TD Securities (USA) LLC v. The Queen

TD Securities (USA) LLC v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2010-04-08
Neutral citation
2010 TCC 186
File numbers
2008-2314(IT)G
Judges and Taxing Officers
Patrick J. Boyle
Subjects
Income Tax Act
Decision Content
Docket: 2008-2314(IT)G
BETWEEN:
TD SECURITIES (USA) LLC,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeal heard on January 20, 21 and 22, and on February 2, 2010,
at Toronto, Ontario.
Before: The Honourable Justice Patrick Boyle
Appearances:
Counsel for the appellant:
Al Meghji
Patrick Marley
Pooja Samtani
Counsel for the respondent:
Elizabeth Chasson
H. Annette Evans
Brandon Siegal
____________________________________________________________________
JUDGMENT
The appeal from the assessments made under the Income Tax Act with respect to the appellant’s 2005 and 2006 taxation years is allowed, with costs, in accordance with the Reasons for Judgment attached hereto.
Signed at Toronto, Ontario, this 8th day of April 2010.
"Patrick Boyle"
Boyle J.
Citation: 2010 TCC 186
Date: 20100408
Docket: 2008-2314(IT)G
BETWEEN:
TD SECURITIES (USA) LLC,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Boyle J.
[1] The issue in this case is whether a limited liability company established in the United States (an “LLC”) is entitled to enjoy the benefit of the Canada‑United States Income Tax Convention (the “US Treaty”) in respect of its Canadian‑sourced income. Since the US Treaty is only applicable to residents of either country or of both countries, and the appellant is not a resident of Canada, the question in this case narrows to whether the appellant is a resident of the United States (the “US”) for purposes of the US Treaty. The Fifth Protocol entered into between Canada and the United States amended the US Treaty to add specific rules that apply to LLCs and other fiscally transparent entities including partnerships (the “Fifth Protocol Amendments”). However the Fifth Protocol Amendments were adopted and came into force after the periods in question.
I. Facts
[2] The appellant, TD Securities (USA) LCC (“TD LLC”) is a limited liability company governed by the Limited Liability Company Act of the State of Delaware.
[3] The sole member of TD LLC is TD Holdings II Inc. (“Holdings II”) a Delaware corporation that is not resident in Canada for purposes of the Income Tax Act (the “Canadian Act”) and is a resident of the US for purposes of the US Treaty. TD LLC’s predecessor entity, TD Securities USA Inc., was a Delaware corporation. In 2004 TD Securities USA Inc. was converted into a LLC and renamed TD LLC. This conversion was a tax‑deferred non‑recognition transaction under the US Internal Revenue Code (the “US Code”). The reorganization was done to allow a consolidation of the losses and gains of the subsidiaries of Holdings II for US state income tax purposes.
[4] An LLC is a company that is recognized as a distinct legal entity separate from its members under Delaware and United States law. The parties agree that a US LLC is similarly recognized as a distinct legal entity separate from its members under Canadian law. The appellant does not contest that TD LLC should be treated as a corporation under Canadian law. The Court was not invited by either party to revisit the characterization issue.
[5] Holdings II is a wholly‑owned direct subsidiary of Toronto Dominion Holdings (USA) Inc. (“TD USA”), another Delaware corporation. TD USA is a wholly‑owned direct subsidiary of The Toronto‑Dominion Bank, a Canadian chartered bank.
[6] TD LLC is a registered US broker‑dealer that provides financial services in the capital markets sector such as foreign exchange trading and interest rate swaps. It has carried on its business since the mid to late 1970s. It is based in New York City because that is where its business can best be transacted and that is where most of its customers are located or headquartered. Its headquarters are in New York City. It has over 500 employees.
[7] TD LLC has a branch operation in Canada for the purpose of serving its US customers. Given the regulation of the financial services sector in both countries, its US customers need or prefer to do business in Canada with a US company.
