U.S.-Canada income tax treaty requires income of U.S. branch to be determined under facts and circumstances.

• Author: Renfroe, Diane L.

The Tax Court held in North West Life Assurance Company of Canada, 107 TC 363 (1996), that the U.S.-Canada income tax treaty requires that income of a U.S. branch of a Canadian corporation be determined based on the facts and circumstances of the separate branch. North West, a Canadian corporation, conducted an insurance business in the U.S. and Canada. The U.S. business was conducted through a permanent establishment (PE). North West computed its income without regard to the minimum net investment income that Sec. 842(b) treats as effectively connected income.

The starting point for the court's separate-entity analysis was the language of Art. VII(2) of the treaty, which provides that "there shall ... 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..."

The court found the language of Art. VII (2) to be ambiguous and, therefore, looked to other sources for clarification. In particular, the court relied on the Commentaries to the Organization for Economic Cooperation and Development (OECD) Model Treaty to support the view that the profits attributable to a PE be determined based on the PE's facts.

The court then analyzed whether Sec. 842(b) prescribes a minimum amount of effectively connected net investment income based on the facts as they relate to the taxpayer's PE. Agreeing with the taxpayer, the court concluded that Sec. 842(b) attributes a deemed amount of income to the taxpayers U.S. branch not based on the activities of the branch, but rather, on the investment performance of domestic insurance companies.

The IPS argued that Sec. 842(b) did not violate the separate-entity principle because the formula is used to determine the assets the taxpayer might be expected to hold if it were a separate entity.

In rejecting the Service's argument, the court again relied on OECD commentary. The commentary provides that, even though formulary approaches to determining income may be appropriate in certain cases, the preferred method of determining income is to use the branch's separate accounts. If other methods (other than using the branch's accounts) are to be used, the method must be customary and based on suitable...