August 21, 2013
Foreign-based multinationals and foreign corporations investing in or through Canada will want to closely follow developments as Canada kicks off formal consultations on possible measures to combat “treaty shopping” abuses and the related erosion of the country’s tax base.
As signaled in the March 2013 federal budget, the Department of Finance released a 25-page discussion paper titled “Consultation Paper on Treaty Shopping — The Problem and Possible Solutions” on August 12, 2013. Finance has begun a four-month consultation period for interested parties to provide input by December 13, 2013 before it decides on a course of action.
|What is treaty shopping? |
The paper describes treaty shopping as an abuse that arises when a non-resident of Canada (who is not entitled to the benefits of a tax treaty with Canada) seeks to obtain the benefits of one of Canada’s treaties by indirectly using an entity resident in another country with which Canada does have a treaty to earn income through Canada. These treaty shopping techniques provide “indirect and unintended tax benefits to residents of third countries.”
The paper generally defines treaty shopping, describes its detrimental effects on Canada and proposes possible solutions. The paper solicits comments from interested parties to help develop an effective anti-treaty-shopping rule to protect the integrity of Canada’s bilateral tax treaties.
Finance is seeking a tax policy approach that will provide effectiveness, certainty and simplicity for taxpayers and ease of administration for the CRA. Finance also wants to determine an appropriate degree of precision to adequately prevent treaty shopping abuses without going too far and undermining Canada’s treaty network and creating a barrier to foreign investment in Canada.
While this initiative is part of Canada’s overall efforts to enhance the integrity of its tax system, we expect the global community to carefully watch developments here, especially in light of the OECD’s high profile focus on tax transparency and its recently released action plan to combat tax base erosion and profit shifting (BEPS). For details, see KPMG’s TaxNewsFlash-Canada 2013-27, “OECD Action Plan Could Signal a Shift in the Global Tax Landscape”.
What are the hallmarks of treaty shopping?
The paper defines treaty shopping as arrangements that embody all of the following “hallmarks”:
- An intermediary entity resident in a treaty country claims benefits under the treaty to reduce Canadian tax otherwise payable on Canadian-source income
- The intermediary entity is owned or controlled mainly by third country residents that are not entitled to at least the same treaty benefits provided by Canada
- The intermediary entity pays low or nil taxes in its residence country on the Canadian-source income (including “stepping-stone conduit” structures whereby the intermediary entity would be subject to tax on the Canadian-source income in its residence country but for offsetting deductions from paying the amounts on to third country residents where little or no tax is ultimately borne on the income)
- The intermediary entity does not carry on real and substantial business activities (other than managing investment income) in its residence country.
When these hallmarks exist, Finance believes they provide strong evidence that one of the main purposes of the intermediary entity is to receive income for the benefit of third country residents. In these circumstances, Finance believes that Canada may justifiably deny treaty benefits.
In the government’s view, treaty shopping extends treaty benefits to third country residents unintentionally without any reciprocal benefits accruing to Canada, and poses significant risks to Canada’s tax base. The reason is that the intermediary (conduit) entity lacks economic substance in the treaty country, making the arrangement artificial and purely tax motivated, such that the third country resident makes improper use of the treaty contrary to its purpose and intent.
Canada’s position on treaty shopping
Canada has consistently expressed its intention to challenge treaty shopping but never adopted a unified approach to address the problem. To combat treaty shopping, the government has either used the general anti-avoidance rule (GAAR) in its domestic taxing statute or negotiated specific rules in various treaties.
These treaty-based rules include residence and beneficial ownership requirements in the passive income articles (e.g., income from interest and dividends), denial of passive income benefits where one of the main purposes of the transactions was to obtain such benefits (a Main Purpose Test), denial of all treaty benefits for entities that enjoy preferential tax regimes, and more recently a comprehensive limitation on benefits (LOB) rule.
According to the paper, jurisprudence indicates that Canadian courts have not been sympathetic to the government in treaty shopping cases on the basis that domestic legislation and Canada’s tax treaties do not include any clear policy against treaty shopping.
Although Canada’s tax laws were amended in 2004 to provide that GAAR can apply to tax treaties, it is not clear that the CRA has tried to establish whether GAAR can be relied upon to attack perceived treaty shopping abuses.
