Revenue Canada's guidelines for treaty-based waivers of Regulation 105 withholding.

October 21, 1998

On October 21, 1998, Tax Executives Institute filed comments in respect of Revenue Canada's Discussion Draft of Guidelines for Treaty-Based Waivers of Withholding Tax Under Regulation 105. The comments took the form of a letter from TEI President Lester D. Ezrati to Sara Greenblatt, Director General of Revenue Canada's International Tax Directorate. The Institute's comments were prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is John M. Allinotte of Dofasco Inc. Contributing substantially to the development of TEI's comments were Alan Wheable of Canada Trust, Vincent Alicandri of Xerox Canada Ltd., and David M. Penney of General Motors of Canada Ltd.

In August, Revenue Canada released a discussion paper entitled Proposed Changes to Revenue Canada's Guidelines for Treaty-Based Waivers of Regulation 105 Withholding. On behalf of Tax Executives Institute, I am pleased to provide the following comments and recommendations.

Background

Tax Executives Institute, Inc. is the principal association of corporate tax executives in North America. The Institute's 5,000 professionals manage the tax affairs of the leading 2,800 companies in Canada and the United States and must contend daily with the planning and compliance aspects of Canada's business tax laws. Canadians make up 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our eight geographic regions. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency. As a result, the comments generally reflect the views of Canadian payers and service purchasers rather than the views of U.S. payees or service providers.

TEI is concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government. We are pleased to respond to the invitation to comment on the recommendations set forth in Revenue Canada's discussion paper concerning the waiver process under Regulation 105.

Discussion

Since the North American Free Trade Agreement (NAFTA) came into force several years ago, there has been explosive growth in cross-border trade and services within the free-trade zone. Before NAFTA, cumbersome procedures restricted the opportunities for cross-border service providers, especially for smaller and medium-sized enterprises. Besides removing trade barriers, publicity surrounding NAFTA itself engendered greater awareness among nonresidents of the business opportunities in Canada as well as awareness among Canadian businesses and consumers that their choices are no longer limited to domestic service providers. Many more firms than before are soliciting business in Canada, thereby affording greater competition for price and performance on ordinary services for Canadian companies. Likewise, Canadians are free to pursue services from niche foreign companies that provide unique services that may not be available domestically.

Regrettably, vestiges of the pre-NAFTA regime remain. Specifically, Regulation 105, issued under the authority of section 153 of the Canadian Income Tax Act, imposes withholding tax on fees paid to non-residents for services rendered and stands as a barrier to the full promise of NAFTA. Regulation 105 also authorizes Revenue Canada to develop administrative procedures to enforce or waive the application of the withholding rules. As a result, TEI is pleased that Revenue Canada has initiated this study of the Regulation 105 waiver process and welcomes the opportunity to provide its comments.

Paragraph 153(1)(g) of the Canadian Income Tax Act and subsection 105(1) of the Income Tax Regulations require a withholding of 15 percent from payments of fees, commissions, or other amounts paid to non-resident individuals, partnerships, or corporations in respect of services rendered in Canada, other than in the course of regular and continuous employment. Payments in respect of regular and continuous employment in Canada, made to non-resident individuals, are not subject to 15-percent withholding but rather are subject to tax deductions on a basis similar to residents. Withholding under Regulation 105 is considered a payment on account of the non-resident's liability and does not constitute the final tax. Many of Canada's treaties provide an exemption from withholding where no fixed base or permanent establishment exists. Hence, where a non-resident can adequately demonstrate, based on treaty protection or on estimated income and expenses, that withholding normally required will exceed the ultimate Canadian tax liability, Revenue Canada may, upon application for a waiver of withholding, reduce the amount required to be withheld.(1) In summary, under the waiver process, a nonresident may receive a complete or partial waiver of the withholding in recognition that the ultimate tax liability will be less than the withholding required on the gross income.

The only formal guidance from Revenue Canada on the required withholding for fees paid to non-residents performing services in Canada is set forth in Interpretation Circular 75-6R. Paragraphs 10 to 16 of that circular summarize the rules governing the process for obtaining a waiver or reduced rates of withholding based on treaty protection. Even though the process for obtaining waivers for treaty-based protection from withholding has existed administratively for more than 12 years, there is no standardized form on which to apply for a waiver. Moreover, the 20 paragraphs in IC 75-6R provide precious little guidance to taxpayers concerning the basis on which waiver applications will be approved. Instead, the circular notes that "[w]aivers based on treaty protection often involve complex determinations regarding the existence of a fixed base or permanent establishment."(2) In the absence of meaningful guidance, the waiver application process is fraught with uncertainty, which is fed by anecdotal evidence that a substantial disparity exists between the waiver process and assessment practice. That is, there are a number of cases where a request for waiver of withholding based on treaty protection is denied, but when the service provider files the requisite return, a full refund of the withheld tax is paid. In TEI's view, the lack of predictability in the waiver process undermines confidence in the fairness of the system and could well retard compliance. Hence, the publication of a clear set of rules, such as those in the Appendix of the draft discussion document, together with modifications recommended during the consultative process, will be a welcome step. TEI commends Revenue Canada for undertaking to provide such guidance.

