The North West Life Assurance Company of Canada v. Commissioner

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 97.00% 3.00%
1990 95.60 4.40

Canada
Individual Annuities Individual Life Policies

1988 64.73% 35.27%
1990 68.44 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. These withdrawals are subject to

surrender charges. 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 currency-

exchange 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 Toronto-

Dominion 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. Wash. Rev. Code Ann. sec.

48.05.090 (West Supp. 1990). 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:

1988 1989 1990

Bonds 11.6% 15.0% 20.6%
Mortgage loans 58.8 58.3 63.5
Real estate 1.2 2.0 2.3
Cash 15.5 12.7 6.1
Policy loans 12.9 12.0 7.4
Stocks 0.0 0.0 0.1
Total 100.0 100.0 100.0

Based on its OFSI statements, petitioner has the following

percentage distribution of assets in connection with its

worldwide operations:
 - 11 -

1988 1989 1990

Bonds 20.7% 24.3% 26.1%
Mortgage loans 53.0 52.7 55.2
Real estate 2.2 2.8 2.9
Cash 12.3 8.7 5.1
Policy loans 9.4 8.8 5.8
Stocks 0.7 0.7 2.6
Other assets and
rounding discrepancies 1.7 2.0 2.3
Total 100.0 100.0 100.0

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. Wash. Rev.

Code Ann. sec. 48.05.340(1) (West Supp. 1990). 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:

1988 1989 1990

U.S. branch 7.70% 9.41% 9.79%
Total company 7.56 8.21 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):

Income Determined Income Determined Additional
Year Under Sec. 842(a) Under Sec. 842(b) Income

1988 $18,501,669 $21,282,045 $2,780,376
1990 20,426,754 20,749,629 322,875

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 Domestic Investment
Percentage Yield

1988 120.5% 10.0%
1989 117.2 8.7
1990 116.5 8.8

J. Motion For Entry of Decision

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. De Geofroy v. Riggs, 133

U.S. 258, 271 (1890). 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. See

S. Exec. Rept. 98-22 at 3. 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. It is not

enough for section 842(b) to be reasonable. 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. We think respondent gives

paragraph 23 too broad a reading. 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. Sec. 819(a)(2)(A); sec.

813(a)(1). 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. Secs.

819(a)(1), 805(b)(2), 813(a)(3). 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 dollar-

denominated 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. To support

18
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. When the language is reasonably clear,

19
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: I concur in the result reached by

the majority. 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." (Emphasis

added.) 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. Attribute means "To assign to a cause

or source". Webster's II New Riverside University Dictionary 137

(1984). 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. This was clearly not the

purpose of section 842(b). 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.