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107 T.C. No. 19
UNITED STATES TAX COURT
THE NORTH WEST LIFE ASSURANCE COMPANY OF CANADA, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4694-94.
Filed December 12, 1996.
P, a Canadian insurance company, operated through
a permanent establishment in the United States for
purposes of the income tax convention between the
United States and Canada. P reported its net
investment income effectively connected with its
conduct of an insurance business within the United
States pursuant to sec. 842(a), I.R.C., without regard
to the minimum amount of net investment income that
sec. 842(b), I.R.C., treated as effectively connected.
P claimed under the Convention With Respect to Taxes on
Income and on Capital, Sept. 26, 1980, U.S.-Can.,
T.I.A.S. No. 11087, 1986-2 C.B. 258 (Canadian
Convention), to be exempt from sec. 842(b), I.R.C.
Held, art. VII(2) of the Canadian Convention requires
that profits attributed to a permanent establishment be
measured based on the permanent establishment's facts
and by reference to the establishment's separate
accounts insofar as those accounts represent the real
facts of the situation. Held, further, sec. 842(b),
I.R.C. in prescribing a statutory minimum amount of net
investment income that must be treated as effectively
- 2 connected with the conduct of P's insurance business
within the United States, fails to attribute profits to
P's permanent establishment based on the
establishment's facts. Held, further, sec. 842(b),
I.R.C. fails to attribute profits by the same method
each year. Held, further, pursuant to art. VII(2) of
the Canadian Convention, P is taxable under subch. L,
part I on its income effectively connected with its
conduct of any trade or business within the United
States without regard to sec. 842(b), I.R.C.
Jerome B. Libin, James V. Heffernan, Richard J. Safranek,
and Steven M. Sobell, for petitioner.1
Gary D. Kallevang, Diane D. Helfgott, Charles M. Ruchelman,
Elizabeth U. Karzon, George Soba, and Sharon J. Bomgardner, for
respondent.
HAMBLEN, Judge:
Respondent determined deficiencies in
petitioner's Federal income and branch profits tax for the
taxable years 1988, 1989, and 1990, in the amounts of $518,102,
$23,730, and $71,662, respectively.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years at
issue, and all Rule references are to the Tax Court Rules of
Practices and Procedure.
The sole issue for decision is whether
the Convention and Protocols Between the United States and Canada
with Respect to Taxes on Income and Capital, Sept. 26, 1980,
T.I.A.S. No. 11087 (effective August 16, 1984), 1986-2 C.B. 258
1
Brief amicus curiae was filed by H. David Rosenbloom and
Daniel B. Rosenbaum for the Government of Canada.
- 3 (Canadian Convention), override section 842(b), which requires a
foreign company conducting an insurance business in the United
States to treat a minimum amount of net investment income as
effectively connected with its conduct of that business.
For the
reasons set forth below, we hold that article VII of the Canadian
Convention, 1986-2 C.B. at 260, overrides section 842(b).
FINDINGS OF FACT
Some of the facts have been stipulated and are found
accordingly.
The stipulation of facts and accompanying exhibits
are incorporated herein by this reference.
The facts found are
those which, unless otherwise specified, existed during the years
at issue.
A.
Petitioner
The North West Life Assurance Co. of Canada (petitioner) is
a life insurance company organized under the corporation laws of
Canada with its principal place of business located in Vancouver,
British Columbia, Canada.
Petitioner operates its life insurance
business solely in the United States and Canada and is in the
business of writing deferred annuities and life insurance
policies.
Petitioner began operating in the United States (U.S.
branch) in 1971, selecting the State of Washington as its State
of entry and subjecting itself to the insurance laws of that
State and to regulation by that State's insurance commissioner.
Petitioner maintains a sales and underwriting office in Bellevue,
- 4 Washington.
In addition, petitioner is licensed to transact
business as a life insurance company in 20 other States.
Petitioner's U.S. branch uses a calendar year accounting
period and the accrual method of accounting.
Petitioner timely
filed its Federal income tax returns (Forms 1120L) for tax years
1988, 1989, and 1990.
B.
Petitioner's Product Mix
Petitioner's U.S. branch operates primarily in the "section
403(b) market", selling individual deferred annuities to school
teachers.
Petitioner has the following product mix, measured by
its reserves, during the years at issue:
United States
Individual Annuities
Individual Life Policies
1988
1990
97.00%
95.60
Individual Annuities
1988
1990
3.00%
4.40
Canada
Individual Life Policies
64.73%
68.44
35.27%
31.56
Petitioner’s U.S. branch sold these products in the United
States, and petitioner's principal office in Vancouver sold them
in Canada.
C.
Pricing of Products
Each of petitioner's annuity contracts includes an
accumulation period and a payout period.
During the accumulation
- 5 period, petitioner collects the premiums on its annuity contracts
(accumulation annuities).
Petitioner does not charge fixed
premiums; rather, the annuity holders pay in as much as they
desire.
Petitioner invested the collected premiums and
guarantees its U.S. annuity holders, on a yearly basis, a
specific rate of return (one-year rate guarantees).
Petitioner
makes primarily 5-year interest rate guarantees to its Canadian
annuity holders. Petitioner's annuity holders are able to
withdraw the accumulated funds from petitioner once annually
during the accumulation period.
surrender charges.
These withdrawals are subject to
The surrender charges are reduced during the
first 5 to 10 years of each annuity contract's existence but are
always eliminated before the payout period begins.
During the payout period, petitioner pays the annuity
holders fixed periodic payments over the remainder of the
annuitant’s life or over a specified number of years (payout
annuities).
Once the payout period begins, petitioner does not
permit early withdrawals.
D.
Investment Strategy
Mr. Arthur W. Putz, vice president of investments and
secretary of petitioner, is primarily responsible for handling
the administrative details of petitioner's investment activity.
Donald R. Francis, executive vice president and appointed actuary
- 6 of petitioner, is primarily responsible for providing actuarial
services to petitioner's life insurance business.
As part of its investment strategy for its U.S. operations,
petitioner sought to avoid the risk of fluctuations in currencyexchange and interest rates.
Petitioner avoids currency-exchange
risk by investing in assets in the same currencies as its
insurance liabilities.
Petitioner attempts to reduce its
interest-rate risk by matching the duration of its assets with
the maturity of its liabilities.
Washington State law allows an
insurance company to invest up to 65 percent of its portfolio in
mortgages.
Wash. Rev. Code Ann. sec. 48.13.265 (West Supp.
1990). Petitioner invested between 58 percent and 63 percent of
its portfolio in mortgages during the years at issue.
In order
to match its investments in mortgages with the 1-year rate
guarantees on its annuities and also enjoy a relatively high
return from such investments, petitioner purchases mortgages with
5-year maturities, with a right of renewal for another 5 years at
market-adjusted interest rates.
The average duration of these
mortgages is approximately 2 ½ years.
Because petitioner's
5-year mortgages are longer than the 1-year rate guarantees, part
of petitioner's strategy is to balance its portfolio by also
investing in assets with a duration shorter than its liabilities.
Petitioner makes longer-term investments in assets backing
both its individual life insurance policies and payout annuities
- 7 than it does in assets supporting its accumulation annuities.
Petitioner's accumulation annuities comprise approximately 99
percent of petitioner's annuity contracts arising from its U.S.
branch and approximately 50 percent of the contracts arising from
its Canadian office.
E.
Flow of Funds
Petitioner collects premiums arising from its U.S. branch
business in U.S. currency (U.S. dollars).
Upon receipt, for
administrative convenience, petitioner transfers the premium
payments into a U.S. dollar-denominated account with TorontoDominion Bank in Vancouver, British Columbia (Toronto bank).
The
Toronto bank pays nominal interest on balances in the account in
excess of $250,000.
Washington State law requires foreign insurance companies to
maintain a trust account (trusteed assets) in order to qualify to
transact insurance in the State.
48.05.090 (West Supp. 1990).
Wash. Rev. Code Ann. sec.
Petitioner maintains a trust
account and an operating account at Seattle First National Bank
in Seattle, Washington (Seattle bank).
Periodically, petitioner
transfers the premiums and interest from the Toronto bank account
to the Seattle bank accounts.
Petitioner transfers the majority
of such funds to the trust account and the balance to the
operating account.
Petitioner pays commissions, claims, and
operating expenses from its operating account.
The Seattle bank
- 8 does not pay any interest on the funds in the operating account.
Petitioner invests the premiums in the Seattle trust account in
U.S. dollar-denominated assets and retains the earnings in the
same account.
As a general business practice, during the years
at issue, petitioner did not withdraw assets until they matured
or rely upon assets outside of the trust account to cover the
liabilities incurred by its U.S. branch.
In 1987, petitioner transferred between $7 and $8 million in
Canadian dollar-denominated bonds from its Canadian business to
the Seattle bank trust account in order to increase its surplus
assets held in the United States relative to the proportion of
its surplus held in the Canadian operation.
In 1988, petitioner
sold stock in a related domestic company for its original cost to
Industrial Alliance Life Insurance Co., petitioner's Canadian
parent corporation.
The stock had been recorded on the books of
petitioner's U.S. branch and included in the Seattle trust
account.
F.
Mandatory Filings
The insurance commissioner of each State in which petitioner
is licensed to carry on an insurance business requires
petitioner's U.S. branch to file certain annual statements
reflecting its U.S. branch operations.
To standardize reporting
requirements, all States require reporting on the annual
statement forms developed by National Association of Insurance
- 9 Commissioners (NAIC), a voluntary association of State insurance
commissioners.
NAIC publishes standard detailed forms upon which
each type of insurance company reports its annual financial
condition.
NAIC form 1A must be filed annually by petitioner with the
State of Washington.
NAIC form 1A requires information regarding
whether a U.S. branch has sufficient admissible assets (all
assets of its U.S. branch other than the separate-accounts
business) over liabilities, including the statutory deposit.
The
inside cover of NAIC form 1A states:
This Annual statement differs in some respects from
that for a United States Company and should not be
interpreted in the same manner. The most important
fact conveyed by the statement is whether the Company
has a sufficient amount of admissible assets to meet
all known liabilities of its United States business
including statutory deposit. For this reason, the
Annual statement balance sheet does not show the amount
of unassigned funds, or surplus, which are accrued from
earnings of the United States business, but rather
total United States admissible assets and total United
States liabilities and statutory deposit.
NAIC form 1 must be filed by domestic insurance companies
with their respective State regulatory agencies.
Differences
between NAIC form 1A and NAIC form 1 include:
1.
NAIC form 1A lists assets and liabilities with the assets
not necessarily equaling liabilities, capital, and surplus,
whereas NAIC form 1 includes a balance sheet;
2.
NAIC form 1A lists income and expenses, but it does not
include realized capital gains and losses;
- 10 3.
Schedule D of NAIC form 1A reflects deposits and withdrawals
of securities from a trust account at book value, whereas
NAIC form 1 reflects purchases and sales of bonds and stocks
at transaction prices;
4.
NAIC form 1A does not include a reconciliation of capital
and surplus from the prior year to the current year, but
NAIC form 1 does include such a reconciliation.
The Office of the Superintendent of Financial Institutions
Canada (OSFI), Ottawa, Canada, also requires petitioner to file
an annual statement (OSFI statement) reflecting its total
business in both Canada and the United States.
The reporting and
accounting requirements for assets, liabilities, income, and
expenses for purposes of the OSFI statement are different in a
number of respects from those for NAIC forms.
G.
Petitioner's Assets and Surplus
Petitioner reports on its NAIC form 1A the following
percentage distribution of assets relating to its U.S.
operations:
Bonds
Mortgage loans
Real estate
Cash
Policy loans
Stocks
Total
1988
1989
1990
11.6%
58.8
1.2
15.5
12.9
0.0
100.0
15.0%
58.3
2.0
12.7
12.0
0.0
100.0
20.6%
63.5
2.3
6.1
7.4
0.1
100.0
Based on its OFSI statements, petitioner has the following
percentage distribution of assets in connection with its
worldwide operations:
- 11 -
Bonds
Mortgage loans
Real estate
Cash
Policy loans
Stocks
Other assets and
rounding discrepancies
Total
1988
1989
1990
20.7%
53.0
2.2
12.3
9.4
0.7
24.3%
52.7
2.8
8.7
8.8
0.7
26.1%
55.2
2.9
5.1
5.8
2.6
1.7
100.0
2.0
100.0
2.3
100.0
Washington State law requires a foreign insurance company to
maintain trusteed assets (equal to the excess of assets over
general account liabilities) of at least $2 million.
