http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/144651/index.do
Société générale valeurs mobilières inc. v. The Queen (May 26, 2016 – 2016 TCC 131, Paris J.).
Précis: Articles XXII(2) and (3) of the Canada-Brazil Tax Treaty provide that Canada must provide a tax credit for interest earned by a Canadian resident in Brazil:
2. Unless the provisions of paragraph 4 or 5 apply, where a resident of Canada derives income which, in accordance with the provisions of this Convention, may be taxed in Brazil, Canada shall allow as a deduction from the tax on the income of that person, an amount equal to the income tax paid in Brazil, including business-income tax and non-business-income-tax. The deduction shall not, however, exceed that part of the income tax as computed before the deduction is given, which is appropriate to the income which may be taxed in Brazil.
3. For the deduction indicated in paragraph 2, Brazilian tax shall always be considered as having been paid at the rate of 25 per cent of the gross amount of the profits to which paragraph 5(b) of Article X applies and at the rate of 20 per cent of the gross amount of the income paid in Brazil in the case of interest to which paragraph 2 of Article XI applies and royalties to which paragraph 2(b) of Article XII applies.
In this pre-trial motion the Tax Court was essentially asked to determine a narrow point of law: is the credit determined on the basis of gross interest income or net interest income? The appellant’s position was that the credit should be based on the gross income which would obviously provide a larger credit and shelter other items of income not necessarily earned in Brazil. The Crown argued for a credit based on the net income determined in accordance with subsection 4(1) of the Income Tax Act.
The Tax Court accepted the Crown’s arguments. Costs on the motion were left to the discretion of the trial judge.
Decision: The Court was asked to determine three questions of law:
[5] The questions to be determined are as follows:
Where a Canadian resident taxpayer earns bond interest income arising in Brazil that may be taxed by Brazil under Article XI of Canada’s tax treaty with Brazil, and earns taxable income from other sources, is the amount of Canadian income tax that is referred to in Article XXII(2) of the treaty as being “appropriate to the income which may be taxed in Brazil”:
a. equal to the Canadian income tax on the amount of such interest income that is or is deemed to be taxed in Brazil, which is a gross amount; and
b. if the answer to (a) is yes, what is the proper test for determining the Canadian income tax payable on the gross amount of income derived from Brazil;
c. if the answer to (a) is no, what is the proper test for determining which amounts of the Canadian resident taxpayer should be included and/or deducted from the gross income arising from sources in Brazil?
The position of the parties was drawn fairly starkly:
[7] The respondent maintains that the maximum foreign tax credit available to the taxpayer under Article XXII(2) of the Treaty is equal to the actual Canadian tax payable on the bond income arising in Brazil, which must take into account applicable expenses incurred by the taxpayer to earn the income. The respondent says that the deduction of the applicable expenses is implicit in the determination of Canadian income tax.
[8] The appellant submits that the maximum foreign tax credit that Canada is required to allow under Article XXII(2) of the Treaty is equal to the Canadian tax rate multiplied by the gross amount of the Brazilian bond interest, without taking into account the expenses incurred to earn the interest.
The Court held that the appellant’s position was contrary to the “tax sparing” policy of the underlying provisions:
[59] It is clear, then, that the purpose of tax sparing is to provide a form of economic aid to developing countries.
[60] The tax sparing provision in Article XXII(3) of the Treaty operates by deeming Brazilian tax to always have been paid at the rate of 20% of the gross interest income arising in Brazil, and by Canada agreeing to grant a foreign tax credit determined in part on the basis of the tax deemed to have been paid by the Canadian resident taxpayer, whether or not the Brazilian tax is in fact paid.
[61] The tax sparing provision in the Treaty is generous by the ordinary standard of Canada’s tax treaties. The rate at which tax is been deemed to be paid, 20%, exceeds the maximum rate of tax that Brazil may charge on interest not connected with a Brazilian permanent establishment that is paid to a Canadian resident company, which is set at 15% under Article XI(2) of the Treaty.
[62] While the tax sparing provision in Article XXII(3) of the Treaty operates to preserve tax incentives adopted by Brazil, I disagree with the appellant’s contention that Canada and Brazil intended that this provision apply in an “as unrestricted manner as possible, the result of which would be to maximally encourage the lending of funds by Canadian enterprises to Brazil.” It appears to me that the tax sparing provision was intended to avoid neutralizing any tax incentive offered by Brazil on interest income, a result that was achieved by means of Canada’s agreement to forego any Canadian income tax on Brazilian interest income earned by a Canadian resident to which Article XXII(3) applies. It seems unlikely that the tax sparing provision was intended by either Canada or Brazil to operate to shelter not only Brazilian interest income from Canadian tax, but income from other sources unrelated to Brazil as well. This would be the effect of the appellant’s interpretation in cases where the Canadian resident taxpayer incurred expenses related to the interest income arising in Brazil. This goes beyond tax sparing and would amount to an additional independent incentive on Canada’s part to invest in Brazil. The appellant has failed to show that the drafters of the Treaty intended that the foreign tax credit available under Article XXII(2) would operate in this fashion. Again, it would take clear language to create an incentive of the nature suggested by the appellant, and such language is not present in this case.
Moreover the appellant’s contention ran contrary to the OECD Model from which the Canada-Brazil Treaty was in part derived:
[72] Article 23B of the 1977 OECD Model follows what is referred to in the Commentaries as the “ordinary credit” method of providing relief from double taxation in respect of income derived by a taxpayer residing in one state from the other contracting state. According to paragraph 57 of the Commentaries, under the ordinary credit method, the State of residence grants a deduction from its own tax equal to the tax paid in the other State but the deduction is restricted to the appropriate portion of its own tax. At paragraph 63 of the Commentaries, the limitation on the deduction is stated to be “normally computed as the tax on net income, i.e. on the income from [the State of source] less allowable deductions.” That paragraph, in its entirety reads:
The maximum deduction is normally computed as the tax on net income, i.e. on the income from state [of source] less allowable deductions (specified or proportional) connected with such income (cf. paragraph 40 above). For such reason, the maximum deduction in many cases may be lower than the tax effectively paid in State [of source]. This may especially be true in the case where, for instance, a resident of State [of residence] deriving interest from State [of source] has borrowed funds from a third person to finance the interest-producing loan. As the interest due on such borrowed money may be offset against the interest derived from State [of source], the amount of net income subject to tax in State R may be very small, or there may even be no net income at all. . . .
[73] The appellant argues that paragraph 63 of the Commentaries does not purport to prescribe a rule of general application; the use of the words “is normally computed as the tax on net income” suggests there are exceptions. However, no such exceptions are described in the Commentaries and there is no suggestion that the method espoused by the appellant for calculating the limitation – i.e. the Canadian tax rate multiplied by the gross Brazilian interest income – is such an exception.
[74] On balance, I find then that the respondent’s interpretation of the limitation to the foreign tax credit provided for in Article XXII(2) is supported by the Commentaries.
Thus the three questions asked were answered as follows:
[91] Question 1: No. The amount of Canadian income tax referred to in the second sentence of Article XXII(2) of the Treaty as being “appropriate to the income which may be taxed in Brazil” is the actual Canadian income tax attributable the income taxed in Brazil, which is computed on the net income arising from Brazil.
[92] Question 2: Not applicable
[93] Question 3: The proper test for determining which amounts of the Canadian resident taxpayer should be included or deducted from the gross interest arising from sources in Brazil is that found in subsection 4(1) of the Income Tax Act.
Costs on the motion were left to the discretion of the trial judge.