During liaison meetings and roundtable discussions with both Revenue Canada and the Department of Finance, TEI has raised concerns about the scope and application of Regulation 105. TEI believes that the policy underlying the statute and the regulation is outmoded in a post-NAFTA environment. Moreover, the administration of the waiver process is burdensome and the operation of both the withholding rules and waiver process impose costs that undermine the competitiveness of Canadian businesses. Indeed, the Part XIII tax in respect of royalties paid on sales and licenses of software formerly imposed administrative burdens and economic detriments on Canadian companies analogous to those imposed under Regulation 105 for services. Ultimately, the Department of Finance was persuaded that the application of Part XIII to royalties on software was a tax borne by Canadian businesses rather than by the nonresident vendor. That is, the Part XIII tax was recognized either to impede access to productivity enhancing tools or, at a minimum, to increase the final cost of the software to Canadians. Rather than repeal the application of Part XIII to non-exclusive software licenses, the Department of Finance, pursuant to the Minister's announcement of April 23, 1993, has undertaken to negotiate reciprocal withholding tax exemptions in selected tax treaties (e.g., the Netherlands and, more important, the United States).(3)

As with the application Part XIII tax, when a non-resident without a permanent establishment (P.E.) in Canada learns (often from the Canadian purchaser) that a 15-percent withholding tax applies to service fees, the result is all too predictable. The non-resident supplier will generally request a gross-up payment in order to maintain the same cash-flow position net of the withholding tax. As a result, a service for which the vendor normally charges $100 is inflated to approximately $117 to account for the withholding tax.(4) Alternatively, the Canadian purchaser may be able to persuade the non-resident to undertake to file an application for a waiver under Regulation 105 and file a Canadian tax return (either a T1 or T2, depending on whether the provider is an individual or corporation) to claim a refund of any excess tax withholding. In order to avail itself of either the waiver process or obtain refunds, however, the non-resident supplier must hire Canadian tax consultants. In either case, the cost of the non-resident's tax consultants is often passed directly or indirectly to the Canadian purchaser.(5) Regardless of whether the supplier receives a waiver or incurs the withholding tax, the Canadian purchaser ultimately bears the cost making it less competitive with similarly situated foreign businesses.(6) To the extent that Revenue Canada believes that section 153 of the Act and Regulation 105 constrain its ability to provide administrative relief through the waiver process -- especially in respect of providing relief for service providers within the NAFTA flee-trade zone -- we urge Revenue Canada to work with TEI in developing an appropriate legislative proposal for the Department of Finance. In this regard, TEI shall be pleased to make further representations to the Department of Finance.

Addressing specific issues raised by the draft discussion paper, the concept for determining when a non-resident is deemed to carry on a trade or business through a P.E. is the most expansive interpretation of P.E. possible. Unless a non-resident's activities within a country are "recurring," most countries' treaties permit nonresidents to carry on activities for up to six months without the risk of establishing a P.E. The discussion paper acknowledges the six-month rule but avers that a non-resident's "recurring" activities of a shorter duration in successive years may constitute a P.E. Although acknowledging that the Organisation for Economic Cooperation and Development has not modified its Model Tax Convention or commentary to adopt the latter interpretation, the discussion paper suggests that such an expansive "recurring activities" rule constrains Revenue Canada's authority to issue waivers.

TEI respectfully disagrees. We believe that the definition of a P.E. set forth in the discussion draft is overbroad and may prove unworkable, especially within the North American free-trade zone. Specifically, the 180-day cumulative limit for determining whether a non-resident's services within a test "period" amounts to "recurring" activities sufficient to constitute a P.E. (Test C of the discussion draft) is subject to a number of uncertainties and may prove problematic to administer. The most important practical limitation is that very few service providers likely keep records cumulating employees' presence in a particular country beyond a particular engagement or contract. In addition, the test "period" for determining whether a nonresident's activities are recurring depends on a review of the non-resident's current year's estimates in the current year, the three preceding years, and the immediately following three years.(7) Assuming a non-resident can account for all the previous year's activities of its employees, the determination of future years presence remains, at best, a guess.

