Foreign Tax Credit for Franchise Tax

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

Intent in Service Contract

Reproduced from the May 2013 edition of the Canadian Tax Highlights:

Wiebe Doors (87 DTC 5025 (FCA)) sets out four factors to determine a service provider’s status as an independent contractor or an employee: control, ownership of tools, chance of profit or risk of loss, and integration. More recently the parties’ expressed intent has been added as a factor (Wolf, [2002] 4 FCA 96, and The Royal Winnipeg Ballet, 2006 FCA 87), but the evidentiary weight attached to intent has been unclear. The FCA decision in 1392644 Ontario Inc. O/A Connor Homes (2013 FCA 85) clarifies the impact of the parties’ expressed intent.

Connor Homes operated foster homes and group homes and provided care for children with serious behavioral and development disorders via child and youth workers, social workers, certified therapists, and psychologists. Written contracts stipulated that those individuals were independent contractors and not “entitled to any benefits” and were responsible for payments such as Canada pension, employment insurance, and taxes. Connor Homes unsuccessfully argued that the contract alone should determine the classification of an individual rendering services, without reference to the four factors of Wiebe Doors. 

The SCC in Sagaz Industries Canada Inc. ([2001] 2 SCR 983) upheld the four-prong test in Wiebe Doors and never considered the agreement’s expressed intent. However, several years later and after  intent had been established as a relevant consideration, Bowman, J. in Lang et al (2007 TCC 547) summarized four different approaches to the treatment of intent:  

(a)    Intent is determinative (Royal Winnipeg Ballet). (Bowman, J. himself said that the decision did not suggest that the matter was that simple.)

(b) Wiebe Door is all that is needed and intent need not be considered (Sagaz,

     Wiebe Door and Precision Gutters).

(c) The Wiebe Door test does not point conclusively in any direction and so

      intent is a tie-breaker (Wolf and City Water).

(d) Common sense, instinct and a consultation with the man 

     on the Clapham omnibus.

The characterization of an employee-employer relationship has far-reaching legal and practical ramifications as stated both by the full FCA in Connor Homes and by the FCA dissent in Royal Winnipeg Ballet. The latter pointed out that the parties’ statement in the contract can be viewed as self-serving and made with a view to achieve their ultimate objective such as an EI premium exemption.  However, the dissent went on to say:

… parties to contracts… are often not in equal bargaining positions. To attribute appreciable weight to a statement in the contractual document signed by the parties that the contract is one for the supply of services may disadvantage the more vulnerable party…[whose] contractual status and consequently her statutory rights may also be prejudiced by the stronger party’s legal characterization of the contract…[Moreover] the legal characterization of a contract may have an impact on third parties, such as the victim of a tort committed by a service provider in the course of performing the contract or, as in this case, Revenue Canada. Not to base legal characterization squarely on the terms of the contract, interpreted contextually, may jeopardize those interests and undermine non‑voluntary protective statutory programs, such as EI and CPP.

The FCA in Connor Homes clarifies that characterization of the relationship is very important in diverse areas such as tort law, social programs, labour relations, and taxation, and therefore the determination cannot be left to the sole subjective discretion of the parties. Thus intent is not determinative. The court summarizes a passage from its majority decision in Royal Winnipeg Ballet:

As a result, Royal Winnipeg Ballet stands for the proposition that what must first be considered is whether there is a mutual understanding or common intention between the parties regarding their relationship. Where such a common intention is found, be it as independent contractor or employee, the test set out in Wiebe Door is then to be applied by considering the relevant factors in light of that mutual intent for the purpose of determining if, on balance, the relevant facts support and are consistent with the common intent.

The FCA in Connor Homes sets out two steps to determine whether an individual is performing services as an employee or as an independent contractor. (1) Establish each party’s subjective intent, determined by the written contractual relationship or by their actual behaviour, such as invoices for services rendered, registration for GST purposes, and filing for income tax as an independent contractor. (2) Determine whether objective reality supports the parties’ subjective intent by applying the four factors in Wiebe Door.

On the facts in Connor Homes the FCA concluded that the parties’ subjective intent as expressed in the contracts was to enter into independent contractor relationships; however, application of the factors in Wiebe Door showed that employee-employer relationships had been established. The FCA found the taxpayer exerted significant control over the activities of the individuals rendering services. Service providers had to strictly adhere to a policy and procedures manual. Furthermore the taxpayer dictated the individuals’ duties daily and guided and instructed the service providers on managing difficult situations with clients. The use of a personal vehicle to transport some of the children was not an overweighing factor.

Sunita Doobay

TaxChambers, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba