Correspondence To the Editor: Re: June 5 Motion Addressing Section 17 Anomalies The June 5, 2000 notice of ways and means motion 1 contains changes to section 17 of the Income Tax Act 2 that correct certain anomalies identified in my article on section 17 published in the Canadian Tax Journal, issue no. 3, 1999. 3 These amendments are effective for taxation years that begin after February 23, 1998. Two of these amendments are as follows: 1) New subsection 17(11.2) provides relief in cases where the conditions in paragraph 17(3)(b) are not otherwise met by exempting an amount owing from the application of the anti-avoidance rule in subsection 17(2). This new provision provides relief in a situation such as that reflected in example 5 on pages 657-58 of my article. 2) The definition of the phrase exempt loan or transfer in subsection 17(15) is expanded to include dividends or a reduction in paid-up capital paid by a corporation resident in Canada on shares of a class of capital stock. An exempt loan or transfer is also exempt from the application of subsection 17(2). Joint Venture Exception to Subsection 17(2) Example 5 (figure 4) at pages 657-58 of my article illustrates how anomalous results previously arose with respect to foreign joint ventures. In this fairly common example, Canco invests in the equity of CFA and CFA makes a noninterest-bearing loan to FA1, a non-controlled foreign affiliate of Canco. The other joint venture partner of FA1 is not related to CFA and also makes a noninterest-bearing loan of the same amount to FA1. Suppose FA1 (the intermediate lender referred to in new subsection 17(11.2)) uses the borrowed funds from CFA (the initial lender ) and the other 1 Canada, Department of Finance, Notice of Ways and Means Motion To Amend the Income Tax Act, the Income Tax Application Rules and Certain Acts Related to the Income Tax Act, June 5, 2000. 2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the Act ). Unless otherwise stated, statutory references are to the Act. 3 Penny Woolford-Marshall, Amendments to Section 17: Imputed Income to Canadian Resident Corporations on Certain Loans to Non-Residents, International Tax Planning feature (1999), vol. 47, no. 3 Canadian Tax Journal 640-62. 867
868 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Figure 4 Canco Joint venture partner 100% CFA 50% 50% FA1 100% FA2 joint venture partner to make a loan to FA2 (the intended borrower ), which uses the funds in an active business it carries on. Before the June 5, 2000 amendments, it appeared that subsection 17(2) would deem the entire loan to FA2 by FA1 to be a loan by Canco to FA2, even though the property transferred by Canco was less than this amount. New subsection 17(11.2) fixes this problem because the loan from FA1 to FA2 will be the lesser of the loan from CFA to FA1 and the loan from FA1 to FA2. The loan made by FA1 to FA2 is deemed made by CFA to FA2 directly under the same terms and conditions. (This solution is suggested in my article at footnote 40.) Exempt Loan or Transfer The changes to the definition of exempt loan or transfer in subsection 17(15) deal with the problems illustrated in example 3 (figure 3) at pages 656-57 of my previous article. Example 3 points out the anomaly of the possible application of the new antiavoidance rule in subsection 17(2) to a transfer of property that includes a return of capital or a dividend payment to a foreign parent by a Canadian corporation ( Canco ) where the funds are subsequently used by the foreign parent to make a loan to a non-resident subsidiary.
CORRESPONDENCE 869 Figure 3 Foreign parent (creditor) Return of capital or dividend 100% 100% Loan Canadian corporation (Canco) Non-resident subsidiary (debtor) Under the old rules, the loan by the foreign parent to its non-resident subsidiary was exempt from the application of subsection 17(2) only if the loan was made under arm s-length terms and conditions, and either Canco and the creditor were not related, in which case the reduction of capital or the dividend paid by Canco would be an exempt transfer pursuant to subsection 17(15); or the debtor and creditor were not related and any interest earned on the loan would not result in foreign accrual property income (FAPI). For purposes of applying the second exception, the creditor is considered a foreign affiliate under subparagraph 17(3)(b)(ii) in determining whether FAPI arises if interest is payable on the loan. As a result, under current legislation, subsection 17(2) applies to deem Canco in the example to have made a loan to the non-resident subsidiary. This problem is now fixed by the specific inclusion in the definition of exempt loan or transfers in subsection 17(15) of dividends and paid-up capital reduction payments made in this circumstance. A complete summary of developments since the publication of my article with respect to the Canada Customs and Revenue Agency s interpretation of technical issues relating to section 17 is beyond the scope of this letter. My comments herein are provided as an update on these recent proposed legislative changes that readers of my previous article should be aware of. Penny Woolford-Marshall KPMG LLP July 13, 2000
870 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Re: A Note on Signing Bonuses Revenue Canada (now the Canada Customs and Revenue Agency the CCRA ) announced in Internal Memo 981931 1 the department s view that a portion of a true (no-strings-attached) athletic signing bonus should be attributed to services rendered outside Canada, and that this portion should therefore not be taxable in Canada. The view is technically incorrect, because it relies on a misreading of the Income Tax Act 2 and on a mistaken evaluation of a US court decision. It gives up revenue without any good reason, and it risks institutionalizing the practice of misrepresenting signing bonuses. [A] true signing bonus, says the memo, is an amount paid simply to induce an athlete to sign a player contract. The payment of the signing bonus should not be dependent on the athlete actually playing for the team and it should not be subject to conditions other than the signing of the player contract. 3 The memo then observes: While it has been argued that paragraph 115(2)(c.1) could be used to tax the full amount of a signing bonus, there does not seem to be any rationale from a tax policy perspective for wanting to tax the signing bonus any differently than the salary earned under the employment contract (i.e. Salary earned under such an athlete s employment contract is apportioned on the basis of the services rendered by the athlete for the Canadian team both within and outside Canada and the portion of the salary which relates to services rendered in Canada is included in the athlete s TIEC [taxable income earned in Canada]). The words where any such service is to be performed in Canada in subparagraph 115(2)(c.1)(i) of the Act and the words for services to be performed in Canada in subparagraph 115(2)(c.1)(ii) of the Act also indicate that the taxable amount of such a signing bonus should be determined on a reasonable basis which reflects the portion of services expected to be rendered by the non-resident athlete in Canada. In this regard, where a signing bonus was paid to enter into a contract to perform services inside and outside Canada, it is also reasonable to regard a portion of this signing bonus to apply to the services to be performed outside Canada. Perhaps it is independently reasonable to adopt this view, but the Act does not. Subparagraphs 115(2)(c.1)(i) and (ii) do not tell us what amounts are 1 CCRA document no. 981931, August 11, 1998. 2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the Act ). Unless otherwise stated, statutory references are to the Act. 3 Other characterizations vary slightly, but the central notion is that a true signing bonus is for something other than services to be rendered afterward by the recipient as a player. Compare, for example, US Rev. rul. 55-727, 1955-2 CB 25; Rev. rul. 58-145, 1958-1 CB 360; and Rev. rul. 74-108, 1974-1 CB 248; a recent Canadian case, Khabibulin v. The Queen, 2000 DTC 1426 (TCC), see infra footnote 11; and a recent article in this journal by Robert E. Beam, Stanley N. Laiken, and Daren A. Raoux, The Taxation of Non-Resident US Athletes Employed by Canadian-Based Professional Sports Teams: Attracting Athletes to Canada, Personal Tax Planning feature (1999), vol. 47, no. 2 Canadian Tax Journal 305-40, at 315.
