Paragraph 212 (1)(a): The Perils of an Obsolete Tax Provision

17 minute read
15 December 2011

Taxation is an area of the law in constant evolution. Whereas legislature keeps amending the Income Tax Act (Canada) (the "Act") in an effort to preserve the tax base and curb abuse of the Act by taxpayers, impetus for changing or abolishing provisions of the Act often also comes from taxpayers where such provisions are perceived to be obsolete, outdated or unfair.

Paragraph 212(1)(a) of the Act is a section that is obsolete, outdated and unfair and has lost its "raison d'être" with the introduction of the transfer pricing and other anti-avoidance rules. In fact, as will be illustrated further below, with no judicial limits imposed on the application of the section, the Canada Revenue Agency ("CRA") feels entitled to take a rather cavalier approach to determining whether any particular payment made by a resident of Canada to a non-arm's length non-resident party is a "management or administration fee or charge."


Paragraph 212(1)(a) generally imposes Part XIII withholding tax at a rate of 25% of the gross amount on "a management or administration fee or charge" paid or credited by a Canadian resident to a non-resident with which the Canadian resident does not either deal at arm's length or where the payment is not a straight reimbursement of expenses. The key factor rendering the fee taxable is the fact that the foreign recipient does not deal at arm's length with the Canadian payor - regardless of whether the recipient is otherwise in the business of providing the very services to third parties and whether the price charged to the Canadian payor reflects an arm's length arrangement.

The arm's length carve-out is provided for in subsection 212(4), which excludes from "management or administration fee or charge", for purposes of paragraph 212(1)(a), amounts paid to a non-resident for services performed in the ordinary course of a business so long as the parties were dealing with each other at arm's length. This would support the notion that paragraph 212(1)(a) was intended to target tax avoidance schemes involving non-arm's length transactions, rather than legitimate business dealings. Also of note is that paragraph 212(1)(a) generally only applies to non-treaty countries. Management or administration fees are not specifically covered in most of the modern tax treaties negotiated between Canada and other countries[1]. Where Canada has a treaty with another country which does not contain a specific article on management or administration fees, any such fees paid to a resident of that country will, to the extent they are reasonable, be considered to be covered by the treaty article dealing with business profits. Pursuant to that article, business profits of a non-resident are exempt from Canadian tax unless they are attributable to a permanent establishment ("PE") in Canada. We submit that it is sufficient for management or administration fees to be subject to Canada's transfer pricing regime rather than both the transfer pricing regime and Part XIII withholding tax.[2]

Paragraph 212(1)(a) was introduced in the old Act in 1963, long before the arrival of the Canadian transfer pricing rules found in section 247 of the current Act. At the time, the weak transfer pricing regime in Canada consisted of then subsections 69(2) and (3). The rationale behind the introduction of paragraph 212(1)(a) in 1963 was to prevent and discourage undue distribution of profits amongst related parties using management fees as a "façade". In 2011, it is our opinion that paragraph 212(1)(a) has lost its purpose and may, in fact, lead to unfair and somewhat absurd results. In addition to our modern transfer pricing rules, there are now further safeguards contained in the Act that preserve the Canadian tax base, such as the foreign affiliate and foreign accrual property income ("FAPI") regime and the general anti-avoidance rule ("GAAR"). Canada's ever-expanding network of double tax agreements and tax information exchange agreements ("TIEAs") also provides further safeguards.

Canadian Tax Regimes that Protect the Canadian Tax Base

Canada's current transfer pricing regime provides significant deterrence to multinational corporations by way of severe penalties in the event that the transfer pricing provisions of the Act are not respected. Thus, the abuse of shifting profits to related companies by excessive inter-company charges is now provided for adequately in the Act. Despite this fact, at the moment, a taxpayer could fully comply with Canada's transfer pricing rules and still be subject to a 25% withholding tax on gross payments pursuant to paragraph 212(1)(a). If the foreign jurisdiction in which the non-resident resides has foreign tax credit legislation similar to Canada, it will not even be able to afford the non-resident full relief by way of a foreign tax credit[3]. These excessive tax results are embarrassing to Canada. Canada's tax system is currently taxing non-resident companies a 25% withholding tax on gross income for services physically performed by non-residents outside Canada for a price consistent with the arm's length principle. To make matters worse, the Act does not allow the non-resident taxpayers to deduct expenses related to these amounts. From CRA's perspective, there may be a need for such a provision, so as to spare CRA from having to invest significant resources to conduct transfer pricing and FAPI audits on small non-arm's length intercompany transactions involving non-treaty countries. However, surely such a concern cannot justify, in policy terms, the existence of a 25% withholding tax.