Code Ann. sec. 48.05.340(1) (West Supp. 1990).
Wash. Rev.
For 1988, 1989,
and 1990, petitioner's Form 1A listed its U.S. branch as having
an excess of admissible assets over liabilities in the amounts of
$15,422,162, $19,016,749, and $19,363,533, respectively.
Petitioner's ratio of excess mean assets to mean total
liabilities are as follows:
U.S. branch
Total company
1988
1989
1990
7.70%
7.56
9.41%
8.21
9.79%
8.38
For each year at issue, a life insurance company
incorporated under the laws of the State of Washington would have
been in compliance with minimum capital and surplus requirements
if it had owned the same assets and incurred the same liabilities
- 12 as petitioner's branch, as reported on petitioner's NAIC form 1A.
H.
Computation of Income
During each year at issue, petitioner reported on its
Federal income tax returns its net investment income effectively
connected with the conduct of its business within the United
States, computed pursuant to section 842(a), without regard to
the amount of minimum effectively connected net investment income
computed pursuant to section 842(b)(1).
During the years at
issue, petitioner used its NAIC form 1A data to identify to what
extent its net investment income was effectively connected for
purposes of section 842(a).
Upon audit of petitioner's Federal tax returns for the years
1988 through 1990, respondent increased petitioner's income by
the extent petitioner's net investment income computed pursuant
to section 842(b) exceeded its income computed pursuant to
section 842(a):
Year
Income Determined
Under Sec. 842(a)
Income Determined
Under Sec. 842(b)
Additional
Income
1988
1990
$18,501,669
20,426,754
$21,282,045
20,749,629
$2,780,376
322,875
Respondent did not include an adjustment based on petitioner's
net investment income for 1989.
All of the "increases in income
tax" for 1988 and 1990 are attributable to the adjustments of
petitioner's taxable income resulting from the application of
section 842(b).
- 13 I.
Treasury Methodology
The Department of Treasury calculates the asset/liability
percentage (i.e., the mean of assets of domestic insurance
companies divided by the mean of total insurance liabilities of
those same domestic companies) and the domestic investment yield
(i.e., the net investment income of domestic insurance companies
divided by the mean of assets of those same domestic insurance
companies) for purposes of section 842(b) using the financial
data obtained from the A.M. Best Co.
The A.M. Best Co. compiled
the data from the NAIC forms 1 filed by domestic insurance
companies with their respective State insurance regulatory
authorities.
The Treasury considers only data from those
companies that appeared in the A.M. Best Co. files for both the
second and third years preceding the year at issue (2-year
aggregate data).
For the years at issue, the Treasury calculated
the following asset/liability percentages and domestic investment
yields:
Return Years
Asset/Liability
Percentage
Domestic Investment
Yield
1988
1989
1990
120.5%
117.2
116.5
J.
Motion For Entry of Decision
10.0%
8.7
8.8
On October 31, 1994, respondent filed a motion for entry of
decision.
On November 1, 1994, petitioner objected to
- 14 respondent's motion.
On November 30, 1994, a hearing was held on
respondent's motion.
On December 5, 1994, respondent's motion
was denied.
OPINION
I.
Statutory Framework
A.
Section 842 and Section 864(c)
Under section 842(a),2 a qualified foreign company carrying
on a life insurance business within the United States is taxable
on its income effectively connected with its conduct of any trade
or business within the United States under subchapter L, part I.
Domestic life insurance companies are also taxed pursuant to the
latter provisions.
Sec. 801 et seq.
Section 864(c)3 and the
2
Sec. 842(a) provides in pertinent part:
(a) Taxation under this subchapter.--If a foreign
company carrying on an insurance business within the
United States would qualify under part I * * * of this
subchapter for the taxable year if (without regard to
income not effectively connected with the conduct of
any trade or business within the United States) it were
a domestic corporation, such company shall be taxable
under such part on its income effectively connected
with its conduct of any trade or business within the
United States * * *.
3
Sec. 864(c) provides in pertinent part:
(c)(2) Periodical, etc., income from sources
within United States--factors.--In determining whether
income from sources within the United States of the
types described in section 871(a)(1), section 871(h),
section 881(a), or section 881(c) or whether gain or
loss from sources within the United States from the
sale or exchange of capital assets, is effectively
(continued...)
- 15 regulations thereunder govern when income is effectively
connected to petitioner's business within the United States for
purposes of section 842(a).
Section 842(b)4 prescribes, by
3
(...continued)
connected with the conduct of a trade or business
within the United States, the factors taken into
account shall include whether-(A) the income, gain, or loss is derived from
assets used in or held for use in the conduct of
such trade or business, or
(B) the activities of such trade or business
were a material factor in the realization of the
income, gain, or loss.
In determining whether an asset is used in or held for
use in the conduct of such trade or business or whether
the activities of such trade or business were a
material factor in realizing an item of income, gain,
or loss, due regard shall be given to whether or not
such asset or such income, gain, or loss was accounted
for through such trade or business.
*
*
*
*
*
*
*
(4) Income from sources without United States.-*
*
*
*
*
*
*
(C) In the case of a foreign corporation
taxable under part I * * * of subchapter L, any
income from sources without the United States
which is attributable to its United States
business shall be treated as effectively connected
with the conduct of a trade or business within the
United States.
4
Sec. 842(b) provides in pertinent part:
(1) In general.--In the case of a foreign company
taxable under part I * * * of this subchapter for the
taxable year, its net investment income for such year
(continued...)
- 16 statutory formula, a minimum amount of net investment income that
a foreign insurance company, which is taxable under subchapter L,
part I, must treat as effectively connected to its conduct of an
insurance business in the United States (minimum ECNII).
In
effect, a foreign insurance company engaged in business in the
United States would be taxable, under Internal Revenue Code
provisions in issue before us, on the greater of its actual
effectively connected net investment income (actual ECNII)
pursuant to section 842(a) or its minimum ECNII as determined by
the statutory formula.
4
(...continued)
which is effectively connected with the conduct of an
insurance business within the United States shall be
not less than the product of-(A) the required U.S. assets of such company, and
(B) the domestic investment yield applicable
to such company for such year.
Sec. 842(b)(5) defines net investment income for purposes of sec.
842(b) as follows:
Net investment income.--For purposes of this
subsection, the term "net investment income" means-(A) gross investment income (within the
meaning of section 834(b)), reduced by
(B) expenses allocable to such income.
- 17 B.
Formula
A foreign insurance company's minimum ECNII is the product
of the company's required U.S. assets and the domestic investment
yield (domestic yield).
Sec. 842(b)(1).
The required U.S.
assets of a company are determined by multiplying the mean of its
total insurance liabilities on its business within the United
States for the taxable year by the domestic asset/liability
percentage (asset/liability percentage) applicable to such
company for that year.
Sec. 842(b)(2).5
The asset/liability
percentage is a ratio, the numerator of which is the mean of the
assets of domestic insurance companies and the denominator of
5
Sec. 842(b)(2) provides:
(2) Required U.S. assets.-(A) In general.--For purposes of paragraph (1),
the required U.S. assets of any foreign company for any
taxable year is an amount equal to the product of-(i) the mean of such foreign company's total
insurance liabilities on United States business, and
(ii) the domestic asset/liability percentage
applicable to such foreign company for such year.
(B) Total insurance liabilities.--For purposes of
this paragraph-(i) Companies taxable under part I.--In the
case of a company taxable under part I, the term
"total insurance liabilities" means the sum of the
total reserves (as defined in section 816(c)) plus
(to the extent not included in total reserves) the
items referred to in paragraphs (3),(4),(5), and
(6) of section 807(c).
- 18 which is the mean of the total insurance liabilities of the same
domestic insurance companies.
Sec. 842(b)(2)(C).6
The domestic
yield is a ratio, the numerator of which is the total net
investment income of domestic life insurance companies and the
denominator of which is the mean annual balance of the total
assets of these same domestic companies.
Sec. 842(b)(3).7
Section 842(b)(2)(C) and (b)(3) direct the Secretary of the
Treasury to calculate both the asset/liability percentage and the
6
Sec. 842(b)(2)(C) provides in pertinent part:
(C) Domestic asset/liability percentage.--The
domestic asset/liability percentage applicable for
purposes of subparagraph (A)(ii) to any foreign company
for any taxable year is a percentage determined by the
Secretary on the basis of a ratio-(i) the numerator of which is the mean of the
assets of domestic insurance companies taxable
under the same part of this subchapter as such
foreign company, and
(ii) the denominator of which is the mean of the
total insurance liabilities of the same companies.
7
Sec. 842(b)(3) provides:
(3) Domestic investment yield.--The domestic
investment yield applicable for purposes of paragraph
(1)(B) to any foreign company for any taxable year is
the percentage determined by the Secretary on the basis
of a ratio-(A) the numerator of which is the net
investment income of domestic insurance companies
taxable under the same part of this subchapter as
such foreign company, and
(B) the denominator of which is the mean of
the assets of the same companies.
- 19 domestic yield each year.
Section 842(c)(4) provides that each
calculation for any taxable year "shall be based on such
representative data with respect to domestic insurance companies
for the second preceding taxable year as the Secretary considers
appropriate."
C.
Worldwide Election
Section 842(b)(4) permits a foreign insurance company to
elect to use its own worldwide current investment yield
(worldwide yield) rather than the domestic yield.8
A company's
worldwide yield is obtained by dividing the net investment income
8
Sec. 842(b)(4) provides in pertinent part:
(4) Election to use worldwide yield.-(A) In general.--If the foreign company makes
an election under this paragraph, such company's
worldwide current investment yield shall be taken
into account in lieu of the domestic investment
yield for purposes of paragraph (1)(B).
(B) Worldwide current investment yield.--For
purposes of subparagraph (A), the term "worldwide
current investment yield" means the percentage
obtained by dividing-(i) the net investment income of the
company from all sources, by
(ii) the mean of all assets of the
company (whether or not held in the United
States).
(C) Election.--An election under this
paragraph shall apply to the taxable year for
which made and all subsequent taxable years unless
revoked with the consent of the Secretary.
- 20 of the company from all sources by the mean of all assets of the
company.
Sec. 842(b)(4)(B).
A company may not revoke the
election without the consent of the Secretary.
Sec. 842
(b)(4)(C).
II.
Canadian Convention
The Canadian Convention is designed to prevent double
taxation and to avoid fiscal evasion (Preamble to Canadian
Convention).
Article VII of the Canadian Convention governs when
and how much of the profits of a qualified Canadian enterprise
are subject to U.S. Federal income tax.
The relevant provisions
of Article VII for making such a determination are as follows:
1. The business profits of a resident of a Contracting
State shall be taxable only in that State unless the
resident carries on business in the other Contracting
State through a permanent establishment situated
therein. If the resident carries on, or has carried
on, business as aforesaid, the business profits of the
resident may be taxed in the other State but only so
much of them as is attributable to that permanent
establishment.
2. Subject to the provisions of paragraph 3, where a
resident of a Contracting State carries on business in
the other Contracting State through a permanent
establishment situated therein, there shall in each
Contracting State 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 and with any other
person related to the resident * * *
3. In determining the business profits of a permanent
establishment, there shall be allowed as deductions
expenses which are incurred for the purposes of the
- 21 permanent establishment, including executive and
general administrative expenses so incurred, whether in
the State in which the permanent establishment is
situated or elsewhere. Nothing in this paragraph shall
require a Contracting State to allow the deduction of
any expenditure which, by reason of its nature, is not
generally allowed as a deduction under the taxation
laws of that State.