CORRESPONDENCE 871 taxable. They elaborate on the characterization addressed in paragraph (c.1), which is the characterization of what it is to be such-and-such a person. For someone who is a person described in this paragraph, income is then determined under paragraphs (d), (e), and (f). In particular, subparagraph (e)(i) captures any remuneration in respect of an office or employment that was paid to the non-resident person directly or indirectly by a person resident in Canada and was received by the non-resident person in the year, except to the extent that the remuneration is attributable to the duties of an office or employment performed by the non-resident person anywhere outside Canada. The exception cannot apply to any part of a true signing bonus, since a true signing bonus is not attributable to the performance of any duties at all. The Act decidedly does not indicate that a true signing bonus should be only partially taxable in Canada. 4 The memo also seeks support in US practice: It is our understanding that the U.S. would tax such a signing bonus in the same manner.... In the U.S. court case referred to, Ken Linseman, a resident of Canada, received a non-refundable signing bonus to sign a standard WHA player s contract with the Birmingham Bulls, a U.S. hockey team which would play games in the U.S. and in Canada. The Court held that the signing bonus was taxable in the U.S. but only to the extent that it related to services to be performed in the U.S. (i.e. a reasonable allocation of the signing bonus was made on the basis of the games the Bulls contemplated playing within and without the U.S. during a regular season). It is true that the decision in the Linseman case 5 was to apportion the income from a true signing bonus, and it is also true that the decision has not been superseded by any later decision. However, Linseman should not be considered an authoritative expression of current US views. The taxation year at issue in Linseman was 1977, which was still governed by the 1942 treaty between Canada and the United States. 6 Not only did that treaty have nothing resembling current article XVI(4) (which was added to the 4 It is not necessary to trace the rest of the argument in detail through the Act. Using the income determined under section 115, we follow section 3 to sections 5 and 6, and in particular to subsection 6(3), which deems the amount to be remuneration for the payee s services rendered as an officer or during the period of employment. The question might be raised whether, since the non-resident athlete s period of employment will include workdays outside Canada, subsection 6(3) tacitly operates to source the income. If it does so operate, the Act offers no relief the operation of section 115 occurs earlier in the calculation. At this point, the only remaining division D deductions are the division C and division F deductions to which paragraph 115(1)(d) refers. Nor, of course, could a foreign tax credit be claimed by an athlete who is at no time in the year resident in Canada. 5 Ken Linseman v. Commissioner, 82 TC 514 (1984). 6 Convention Between Canada and the United States on Income Taxation, signed at Washington, DC on March 4, 1942, as modified by supplementary conventions in 1950, 1956, and 1966.
872 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE 1980 treaty 7 by the 1984 protocol); it also did not contain the general protection that article XV(1) provides in the 1980 treaty. The differences have two important effects: 1) Absent article XVI(4), there was nothing that would have allowed the court to tax the entire amount of the bonus, given its finding that the bonus was not compensation for services to be rendered. As a matter of logic, there were only two possible outcomes either none of the bonus was taxable, or some of it was. If a similar case were heard today, it would be open to the court to invoke article XVI(4) to claim jurisdiction over the entire amount. 8 2) The court was not hindered in its judgment by article XV(1). In the 1942 treaty, the dependent personal services article (article VII) contained no general prohibition against taxing employment income unless services were rendered in the country of non-residence; it contained only the kind of protection that is now found in article XV(2). By contrast, article XV(1) of the 1980 treaty introduced the much stronger constraint that salary, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. The court was thus not prevented from finding that a portion of the employment income was taxable in the United States even though that income was not linked to services performed in the United States. With the advent of article XV(1), it would be impossible for a court to arrive at the finding in Linseman without giving up the premise that the bonus is not compensation for services to be rendered. In short, the context of Linseman has been crucially altered by the 1980 treaty and the 1984 protocol to it. There is no reason to think that the view expressed in the memo will be reciprocated in the United States; it is hard to see how US authorities would fail now to apply the straightforward treatment available to them under article XVI(4) of the treaty. 9 The effect on revenue, and on player preferences, can be seen from the following table. The obvious effect on revenue is that, where a true signing bonus is at issue, players from non-treaty countries will pay less Canadian tax, and players from 7 The Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, and July 29, 1997. 8 Article XVI(4) allows the country where the team (but not the signing player) is resident to tax a signing bonus but limits the tax to 15 percent of the gross. Article XXIV(3) stipulates that income that is taxable in a country is deemed to arise in that country. Thus, the treaty would source the entire amount of a signing bonus to the country where the team is resident. 9 See supra footnote 8.
