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.