In order to provide an expedient and efficient waiver administration process while providing Revenue Canada with a means to detect nonresidents for which inquiries should be made, we recommend that Revenue Canada consider dovetailing the waiver process with the new reporting requirements under Resolution 40 of the Notice of Ways and Means Motion accompanying the 1998 budget. Specifically, Resolution 40 will impose substantial new reporting requirements on foreign businesses, presumably to assist in the identification of companies with P.E.s in Canada that are subject to a requirement to file tax returns. Since the purpose of Regulation 105 is likewise to protect the fisc and identify nonresident service providers liable to tax, TEI believes the purposes of Resolution 40 and Regulation 105 can be addressed in tandem. Since the activities that will be subject to the new reporting requirements substantially overlap the activities that Regulation 105 addresses, TEI recommends that withholding automatically be waived where a payee files a form (to be prescribed in order to implement the Resolution 40 reporting requirement) jointly with the payer and Revenue Canada affirming that the service provider will undertake to file a return under either subsection 150(1) of the Income Tax Act or under the legislative proposal.

Revenue Canada can also improve the guidelines governing the waiver administration process under Regulation 105 -- reducing both the compliance burden for companies and the administrative burden for Revenue Canada -- by creating a de minimis exception for non-resident corporations that render services. Indeed, a $5,000 exemption for services rendered by non-resident corporations -- the same amount as for individuals -- would substantially diminish the number of waiver applications that Revenue Canada would be required to process and review. A de minimis exception, coupled with the rules that permit non-residents to invoice Canadian source services separately from non-Canadian source services, would reduce the compliance burden for both non-resident companies and Canadian purchasers. Moreover, Revenue Canada would be able to focus its resources for administration of the waiver process on large transactions or in identifying non-resident service providers with frequently recurring activities. TEI recommends that Revenue Canada incorporate a $5,000 de minimis exemption for corporations providing services.

TEI submits that the discussion draft is also deficient in its proposed treatment of Canadian residents that subcontract for non-residents. Specifically, the flush language following exception 9 on page 14 of the discussion draft states:

   Where a non-resident person has a contract to perform services in Canada
   but subcontracts with either residents of Canada or other non-residents to
   undertake the actual performance of those services, a treaty-based waiver
   will not be granted in respect of the contract unless the activities of the
   sub-contractors, along with any other activities which the primary
   contractor undertakes in Canada, falls within the guidelines of the
   substantial presence test. For the purpose of applying the test ... the
   activities of the Canadian resident contractor shall be viewed as if they
   were nonresident....

Under the foregoing language, the non-resident will be ineligible for a waiver even where it performs its obligations entirely outside of Canada. For example, assume that Canadian purchaser P contracts with third-party service provider NR. Before NR can perform its services for P, however, there must be initial "installation" or "set-up" services performed in Canada for P. Hence, NR subcontracts with third party, CS, a resident of Canada to provide the "set-up" service. Under the proposed draft, notwithstanding the arm's-length relationship between NR and CS, the non-resident will not qualify for a waiver. We believe this is the wrong result, especially under NAFTA. We recommend that the discussion draft be revised to permit waivers to be granted where the applicable treaty under which a waiver is sought contains a clause similar to Article V, paragraph 7 of the Canada. U.S. treaty and there are no other factors indicating the presence of a P.E.(8)

Apart from the substantive rules governing when and under what circumstances waivers should be issued, TEI has several recommendations that will improve the administration of the waiver application process itself.

The section on Returns in Appendix 1 of the discussion draft states that waivers will not be issued in the current year where a waiver was provided in a previous year and a tax return was not subsequently filed by the non-resident. The requirement to file a tax return will prevent many non-residents from obtaining subsequent waivers where their presence in Canada is "recurring." Moreover, where a non-resident's period of service in Canada falls below the physical presence threshold to establish a P.E., TEI questions Revenue Canada's authority even to impose a return-filing requirement. Assuming that such a filing requirement is proper, we recommend that Revenue Canada develop a simple, one-page return for non-residents whose service agreement is for a period of less than a requisite number of days.(9) Eligibility to employ the simplified return could be joined with the proposed waiver rules. For example, where a nonresident's presence is "nonrecurring" and the period of service less than 120 days (Test B of the discussion paper), the nonresident should be eligible to file the simplified return. Similarly, where the nonresident is present less than 180 days during "the period" and less than 90 days during the current contract/engagement for "recurring" services (Test C of the draft), the nonresident should be eligible to use the simplified return. The instructions for filing must be clear, especially concerning eligibility to use the simplified return in lieu of filing Form T1 or T2. The simplified form could be supplied to the taxpayer with the waiver.