CORRESPONDENCE 873 Player Services True bonus True bonus origin bonus (correct) (per memo) Non-treaty Graduated rates Graduated rates Graduated rates country applied to portion a applied to whole applied to portion United States Graduated rates Lesser of 15% Lesser of 15% applied to portion b of gross and of gross and graduated rates graduated rates rates applied rates applied to whole to portion Other treaty Graduated rates Exempt from tax Exempt from tax countries c applied to portion in Canada d in Canada a Subparagraph 115(2)(e)(i) makes it clear that Canadian domestic law will not tax an amount to the extent that the remuneration is attributable to the duties of an office or employment performed by the non-resident person anywhere outside Canada. b A bonus related to services is covered under article XV rather than under article XVI. c None of Canada s other treaties contains a clause similar to article XVI(4) in the treaty with the United States, and amounts paid to athletes are generally within the scope of the dependent personal services article. That article, and the article on artistes and athletes, is substantially the same and often identical among Canada s treaties with the countries from which hockey players are signed (Austria, the Czech Republic, Denmark, Finland, the Netherlands, Norway, Sweden, and Russia). Most of the rest of Canada s imported professional athletes are baseball players from the United States. d The exemption is by virtue of the standard dependent personal services article (article XV). The treaty protection is not, perhaps, immediately evident from the wording, which prevents taxation by the state where the employee is not resident (the other contracting state) unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State. The syntax is not the happiest, but the intended referent of therefrom is widely agreed to be the exercise of duties in the other State, and not the whole employment. The commentary on the OECD model (from which the articles are drawn) makes this clear: Employment is exercised in the place where the employee is physically present when performing the activities for which the employment income is paid. (Organisation for Economic Co-operation and Development, Model Tax Convention on Income and on Capital (Paris: OECD) (looseleaf), paragraph 1 of the commentary on article 15.) In any case, it would be wrong to read the article as extending the taxing power asserted in the domestic laws of the two countries; it must, instead, be restraining it. the United States might pay less Canadian tax. Notice also, however, that the policy expressed in the memo gives all signing players the same dominant strategy: no matter what a player s country of origin, the treatment of a true signing bonus is never worse, and sometimes better, than the treatment of a services-linked bonus. There thus appears to be some risk that the memo s policy will increase non-compliance by institutionalizing a preference. 10 10 It could be argued that there is already an incentive for a player to misrepresent the character of a bonus. The only difference, it might be said, is that the current incentive points some-
874 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Finally, it might be objected that the memo simply offers a concession that taxpayers should welcome. But, given that the memo is based on a misreading of the Act and an incomplete assessment of the probable state of US practice, it scarcely provides taxpayers with much foundation for confidence. Moreover, the position taken in the memo has a very different character from most positions that are characterized as administrative concessions. Administrative concessions typically relax formal requirements, disregard inadvertent errors and insignificant amounts, or correct legislative oversights. But memo 981931 does much more than this. The amounts involved are not insignificant, and the legislation is clear. The memo does not merely make a concession; it confers a large advantage that is supported neither in the Act or the treaty, nor in US case law. Taxpayers who consider relying on it should take very seriously its standard disclaimer that the document, although believed to be correct at the time of issue, may not represent the current position of the Department. 11 Geoff Powers Deloitte & Touche Washington, DC July 2000 times to one kind of misrepresentation, sometimes to another, depending on a player s residence and circumstances. But making a pure signing bonus always tax-preferable to a services-linked signing bonus might tend to institutionalize a preference for misrepresentation. This kind of effect can be observed elsewhere, in the widespread tendency of taxpayers to misclassify themselves as independent contractors rather than as employees, or as nonresidents rather than as residents. What supports the institutional character of the practice is the prevalence of the view that one position is better than the other in all circumstances. People are sometimes wrong about this, of course, but the perception is what counts. In the present instance, people would be correct to think that they cannot lose, and might win, by claiming that a bonus is a true signing bonus. 11 Taxpayers might also take warning from a recent Tax Court of Canada case, Khabibulin v. The Queen, supra footnote 3, in which the court outlined some means by which a pure signing bonus may be distinguished from a services-related bonus. The court examined a player s reputation, experience, recognized prospects, and, in general, the surrounding circumstances, in order to determine whether an amount could reasonably be regarded as being purely in respect of the player s signing a contract. Consideration of the other circumstances prevailed, in fact, over the actual wording of the player s contract. Thus, even if the CCRA persists in the policy enunciated in CCRA document no. 981931, the characterization of an amount as a true signing bonus, rather than as a services-related bonus, can be challenged.