U.S.-Canada income tax treaty requires income of U.S. branch to be determined under facts and circumstances.

The Tax Court held in North West Life Assurance Company of Canada, 107 TC 363 (1996), that the U.S.-Canada income tax treaty requires that income of a U.S. branch of a Canadian corporation be determined based on the facts and circumstances of the separate branch. North West, a Canadian corporation, conducted an insurance business in the U.S. and Canada. The U.S. business was conducted through a permanent establishment (PE). North West computed its income without regard to the minimum net investment income that Sec. 842(b) treats as effectively connected income.

The starting point for the court's separate-entity analysis was the language of Art. VII(2) of the treaty, which provides that "there shall ... be attributed to that permanent establishment the business profits which it might be expected to make if it were a distinct and separate person engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the resident..."

The court found the language of Art. VII (2) to be ambiguous and, therefore, looked to other sources for clarification. In particular, the court relied on the Commentaries to the Organization for Economic Cooperation and Development (OECD) Model Treaty to support the view that the profits attributable to a PE be determined based on the PE's facts.

The court then analyzed whether Sec. 842(b) prescribes a minimum amount of effectively connected net investment income based on the facts as they relate to the taxpayer's PE. Agreeing with the taxpayer, the court concluded that Sec. 842(b) attributes a deemed amount of income to the taxpayers U.S. branch not based on the activities of the branch, but rather, on the investment performance of domestic insurance companies.

The IPS argued that Sec. 842(b) did not violate the separate-entity principle because the formula is used to determine the assets the taxpayer might be expected to hold if it were a separate entity.

In rejecting the Service's argument, the court again relied on OECD commentary. The commentary provides that, even though formulary approaches to determining income may be appropriate in certain cases, the preferred method of determining income is to use the branch's separate accounts. If other methods (other than using the branch's accounts) are to be used, the method must be customary and based on suitable criteria. The court found that Sec. 842(b) violates these tests. Sec. 842(b) was revised in important respects after the adoption of the treaty, and looks to either domestic industry averages or the taxpayer's worldwide investment (not the branch activities) and imputes income on all the taxpayer's investment assets (rather than merely the excess).

The court also relied on the fact that the taxpayer did not commingle the assets of the PE and the home office and that the PE and the home office maintained separate investment strategies for reasons relating to currency risk and the maturity of liabilities.

The court also found Sec. 84 inconsistent with Art. VII(5), which requires a PE's income to be determined by the same method from year to year, unless there is a good and sufficient reason to the contrary. The taxpayer was not in fact subject to Sec. 842(b) in all years because in some years, its effectively connected net investment income exceeded the minimum amount determined under Sec. 842(b).

The court took notice that the IRS did not argue that Sec. 482 applied in this case, and, therefore, did not consider its application in light of the treaty.

The North West case may support the position that other formulary methods contained in the Code do not apply when the applicable treaty contains language similar to that in the U.S.-Canada treaty. Foreign corporations engaged in a U.S. insurance or other business and entitled to treaty benefits should review the North West case and the applicable treaty to determine if they can reduce their U.S. effectively connected income or increase their deductible interest expense on a separate-entity approach.

For a foreign corporation subject to the U.S. branch-profits tax, a reduction in U.S. profits attributable to a PE or an increase in deductible interest would decrease the branch-profits tax as well as the corporate tax liability.

From Diane L. Renfroe, J.D., Washington D.C.