[8] TD LLC’s Canadian branch profits for 2005 and 2006 were reported by it in its Canadian tax returns. Non‑residents of Canada that carry on business in Canada are subject to ordinary Canadian income tax under Part I of the Canadian Act on the income from their Canadian business activity. The US Treaty provides that a US resident that carries on business in Canada is only subject to Canadian income tax if the business is carried on through a permanent establishment (“PE”) in Canada. There is no dispute that TD LLC’s Canadian branch satisfies the definition of a PE.
[9] Part XIV of the Canadian Act also provides that a non‑resident carrying on business in Canada will be liable for an additional tax of 25% of its Canadian net after‑tax income. This is commonly called “branch tax”. Its serves as the equivalent of the 25% Canadian non‑resident withholding tax on dividends levied under Part XIII of the Canadian Act that would have been payable if the non‑resident had carried its Canadian business through a Canadian subsidiary corporation, instead of directly through a branch, and had paid a dividend equal to its net after‑tax income. In this way, the Canadian tax consequences are generally the same for non‑residents of Canada whether their Canadian business is carried on through a Canadian subsidiary or a Canadian branch.
[10] Part XIV of the Canadian Act provides that, if a Canadian tax treaty with the country of residence of a non‑resident carrying on business in Canada through a branch provides for a lesser withholding tax rate on dividends than 25%, the 25% rate under Part XIV is similarly reduced[1] unless the treaty itself reduces the rate under Part XIV. The US Treaty expressly provides[2] that the rate of Canadian Part XIV tax for Canadian branches of US residents is reduced to the same 5% rate applicable under the US Treaty to dividends paid by a wholly‑owned Canadian subsidiary to its US parent. TD LLC claimed the reduced rate of Canadian branch tax of 5% under the US Treaty in respect of the 2005 and 2006 income of its Canadian branch.
[11] The Canada Agency Revenue (“CRA”) assessed TD LLC to deny it the benefit of the 5% US Treaty rate of branch tax and assessed Part XIV branch tax at the statutory rate of 25%.
[12] The US Code taxes individuals based upon citizenship or residence. It does not use the concept of residence to levy income tax on corporations. Under the US Code corporations are divided into domestic and foreign corporations. Domestic corporations, those established, organized or incorporated in the US, are generally subject to tax on their worldwide income whereas foreign corporations, those that are not domestic corporations, are not subject to worldwide tax but are taxed on their US‑sourced income.
[13] Under the US Code an LLC is entitled to elect to be treated as either (i) a corporation subject to US federal income tax like any other US domestic corporation, or (ii) a flow‑through or disregarded entity whose income will be flowed through to its member or members. If it elects to be disregarded and it has more than one member, the LLC will be regarded as a partnership for US federal income tax purposes[3]. Under the US Code, as under the Canadian Act, the income of a partnership is required to be allocated amongst its partners and included in income at the partner level. If an LLC elects to be disregarded and has only one member, its activities will be treated in the same manner as a sole proprietorship, branch, or division of the member. If an LLC does not file an election under the so‑called “check‑the‑box” regulations, it will be deemed to have elected to be a disregarded flow‑through entity.
[14] Under the US Code both a partnership and a disregarded LLC are treated as a pass‑through entity, that is an entity that is not taxed at the entity level but is taxed at the level of the owners of the entity.[4]
[15] TD LLC did not file an election under the “check‑the‑box” regulations. Accordingly, under the US Code it is a disregarded entity and it is not itself subject to tax on its income. Instead, all of its income is required to be included in the income of its sole member, Holdings II, as if the activities of TD LLC were carried on directly by Holdings II. The 2005 and 2006 income of TD LLC’s Canadian branch was included in the income of Holdings II in this manner under the US Code.
[16] The income of Holdings II is consolidated with the income of its direct parent, TD USA, under the US Code provisions for consolidated returns by US parent corporations. In this way, TD USA pays US tax on all of the income computed under the US Code for Holdings II. This includes all of the income of TD LLC, just as it did prior to the reorganization when TD LLC was a corporation wholly‑owned by Holdings II. Under the provisions of the consolidated group’s tax reimbursement agreement, the taxes payable by TD USA under the US Code on the earnings of Holdings II and TD LLC are charged back to, and borne by, each of Holdings II and TD LLC being the entities that earned the income giving rise to the tax.