Extent of treaty shopping into Canada
The paper indicates that erosion of the Canadian tax base from treaty shopping may be significant. Apart from its direct knowledge of what it considers to be cases of treaty shopping through tax audits and litigation, the government also points to certain statistical data as circumstantial evidence that treaty shopping has a significant role in inbound direct investment into Canada.
Possible approaches to prevent treaty shopping
The paper puts forward a range of approaches that may be available to prevent treaty shopping more effectively and solicits comments on specific questions to help shape the features of an effective anti-treaty-shopping rule for Canada.
A key question is whether an anti-treaty-shopping rule should be implemented in Canada’s domestic taxing statute or through its bilateral tax treaties or both. A domestic amendment could be implemented faster with immediate effect across Canada’s tax treaty network, promoting consistency in practice. In contrast, an exclusively treaty-based approach could take decades to negotiate bilaterally. A domestic law approach would provide that the domestic law provisions would prevail over Canada’s tax treaties. However, Finance takes the position that a domestic override that is consistent with an approach endorsed by the OECD would not create such a conflict between Canada’s domestic law and its treaty obligations.
A secondary question is whether the anti-treaty-shopping rule ought to be general or specific in nature. General rules are flexible and less complex but at a cost of greater uncertainty and a higher administrative burden. Specific rules can be clearer but may produce more inappropriate outcomes, absent the exercise of discretionary authority by the CRA.
In describing the possible options, the paper highlights certain approaches endorsed by the OECD, including the following:
- A “look-through approach”, disallowing treaty benefits to an intermediary entity owned or controlled, directly or indirectly, by persons who are not residents of the treaty country
- A “subject-to-tax approach”, allowing treaty benefits only if the income in question is subject to tax in the recipient’s residence country
- A “channel approach”, disallowing treaty benefits where the intermediary entity receives Canadian-source income if more than 50% of that income is paid on as a deductible amount to a third country resident that has, directly or indirectly, a substantial interest in (or exercises management or control over) the intermediary
- Approaches already used in Canada’s treaty network, such as a LOB, Main Purpose Test, and denial of treaty benefits for entities that enjoy preferential tax regimes.
The paper also suggests a novel, domestic law-based rule that combines elements of the look-through, subject-to-tax and channel approaches, focuses on the hallmarks of treaty shopping described above, and provides exceptions for entities meeting a substance test and those controlled by third country residents which would have enjoyed similar tax treaty benefits (a so-called “derivative benefits test”).
Consultation paper questions
The paper seeks input from interested parties on the following questions:
- What are the advantages and disadvantages of a domestic law approach, a treaty based approach, or a combination of both?
- What are the relative merits of the various approaches to treaty shopping identified by the OECD? Should Canada consider other approaches and types of rules in evaluating how best to address the problem of treaty shopping?
- Is a general approach preferred over a relatively more specific and objective approach?
- Would a main purpose test, if enacted in domestic tax laws, be effective in preventing treaty shopping and achieve an acceptable level of certainty for taxpayers?
- Which of the approaches (a main purpose approach or a more specific approach) strikes the best overall balance between effectiveness, certainty and simplicity, and ease of administration?
- For interested parties who favour a more specific approach over a main purpose approach, how should Canada design the conditions and the exceptions (e.g., the substantive business operations and derivative benefits exceptions) under a more specific approach? Should any other exceptions be considered under this approach with a view to ensuring the measure is effective and applies in a reasonably straightforward manner with predictable outcomes?
- Should a domestic anti-treaty shopping rule apply if a tax treaty contains a comprehensive anti-treaty shopping rule?
Final proposal expected in 2014
It seems clear that Finance perceives treaty shopping to be a significant problem that erodes Canada’s tax base. While an anti-treaty-shopping rule will almost certainly be forthcoming, its precise form remains unclear. We expect the government’s final proposal to appear sometime in 2014 after the public comment period closes on December 13, 2013, perhaps in the 2014 federal budget.
We can help
Your KPMG adviser can help you assess the potential impact of an upcoming anti-treaty shopping rule on your corporate structure and your international tax planning, and to prepare for forthcoming changes to the international tax landscape. For more details on these developments and their potential impact, contact your KPMG adviser or Marc Desrosiers, Leader of KPMG in Canada’s International Corporate Tax practice, at firstname.lastname@example.org.
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Information is current to August 20, 2013. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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