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 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 and separate person” dealing wholly independently with the foreign entity. (Emphasis added.)
Use of the words “attributable” and “attributed” connotes 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:
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.]
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 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
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 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.
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 determin investment yield branch) by the for the entire company 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 Xworldwide 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 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 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 U.S. 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 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 vn, 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 at 984, 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 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 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.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.
The majority narrowly reads the Technical Explanation’s use of domestic tax law rules of attribution as being limited to par. (7) of art. VII of the treaty. See majority op. pp. 384-385. 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.]
The current earnings rate for sec. 819(a)(1)(B) was defined in sec. 805(b)(2).
As explained in the House committee report, “The committee adopted the worldwide yiefd 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.
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. 398.