[17] TD USA was unable to claim a full foreign tax credit in its consolidated US return under the US Code in respect of the Part XIV branch tax payable on the Canadian income of TD LLC. TD USA was subject to the limitations on foreign tax credits under the US Code that relate to the comparable US rate of taxation on foreign‑sourced income. Thus, the assessments in question increased the combined US and Canadian tax imposed on the Canadian‑sourced income of TD LLC.
[18] Three experts on US taxation law testified, one called by the appellant and two by the respondent. They agreed on how the income of LLCs and partnerships is subject to tax under the US Code generally, and on how the income of TD LLC would have been taxed in the US in its particular circumstances. These are as summarized above.
[19] The expert called by the appellant differed in his views from those of the experts called by the respondent as regards whether, at the relevant time, the US Internal Revenue Service (“IRS”) would have interpreted the term “resident of a Contracting State” under the US Treaty to include a Canadian flow‑through entity or other disregarded entity in comparable circumstances. Based upon the expert evidence presented, the Court is unable to conclude as a matter of fact whether or not the IRS would have regarded a Canadian flow‑through entity in those years as a resident of Canada for purposes of the US Treaty entitled to treaty benefits in respect of any of its US‑sourced income. It appears from each of the three experts that the IRS and the US never made such a determination. In addressing this question the experts instead addressed what they thought the IRS would have done if it was required to make such a determination based upon US legal and administrative positions in related areas. The information provided by the experts in their reports and in their testimonies was helpful, factual evidence as described in greater detail below.
[20] The expert reports filed by the respondent included questions and answers phrased in terms of the very question to be determined by this Court as a matter of Canadian law, i.e., whether TD LLC was a resident of the US for purposes of the US Treaty. Appellant’s counsel took initial exceptions to the reports on this basis. Both of the respondent’s reports were admitted into evidence as expert opinion evidence because the information contained in their written reasoning working towards their answer was itself very helpful and informative factual evidence of US law and IRS practice and that information was admissible expert opinion evidence. The respondent’s expert opinions have been disregarded in so far as they are opining on what this Court’s answer should be to the question before it.
[21] There was no evidence whether TD LLC and/or Holdings II requested the assistance of the US competent authority as provided for in the US Treaty to resolve their treaty dispute nor, if so, what the positions of the US and Canadian competent authorities were, nor what the outcome was.
II. Positions of the Parties
[22] It is the respondent’s position that the meaning of the phrase resident of a Contracting State set out in the US Treaty is clear and unambiguous and that the evidence is clear that TD LLC was not itself liable to tax in the US. The respondent maintains that the meaning of the language chosen by two countries to define to whom the US Treaty applies cannot be interpreted in a manner which will entitle TD LLC to the benefits of the treaty without either ignoring some of the words used or reading some words into it. As the respondent argued, treaties should be interpreted liberally and purposively but, in the end, effect must be given to the words chosen.
[23] The respondent further maintains that, even if TD LLC is considered to be liable to tax in the US by virtue of its income being taxed to Holdings II, that tax is not “by reason of [TD LLC’s] domicile, residence, place of management, citizenship, place of incorporation or any other criterion of a similar nature” as required by Article IV of the US Treaty.
[24] The respondent also maintains that, if TD LLC is successful, LLCs will, in the future, be able to claim treaty relief on the same basis instead of on the basis of the Fifth Protocol Amendments. The respondent is concerned that this will be an inappropriate result since the Fifth Protocol Amendments have set out specific conditions which must be met to claim relief which would be rendered meaningless if a US LLC could claim relief otherwise than under paragraphs 6 and 7 of Article IV added by the Fifth Protocol Amendments.
[25] The appellant has two distinct bases which it puts forth to support its claim for treaty relief for the Canadian-sourced income of TD LLC.