*
*
*
*
*
*
*
5. For the purposes of the preceding paragraphs, the
business profits to be attributed to a permanent
establishment shall be determined by the same method
year by year unless there is good and sufficient reason
to the contrary.
*
*
*
*
*
*
*
7. For the purposes of the Convention, the business
profits attributable to a permanent establishment shall
include only those profits derived from the assets or
activities of the permanent establishment.
[Canadian Convention, art. VII, 1986-2 C.B. at 260; emphasis
added.]
Article XXV, paragraph (6) of the Canadian Convention states
in pertinent part:
6. Notwithstanding the provisions of Article XXIV
(Elimination of Double Taxation), the taxation on a
permanent establishment which a resident of a
Contracting State has in the other Contracting State
shall not be less favorably levied in the other State
than the taxation levied on residents of the other
State carrying on the same activities. * * * [Canadian
Convention, art. XXV, par. (6), 1986-2 C.B. at 268.]
In the instant case, the parties agree that petitioner is
entitled to the benefits of the Canadian Convention and that
- 22 petitioner operates its insurance business in the United States
through a U.S. permanent establishment.
Congress can override a convention provision by enacting a
subsequent statute.
Reid v. Covert, 354 U.S. 1, 18 (1957).
Congress ratified the Canadian Convention in 1984.
Convention,
Sept. 26, 1980, T.I.A.S. No. 11087, 1986-2 C.B. 258 (effective
August 16, 1984).
It initially appears that Congress sought to
override the Canadian Convention in the Omnibus Budget
Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat. 1330, by
amending section 842 to incorporate subsection 842(b).
In the
conference report to section 842(b), Congress stated, however,
that it did "not intend to apply the general principle that, in
the case of a conflict, a later enacted statute prevails over
earlier enacted statutes or treaties".
H. Conf. Rept. 100-495
(1987) 915, 983, 1987-3 C.B. 193, 263.
Respondent contends that we should construe the Canadian
Convention so as to harmonize the convention with the statute.
If, however, we find that the Canadian Convention and section
842(b) conflict, respondent concedes that the Convention prevails
and that no deficiencies in income tax or branch profits tax for
the years at issue exist.
Petitioner does not challenge the taxation of its actual
ECNII or respondent’s calculations of its minimum ECNII for any
of the years at issue.
Accordingly, if we find that the Canadian
- 23 Convention and section 842(b) are consistent, petitioner concedes
that section 842(b) applies in this case and that it owes the
income and branch profits tax as determined by respondent in her
statutory notices of deficiency.
The parties present various alternative arguments based on
provisions of Article VII and Article XXV.
In deciding whether
petitioner is entitled to relief from section 842(b) as a result
of the Canadian Convention, we must determine whether:
1. Section 842(b), in requiring petitioner to report a
minimum amount of ECNII, conflicts with the requirements of
paragraphs 1, 2, and 7 of Article VII on how to determine
the profits attributable to a permanent establishment;
2. section 842(b) violates paragraph 5 of Article VII,
which requires a consistent method of profit attribution to
be applied unless a good and sufficient reason to the
contrary exists; or
3. section 842(b) violates Article XXV, paragraph (6) by
levying taxation less favorably on petitioner than the
Internal Revenue Code levies taxation on U.S. residents
carrying on the same activities.
We discuss these issues in the context of the relevant convention
Articles.
The issues before us are of first impression.
III. Principles of Convention Obligations
Before addressing the parties' arguments pertaining to
specific convention provisions, we consider the principles for
interpreting conventions.
The goal of convention interpretation is to "give the
specific words of a * * * [convention] a meaning consistent with
- 24 the genuine shared expectations of the contracting parties".
Maximov v. United States, 299 F.2d 565, 568 (2d Cir. 1962), affd.
373 U.S. 49 (1963).
Courts liberally construe treaties to give
effect to their purpose.
United States v. Stuart, 489 U.S.
353, 368 (1989); Bacardi Corp. of Am. v. Domenech, 311 U.S. 150,
163 (1940).
Even where a provision of a treaty fairly admits of
two constructions, one restricting, the other enlarging, rights
which may be claimed under it, the more liberal interpretation is
to be preferred.
United States v. Stuart, supra at 368.
In
construing a convention, we give the language its ordinary
meaning in the context of the convention, unless a more
restricted sense is clearly intended.
U.S. 258, 271 (1890).
De Geofroy v. Riggs, 133
Finally, it is well settled that when a
convention and a statute relate to the same subject, courts will
always attempt to construe them so as to give effect to both.
Estate of Burghardt v. Commissioner, 80 T.C. 705, 713 (1983),
affd. without published opinion 734 F.2d 3 (3d Cir. 1984).
"Although not conclusive, the meaning attributed to treaty
provisions by the Government agencies charged with their
negotiation and enforcement is given great weight".
United
States v. Stuart, supra at 369 (citing Kolovrat v. Oregon, 366
U.S. 187, 194 (1961)).
The Model Double Taxation Convention on Income and on
Capital, Report of the O.E.C.D. Committee on Fiscal Affairs
- 25 (1977) (Model Treaty), and explanatory commentaries (Model
Commentaries) provide helpful guidance.
See Letter of
Transmittal from President Carter to the Senate of the United
States requesting ratification of the Convention, dated November
12, 1980, 4 Roberts & Holland, Legislative History of United
States Tax Conventions, p. 242 (1986); S. Comm. on Foreign
Relations, Tax Convention and Proposed Protocols with Canada, S.
Exec. Rept. 98-22 (1984), 4 Roberts & Holland, supra at 1096;
Taisei Fire & Marine Ins. Co. v. Commissioner, 104 T.C. 535
(1995)(use of O.E.C.D. Commentaries in interpreting meaning of
permanent establishments).
It is the role of the judiciary to
interpret international conventions and to enforce domestic
rights arising from them.
See Kolovrat v. Oregon, 366 U.S. 187
(1961); Perkins v. Elg, 307 U.S. 325 (1939); Charlton
v. Kelly,
229 U.S. 447 (1913); United States v. Rauscher, 119 U.S. 407
(1886).
Tax treaties are purposive, and, accordingly, we should
consider the perceived underlying intent or purpose of the treaty
provision.
See, e.g., Estate of Burghardt v. Commissioner, supra
at 717 (treating a reference to a "specific exemption" in a U.S.Italy estate tax treaty as not limited to an exemption as such,
but included a subsequently enacted unified credit having the
same function as an exemption); Smith, Tax Treaty Interpretation
by the Judiciary, 49 Tax Lawyer 845, 858-867 (1996).
In
- 26 addressing the issues of this case, we shall keep at the
forefront our role in the interpretation of conventions.
Respondent asserts two principles of convention
interpretation with which petitioner disagrees.
First,
respondent argues that the literal terms of a convention must be
interpreted consistently with the expectations and intentions of
the United States in entering the Canadian Convention.
In
support of this contention, respondent cites United States v.
Stuart, supra at 365-366, and Sumitomo Shoji Am., Inc. v.
Avagliano, 457 U.S. 176, 185 (1982).
Second, respondent
represents that the principles of treaty interpretation, set
forth in her brief, were approved by the Office of International
Tax Counsel of the Treasury Department as interpretations
consistently held by the United States.
Respondent contends that
any contrary interpretations held by Canada are subordinate to
such consistently maintained U.S. interpretations.
Respondent
relies upon United States v. A.L. Burbank & Co., 525 F.2d 9 (2d
Cir. 1975) for support of her contention.
None of these cases supports respondent's position.
As
evidenced by Sumitomo Shoji Am., Inc. v. Avagliano, supra at 180,
and later in United States v. Stuart, supra at 365-366, the
Supreme Court has consistently held that we must consider the
expectations and intentions of both signatories, not just those
of the United States.
The Court states:
- 27 The clear import of treaty language controls unless
"application of the words of the treaty according to
their obvious meaning effects a result inconsistent
with the intent or expectations of its signatories."
[United States v. Stuart, supra at 365-366 (citing
Sumitomo Shoji Am., Inc. v. Avagliano, supra at 180,
quoting Maximov v. United States, supra at 54).]
Moreover, we do not agree with respondent's contention that
A.L. Burbank & Co. stands for the proposition that the
Government's position is entitled to deference at the expense of
our convention partner's interpretation.
In A.L. Burbank & Co.,
the Canadian tax authorities requested the Internal Revenue
Service (the Service) to obtain information to assist them in
their Canadian tax investigation.
The Canadian authorities made
their request pursuant to the 1942 tax convention between the
United States and Canada.
Convention on Double Taxation, Mar. 4,
1942, U.S.-Can., T.S. No. 983, 56 Stat. 1399.
The United States
had no interest in the investigation, and there was no claim that
U.S. income taxes were due.
The Service's understanding of the
Canadian position was that Canadian tax authorities might not act
on a reciprocal request to obtain information for the United
States unless Canadian taxes were also at issue.
The Court of
Appeals for the Second Circuit held that even if Canada failed to
satisfy its reciprocal obligation under the convention, the
United States was permitted to use the summons authority of
section 7602 to obtain the information requested by Canadian tax
officials.
United States v. A.L. Burbank & Co., supra at 15.
- 28 As we stated above, our goal is to construe the Convention
according to the "genuine shared expectations of the contracting
parties".
Maximov v. United States, 299 F.2d at 568.
While the
meaning attributed to treaty provisions by Government agencies
charged with their negotiation and enforcement can be very
helpful to us, and we give great weight to that meaning, United
States v. Stuart, 489 U.S. at 369, deference is not the same as
blind acceptance.
See Coplin v. United States, 6 Cl.Ct. 115
(1984), revd. on other grounds 761 F.2d 688 (Fed. Cir. 1985),
affd. 479 U.S. 27 (1986). There is no authority for the
proposition that a court construing a convention must follow the
interpretation suggested by our Government when that
interpretation runs contrary to what the Court concludes was the
intent of the contracting parties. Id. Indeed, the Supreme Court
has noted that "courts interpret treaties for themselves,"
Kolovrat v. Oregon, 366 U.S. 187, 194 (1961), and that the
construction given by Government agencies is not conclusive.
Sumitomo Shoji Am., Inc. v. Avagliano, supra at 184.
The
deference afforded depends upon the degree to which the
interpretation proffered by respondent, as the official U.S.
position, is reasonable, unbiased, and consistent with what
appear to be the circumstances surrounding the convention.
Coplin v. United States, supra.
As discussed below, other
evidence in the record undermines the plausibility of
- 29 respondent's position and hence the deference that the Court is
able to afford to that interpretation.
IV.
Article VII of the Canadian Convention
Petitioner argues that paragraphs 1, 2, and 7 of article VII
of the Canadian Convention require that profits be attributed to
its permanent establishment as if the latter were a separate
entity distinct from petitioner's head office, with income
measured by reference to the permanent establishment's own
specific operations.
Petitioner goes on to argue that the
statute mandates the application of section 842(b) in all
instances where there is effectively connected investment income.
If the actual income is less than the minimum under the statute,
then the provision applies--a result that, in petitioner's
opinion, conflicts with article VII, paragraphs (1), (2), and
(7), which petitioner interprets to preclude taxing Canadian
companies on a fictional amount that is greater than their actual
income derived from their business in the United States.
Respondent raises various arguments supporting why section
842(b) is consistent with article VII of the Canadian Convention
and contends: (1) Section 842(b) is a permissible method of
attributing profits to a permanent establishment under article
VII; (2) section 842(b) serves as a backstop to section 842(a)
and corrects any underreporting by foreign insurance companies of
their actual ECNII; and (3) the United States Senate, which
- 30 advised and consented to the Canadian Convention and approved
section 842(b), believed that section 842(b) was consistent with
the Convention.
In our view, resolution of this controversy depends on the
interpretation given to article VII, paragraphs (2) and (5).
While article VII, paragraph (1) limits U.S. taxation of income
earned by a Canadian enterprise to the income "attributable" to
the enterprise's permanent establishment, article VII, paragraphs
(2) and (5) direct how those attributable profits are to be
determined.
