Group Consistency and the Canada Treaty Re-Sourcing Rule(1)

by Dirk J.J. Suringa, Esq.
Covington & Burling LLP
Washington, D.C.

Like several other income tax treaties to which the United States is a party, the U.S.-Canada Income Tax Treaty (“Canada Treaty”) has a re-sourcing rule. Article 24(3)(a) treats income of a U.S. resident that may be taxed in Canada under the treaty as arising in Canada for purposes of the U.S. foreign tax credit. Re-sourcing rules like this one backstop the allocation of taxing rights under the treaty. They ensure that when the United States cedes taxing rights to Canada by providing a credit for the Canadian tax imposed, the U.S. foreign tax credit limitation under §904 does not cut off the credit by treating the income subject to the Canadian tax as U.S.-source income under U.S. domestic law. Thus, Article 24(3)(a) applies notwithstanding the saving clause of Article 29(2).

In cross-border tax planning, re-sourcing rules like this one may be implicated by the use of hybrids and reverse hybrids, which can result in the imposition of Canadian tax on income the United States views as domestic-source. In some but not all of those cases, §904(h)(10) limits the benefit of the re-sourcing rule by imposing a separate limitation with respect to the Canadian taxes imposed on the re-sourced income. That separate limitation prevents excess non-Canadian taxes from offsetting residual U.S. tax on foreign-source income created by the re-sourcing rule.

Unlike the re-sourcing rule in other treaties, the rule in the Canada Treaty requires taxpayers that use it to apply the source rules of the treaty in their entirety. This consistency rule is found in the 1984 Technical Explanation (TE): “a taxpayer claiming credit for Canadian taxes which are creditable under the Code and who wishes to use the source rules of the Convention in computing that credit must apply the source rules of the Convention in their entirety.” 1

1 U.S. Department of the Treasury, Technical Explanation of the Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital Signed at Washington, D.C. on Sept. 26, 1980, as Amended by the Protocol signed at Ottawa on June 14, 1983 and the Protocol signed at Washington on Mar. 28, 1984 (1984), reprinted in 1 Tax Treaties (CCH), at ¶1950, p. 41,345.

The consistency rule does not appear in the text of the treaty itself. Article 24(9) does impose a kind of reverse-per-country limitation on non-Canadian taxes, but the consistency rule is not necessary to render that limitation operational. The fact that the consistency rule is found in the TE, rather than in the text of the treaty itself, would undermine its authoritative weight in court. 2 Nevertheless, the IRS has “consistently” applied a type of consistency doctrine in treaty matters for many years, 3 and presumably it would defend the consistency rule in the Canada TE. Assuming for discussion purposes that the consistency rule would be upheld in court, a taxpayer that seeks a U.S. foreign tax credit for a Canadian tax on what would be U.S.-source income under domestic law must consider all the other sourcing rules of the treaty before deciding to apply Article 24(3)(a).

2 See National Westminster Bank v. U.S., 58 Fed. Cl. 491, 499 (2003); N.W. Life Assurance Co. of Canada v. Comr., 107 T.C. 363, 379-81 (1996).

3 See, e.g., Rev. Rul. 84-17, 1984-1 C.B. 308, 309 (“If, for the taxable year, the taxpayer desires to use the provisions of the Code with respect to the taxability of the product c loss, the provisions of the Code must also be used with respect to the taxability of the gain from products a and b.”); 1995 FSA LEXIS 202, at *5-6 & n. 3 (Sept. 7, 1995) (arguing that a foreign bank could not elect to apply the U.S.-Ireland Income Tax Treaty to exclude interest income from loans made by its U.S. banking branch and then offset losses incurred on the sale of those loans against its U.S. taxable income).

Take, for example, Article 13(4) of the Canada Treaty, which provides for exclusive residence-based taxation of inventory (other than inventory belonging to a PE). Article 24(3)(b) would source gain from the sale of such inventory to the residence State. Read together, these provisions imply that the Canadian-source component of §863(b) sales of a U.S. taxpayer could be converted into U.S.-source income if the taxpayer elects to apply the re-sourcing rule.