[26] The appellant’s first position is that the phrase “liable to tax in” the US is a phrase which is not defined in the US Treaty and which therefore falls to be defined by this Court by reference to Canadian law, and is different from the mere determination whether a person is required to pay tax on its income under the US Code. The appellant submits that, on this basis, this Court can conclude that TD LLC was liable to tax in the US and hence was a resident of the US for purposes of Article IV.
[27] The appellant’s alternative argument is that, consistent with the commentaries to the relevant provisions of the Model Tax Convention on Income and on Capital of the Organisation for Economic Co‑operation and Development (the “OECD and the OECD Model Treaty”), which commentaries neither Canada nor the US reserved upon nor made material observations, a liberal interpretation and application of the US Treaty designed to achieve its purpose must give a meaning to the phrase “resident of a Contracting State” that includes a US LLC such as TD LLC. In addition to the OECD commentaries, the appellant relies upon the 1999 OECD report on the Application of the OECD Model Tax Convention to Partnerships (the “OECD Partnership Report”).
III. Analysis, Law and Authorities
A. The US Treaty Provisions
[28] The US Treaty was entered into by Canada and the US in 1980 and came into force in 1984. It replaced a previous income tax convention between the two states.
[29] Article I of the US Treaty provides that the Convention “. . . is generally applicable to persons who are residents of one or both of the Contracting States.”
[30] Article II provides that the Convention “. . . shall apply to taxes on income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are levied”.
[31] Article III of the US Treaty sets out the definitions applicable for purposes of the Convention “. . . unless the context otherwise requires”.
[32] Person is defined in Article III to include “. . . an individual, an estate, a trust, a company and any other body of persons”. Company is defined to mean “. . . any body corporate or any entity which is treated as a body corporate for tax purposes”.
[33] It is not disputed that TD LLC is a person as defined. It is not clear if the Court needs to decide if it is a company but it appears that, for purposes of applying the US Treaty in Canada, TD LLC is a company since Canada treats such an LLC as a body corporate for purposes of the Canadian Act.
[34] The US Technical Explanation to the treaty issued by the US Treasury Department in 1984 expressly confirms that a partnership is a person for this purpose. The Canadian Minister of Finance indicated by press release that the US Technical Explanation accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the US Treaty.[5] Little purpose is advanced by confirming that a partnership is a person if not to confirm that a partnership’s income can qualify for treaty benefits. It would hardly warrant express mention in the Technical Explanation otherwise.
[35] Article III goes on to provide that “[a]s regards the application of the Convention by a Contracting State any term not defined therein shall, unless the context otherwise requires and subject to the provisions of Article XXVI (Mutual Agreement Procedure), have the meaning which it has under the law of that State concerning the taxes to which the Convention applies.” Section 3 of the Income Tax Conventions Interpretation Act is to a similar effect. In other words, in these proceedings, this Court is to give any term used in the US Treaty and not defined therein the meaning that term has in Canadian law for purposes of the Canadian Act unless the context otherwise requires.
[36] Article IV deals with residence. It provides that “. . . the term ‘resident’ of a Contracting State means any person that, under the laws of that State, is liable to tax therein by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature, . . .”.
[37] The definition carries on “. . . but in the case of an estate or trust, only to the extent that income derived by the estate or trust is liable to tax in that State, either in its hands or in the hands of its beneficiaries.” Under the US Code, as under the Canadian Act, the income of an estate or trust may flow out to its beneficiaries for tax purposes in certain circumstances. Thus, the US Treaty assumes that an estate or trust can satisfy the definition, but places a specific restriction thereon.