Article VII, paragraph (2) limits "attributable"
profits to those which a "distinct and separate person engaged in
the same or similar activities under the same or similar
conditions" would be expected to make (hereafter referred to as
the separate-entity principle or basis).
Article VII, paragraph
(5) requires that profits be attributed by the same method each
year unless there is a good and sufficient reason to the
contrary.
To satisfy the convention obligations of the United
States, the domestic rules of attribution must determine the
profits attributable to petitioner's permanent establishment
within the limits set forth therein.
Our analysis begins by
considering how to measure the profits on a separate-entity basis
and whether section 842(b) determines minimum amounts of ECNII in
a manner consistent with those limits.
- 31 V.
Measurement of Profits on a Separate-Entity Basis
Petitioner argues that the language of Article VII requires
income to be attributed to a permanent establishment based on its
own particular operations.
Respondent argues that Article VII
does not require a specific method or guarantee mathematical
certainty and that, consequently, either country may use its
domestic law in determining the profits attributable to a
permanent establishment.
It is axiomatic that the "Interpretation of the * * * Treaty
* * * must, of course, begin with the language of the Treaty
itself."
Sumitomo Shoji Am., Inc. v. Avagliano, 457 U.S. at 180.
As we stated above, the clear import of treaty language controls.
Id.
But Article VII, paragraph (2) speaks in ambiguous terms,
and when language is susceptible to differing interpretations,
extrinsic materials bearing on the parties' intent should be
considered.
Day v. Trans World Airlines, Inc., 528 F.2d 31, 34
(2d Cir. 1975); Hidalgo County Water Control & Improvement
District v. Hedrick, 226 F.2d 1, 8 (5th Cir. 1955).
The Senate's preratification materials confirm that the
Canadian Convention was based in part on the Model Treaty.
S. Exec. Rept. 98-22 at 3.
See
Our examination shows that the
business profits article of the Model Treaty9 includes provisions
9
Art. 7 of Model Double Taxation Convention on Income and on
Capital, Report of the O.E.C.D. Comm. on Fiscal Affairs (1977)
(continued...)
- 32 substantially similar to Article VII, paragraphs (1) and (2) of
the Canadian Convention.
While the Model Treaty itself provides
no more explanation than the Canadian Convention on how to
determine the profits attributable to a permanent establishment,
the Model is explained in part by the Model Commentaries.
Petitioner relies upon paragraphs 10 and 13 of the Model
Commentaries to Article 7, paragraph (2) of the Model Treaty in
support of its contention that the separate-entity language of
Article VII, paragraph (2) requires that taxable profits be
attributed to a permanent establishment based on the
establishment's facts.
These paragraphs provide in pertinent
part:
9
(...continued)
(Model Treaty) provides in pertinent part:
Par. 1. The profits of an enterprise of a Contracting
State shall be taxable only in that State unless the
enterprise carries on business in the other Contracting
State through a permanent establishment situated
therein. If the enterprise carries on business as
aforesaid, the profits of the enterprise may be taxed
in the other State but only so much of them as is
attributable to that permanent establishment.
Par. 2. Subject to the provisions of paragraph 3,
where an enterprise of a Contracting State carries on
business in the other Contracting State through a
permanent establishment situated therein, there shall
in each Contracting State be attributed to that
permanent establishment the profits which it might be
expected to make if it were a distinct and separate
enterprise engaged in the same or similar activities
under the same or similar conditions * * *
- 33 10. This paragraph contains the central directive on
which the allocation of profits to a permanent
establishment is intended to be based. The paragraph
incorporates the view, which is generally contained in
bilateral conventions, that the profits to be
attributed to a permanent establishment are those which
that permanent establishment would have made if,
instead of dealing with its head office, it had been
dealing with an entirely separate enterprise under
conditions and at prices prevailing in the ordinary
market. Normally, these would be the same profits that
one would expect to be determined by the ordinary
processes of good business accountancy. * * *
13. Clearly many special problems of this kind may
arise in individual cases but the general rule should
always be that the profits attributed to a permanent
establishment should be based on that establishment’s
accounts insofar as accounts are available which
represent the real facts of the situation. * * * [Model
Commentaries to Article 7, paragraph (2) of the Model
Treaty; emphasis added.]
In her trial memorandum, respondent acknowledges: "[The
model] Commentar[ies] express[] a preference for an arm's-length
standard for the 'distinct and separate person' entity with
separate accounts".
Respondent contends, however, that Article
VII permits either country to apply its domestic law in
determining the profits attributable to a permanent
establishment.
In this regard, respondent relies upon the
Technical Explanation, prepared by the Treasury Department and
submitted to the Senate Foreign Relations Committee.
The
Technical Explanation states in pertinent part:
Paragraph 7 provides a definition for the term
"attributable to". Profits "attributable to" a
permanent establishment are those derived from the
assets or activities of the permanent establishment.
- 34 Paragraph 7 does not preclude Canada or the United
States from using appropriate domestic tax law rules of
attribution. The "attributable to" definition does
not, for example, preclude a taxpayer from using the
rules of section 1.864-4(c)(5) of the Treasury
Regulations to assure for U.S. tax purposes that
interest arising in the United States is attributable
to a permanent establishment in the United States.
(Interest arising outside the United States is
attributable to a permanent establishment in the United
States based on the principles of Regulations sections
1.864-5 and 1.864-6 and Revenue Ruling 75-253, 1975-2
C.B. 203.) Income that would be taxable under the Code
and that is "attributable to" a permanent establishment
under paragraph 7 is taxable pursuant to Article VII,
however, even if such income might under the Code be
treated as fixed or determinable annual or periodical
gains or income not effectively connected with the
conduct of a trade or business within the United
States. The "attributable to" definition means that
the limited "force-of-attraction" rule of Code section
864(c)(3) does not apply for U.S. tax purposes under
the Convention. [Technical Explanation by the Treasury
Department 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 September
26, 1980, as Amended by the Protocols Signed on June
14, 1983 and March 28, 1984, 4 Roberts & Holland,
Legislative History of United States Tax Conventions,
p. 1020, 1032 (1986); 1986-2 C.B. 275, 279.]
In the alternative, respondent infers from the absence of any
reference in the Technical Explanation to a conflict between the
Canadian Convention and prior section 819(a) of the Internal
Revenue Code of 195410 that Canada implicitly accepted that
attribution rules such as section 842(b) would apply.
Nevertheless, we are satisfied that petitioner's
construction of the separate-entity principle of Article VII,
10
Congress enacted sec. 819(a) as part of the Life Insurance
Company Income Tax Act of 1959, Pub. L. 86-69, 73 Stat. 136.
- 35 paragraph (2) is correct.
The extrinsic evidence and the Model
Treaty and Commentaries, on which the Canadian Convention is
based in part, support that construction.
The Senate's
preratification materials to the Convention do not ascribe a
different meaning to the separate-entity language of Article VII,
paragraph (2).
See S. Exec. Rept. 98-22, 20 (1984).
Moreover,
it is consistent with the approach historically taken by the
United States and Canada.
Art. III(1) of the Convention on
Double Taxation, Mar. 4, 1942, U.S.-Can., T.S. No. 983, 56 Stat.
1399.11
While the Treasury's interpretation, set forth in the
Technical Explanation, is particularly persuasive in light of the
fact that the Canadian Department of Finance has generally
accepted the Technical Explanation as an accurate portrayal of
the understandings and context in which the Convention was
negotiated, see ALI Project, 18 (1992); Canadian Department of
Finance, Rel. No. 81-6 (Feb. 4, 1981), we think that respondent
11
Art. III(1) in the second income tax convention with
Canada signed in 1942 provided in pertinent part:
1. If an enterprise of one of the contracting
States has a permanent establishment in the other
State, there shall be attributed to such permanent
establishment the net industrial and commercial profit
which it might be expected to derive if it were an
independent enterprise engaged in the same or similar
activities under the same or similar conditions. Such
net profit will, in principle, be determined on the
basis of the separate accounts pertaining to such
establishment. * * *
- 36 misconstrues the Treasury's interpretation.
We are not persuaded
that the language set forth in the Technical Explanation of
Article VII, paragraph (7), see supra p. 31, was intended to
interpret Article VII as preserving the right to the use of all
of the domestic attribution rules.
In this context, the
Technical Explanation's use of the word "paragraph" takes on a
significant meaning.
The word "paragraph" in the Technical
Explanation's discussion of Article VII, paragraph (7) signals
that under paragraph 7 of Article VII, domestic rules of
attribution may remain viable.
It does not necessarily follow
that all domestic rules remain so under the rest of Article VII,
particularly Article VII, paragraph (2).
To adopt respondent's
interpretation would require us to substitute the word "article"
for "paragraph" and would render the limit imposed by the
separate-entity principle meaningless.
By way of contrast, our
interpretation of the Technical Explanation, as it relates to
Article VII, paragraph (7), gives effect to the word "paragraph"
without modification but still preserves the rest of Article VII.
In a similar vein, we decline to infer an implicit
acceptance of attribution rules like section 842(b), on the part
of Canada, from the fact that the Technical Explanation does not
mention any conflict between the Canadian Convention and section
819(a).
As we discuss below, see infra pp. 42-47, there is a
superficial similarity between prior section 819(a) and section
- 37 842(b), but, nevertheless, there are important differences
between them.
Accordingly, we hold that the disposition of this case turns
on whether the section 842(b)(1) formula prescribes a minimum
amount of ECNII based on the facts as they relate to petitioner's
permanent establishment, by reference to the establishment's
separate accounts insofar as those accounts represent the facts
of the situation, and by the same method each year unless there
is a good and sufficient reason to do otherwise.
It is to that
review that we direct our attention.
Petitioner retained Dale S. Hagstrom and Daniel J. McCarthy
of Milliman & Robertson, Inc.12 (Hagstrom), whose report
endeavored to analyze the hypothetical impact of applying the
section 842(b) formula to the domestic insurance industry, and/or
to U.S. branches of Canadian insurance companies.
Without going
into the details of the conclusions reached by petitioner's
experts suffice it to say that, overall, we do not find their
analysis to be helpful.
For example, significantly section
842(b) does not apply to domestic insurance companies.
12
Mr. Hagstrom holds a B.A. in mathematics from Princeton
University. He is a Fellow of the Society of Actuaries and a
member of the American Academy of Actuaries. Mr. McCarthy holds
a B.S. in mathematics from Fordham University. In addition, he
is a Fellow of the Society of Actuaries and a charter member of
the American Academy of Actuaries. He has been designated as an
enrolled actuary by the Joint Board for the Enrollment of
Actuaries.
- 38 Furthermore, we agree with petitioner that section 842(b)
attributes a fictional amount of income to petitioner's U.S.
branch that is not based on its own activities but rather on the
investment performance achieved by domestic insurance companies.
Respondent contends that section 842(b) does not violate the
separate-entity principle because the formula therein uses
petitioner's liabilities to determine the assets petitioner might
be expected to hold if it were a separate entity.
Whether the
hypothetical amount of assets calculated pursuant to section
842(b) represents a reasonable estimate of the amount of assets
petitioner would hold if it were a separate entity misses the
point; that amount is simply extraneous to petitioner's
operations.
Section 842(b) incorporates domestic insurance
industry data via the domestic yield or company's worldwide
earnings data via the worldwide yield, all of which are
extraneous to the operations of petitioner's U.S. permanent
establishment.
We are not persuaded that the separate-entity
principle is satisfied merely by starting with the real facts as
they relate to petitioner's permanent establishment but then
incorporating extraneous data that is inconsistent with that
principle.
Cf. Ostime (Inspector of Taxes) v. Australian Mutual
Provident Society, [1960] AC 459 (United Kingdom case with a
similar business profits article stating that "the worldwide
investment income, which forms the first stage of the * * *
- 39 calculation of profits, cannot be attributed to the hypothetical
independent enterprise without violating the very hypothesis
which * * * the treaty is designed to lay down as the basis of
taxability", i.e., the separate-entity principle).