Similarly, if a U.S. taxpayer receives from a U.S. person royalties for the use of intellectual property in Canada, the taxpayer may take the position that the royalties are foreign-source income under U.S. domestic law, based on the foreign place of use of the intellectual property. Article 12(6)(a), however, could make those royalties U.S.-source, unless the payor has a Canadian PE. Other provisions of the Canada Treaty, like pensions and “other income,” may also implicate this issue.

A U.S. taxpayer considering the ramifications of its decision to apply the re-sourcing rule thus may have to confront the question of how far its decision extends. Consider the case of a U.S. affiliated group, one member of which seeks to apply the re-sourcing rule. If that decision applies to the individual group member only, the consequences of the choice may be clear. That member may have only one type of income, or the group may be able to restructure itself so that the member has only one type of income. If the decision to apply the re-sourcing rule applies to the group as a whole, however, then the consequences of the decision may be more far-reaching. Other group members may have significant Canadian-source income that would be re-sourced to the United States under the treaty.

The “right answer” would seem to be that the re-sourcing rule applies member-by-member and not to the group as a whole. The consistency rule in the Canada TE refers to “a taxpayer” and makes no reference to affiliated groups. The consolidated return regulations give the group parent the authority to make elections on behalf of members, 4 which suggests that the common parent would simply act as agent for the individual group member in making the election. 5 Such an approach was suggested, however obliquely, by PLR 199918047. 6

Historically, at least, single-entity treatment for affiliated groups has not been the norm. 7 Applying one member's decision to the group as a whole would not invariably benefit the fisc: another group member could have foreign-source losses that would be converted into U.S.-source losses under the Canada Treaty, for instance.

4 Regs. §1.1502-77(a).

5 Cf. Regs. §1.1502-77(a)(3) (“Except as provided in this paragraph (a)(3) and paragraph (a)(6) of this section, no subsidiary has authority to act for or to represent itself in any matter related to the tax liability for the consolidated return year”); Regs. §301.6114-1(a)(2)(i) (“A taxpayer is considered to adopt a ‘return position’ when the taxpayer determines its tax liability with respect to a particular item of income, deduction or credit”).

6 PLR 199918047 (May 10, 1999).

7 See, e.g., H. Enter. Int'l Inc. v. Comr., 105 T.C. 71, 85 (1995) (“Where the consolidated return regulations do not require that corporations filing such returns be treated differently from the way separate entities would be treated, these corporations shall be treated as separate entities when applying provisions of the Code”); see generally Regs. §1.1502-80 (“The Internal Revenue Code (Code), or other law, shall be applicable to the group to the extent the regulations do not exclude its application”); Dubroff et al., Federal Income Taxation of Corporations Filing Consolidated Returns, §1.05 & n. 91 (Lexis ed. 2008) (“It has generally been assumed that [Regs. §1.1502-80(a)] means that separate entity treatment applies in the absence of express guidance”). But see United Dominion Indus. v. U.S., 532 U.S. 822 (2001) (applying single-entity treatment where, in the absence of regulations specifying the calculation of a group's specified limited liability loss carryback, single-entity principles were better suited to formulating a method of calculation); but cf. Dubroff, above, at §1.05 & n. 91 (“The consolidated return regulations have historically tended to modify separate return treatment to only a limited extent, … [but] starting in the early 1990's, nearly all of the regulations issued have shown a trend toward an increasing single-entity view of consolidated groups”).

Nevertheless, the consolidated return regulations specifically apply the §904 foreign tax credit limitation at the group level: “The foreign tax credit for the consolidated group shall be determined on a consolidated basis under the principles of sections 901 through 905 and section 960.” 8 Would a court construe this provision to specify single-entity treatment for the decision to apply Article 24(3)(a)? The numerator of the limitation fraction is the aggregate of the separate foreign-source taxable incomes of the members. 9

Different sourcing rules certainly could be applied to one particular group member before aggregating the group's foreign-source income. Still, that approach would be different from other relevant rules, such as §864(e)’s single-entity treatment of interest expense allocation. Thus, concerns about group-wide application of the treaty sourcing rules remain, particularly where the group has excess non-Canadian taxes and therefore has to apply the special Canadian per-country limitation as well.

8 Regs. §1.1502-4(c).

9 Regs. §1.1502-4(d)(1).