[38] Subparagraph (b) of the definition of resident of a Contracting State provides that it includes not‑for‑profit organizations and pension funds that were constituted in a contracting state and generally exempt from income taxation in that state by reason of their status. This part of the definition was added to the US Treaty by the Third Protocol in 1995. The 1995 Technical Explanation to the Third Protocol issued by the US Treasury Department[6] describes the addition as a clarification that corresponded to the interpretation previously adopted by both Canada and the US. US not‑for‑profit organizations and pension funds would need to be residents of the US to obtain the general treaty‑reduced rate of Canadian withholding tax on dividends and interest received on their Canadian investments. Further, Article XXI of the US Treaty provides certain not‑for‑profit organizations and pension funds with a complete exemption from Canadian withholding taxes on certain of their cross‑border investments. The contracting states were able to interpret and apply the definition of resident of a contracting state to contextually require the recognition of not‑for‑profit organizations and pension funds as residents of their home country even though they do not generally pay income tax in their home country because they are exempt from tax.
[39] Similarly, the Third Protocol in 1995 added a clause which deemed the government of one of the countries or a political subdivision or local authority thereof, or an agency or instrumentality of any thereof, to be itself a resident of that state. The 1995 Technical Explanation describes this amendment as confirmatory in nature and “it is implicit in the current [pre‑1995 Protocol] Convention and in other US and Canadian treaties, even where not specified”. Treaty residence for government entities was necessary for them to get the general benefit of reduced withholding on cross‑border investments and for public sector pension plans to enjoy the benefit of the Article XXI exemption as fully as private sector pension funds.
[40] These latter are both examples of where specific amendments to the definition of “resident of a Contracting State” were added to the US Treaty even though both countries agreed they were not needed, were confirmatory or clarifying in nature, and had interpreted and applied the pre‑amendment treaty to treat such persons as residents as defined because the context required or because it was implicit.
[41] Article XXVI of the US Treaty deals with the Mutual Agreement Procedure between the Canadian and US competent authorities. It provides specifically that the competent authorities may, in trying to resolve any difficulties or doubts regarding the interpretation or application of the treaty, agree to the elimination of double taxation with respect to income distributed by an estate or trust in subparagraph (e), and to the elimination of double taxation with respect to a partnership in subparagraph (f). It also provides that the competent authorities may consult together for the elimination of double taxation in cases not provided for in the treaty. Subparagraph (f) dealing with partnerships was neither revised nor repealed when the Fifth Protocol Amendments were added.
B. The Fifth Protocol Amendments
[42] The Fifth Protocol Amendments were agreed to between Canada and the US in 2007. The Fifth Protocol Amendments specifically address how the US Treaty thereafter applies to fiscally transparent entities, such as partnerships and LLCs. This was accomplished by adding new paragraphs 6 and 7 to Article IV of the US Treaty as follows:
6. An amount of income, profit or gain shall be considered to be derived by a person who is resident of a Contracting State where:
(a) The person is considered under the taxation law of that State to have derived the amount through an entity (other than an entity that is a resident of the other Contracting State); and
(b) By reason of the entity being treated as fiscally transparent under the laws of the first‑mentioned State, the treatment of the amount under the taxation law of that State is the same as its treatment would be if that amount had been derived directly by that person.
7. An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where:
(a) The person is considered under the taxation law of the other Contracting State to have derived the amount through an entity that is not a resident of the first‑mentioned State, but by reason of the entity not being treated as fiscally transparent under the laws of that State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that amount had been derived directly by that person; or
(b) The person is considered under the taxation law of the other Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as fiscally transparent under the laws of the first‑mentioned State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State.
[43] The Fifth Protocol Amendments are not retroactive and therefore do not apply to TD LLC’s 2005 and 2006 Canadian branch profits. That is not to say, however, that they are irrelevant to the analysis of the issue. The two countries did not agree that the treaty did not previously apply to LLCs and other fiscally transparent entities such as partnerships. They have only specified that, subsequent to the coming into force of the Fifth Protocol Amendments, the treaty will be applicable to such entities on the basis set out and agreed.
[44] The US Treasury Department issued a Technical Explanation in respect of the amendments made to the treaty by the Fifth Protocol. The Canadian Minister of Finance has indicated publicly that Canada was given an opportunity to review and comment on the Technical Explanation to the Fifth Protocol and that “Canada agrees that the Technical Explanation accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the Protocol.”