Respondent's
own witness, Dr. Newlon, an international economist with the
Treasury, admitted that the formula could be improved.
We are
convinced that section 842(b) is contrary to and inconsistent
with Article VII, paragraph (2), which precludes the fictional
allocation of business profits to petitioner's permanent
establishment.
Imputing a level of assets and yields to petitioner's U.S.
branch, respondent contends, is not unreasonable because the
formula incorporates actual business data and petitioner operates
in the United States market and directly competes with domestic
life insurance companies.
To conclude that section 842(b) is
reasonable in light of the fact that petitioner operates in the
United States would not resolve the dispute before us.
enough for section 842(b) to be reasonable.
It is not
To sustain the
application of section 842(b) based on the facts before us, we
must conclude that it comports with our Convention obligation.
See United States v. A.L. Burbank & Co., 525 F.2d at 15.
As we
have stated above, we must conclude that the statute does not;
consequently, it cannot prevail in the presence of the
Convention.
- 40 Respondent asserts that Article VII, paragraph (2) permits
the use of formulas in determining the taxable profits under
limited circumstances.
In support, respondent relies upon
paragraph 23 of the Model Commentaries to Article 7, paragraph
(3) of the Model Treaty, which states in pertinent part:
23. It is usually found that there are, or there
can be constructed, adequate accounts for each part or
section of an enterprise so that profits and expenses,
adjusted as may be necessary, can be allocated to a
particular part of the enterprise with a considerable
degree of precision. This method of allocation is, it
is thought, to be preferred in general wherever it is
reasonably practicable to adopt it. There are,
however, circumstances in which this may not be the
case and paragraphs 2 and 3 are in no way intended to
imply that other methods cannot properly be adopted
where appropriate in order to arrive at the profits of
a permanent establishment on a "separate enterprise"
footing. It may well be, for example, that profits of
insurance enterprises can most conveniently be
ascertained by special methods of computation, e.g. by
applying appropriate co-efficients to gross premiums
received from policy holders in the country concerned.
Again, in the case of a relatively small enterprise
operating on both sides of the border between two
countries, there may be no proper accounts for the
permanent establishment nor means of constructing them.
There may, too, be other cases where the affairs of the
permanent establishment are so closely bound up with
those of the head office that it would be impossible to
disentangle them on any strict basis of branch
accounts. Where it has been customary in such cases to
estimate the arm's length profit of a permanent
establishment by reference to suitable criteria, it may
well be reasonable that that method should continue to
be followed, notwithstanding that the estimate thus
made may not achieve as high a degree of accurate
measurement of the profit as adequate accounts. Even
where such a course has not been customary, it may,
exceptionally, be necessary for practical reasons to
estimate the arm's length profits.
- 41 Respondent argues that paragraph 23 of the Model
Commentaries permits the adoption of formulas if any one of the
following circumstances is satisfied: (1) Formulas are found to
be more convenient or administratively necessary; (2) the
permanent establishment lacks adequate accounts by which to
determine the attributable profits; (3) the other method is
customary; (4) the permanent establishment is a foreign insurance
enterprise; and (5) an exceptional need for the method is
demonstrated.
In respondent's view, each circumstance is
satisfied in the instant case, and section 842(b) is a
permissible method by which to determine attributable profits
within the meaning of the Canadian Convention.
The amicus curiae
brief submitted by the Government of Canada asserts that when
contracting parties to a tax convention intend to permit the use
of formulas to determine profits of a permanent establishment
engaged in the insurance business, the convention will contain a
specific provision to that effect.
We need not decide whether Article VII, paragraph (2)
permits the use of formulas in determining the profits
attributable to a permanent establishment.
As a preliminary
matter, we find respondent's reliance on paragraph 23 of the
Model Commentaries to be misplaced.
paragraph 23 too broad a reading.
We think respondent gives
Our reading leads us to the
conclusion that, at a minimum, before other methods (other than
- 42 using the accounts of a permanent establishment) may be adopted
under the guidance of paragraph 23, the other method must be
customary and based on suitable criteria or the circumstances
must be exceptional.
Respondent contends that section 842(b) is customary because
it is substantially similar to the prior sections 819(a)13
13
Sec. 819(a) of the Internal Revenue Code of 1954, as
amended and in effect for 1983, provided in pertinent part:
(1) In general.--In the case of any foreign
corporation taxable under this part, if the minimum
figure determined under paragraph (2) exceeds the
surplus held in the United States, then-(A) the amount of the policy and other
contract liability requirements (determined under
section 805 without regard to this subsection),
and
(B) the amount of the required interest
(determined under section 809(a)(2) without regard
to this subsection),
shall each be reduced by an amount determined by
multiplying such excess by the current earnings rate
(as defined in section 805(b)(2)).
(2) Definitions.--For purposes of paragraph (1)-(A) The minimum figure is the amount
determined by multiplying the taxpayer's total
insurance liabilities on United States business by
a percentage for the taxable year to be determined
and proclaimed by the Secretary.
The percentage determined and proclaimed by the
Secretary under the preceding sentence shall be based
on such data with respect to domestic life insurance
companies for the preceding taxable year as the
Secretary considers representative. Such percentage
(continued...)
- 43 -
13
(...continued)
shall be computed on the basis of a ratio the numerator
of which is the excess of the assets over the total
insurance liabilities, and the denominator of which is
the total insurance liabilities.
Sec. 805(a) of the 1954 Internal Revenue Code, as amended,
defined policy and other contract liability requirements as the
sum of:
(1) the adjusted life insurance reserves,
multiplied by the adjusted reserves rate,
(2) the mean of the pension plan reserves at the
beginning and end of the taxable year, multiplied by
the current earnings rate, and
(3) the interest paid.
Sec. 805(b)(2) of the 1954 Internal Revenue Code, as
amended, defined the current earnings rate as:
* * * the amount determined by dividing-(A) the taxpayer's investment yield for such
taxable year, by
(B) the mean of the taxpayer's assets at the
beginning and end of the taxable year.
Sec. 805(b)(4) defined assets for purposes of the above sec.
805(b)(2) as follows "all assets of the company (including
nonadmitted assets), other than real and personal property
(excluding money) used by it in carrying on an insurance trade or
business."
Sec. 809(a)(2) of the 1954 Internal Revenue Code, as
amended, defined "required interest" for purposes of subsection
819 as:
the sum of the products obtained by multiplying-(A) each rate of interest required, or
assumed by the taxpayer, in calculating the
reserves described in section 810(c) by
(continued...)
- 44 (applying from years 1959 through 1983) and 813 of the Internal
Revenue Code of 1954, as amended, and section 813 of the Internal
Revenue Code of 198614 (applying from years 1984 through 1987).
13
(...continued)
(B) the means of the amount of such reserves
computed at that rate at the beginning and end of
the taxable year.
The Life Insurance Company Income Tax Act of 1959, Pub. L. 86-69,
sec. 2, 73 Stat. 136, added sec. 819(b), which required the same
adjustment as sec. 819(a) except that the minimum figure was
determined by multiplying the foreign life insurance company's
total insurance liabilities on U.S. business by 9 percent for
tax years beginning before January 1, 1959 and by an annual
percentage determined by the Treasury for tax years thereafter.
The Foreign Investors Act of 1966, Pub. L. 89-809, sec. 104,
104(i)(3), 80 Stat. 1539, 1561, redesignated the adjustment
provision as sec. 819(a) for tax years beginning after 1966.
From 1966 until 1983, sec. 819(a) remained unchanged except for
minor changes, which are not relevant to the instant case.
14
Sec. 813 provided in pertinent part:
(a) Adjustment where surplus held in the United States
is less than specified minimum-(1) In general.--In the case of any foreign company
taxable under this part, if-(A) the required surplus determined under
paragraph (2), exceeds
(B) the surplus held in the United States,
then its income effectively connected with the conduct
of an insurance business within the United States shall
be increased by an amount determined by multiplying
such excess by such company's current investment yield.
* * *
(2) Required surplus.--For purposes of this subsection-(A) In general.--The term "required surplus" means
(continued...)
- 45 The prior sections 819(a) and 813 both required a foreign
insurance company to compare its branch's actual surplus (excess
of assets over total insurance liabilities) held in the United
States to a statutory minimum surplus.
813(a)(1).
Sec. 819(a)(2)(A); sec.
If the branch's surplus was less than a statutory
minimum, the deficiency was treated as additional assets of the
branch which were deemed to have earned the same yield that the
branch had earned on the assets it actually held.
819(a)(1), 805(b)(2), 813(a)(3).
Secs.
The Deficit Reduction Act of
1984, Pub. L. 98-369, sec. 211(a), 98 Stat. 720, 743 repealed
14
(...continued)
the amount determined by multiplying the taxpayer's
total insurance liabilities on United States business
by a percentage for the taxable year determined and
proclaimed by the Secretary under subparagraph (B).
(B) Determination of percentage.--The percentage
determined and proclaimed by the Secretary under this
subparagraph shall be based on such data with respect to
domestic life insurance companies for the preceding taxable
year as the Secretary considers representative. Such
percentage shall be computed on the basis of a ratio the
numerator of which is the excess of the assets over the
total insurance liabilities, and the denominator of which is
the total insurance liabilities.
(3) Current investment yield.--For purposes of this
subsection-(A) In general.--The term "current investment
yield" means the percent obtained by dividing-(i) the net investment income on assets held in
the United States, by
(ii) the mean of the assets held in the United
States during the taxable year.
- 46 prior section 819 and added prior section 813.
The prior section
819(a) required a foreign life insurance company to reduce
certain deductions by the product of the deficiency and the
foreign insurance company's actual yield.
Sec. 819(a).
The
Deficit Reduction Act of 1984, Pub. L. 98-369, modified how
taxable income was calculated for foreign insurance companies.
Sec. 801; see H. Rept. 98-861, 1984-3 C.B. (Vol. 2) 1, 297-298.
This change necessitated treating the product of the deficiency
and the foreign insurance company's actual yield as additional
effectively connected income instead of as a reduction of certain
deductions which was done under the previous section 819.
Subsequently, Omnibus Budget Reconciliation Act of 1987,
Pub. L. 100-203, 101 Stat. 1330, repealed prior section 813 and
added section 842(b).
We do not find that section 842(b) is
similar enough to prior sections 819 and 813 so as to establish
that section 842(b) was customary within the meaning of paragraph
23 of the Model Commentaries.
Two features of section 842(b) go
beyond the historical approach taken by both of the earlier
statutes.
First, section 842(b)(1) imputes additional income
based on an earnings yield derived from domestic industry
averages, sec. 842(b)(3), or petitioner's worldwide operations,
sec. 842(b)(4), whereas both prior section 819 and section 813
imputed income based on the U.S. branch's actual earnings yield.
Secs. 819(a)(1)(B), 805(b)(2), 813(a)(3).
Second, section 842(b)
- 47 applies an entirely new yield to all of the branch's assets not
just to the additional imputed assets.
Prior sections 819(a) and
813, on the other hand, imputed additional income for just those
deemed assets.
We recognize that a convention, like a constitution, is a
dynamic instrument, drafted to take account of changing
conditions and expectations.
See Day v. Trans World Airlines,
Inc., 528 F.2d at 35; Maximov v. United States, 299 F.2d at 568.
If we were to accept respondent's argument, however, the United
States could, through various amendments to the Internal Revenue
Code, always eliminate unilaterally the separate-entity
principles in Article VII, paragraph (2) without ever violating
the Canadian Convention.
Nor are we are persuaded that the circumstances herein are
exceptional.
While paragraph 23 does not prescribe when
circumstances are considered exceptional, we do have other
guidance as to when such circumstances may exist.
Paragraph 11
of the Model Commentaries states that:
11. In the great majority of cases, trading accounts
of the permanent establishment * * * will be used by
the taxation authorities concerned to ascertain the
profit properly attributable to that establishment.
Exceptionally there may be no separate accounts (cf.
paragraphs 23 to 27 below). * * * [Emphasis added.]