Next, Paragraph 14 of IC 75-6R states that the application for waiver must be filed (a) no later than one month prior to the commencement of the engagement when the request for waiver of withholding is based on tax treaty protection and (b) no later than 10 working days prior to the commencement of the engagement when the waiver request is based on the applicant's estimated income and expense. Regrettably, the discussion draft retains the requirement that the waiver request be filed 30 days prior to the commencement of services. TEI believes that the requirement to file a waiver request prior to commencement of the engagement is unworkable for most commercial consultations. Hence, we recommend that paragraph 14 of IC 75-6R be deleted. Service agreements can be contracted by many different business units within a company. Nonetheless, the tax department is the only place within a company where the personnel are knowledgeable about the requirements of Regulation 105. More often than not, the tax department is alerted that a non-resident has performed services for a company only when the accounts payable department is evaluating an invoice for a progress payment. In other words, the requirement that a waiver application be filed in advance of the commencement of services makes the waiver process nearly useless for large companies with decentralized decision-making authority. TEI recommends that a waiver request be considered timely filed as long as an application is approved prior to the date of payment for the services.

Finally, we urge Revenue Canada to release an updated information circular in draft form and consult with interested parties (including TEI) on the draft. We shall be pleased to meet with representatives from Revenue Canada to discuss our recommendations and to review and comment on the draft circular.

Conclusion

TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is John M. Allinotte. If you should have any questions about the submission, please do not hesitate to call Mr. Allinotte at [phone] (ext. 6821), or Pierre M. Bocti, TEI's Vice President for Canadian Affairs, at [phone].

Notes

(1) See generally Interpretation Circular 75-6R, Required Withholding from Amounts Paid to Non-Resident Persons Performing Services in Canada (January 15, 1988).

(2) IC 75-6R [paragraph] 11.

(3) TEI has urged the Department of Finance to continue its treaty negotiation efforts in order to expand the number of countries for which the bilateral exemption is available.

(4) Quebec's practice is to follow the federal tax treatment. Where a waiver of withholding is granted for federal tax purposes, no Quebec withholding is required. Where federal withholding tax is required, Quebec imposes an additional nine-percent withholding tax. As a result, a $100 pretax cost to companies for non-resident services rendered in Quebec is often inflated to approximately $132.

(5) In the case of non-resident companies with affiliates or a parent company in Canada, the company's tax department will often file the waiver application and work with Revenue Canada until the waiver is issued. The resulting diversion of corporate resources is burdensome.

(6) TEI believes that most of the revenue collected pursuant to Regulation 105, over and above amounts to which the Government is legitimately entitled for the activities of Canadian "branches" and for which a return likely is filed, is a windfall. The windfall arises from two scenarios. In the first, Canadian companies have been required, as a result of the bargaining strength of the vendor (e.g., a monopoly service provider), to bear the tax cost through a gross-up provision. Since there is no mechanism afforded the Canadian company to recoup the tax, and since the non-resident is indifferent to filing for a refund because it has been made "whole," the revenues collected are a windfall for the Government. The second case is similar to that described in the text. The Canadian purchaser has superior bargaining power and withholds the tax from a nonresident lacking a P.E. in Canada. Nonresidents lacking a P.E. in Canada are quite likely to be unsophisticated in Canadian tax matters, and unless that non-resident is willing to pay high fees for sophisticated tax planning and compliance advice on "foreign" tax issues, the lack of formal guidance inhibits the filing of refund claims.

(7) The discussion draft does not specify how the services in the "following years" are to be determined. The examples in the Appendix to the discussion draft specifically state whether there is a contract for services in future periods and, in each case, the contract is for a term certain and the analysis assumes that the number of days of activity is equivalent to the term of the agreement. At the time of application for a waiver, the non-resident is presumably only required to disclose known contractual term commitments. Even with known future commitments, however, it is unclear how the non-resident is to project its total days of service in Canada -- especially if the contract is indefinite in duration (e.g., "until completion"). Is an applicant's good faith estimate of the number of days to complete the services sufficient? At a minimum, the draft should clarify that a good-faith estimate of the period of future service is all that is necessary.

(8) Article V, [paragraph] 7 of the treaty states "[a] resident of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because such resident carries on business in the other State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business."

(9) The elements of a simple form might include identifying information for the taxpayer, a question concerning the number of days for which services were performed under the contract, a question about whether the taxpayer obtained a waiver and the date of such waiver application or grant date, the total amount of income earned during the term, the amount of tax withheld (if any), a designation of the treaty under which protection is sought, a request for a refund of tax withheld (if any), and the taxpayer's signature.