[45] It is clear that the US did not agree with Canada’s position that, absent the Fifth Protocol Amendments, the US Treaty did not extend to US LLCs. The Technical Explanation confirms this by its choice of language in its discussion of new paragraph 6 of Article IV: “. . . but for new paragraph 6 Canada would not apply the Convention in taxing the income.”(Emphasis added) This sentence appears under the heading “Application of paragraph 6 and related treaty provisions by Canada”. (Emphasis added)
[46] A perhaps surprising and relevant aspect of the Fifth Protocol Amendments is that they are not drafted in a manner that, applied literally, would resolve the problem faced by TD LLC or other US LLCs in later years to which the Fifth Protocol Amendments apply and this is acknowledged in the Technical Explanation. Under the Canadian Act, TD LLC is the legal entity that is the taxpayer required to prepare and file a Canadian income tax return in respect of its Canadian branch profits. The Fifth Protocol Amendments are clearly intended to ensure the LLC’s income enjoys the benefits of the US Treaty. Yet, the Fifth Protocol Amendments do not provide that the LLC will be treated as a resident. To that extent TD LLC and other US LLCs will still not be able to get treaty relief if one seeks to apply the text of the treaty literally. Paragraph 6 provides that the income of an LLC or other fiscally transparent entity will be considered the income of its member, Holdings II in the case of TD LLC. That still does not address how, or strictly speaking why, the LLC would be able to claim the treaty reduction in its Canadian income tax return. The Canadian taxpayer will still be the LLC, not the member. The Fifth Protocol Amendments contemplate relief at the member level, Holdings II, not at the entity level; yet they do not by these terms deliver the contemplated relief if applied strictly and literally.
[47] This is instead dealt with quite differently by the agreement between the tax administrators of Canada and the US in the Technical Explanation. The Technical Explanation acknowledges that a literal application of new paragraph 6 does not resolve the problem. The Technical Explanation provides:
If new paragraph 6 applies in respect of an amount of income, profit or gain, such amount is considered as having been derived by one or more U.S. resident shareholders of USLLC, and Canada shall grant benefits of the Convention to the payment to USLLC and eliminate or reduce Canadian tax as provided in the Convention. The effect of the rule is to suppress Canadian taxation of USLLC to give effect to the benefits available under the Convention to the U.S. residents in respect of the particular amount of income, profit or gain.
However, for Canadian tax purposes, USLLC remains the only “visible” taxpayer in relation to this amount In other words, the Canadian tax treatment of this taxpayer (USLLC) is modified because of the entitlement of its U.S. resident shareholders to benefits under the Convention, but this does not alter USLLC’s status under Canadian law. Canada does not, for example, treat USLLC as though it did not exist, substituting the shareholders for it in the role of taxpayer under Canada’s system.
Some of the implications of this are as follows. First, Canada will not require the shareholders of USLLC to file Canadian tax returns in respect of income that benefits from new paragraph 6. Instead, USLLC itself will file a Canadian tax return in which it will claim the benefit of the paragraph and supply any documentation required to support the claim. (The Canada Revenue Agency will supply additional practical guidance in this regard, including instructions for seeking to establish entitlement to Convention benefits in advance of payment.). Second, as is explained in greater detail below, if the income in question is business profits, it will be necessary to determine whether the income was earned through a permanent establishment in Canada. This determination will be based on the presence and activities in Canada of USLLC itself, not of its shareholders acting in their own right.
[Emphasis added.]
[48] Like the earlier US Treaty amendments dealing with not‑for‑profit organizations and government entities, this is another example of the Canadian and US tax administrators interpreting and applying the chosen language of the treaty to deal with residence in a workable manner to achieve a result consistent with its purpose and context.
[49] What is even more telling with the Technical Explanation to the Fifth Protocol Amendments is that, as the two countries are turning their minds to the wording of new provisions being drafted contemporaneously with the administrative provisions, they are content relying upon a sensible approach to the application and interpretation of the words and not the strict meaning or result of the words chosen for the treaty.