The above language suggests that other methods may only be
adopted when a permanent establishment does not have any
- 48 accounts.
As we discuss below, the real facts (accounts) are
ascertainable in the instant case.
Respondent also seeks to justify the application of section
842(b) on the grounds that the statute serves as a necessary
backstop to section 842(a) and corrects any underreporting of
actual ECNII by foreign insurance companies.
The parties agree
that petitioner as well as other foreign insurance companies use
their NAIC form 1A data to identify to what extent their net
investment income is effectively connected to their U.S.
businesses for purposes of section 842(a).
In this context, respondent contends that foreign insurance
companies have significant discretion in moving their assets
between taxing jurisdictions once their State statutory trust
requirements are satisfied.
Respondent points out that
Washington State law does not require a foreign insurer to
deposit income earned on trusteed assets in the trust account and
that it permits petitioner to replace trusteed assets with other
assets of equal value and quality, subject to the investment
rules.
Consequently, forms 1A, respondent argues, fail to
reflect the economic realities of the businesses of foreign
insurance companies operating in the U.S. and are unreliable for
the purpose determining their actual ECNII.
Respondent goes on
to argue that absent section 842(b), foreign insurance companies
- 49 may escape U.S. taxation on investment income attributable to
their U.S. business.
Respondent retained Richard E. Stewart, Richard S.L. Roddis,
and Barbara D. Stewart of Stewart Economics, Inc.15 (Stewart), as
expert witnesses to give their professional opinion as to the
reasons and incentives Canadian life insurance companies have for
holding certain assets in the United States and why the
investment income earned on those assets is not an inherently
reliable measure of the investment income flowing from the branch
operations. We have received into evidence their report.16
Stewart reviewed the history of the State regulations applying to
foreign insurance companies, including the NAIC annual statement
and the trust requirements for such companies.
The report agrees
with respondent that NAIC form 1A is not an effective means by
which to ascertain the net investment income that is effectively
15
Richard E. Stewart holds a degree from West Virginia
University and a law degree from Harvard Law School. He is
former Superintendent of Insurance of the State of New York and a
former officer and director of The Chubb Group of Insurance
Companies. Richard S.L. Roddis holds a degree from San Diego
University and a law degree from Boalt Hall School of Law at the
University of California at Berkeley. He is a former
Superintendent of Insurance of the State of California.
Barbara D. Stewart holds a bachelor's degree in economics and
business administration from Beaver College. She is a former
corporate economist of the Chubb Group.
16
We have disregarded the Stewart report to the extent that
it relies on State law of Washington for years not at issue. The
record does not indicate that petitioner operated in Michigan;
we have also disregarded the report to the extent that it relies
on Michigan State law.
- 50 connected to an insurance business within the United States and
that NAIC form 1A (foreign insurers' form) differs significantly
from NAIC form 1 (domestic insurers' form). Stewart concluded
that:
Canadian life insurance companies are not required to
earmark specific assets for their U.S. business * * *.
[B]ecause Canadian life insurance companies have
economic incentives to place higher yielding assets in
lower taxing jurisdictions, something other than NAIC
statement assets and investment yields are needed to
determine the investment income derived from the
trusteed assets of a Canadian life insurance company.
Respondent also points to various facts, which she claims
indicate that petitioner's NAIC forms 1A fail to reflect the
economic realities of petitioner's U.S. branch: (1)
During 1988
through 1990, petitioner’s total cash and term deposits, which
were maintained as a part of its U.S. branch, were 75 percent, 90
percent, and 75 percent, respectively, of its total worldwide
funds; (2) petitioner maintained only 35 percent, 38 percent, and
50 percent of its total bond portfolio--arguably higher-yielding
assets--in its U.S. branch, for 1988, 1989, and 1990,
respectively; (3) petitioner transferred Canadian dollardenominated bonds from its Canadian business to its Seattle bank
trust account in order to equalize the surplus held in each
operation; and (4) petitioner transferred from its Seattle bank
trust account to its Canadian parent stock that petitioner held
in a subsidiary and for purposes of the transfer the stock was
valued at its cost rather than at its fair market value.
- 51 We agree with respondent and respondent's expert that the
NAIC form 1A is not the ideal means for reconciling and
identifying all of the income attributable to a permanent
establishment.
It does not include a closed, self-contained book
of accounts, reconciliation of any surplus, or information
regarding capital gains or losses.
The form is not designed to
identify taxable income but rather to monitor compliance with
State regulatory requirements on trusteed assets.
That
conclusion, however, does not resolve the issue before us.
The record is clear that petitioner occasionally exercised
its discretion in moving assets between jurisdictions as
evidenced by petitioner's transfer of its Canadian bonds from its
Canadian operations to its Seattle bank trust account and by the
sale of its stock in a subsidiary to its foreign parent.
Through
the testimony of Mr. Putz and Mr. Francis, whom we found to be
informative and credible witnesses, petitioner has established,
however, as a general business practice, that it did not
commingle assets between its Seattle bank trust account and its
Canadian investment portfolio and had separate investment
strategies in each country.
We are satisfied with their explanations of the business
reasons behind petitioner's investment strategy.
According to
Mr. Francis' testimony, petitioner's U.S. branch had significant
liquidity demands as a result of its need to balance its 5-year
- 52 mortgage holdings.
Petitioner has established that, in fact, it
avoided currency risk and only invested assets in the same
currencies as its insurance liabilities because of the narrow
profit margins on its products.
As petitioner correctly points out, if petitioner's accounts
were considered so inherently unreliable as to justify ignoring
those accounts for purposes of the Canadian Convention, such a
method should be used in all years, not just when the statute
produces a higher amount than does petitioner's accounts.
Article VII, paragraph (5) of the Canadian Convention makes clear
that the same method of profit allocation is to be used each year
unless there is a "good and sufficient reason to the contrary."
Paragraph 30 of the Model Commentaries to Article 7, paragraph
(6)17 explains that "a method of allocation once used should not
be changed merely because in a particular year some other method
produces more favourable results".
The parties stipulated that
for 1989 petitioner's actual ECNII and minimum ECNII were
$19,910,031 and $19,606,065, respectively.
As a result, section
842(b) would not increase petitioner's net investment income for
1989 because petitioner's actual ECNII exceeded petitioner's
17
Art. 7(6) of the Model Treaty is substantially similar to
Art. VII(5) of the Canadian Convention. Art. 7(6) provides in
pertinent part: "For the purposes of the preceding paragraphs,
the profits to be attributed to the permanent establishment shall
be determined by the same method year by year unless there is
good and sufficient reason to the contrary."
- 53 minimum ECNII.
On the other hand, those accounts that were
adequate for 1989 were deemed inadequate for years 1988 and 1990
solely on the basis that petitioner's minimum ECNII of
$21,282,045 and $20,749,629 exceeded its actual ECNII of
$18,501,669 and $20,426,754 and not based on the actual
inaccuracies of those accounts.
We find that section 842(b)
contravenes the basic premise set forth in Article VII, paragraph
(5) of the Canadian Convention.
In the totality of petitioner's circumstances, we do not
believe that petitioner underreported its actual ECNII during the
years at issue despite whatever deficiencies may exist in using
form 1A to identify the extent to which petitioner's net
investment income was effectively connected.
Section 842(b) has the effect of penalizing petitioner, who
reported income commensurate with its U.S. business but whose
investment performance does not attain the U.S. average in each
year.
Such an approach is simply not consistent with either
Article VII, paragraph (2) or (5).
Respondent argues that petitioner's facts are not
representative of the foreign insurance industry in the United
States.
Respondent admits that petitioner may be adversely
affected by section 842(b) as written but contends, as a policy
matter, the Court should not find the statute to be inconsistent
with the Canadian Convention merely because one particular
- 54 taxpayer is adversely affected if the Court concludes that the
statute as a whole is designed to achieve the appropriate results
for taxpayers in general over the long term.
But both parties
agree that this case does not turn on the validity of the policy
reasons underlying the adoption of section 842(b) (i.e., the
potentially abusive ability of foreign insurance companies to
hold excess liquid assets outside of the U.S. or to hold higher
yielding assets outside of the U.S.), and we agree with them.
Respondent retained Christian DesRochers of the Avon
Consulting Group18
to give his professional opinion as to the
economic impact of section 842(b).
DesRochers analyzed section
842(b) and the hypothetical impact of applying the formula
therein to the U.S. branches of Canadian insurance companies.
DesRocher's analysis of the impact of section 842(b) on
taxpayers not before us is of little help.
As a threshold
matter, respondent's argument raises an issue as to the proper
factual focus of our review.
Respondent argues that the United
States, Canada, and petitioner all accepted that a domestic
attribution rule would be tested against Article VII on the basis
of the circumstances of all Canadian life insurance companies
rather than just on a particular taxpayer's facts.
18
To support
Mr. DesRochers holds an undergraduate degree in political
science from the University of Connecticut. He is a Fellow of
the Society of Actuaries and a member of the American Academy of
Actuaries.
- 55 this contention, respondent relies in part on the discussion in
the Technical Explanation, see supra pp. 33-34.
In respondent's
view, because both countries expected all of their respective
domestic attribution rules to apply, it follows that each country
expected the domestic rule to be reviewed based on the facts of
the entire industry.
We need not engage in a detailed analysis of whether various
foreign insurance companies pay Federal income tax in accordance
with our tax laws.19
Respondent's argument essentially ignores
the language of the referenced discussion of the Technical
Explanation, see supra pp. 33-34.
As we previously discussed,
see supra pp. 36-37, we do not believe that the United States and
Canada intended for all domestic attribution rules to be
preserved under Article VII.
Throughout Article VII and particularly Article VII,
paragraph (2), the language therein refers only to a single
permanent establishment rather than the industry in which the
establishment operates.
19
When the language is reasonably clear,
Respondent's proposed findings of fact include data
relating to other Canadian life insurance companies carrying on
insurance businesses through branches in the United States. On
brief, petitioner objected to the relevancy of these findings
unless the Court concluded that they were relevant "in light of
the ‘test case’ aspect of the proceeding". Because we have
decided the controverted issues without considering these
stipulations in our Findings of Fact and our Opinion, the
admissibility of these stipulations has become moot. Although we
reviewed all the material submitted in this case, we only address
facts affecting petitioner.
- 56 as it is in this particular context, the party proffering a
contrary interpretation must persuade the court that its
construction comports with the view of both parties.
See
Sumitomo Shoji Am., Inc. v. Avagliano, 457 U.S. at 180.
In light of the foregoing, the language and purpose of
Article VII, paragraph (2) and the content of the Canadian
Convention as a whole, we also do not believe that the approach
suggested by respondent could have been within the "shared
expectations of the contracting parties," Maximov v. United
States, 299 F.2d at 568, and, consequently, we do not agree that
petitioner implicitly accepted respondent's approach to
interpreting Article VII.
Respondent is generally correct that section 842(b) was
intended to serve as a backstop to the rules in section 842(a)
and section 864(c).
The conference report to section 842(b)
states:
The conferees understand that the provision
governing foreign insurance companies solves a
statutory problem in the context of the broader issue:
measuring the U.S. taxable income of a foreign
corporation that is effectively connected with its U.S.
trade or business. That issue more generally involves
the determination of which of the corporation's assets
generate gross effectively connected income, and which
of its expenses and liabilities are connected with such
income. Certain types of assets and liabilities that
must, in this process, be attributed in whole or in
part to a U.S. trade or business may be particularly
suitable for movement among various trades or
businesses of a single foreign corporation, may be
fungible with assets and liabilities identified with
other trades or businesses of the corporation, or may
- 57 be usable by more than one such trade or business
simultaneously. * * * [H. Conf. Rept. 100-495 (1987)
at 984, 1987-3 C.B. 193, 264.]
But such a conclusion does not affect the outcome of this case.
To begin with, as previously noted, the issues in this case do
not concern policy in section 842(b) or any other provisions of
the Internal Revenue Code.
Rather, the issues concern whether
the statute comports with our convention obligations.
