Reproduced from the June 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication
Ruling 2011-0428791E5, dated May 11, 2012, concluded that a
US state franchise tax – the name of the state was not disclosed - qualified
for a foreign tax credit under the Act. The taxpayer did not have a US PE and
was thus treaty exempt from US federal tax.
A Canco that expands
into the United States is often subject to state tax despite structuring to
avoid a US PE and thus US federal tax. Several US states – such as Florida and
Michigan - voluntarily adhere to the treaty and do not impose a corporate
income tax if the taxpayer is treaty exempt from federal taxation. Federal
public Law 86-272 grants further protection against state corporate income tax:
a state cannot levy an income tax on income derived by an independent agent who
solicits orders for tangible goods warehoused outside the state if the contracts
are concluded outside the state. However,
a state may impose a non-income tax or an income tax on income generated from
sales within a state of tangible or intangible personal property.
To ensure that foreign income is not subject to double
taxation, the foreign tax credit in section 126 of the Act allows a credit for income
tax paid to foreign jurisdiction against Canadian income tax otherwise
payable. The foreign tax must be levied
against income and paid to the government of a foreign country or its state,
province, or other political subdivision.
The credit applies to a foreign tax levied on business and non-business
income, and some exceptions are provided in the Act and in the Canada-US treaty
for non-income taxes. Subsection 126(5), for example, allows a foreign tax
credit for some oil and gas levies and the Canada–US treaty allows a credit for
US estate tax. A foreign tax that is not
creditable may be deductible as an expense under subsection 9(1) if incurred for
the purpose of earning income.
In the ruling the CRA said that a foreign tax credit is
available for a business-income tax on income or profits if the tax is paid to
a foreign government (including a state) and can reasonably be regarded as being
in respect of income from a business carried on by the taxpayer in the foreign
country. To be creditable the foreign tax must be substantially similar to the
income tax imposed under the Act and thus must be levied on net income or
profits. The CRA is of the view that a state tax that is determined as a
percentage of the Canco’s allocated net income is an income or profits tax and
is thus eligible for the business-income foreign tax credit. This assumes that
a business is carried on in the state and the ruling contains a list of
relevant factors to determine whether a business is carried on in a particular
place, such as the place where the contract is made – including decisions to
purchase or sell – and where goods are delivered or payments made. In
determining net foreign business income, the CRA notes that the determination
is made under subsection 126(9) and is not the income allocated to the
particular state using the three-factor formula. The CRA went on to discuss the application of
the treaty, whose primary purpose, it says, is the minimization of double
taxation. The CRA noted that taxation of a corporation’s business profits in a
place where no PE exists is contrary to the treaty source rules and article
XXIV(7) provides that the treaty does not extend relief for a tax that is
levied in a manner inconsistent with the treaty. However, relief from the
particular state tax appears to be provided under the Act’s foreign tax credit system
and thus treaty article XXIV generally does not reduce the foreign tax credit
available under the Act.
US state franchise taxes are not structurally uniform and
thus care should be taken not to assume
that a foreign tax credit is available for all franchise taxes. A franchise tax
is generally based on the income earned within the state but in some instances
is a flat fee or a capital tax. For
example, Delaware does not impose a corporate income tax but does levy a
franchise tax on corporations incorporated in Delaware based on a corporation’s
capital. The franchise tax in the ruling was calculated as a percentage of
Canco`s allocated net income from the carrying on of a business in the state
and thus qualified as a business income tax.
Sunita Doobay
TaxChambers, Toronto
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