C. The Interpretation of Treaties
[50] The Vienna Convention on the Law of Treaties[7] provides that a treaty is to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose. It also authorizes regard to subsequent practice in the application of the treaty in certain circumstances and for certain purposes, as well as the use of other supplementary means of interpretation when the interpretation of the treaty otherwise leads to a result which is manifestly absurd or unreasonable.
[51] It is fair to say that in this case there is a tension between the ordinary meaning of the terms used in the treaty and its object and purpose. This is a case where it prima facie appears that a strict application of the terms used to define resident of a Contracting State leads to an unreasonable result and thus, regard to supplementary means of interpretation is an appropriate part of the required analysis. The prima facie unreasonableness is demonstrated by, amongst other things, the fact that a strict application of the text would conflict with how both countries have interpreted and applied the treaty to government entities, not‑for‑profit organizations, pension funds and, as described below, partnerships which are themselves also fiscally transparent flow‑through entities.
[52] In The Queen v. Crown Forest Industries Limited et al., 95 DTC 5389, the Supreme Court of Canada had occasion to consider the appropriate interpretation to be given to the phrase “resident of a Contracting State” in Article IV of the US Treaty and, in particular, what it meant to be “liable to tax” in the US by reason of the enumerated criteria.
[53] The Court began from the premise that: “In interpreting a treaty, the paramount goal is to find the meaning of the words in question. This process involves looking to the language used and the intentions of the parties.” The Court went on to quote approvingly from Addy J. in Gladden Estate v. The Queen, 85 DTC 5188, wherein he wrote at p. 5191:
Contrary to an ordinary taxing statute a tax treaty or convention must be given a liberal interpretation with a view to implementing the true intentions of the parties. A literal or legalistic interpretation must be avoided when the basic object of the treaty might be defeated or frustrated insofar as the particular item under consideration is concerned.
[54] Both the Vienna Convention and the Supreme Court of Canada in Crown Forest confirm that “literalism has no role to play in the interpretation of treaties”: Coblentz v. The Queen, 96 DTC 6531 (FCA).
[55] In Crown Forest the Supreme Court of Canada also held that, in ascertaining the purposes of a treaty article, a court may refer to extrinsic materials which form part of the legal context, including model conventions and official commentaries thereon, without the need to first find an ambiguity before turning to such materials.
[56] The Preamble to the US Treaty sets out its purposes of reducing or eliminating double taxation of income earned by a resident of one country from sources in the other country, and of preventing tax avoidance or evasion. In Crown Forest the Supreme Court of Canada held that the purposes of the US Treaty also included the promotion of international trade between the two countries and the mitigation of administrative complexities arising from having to comply with two uncoordinated taxation systems.
[57] In Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54, 2005 DTC 5523, the Supreme Court of Canada emphasized that “[t]he provisions of the Income Tax Act must be interpreted in order to achieve consistency, predictability and fairness so that taxpayers may manage their affairs intelligently.” This Court sees no reason why the objectives of consistency, predictability and fairness should be any less in the case of the interpretation and application of international tax conventions forming part of applicable Canadian income tax law.
[58] On the substantive issue of the meaning of the phrases resident of a contracting state and liable to tax by reason of the enumerated criteria, the Supreme Court of Canada in Crown Forest clearly concluded that the definition sought to describe those who are subject to as comprehensive a tax liability as is imposed by a state, which in the US as in Canada is taxation on worldwide income. The Court was not faced in Crown Forest with circumstances where one person’s worldwide income was subject to tax in the hands of another related entity resident in the same jurisdiction by virtue of specific US domestic taxing rules. It is nonetheless a strong confirmation that the intended purpose and scope of Articles I and IV of the US Treaty were that the treaty apply to those bearing full tax liability in either of the contracting states based upon the nature and extent of their connections with that country.