As alluded to above, not only does the transfer pricing regime provide a comfortable level of protection, but it receives reinforcement through GAAR and Canada's comprehensive foreign affiliate and FAPI regimes. With respect to Canada's foreign affiliate and FAPI regimes, where the paragraph 212(1)(a) transaction is carried out within an outbound structure where the service fees are paid to a foreign affiliate, one only needs to look at the impact of paragraph 95(2)(b) as an example of adequate protection against the Canadian tax base.

Non-Resident Investment Service Providers

To illustrate the absurdity to which 212(1)(a) may lead in practice, as recently as earlier this year, CRA utilized paragraph 212(1)(a) to assess a Canadian resident corporation for failure to withhold and remit Part XIII tax with respect to fees paid to a related non-resident entity for the provision of stock advisory services performed in the foreign jurisdiction.

To support its position that "a management or administration fee or charge" pursuant to paragraph 212(1)(a) of the Act includes stock advisory fees, the CRA has relied heavily on the 1991 case of Peter Cundill & Associates Ltd.[4] However, the Cundill case predates the modern transfer pricing regime, and can easily be distinguished on the facts from the recent 212(1)(a) stock advisory cases we have encountered. In addition, the post-Cundill jurisprudence irrefutably confirms that the precedential value of the Cundill case is derived from the Court's non-arm's length analysis only and not the analysis of the scope of the phrase "management or administration fee or charge".

In Cundill, the plaintiff B.C. corporation (e.g. the Canadian payer of the so-called management fees) managed the portfolios of two investment funds and contracted with a Bermuda corporation to provide the necessary investment counselling and transaction skills. Mr. Cundill owned 50% of the B.C. company and 100% of the Bermuda company, and his personal expertise was the driving force behind both enterprises. The Federal Court of Appeal ("FCA") held that the fees paid by the B.C. company to the Bermuda company were management fees under section 212(1)(a). The Court's reasoning was essentially that, in the case of a company whose business is portfolio management, investment decisions are management tasks. Of note is that the Canadian taxpayer in Cundill did not have its own management or expertise to conduct its core business, so it depended on a non-resident party to manage and control its business. Further, the Federal Court (Trial Division) did not engage in a thorough analysis of the meaning of "management or administration fee or charge" in paragraph 212(1)(a). Rather, the Court very generally stated that a management fee is "… an amount paid in respect of managerial services in connection with the direction or supervision of business activities."

Unfortunately, the CRA has been applying the Court's ruling to cases with vastly different circumstances and scenarios than that in Cundill. As alluded to above, in the cases of which we are aware, the entities in question are large multinational corporations and the payments in question are legitimate intra-group payments for stock advisory services. The Canadian taxpayers in these cases do not solely rely on their investment planning to generate revenues, and investment decisions are not the only relevant consideration regarding the future direction and operation of their companies, as was the case in Cundill. Rather, these taxpayers operate completely different business models than Cundill where client recruitment is the main profit driver. All of the business, corporate management and administrative operations of these taxpayers are undertaken by their own directors, officers and employees. It is our opinion that stock advisory services do not amount, under these circumstances, to "management or administrative" services, as contemplated by paragraph 212(1)(a).

Our position on the dangers of the continued existence of 212(1)(a) in the Act is also supported by recent case law. In Canadian Medical Protective Assn. v. R,[5] the Tax Court of Canada ("TCC") held that the words "management or administrative service" in the Excise Tax Act (Canada) ("GST Act") refer to management of a business and not an asset management service. The FCA agreed with the TCC and held that discretionary investment management services were not "management or administrative services" for this purpose. As a result of the decision of the FCA in Canadian Medical Protective Assn., Parliament amended the GST Act to extend the term "management or administrative service" to include "asset management services" and "investment advisory services". No such amendment to the definition of "management or administration fee or charge" in the Act has been made. Without such a specific statutory amendment, an investment advisory service should not be considered a management or administrative service. Without an express definition, the phrase "management or administrative service" should take its ordinary meaning, which has been held by a lower court not to include an asset management or investment advisory service.

TIEAs and Canada-US Anti-Hybrid Rules

As a consequence of TIEAs and the new anti-hybrid rules in the Canada-US treaty (the "US Treaty")[6], the impact of paragraph 212(1)(a) is only going to get worse. TIEAs are bilateral agreements used to promote international co-operation in tax matters through the exchange of information. TIEAs are an option for Canada with respect to countries and jurisdictions with which they do not have or are not considering the negotiation of a comprehensive tax treaty. With the signature of several TIEAs over the past four years, CRA may be better equipped to monitor profit shifting arrangements that run afoul of transfer pricing principles, FAPI or GAAR. However, this also means that, from the taxpayer's perspective, paragraph 212(1)(a) could become an even bigger concern as many corporate structures will be incorporating subsidiaries in TIEA countries which will not be able to rely on treaty exemptions. Even though this will have an impact for non-resident investment service providers, the impact will be even larger on those everyday management and administrative services that require a mark-up and are not simply a reimbursement of expenses[7]. With no limits on CRA's ability to define "management or administration fee or charge," we anticipate numerous 212(1)(a) casualties.

