is a consolidated return of RPC Energy Services and all subsidiaries, so if it were included, which it wasn't, it would eliminate anyway. There would be the income and then off-setting expense. [emphasis added]
Because the amount of notional rent was never included as income in the RPC"s records, the permanent establishment may not derive the corresponding benefit of a deduction for rent. To allow such a deduction would lead to the avoidance of tax on the rental income attributed to the parent, similar to the result in Crown Forest, supra .
[33] While no actual money had to exchange hands between the appellant, Cudd Pressure Control Inc., and its parent, RPC (indeed, the point is that the expense is notional), it nevertheless must be included as income in the parent corporation's return so that, if necessary, it can be subject to tax. Including the amount of notional rent in the parent corporation's return also accords with the separate accounts principle. Under this method, profits and expenses must be reflected in the separate accounts of the permanent establishment and the parent corporation: see Caroll, Draft Convention, supra. The appellant can not derive the benefit of having its profits drastically reduced and then not have the amount included as income in the parent corporation's records. If this were not the case, then the payment of rent would never be subjected to tax.
[34] Before concluding, one further comment is necessary in respect of an argument advanced by the Minister. The Minister claims that it would be contrary to the purpose of the 1942 Convention to allow a foreign corporation"s permanent establishment in Canada to deduct notional expenses as this would grant the permanent establishment more favourable tax treatment than its Canadian competitors in the same industry. The Tax Court Judge found this argument persuasive. While there is some merit to this argument, I am of the view that it does not provide a legal basis for disallowing these types of deductions.
[35] If the 1942 Convention allows for a deduction that the Canadian Income Tax Act does not and this is seen as unfair to Canadian business then the answer lies with Parliament. The answer cannot be to deny a deduction that is contemplated by a legally binding tax convention. I fail to understand why someone in the appellant's position should be denied a valid deduction on the grounds that the Act does not provide a corresponding benefit to Canadian business. I recognize that there is dicta to the contrary in Utah Mines, supra, however, in that case the Court was of the view that the deduction at issue was not contemplated by the 1942 Convention. That is not the case here.
[36] I am of the opinion that if the language of the 1942 Convention allows for the deduction of an expense that language should be followed. Indeed, this view is supported by Utah Mines, supra, where, as noted above, the Court held that under the terms of the implementing legislation, the 1942 Convention prevails over domestic legislation in the event of inconsistency. Further, as a member of the OECD, Canada is expected to conform to the OECD Convention in negotiating and interpreting its bilateral tax treaties. If the OECD Convention specifies that a deduction for certain expenses should be allowed, as I have indicated it does in this case, then to the extent that it is possible, Canada should attempt to abide by the Convention as closely as possible.
Conclusion
[37] To the extent that the Tax Court Judge's decision may be interpreted as prohibiting the concept of notional contracts, it is clarified so as to allow these contracts and the associated tax deductions under the 1942 Convention, where such notional expenses are supported by the facts of the case. On these facts, however, I am satisfied that the Tax Court Judge was correct to find that a third party would not have agreed to rent the snubbing equipment. Accordingly, the appellant cannot succeed.
Disposition
[38] The appeal from the Tax Court of Canada is dismissed with costs.
| "F.J. McDonald" |
| J.A. |
FEDERAL COURT OF APPEAL
Date: 19981019
Docket: A-369-95
BETWEEN:
CUDD PRESSURE CONTROL INC.,
Appellant
- and -
HER MAJESTY THE QUEEN,
Respondent
REASONS FOR JUDGMENT