[59] In The Queen v. Prévost Car Inc., 2009 FCA 57, 2009 DTC 5053, the Federal Court of Appeal wrote:
10 The worldwide recognition of the provisions of the Model Convention and their incorporation into a majority of bilateral conventions have made the Commentaries on the provisions of the OECD Model a widely‑accepted guide to the interpretation and application of the provisions of existing bilateral conventions (see Crown Forest Industries Ltd. v. Canada, [1995] 2 S.C.R. 802; Klaus Vogel, “Klaus Vogel on Double Taxation Conventions” 3rd ed. (The Hague: Kluwer Law International, 1997) at 43. In the case at bar, Article 10(2) of the Tax Treaty is mirrored on Article 10(2) of the Model Convention.
11 The same may be said with respect to later commentaries, when they represent a fair interpretation of the words of the Model Convention and do not conflict with Commentaries in existence at the time a specific treaty was entered and when, of course, neither treaty partner has registered an objection to the new Commentaries. For example, in the introduction to the Income and Capital Model Convention and Commentary (2003), the OECD invites its members to interpret their bilateral treaties in accordance with the Commentaries “as modified from time to time” (par. 3) and “in the spirit of the revised Commentaries” (par. 33). The Introduction goes on, at par. 35, to note that changes to the Commentaries are not relevant “where the provisions… are different in substance from the amended Articles” and, at par. 36, that “many amendments are intended to simply clarify, not change, the meaning of the Articles or the Commentaries”.
D. OECD Model Treaty
[60] Articles 1 and 4 of the OECD Model Treaty correspond to Articles I and IV of the US Treaty.
[61] The language used in Article I of the US Treaty and Article 1 of the OECD Model Treaty differ in that the US Treaty provides that the treaty is “generally applicable” to residents of a contracting state whereas the OECD Model Treaty uses the word “applicable”. The use of the phrase “generally applicable” in the US Treaty suggests that the US Treaty may also be applicable to others in particular circumstances. Indeed, this is confirmed in the original Technical Explanation to the US Treaty.
[62] The OECD Commentary on Article 1 has more than three pages of commentary on the application of the OECD Model Treaty to partnerships. The commentary on partnerships is instructive in interpreting the phrase “liable to tax” in a contracting state because neither the OECD Model Treaty nor, in the years in question, the US Treaty expressly provided how they applied to partnerships and partners. Of specific interest are paragraphs 4, 5 and 6.3 of the OECD Commentary on Article 1 which read as follows:
4. A first difficulty is the extent to which a partnership is entitled as such to the benefits of the provisions of the Convention. Under Article 1, only persons who are residents of the Contracting States are entitled to the benefits of the tax Convention entered into by these States. While paragraph 2 of the Commentary on Article 3 explains why a partnership constitutes a person, a partnership does not necessarily qualify as a resident of a Contracting State under Article 4.
5. Where a partnership is treated as a company or taxed in the same way, it is a resident of the Contracting State that taxes the partnership on the grounds mentioned in paragraph 1 of Article 4 and, therefore, it is entitled to the benefits of the Convention. Where, however, a partnership is treated as fiscally transparent in a State, the partnership is not “liable to tax” in that State within the meaning of paragraph 1 of Article 4, and so cannot be a resident thereof for purposes of the Convention. In such a case, the application of the Convention to the partnership as such would be refused, unless a special rule covering partnerships were provided for in the Convention. Where the application of the Convention is so refused, the partners should be entitled, with respect to their share of the income of the partnership, to the benefits provided by the Conventions entered into by the States of which they are residents to the extent that the partnership’s income is allocated to them for the purposes of taxation in their State of residence (cf. paragraph 8.7 of the Commentary on Article 4).
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6.3 The results described in the preceding paragraph should obtain even if, as a matter of the domestic law of the State of source, the partnership would not be regarded as transparent for tax purposes but as a separate taxable entity to which the income would be attributed, provided that the partnership is not actually considered as a resident of the State of source. This conclusion is founded upon the principle that the State of source should take into account, as part of the factual context in which the C