Unfortunately, in the instant case, section 842(b) cannot survive
in the presence of the Canadian Convention.
Finally, respondent argues that we should construe section
842(b) as agreeing with the Canadian Convention because the
United States Senate, which advised and consented to the Canadian
Convention and approved the statute, believed the statute did not
violate any existing conventions.
In support, respondent points
to several statements in the conference report to section
842(b).20
20
The conference report, H. Conf. Rept. 100-495, at 983-984,
1987-3 C.B. 263-264, listed several factors, originally developed
by the Treasury Department, indicating why section 842(b) and
United States treaties were consistent:(1) Section 842(b) applies
to life insurance companies in a manner substantially similar to
the present-law rules which Treasury did not consider to violate
United States treaties; (2) section 842(b) attributes to the U.S.
trade or business of a foreign life insurance company an amount
of assets determined by reference to the assets of comparable
domestic insurance companies, thereby reasonably measuring the
amount of assets that the U.S. trade or business of a foreign
insurance company would be expected to have were it a separate
company dealing independently with non-United States offices of
the foreign insurance company; and (3) section 842(b) furnishes
(continued...)
- 58 We are not persuaded by respondent's assertion that this
statement in the conference report should guide the result in
this case.
To the extent that the statements in the conference
report may be read as expressing the view of the Senate that
section 842(b) is consistent with the Canadian Convention they
are the statements of a subsequent Senate and, therefore, at
best, "form a hazardous basis for inferring the intent of an
earlier one."
South Carolina v. Regan, 465 U.S. 367, 379 n.16
(1984); Consumer Prod. Safety Commn. v. GTE Sylvania, 447 U.S.
102, 117 (1980).
In the end, the courts alone must declare what
the Canadian Convention and particularly Article VII mean.
See
American Exch. Sec. Corp. v. Helvering, 74 F.2d 213, 214 (1934).
In sum, we are confronted with a situation, in which the
language of Article VII, paragraph (2) is at best murky, and the
interpretations of both parties have advantages and
disadvantages.
We are impressed that the Canadian Convention may
give an economic advantage to Canadian insurance companies
operating through a permanent establishment in the United States.
Nevertheless, our view is that petitioner's interpretation of
Article VII, paragraph (2) best carries out the intent of the
20
(...continued)
regulatory authority for the Secretary to provide a relief
mechanism to mitigate the effects of any increase in tax
resulting from the fact that a taxpayer's deemed income from
required U.S. assets exceeds its actual income from those assets.
- 59 United States and Canada as set forth in the Canadian Convention
and satisfies the purpose of Article VII of the Canadian
Convention--to attribute income to a permanent establishment
based on its real facts, and, accordingly, we so hold.
Having found that petitioner is entitled to relief from
section 842(b) based on Article VII, paragraph (2) of the
Canadian Convention, we have no need to delve into the question
of whether petitioner is also entitled to such relief based on
Article XXV, paragraph (6).
Finally, we note that respondent did not contend that
section 482 applied in the instant case.
Accordingly, our
decision in the instant case does not consider the application of
section 482 in those circumstances in which the Convention also
applies.
The Executive Branch with the advice and consent of the
Senate has the option of negotiating a new protocol with Canada
creating an exception similar to one included in subsequent
conventions.
These conventions contain a general directive to
determine profits as if the taxpayer was a separate entity yet
also include explicit exceptions permitting each country to apply
its own internal methods of taxation to the business profits of
an insurance company's permanent establishment.
See, e.g., art.
7(7), Tax Convention, U.S.-N.Z., 7/23/82, 35 U.S.T. (Part 2)
- 60 1949, 1990-2 C.B. 274.21
We have considered all of the other
arguments made by respondent and, to the extent we have not
addressed them, find them to be without merit.
Decision will be entered
for petitioner.
Reviewed by the Court.
COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, WHALEN, BEGHE,
LARO, and VASQUEZ, JJ., agree with this majority opinion.
CHIECHI, J., did not participate in the consideration of
this opinion.
21
Art. 7(7) of the U.S.-New Zealand Convention includes a
provision regarding the taxation of permanent establishments of
insurance companies. This provision provides:
Nothing in this Article shall prevent either
Contracting State from taxing according to its law the
income or profits from the business of any form of
insurance. [Tax Convention, July 23, 1982, U.S.-N.Z.,
35 U.S.T. (Part 2) 1949, 1964.]
- 61 HALPERN, J., concurring:
the majority.
I concur in the result reached by
Like the majority, I believe that this case turns
on an interpretation of Article VII of the United States-Canada
Income Tax Convention, Sept. 26, 1980, T.I.A.S. No. 11087, 1986-2
C.B. 258 (Canadian Convention).
Unlike the majority, I do not
believe that this case turns on Article VII, paragraph 2
(paragraph 2).
I believe that one need look no further than
Article VII, paragraph 1 (paragraph 1), to conclude that
petitioner prevails.
Section 842(b) is inconsistent with paragraph 1.
The
imputation to a foreign insurance company of a notional amount of
investment income under section 842(b) (minimum ECNII), see
majority op. part I, contravenes the threshold requirement in
paragraph 1 that the business profits attributed to a permanent
establishment come from the pool of business profits of the
resident carrying on business through the permanent
establishment.
Paragraph 1 provides:
The business profits of a resident of a Contracting
State shall be taxable only in that State unless the
resident carries on business in the other Contracting
State through a permanent establishment situated
therein. If the resident carries on, or has carried
on, business as aforesaid, the business profits of the
resident may be taxed in the other State but only so
much of them as is attributable to that permanent
establishment. [Emphasis added.]
The notion that there exists a pool of business profits of which
the business profits of the permanent establishment are a subset
- 62 is derived from the pronoun in the phrase "only so much of them",
which refers to the business profits of the resident carrying on
business through the permanent establishment.
Although the
precise meaning of the phrase "business profits of the resident"
may be subject to debate, I believe that it does not include a
notional amount of investment income derived from a formula based
on the domestic asset/liability percentage and the domestic
investment yield as provided in section 842(b).
Minimum ECNII is not income of a type that is subject to
attribution under paragraph 1, and, therefore, the issue as to
whether the method of attribution under section 842(b) is
consistent with the "separate-entity principle" embodied in
paragraph 2 need not be addressed.
The majority, however,
focuses its analysis on that particular issue and ultimately
decides for petitioner on the basis that the methodology in
section 842(b) is inconsistent with paragraph 2.
The majority
states,
we hold that the disposition of this case turns on
whether the section 842(b)(1) formula prescribes a
minimum amount of ECNII based on the facts as they
relate to petitioner's permanent establishment, by
reference to the establishment's separate accounts
insofar as those accounts represent the facts of the
situation * * *. [Majority op. p. 37.]
The majority concludes, "We are convinced that section 842(b) is
contrary to and inconsistent with Article VII, paragraph (2),
- 63 which precludes the fictional allocation of business profits to
petitioner's permanent establishment."
Majority op. p. 39.
I believe that the majority need not have considered
paragraph 2.
Attribution of notional income is precluded not by
paragraph 2, but, rather, by the restrictive language of
paragraph 1 set forth above.
Paragraph 11 of the Commentary on
Article VII of the Model Double Taxation Convention on Income and
on Capital, Report of the O.E.C.D. Committee on Fiscal Affairs
(1977) (Model Treaty), cited by the majority on page 44,
provides, in part, "It should perhaps be emphasized that the
directive contained in paragraph 2 is no justification for tax
administrations to construct hypothetical profit figures in
vacuo”.
(Emphasis added.)
It is noteworthy that Article VII,
paragraph 2, of the Model Treaty, which is identical in relevant
respect to the Canadian Convention, does not affirmatively
restrict the use of hypothetical profit figures, but, rather,
only provides no justification to employ fictional profit figures
in calculating the income attributable to a permanent
establishment.
It seems unlikely that paragraph 2 could restrict
the use of hypothetical profit figures as the majority opines and
simultaneously provide a potential justification to use such
figures that is sufficiently colorable to require an explicit
O.E.C.D. commentary advising against the practice.
Accordingly,
I cannot join the reasoning of the majority.
WHALEN, J., agrees with this concurring opinion.
- 64 RUWE, J., dissenting:
Section 842(b) was enacted to prevent
foreign insurance companies operating permanent business
establishments in the United States from being able to shift
profits on investments out of the U.S. taxing jurisdiction.
Section 842(b) does this by attributing a minimum amount of
income to the permanent U.S. business establishment.
This
minimum amount of U.S. income is computed by a statutory formula
that essentially uses the investment experience of comparable
domestic insurance companies and applies that data to the U.S.
branch of the foreign company, based on the actual insurance
coverage liabilities incurred by the U.S. branch as a result of
insurance sold by its U.S. business.
This provision was to serve
as a backstop in recognition that assets and liabilities can be
moved between the U.S. business and the foreign corporation,
resulting in the reduction of U.S. tax.
The parties agree that section 842(b) applies, unless it is
trumped by provisions of the Treaty between the United States and
Canada.
Convention with Respect to Taxes on Income and on
Capital, Sept. 26, 1980, U.S.-Can., T.I.A.S. No. 11087.
Respondent argues that section 842(b) is a permissible method of
attributing profits to a permanent establishment within the terms
of the Treaty.
Petitioner contends that article VII, paragraph
(2) of the Treaty requires the income of a permanent
establishment to be measured by its own specific operations as
reflected in its books and precludes taxing Canadian companies on
- 65 amounts greater than the actual income derived from their
business in the United States.
The majority agrees with
petitioner that article VII, paragraph (2) precludes the
allocation of business profits to petitioner's permanent U.S.
establishment that is in excess of its actual income as reported
in its records.
I disagree.
Article VII, paragraph (2) of the Canadian Treaty provides:
2. Subject to the provisions of paragraph 3, where a
resident of a Contracting State carries on business in
the other Contracting State through a permanent
establishment situated therein, there shall in each
Contracting State 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 and with any other
person related to the resident * * * [Emphasis added.]
This provision of the Canadian Treaty does not restrict U.S.
taxation of profits of a foreign corporation's permanent
establishment to amounts actually earned by the U.S. business as
reflected in its records.
Article VII, paragraph (1) of the
Treaty provides that if a Canadian corporation carries on
business in the United States through a permanent establishment,
the United States may tax its profits, "but only so much of them
as is attributable to that permanent establishment."
added.)
(Emphasis
Article VII, paragraph (2) provides that the amount to
"be attributed to that permanent establishment" is "the business
profits which it might be expected to make if it were a distinct
- 66 and separate person" dealing wholly independently with the
foreign entity.
(Emphasis added.)
Use of the words "attributable" and "attributed" connote
going beyond the actual profits earned and reported by the
permanent establishment.
or source".
(1984).
Attribute means "To assign to a cause
Webster's II New Riverside University Dictionary 137
For example, the "attribution" rules of section 267(c)
assign ownership of stock to persons other than the actual
owners.
The profits to be attributed are those "which it [U.S.
business] might be expected to make if" it were a separate person
engaged in the same or similar activities and dealing
independently.
The words "might be expected to make" obviously
mean something other than "actually made".
"Might" means a
"condition or state contrary to fact", Webster's II New Riverside
University Dictionary 751 (1984); "expected" means something that
probably could or would have been; and the word "if" refers to
conditions other than those that actually occurred (i.e., if the
U.S. business were a distinct and separate person dealing
independently).
Thus, the Treaty must be read in a manner that
allows the attribution of profits to the U.S. business
establishment in an amount that is at variance with the actual
profits reported by the U.S. business.
Any other interpretation
makes the aforementioned Treaty provisions redundant.
The Model Commentaries to article VII, paragraph (2) support
this interpretation.
They provide:
- 67 -
10. This paragraph contains the central directive on
which the allocation of profits to a permanent
establishment is intended to be based. The paragraph
incorporates the view, which is generally contained in
bilateral conventions, that the profits to be
attributed to a permanent establishment are those which
that permanent establishment would have made if,
instead of dealing with its head office, it had been
dealing with an entirely separate enterprise under
conditions and at prices prevailing in the ordinary
market. Normally, these would be the same profits that
one would expect to be determined by the ordinary
processes of good business accountancy. * * *
[Emphasis added.]