A further facet is added to the present discussion if we consider the new anti-hybrid rules in the US Treaty. Where a U.S. resident would qualify for treaty protection (e.g., PE protection under Article VII), but CRA considers the arrangement with the Canadian payor to offend the anti-hybrid rules, CRA may be able to deny treaty benefits and draw on 212(1)(a) to impose the 25% withholding tax. The anti-hybrid rules themselves are subject to further clarification and, while confusion reigns, the continued existence of 212(1)(a) may lead to unfair results.


In summary, there is ample, overwhelming evidence that paragraph 212(1)(a) must either be repealed or the judiciary or Parliament must place brakes on CRA's ability to designate legitimate, market priced services between related parties as "management or administration fees or charges" for purposes of 212(1)(a). Fundamentally, profits in accordance with the arm's length principle arising from services performed outside Canada by non-residents of Canada should not be subject to Canadian tax. Canada should not require a tax treaty to achieve this tax exemption. From the perspective of investment services and stock advisory services, it perplexes the authors how under section 115.2 of the Act, a non-resident fund which utilizes the services of a Canadian investment service provider is generally exempt from Part I tax while, under paragraph 212(1)(a), a non-resident providing investment services outside of Canada directly to residents of Canada is subject to 25% withholding tax on gross payment amounts. Canada's current transfer pricing and FAPI regimes protect the Canadian tax base from excessive Canadian expenditures pertaining to the provision of services. The resources required by CRA to conduct transfer pricing audits or FAPI audits depending on the structure, on smaller transactions should not be a basis for maintaining a provision that results in such excessive taxation, assuming that is a tax policy tactic for maintaining such a provision.

The consequence of a reassessment under paragraph 212(1)(a) which is not protected by the Business Profits Article of a tax treaty is an excessive 25% withholding tax, which is applied to the gross payment amount, rendering these intra-group service arrangements unprofitable and thus discouraging legitimate business activity. The application of a Part XIII tax of this nature without the opportunity or election for the non-resident taxpayer to at least file a Canadian tax return and pay Part I taxes on a net profit basis is economically disastrous to the non-resident.[8] Furthermore, as there is no statute of limitations in Part XIII for CRA to raise a failure to withhold assessment CRA is free to go back as many years as they want in assessing the Canadian taxpayer for failure to withhold.[9]

In closing, a non-resident service provider who does not physically provide services in Canada should not be taxed in Canada, never mind at such excessive rates. The authors respectfully suggest that Canada needs to revisit this issue. With CRA not prepared to revisit or distinguish the Cundill case from other non-arm's length investment service contracts, with Canadian operations starting to expand to non-treaty countries because of TIEAs, and with the introduction of anti-hybrid rules that could effectively deny the benefits of the US Treaty to certain transactions, one thing is for certain: the status quo can no longer be an option.

[1] See Article XIII of the Canada-Barbados Income Tax Agreement for an example of an Article that strictly deals with management fees.

[2] Canada's Part XIII system generally applies to passive investment received by non-residents from Canadian sources income and only in exceptional circumstances does it include compensation for services rendered by a non-resident.

[3] For example, in a reverse situation, Canada would consider the services rendered in Canada by a Canadian resident service provider to a non-resident to be Canadian source income. Subsection 20(12) would prevail and only a tax deduction would be allowed in Canada in respect of foreign taxes paid.

[4] [1991] 1 C.T.C. 197 (F.C.T.D.); aff'd [1991] 2 C.T.C. 221 (F.C.A.) ("Cundill")

[5] Canadian Medical Protective Assn. v. R., 2008 TCC 33, and case on appeal [2009] G.S.T.C. 65 (F.C.A.) (see Brief, at tab 4).

[6] Paragraph 7 of Article IV of the US Treaty, introduced in the 5th Protocol.

[7] See the carve out in 212(4)(b) for reimbursements of specific expenses (e.g. head office wages for the benefit of the Canadian subsidiary).

[8] Compared to section 216 and 217 elections which both recognize the excessive taxation element of a 25% withholding tax on the gross revenue.

[9] In our recent experience, CRA went back seven years in raising a paragraph 212(1)(a) failure to withhold assessments on stock advisory service payments.

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