13. Clearly many special problems of this kind may
arise in individual cases but the general rule should
always be that the profits attributed to a permanent
establishment should be based on that establishment’s
accounts insofar as accounts are available which
represent the real facts of the situation. * * *.
[Model Commentaries to Article 7, paragraph (2) of the
Model Treaty; emphasis added.]
The Commentaries speak of "allocation" of profits.
Allocations are generally understood to include adjustments to
what was actually done and reported.
See, for example, the
authority to "allocate" income between related parties under
section 482.
The Commentaries eliminate any doubt that the term
"allocation" is used in this sense when it says that the profits
to be "allocated" or "attributed" are profits which "would have
[been] made if, instead of dealing with its head office, it [the
U.S. establishment] had been dealing with an entirely separate
enterprise".
(Emphasis added.)
"Would have", "if", "instead
of", and "it had been", clearly refer to an allocation and
- 68 attribution of profits based on a hypothetical situation
different from the facts that actually occurred.
Paragraph 13 of the above-quoted Commentaries does not
contradict paragraph 10.
It simply states that profits
"attributed" should be based on the establishment's accounts to
the extent they represent real facts.
The profits "allocated"
and "attributed" pursuant to section 842(b) are based on the real
facts regarding the amount of insurance coverage sold by
petitioner's U.S. insurance business.
The volume of petitioner's
U.S. business is reflected by its actual liabilities on policies
issued by the U.S. branch.
The amount of assets that would have
been expected to be held by a separate U.S. entity with those
actual liabilities and the expected profits on the assets of such
a separate entity are hypothetical.
However, to require total
acceptance of all figures reported in petitioner's records
reflecting its profits on U.S. operations carried out as a branch
of a foreign corporation would not only nullify section 842(b)
but also nullify the allocation procedure specifically permitted
in article VII, paragraph (2).1
1
Sec. 842(b) does not contravene the admonition in par. 11
of the Model Commentary that tax administrators should not
"construct hypothetical profit figures in vacuo." Sec. 842(b)
starts with the taxpayer's real facts regarding the amount of
insurance liabilities it incurred selling insurance in the United
States and then makes adjustments based on comparable domestic
companies.
- 69 The contemporaneous Technical Explanation of the Treaty
prepared by the Treasury Department and submitted to the Senate
Foreign Relations Committee for its consideration prior to
ratification is consistent with my interpretation of the Treaty.
The Technical Explanation states in pertinent part:
Paragraph 7 provides a definition for the term
"attributable to." Profits "attributable to" a
permanent establishment are those derived from the
assets or activities of the permanent establishment.
Paragraph 7 does not preclude Canada or the United
States from using appropriate domestic tax law rules of
attribution. * * * [U.S. Dept. of the Treasury,
Technical Explanation of Convention With Respect to
Taxes on Income and on Capital, Sept. 26, 1980, U.S.Can., as amended, at 13 (Apr. 26, 1995) (emphasis
added.)2]
Provisions substantially similar to section 842(b) were
already in the Code at the time the Canadian Treaty was signed
and ratified.
Under the regime of section 813, which was in effect in 1984
when the Treaty was ratified and became effective, a foreign life
insurance company's income that was effectively connected with
2
The majority narrowly reads the Technical Explanation's use
of domestic tax law rules of attribution as being limited to
paragraph 7 of article VII of the Treaty. See majority op. p.
36. However, paragraph 7 of article VII of the Treaty itself
applies to the entire Convention:
7. For the purposes of the Convention, the business
profits attributable to a permanent establishment shall
include only those profits derived from the assets or
activities of the permanent establishment. [Emphasis
added.]
- 70 the conduct of a U.S. insurance business was increased by an
imputed amount if its surplus held in the United States was less
than a statutorily defined required surplus.
Sec. 813(a)(1).
The minimum surplus was computed in the same manner as prior
section 819(a)(2), which was in effect in 1980 when the Treaty
was signed.
Sec. 813(a)(2).
Under section 819, a foreign life
insurance company was required to reduce certain deductions by an
imputed amount if its surplus fell below a statutorily defined
amount.
Sec. 819(a)(2).
The required surplus was computed by
multiplying the company's total insurance liabilities on U.S.
business by the ratio of the surplus to total insurance
liabilities of domestic life insurance companies.
Sec.
819(a)(2).
Similarly, section 842(b) imputes to the U.S. branch a
minimum amount of assets based upon the branch's actual
liabilities.
This minimum amount is determined by multiplying
the U.S. branch's own liabilities by the applicable
asset/liability ratio.
Sec. 842(b)(2)(A).
Resembling sections
819(a)(2) and 813(a)(2), section 842(b) uses asset and liability
figures from domestic life insurance companies in order to
calculate this applicable ratio.
Sec. 842(b)(2)(C).
Therefore,
the rule in section 842(b)(2), which imputes an amount of
"required U.S. assets" is merely a continuation of a principle
that has been consistently applied for over 35 years.
- 71 In addition, the calculation of the investment yield under
section 842(b)(4) is substantially similar to the computation
under prior section 819(a).
The earnings rate of section
819(a)(1)(B) was determined by dividing the investment yield for
the entire company (not just the U.S. branch) by the mean of all
the company's assets.3
The election available to taxpayers under
section 842(b)(4) also calculates investment yield using the
company's own worldwide figures.4
Section 842(b)(4) calculates
the company's worldwide investment yield by dividing the net
investment income of the company from all sources by the mean of
all the company's assets.
Therefore, section 842(b) is
substantially similar to the historic approach in both the manner
in which assets are imputed and the calculation of investment
yield.
Three years after the effective date of the Treaty, Congress
enacted section 842(b) to replace section 813.
The conference
report regarding enactment of section 842(b) indicates that the
Treasury Department and Congress carefully considered existing
3
The current earnings rate for sec. 819(a)(1)(B) was defined
in sec. 805(b)(2).
4
As explained in the House committee report, "The committee
adopted the worldwide yield alternative to avoid discriminating
against foreign companies whose investment performance does not
attain the U.S. average." H. Rept. 100-391 (Part 2), at 1110
(1987). If the taxpayer does not make this election to use its
own investment yield, sec. 842(b)(3) requires use of the
investment yield of domestic insurance companies.
- 72 treaties and concluded that section 842(b) was consistent with
existing treaties, including the Canadian Treaty.
The conference report on section 842(b) states:
In particular, the Treasury Department believes that
the provision does not violate treaty requirements that
foreign corporations be taxed only on profits derived
from the assets or activities of a corporation's U.S.
permanent establishment, that permanent establishments
of foreign corporations be taxed only on profits the
permanent establishments might be expected to make were
they separate enterprises dealing independently with
the foreign corporations of which they are a part, or
that permanent establishments of foreign corporations
be taxed in a manner no more burdensome than the manner
in which domestic corporations in the same
circumstances are taxed. The conferees similarly
believe that this provision does not violate any treaty
now in effect.
Several factors are cited by the Treasury
Department in support of this view. First, the
provision applies to life insurance companies and
property and casualty insurance companies in a manner
substantially similar to present-law rules covering
only life insurance companies. The Treasury Department
does not consider those present-law rules to violate
U.S. treaties.
Second, the provision attributes to a foreign
insurance company an amount of assets determined by
reference to the assets of comparable domestic
insurance companies, thus reasonably measuring the
amount of assets that the U.S. trade or business of a
foreign insurance company would be expected to have
were it a separate company dealing independently with
non-U.S. offices of the foreign insurance company. In
addition, a foreign insurance company can elect to
determine its investment income based on the company's
worldwide investment yield, or utilize the statutory
formula based on domestic industry averages. It is
well established that use of a formula as an element in
determining taxable income does not necessarily violate
"separate entity" accounting. The Internal Revenue
Code contains a number of provisions that apply
fungibility principles to financial assets; use of
- 73 fungibility principles in these ways is not
inconsistent with the arm's-length standard and does
not violate U.S. income tax treaties. Similarly, the
agreement's provision, which takes into account both
the taxpayer's actual investment yield and arm's-length
measures of yield and U.S.-connected assets, is
appropriate under income tax treaties. [H. Conf. Rept.
100-495, at 983-984 (1987), 1987-3 C.B. 193, 263-264;
emphasis added.]
The majority correctly states that we must consider the
expectation and intentions of the signatories to a Treaty.
I
believe that the plain language of the Treaty and Commentaries
supports respondent's position that section 842(b) is consistent
with the Treaty.
Clearly, the Treasury Department's
preratification explanation of the Treaty, the statutory
provisions in place when the Treaty was signed and ratified, the
consistent interpretation of the Treaty provisions by the United
States Government, and the express view of Congress shortly after
ratification that section 842(b) was consistent with the Treaty,
all support the conclusion that the United States intended and
believed that the Treaty and section 842(b) were consistent.
The
majority cites to no contrary statements of intent made by the
Canadian Government during the 15 years between signing the
Treaty and this litigation.
Applying settled principles of
interpretation to the situation before us, it is clear that the
language of the Treaty contemplates the attribution of profits
beyond the actual profits that were earned or reported.
Section
- 74 842(b) accomplishes this in a rational manner using substantially
the same methodology that has been in the Code for over 35 years.
The majority also finds that section 842(b) is not
consistent with article VII, paragraph (5) of the Treaty.
This
provision of the Treaty requires that the same method be used to
attribute business profits in each year, unless there is good and
sufficient reason to the contrary.
The Model Commentary to this
provision explains that its purpose is to assure an enterprise
with a permanent establishment in another state, continuous and
consistent tax treatment in the interest of providing some degree
of certainty.
Section 842(b), as did its predecessors, applies
consistently to each taxable period by requiring foreign
insurance companies to report at least a minimum amount of
effectively connected net investment income.
Finally, it has been suggested that the minimum effectively
connected income formula of section 842(b) "creates" income even
if the foreign company has earned no overall profit during a
given taxable year.
It is argued that this could go beyond the
"allocation" of the foreign company's profits permitted by
article VII, paragraph 1 of the Treaty.
purpose of section 842(b).
This was clearly not the
As stated in the conference report,
H. Conf. Rept. 100-495, supra, 1987-3 C.B. at 264, Congress
intended that the Secretary issue regulations "to mitigate the
effects of any increase in tax resulting from the fact that a
taxpayer's deemed income from U.S.-connected investments exceeds
- 75 its actual income from those assets."
In Notice 89-96, 1989-2
C.B. 417, 420, which was issued as interim guidance until
regulations are published, the Commissioner provides that "a
foreign insurance company's minimum effectively connected net
investment income includible in taxable income for the taxable
year shall not exceed its worldwide gross investment income for
the taxable year".
Petitioner does not allege that it comes
within this provision.
The ramifications of the majority opinion go well beyond the
resolution of this case.
The provisions of the Canadian Treaty
are based on Model Treaty Provisions used in many other treaties.
In essence, the majority nullifies section 842(b).
This raises
the distinct possibility that foreign insurance companies with
operations in the United States will have an advantage over
domestic companies.
Such a result is clearly contrary to the
Internal Revenue Code and article VII, paragraph (2) of the
Treaty.5
Moreover, the majority's interpretation of article VII,
paragraph (2) raises serious questions about the use of other
statutory methods of allocating the income and expenses of
foreign persons that operate businesses in the United States
5
Sec. 842(b) puts foreign insurance companies in the same
situation, taxwise, as comparable domestic companies. It does
not discriminate against foreign companies. On the other hand,
the majority acknowledges that its interpretation of the Treaty
invalidating sec. 842(b) may give Canadian insurance companies,
operating a permanent establishment in the United States, an
economic advantage over U.S. companies. See majority op. p. 55.
- 76 where such allocations are premised on the use of comparables to
determine what "might have" or "would have" occurred "if"
conditions or events were different from those that actually
occurred.
SWIFT, COLVIN, FOLEY, and GALE, JJ., agree with this
dissent.
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