Foreign-based multinationals and foreign corporations investing in or through Canada will want to closely follow developments of the 2014 federal budget's proposed rule to prevent “treaty shopping”. In the budget, the Department of Finance proposed a broad main purpose domestic rule (rather than a more specific treaty-based approach) to deal with the perceived abuse of Canada's tax treaties. Finance is accepting comments on these proposals until April 11, 2014.
Finance considers treaty shopping to be an abuse in which a non-resident of Canada (who is not entitled to the benefits of a particular tax treaty with Canada) obtains the benefits of one of Canada's bilateral treaties by indirectly using an entity resident in another country with which Canada has concluded a tax treaty to earn income through Canada. According to Finance, these treaty shopping practices provide indirect and unintended tax benefits to residents of third countries.
Finance released “Consultation Paper on Treaty Shopping — The Problem and Possible Solutions”, on August 12, 2013, in which it sought input on possible approaches to address treaty shopping.
Several stakeholders, including KPMG, responded to Finance's consultation paper. In its submission, KPMG recommended a “wait and see” approach, suggesting that Canada's ultimate action on treaty shopping should encompass not only the findings of the Organisation for Economic Co-operation and Development (OECD) under its Action Plan on Base Erosion and Profit Shifting (BEPS), but also the experiences of other countries as they navigate anti-treaty shopping waters. Some submission expressed concerns that a general, main purpose provision would provide less clarity and certainty for taxpayers than a more specific, limitation on benefits approach. Stakeholders also recommended a treaty-based approach, in which Canada would re–negotiate treaties with certain jurisdictions, to provide additional certainty for taxpayers rather than a domestic law approach.
For details, see TaxNewsFlash-Canada 2013-31, “ Canada Moves to Curtail Treaty Shopping ”, TaxNewsFlash-Canada 2013-43, “ New Treaty Shopping Rules – Should Canada “Wait and See”? ” and TaxNewsFlash-Canada 2014-09, “ Canada Deepens Commitment to BEPS Action Plan ”.
Proposed domestic anti-treaty shopping rule
In the 2014 federal budget, Finance outlined its proposed response to comments received during the treaty-shopping consultation process. The budget proposes a general, main purpose provision and a domestic law approach, stating that a treaty-based approach would be time consuming to implement and less effective than a domestic rule. Accordingly, the budget lays out proposed elements of a domestic rule based on a general, main purpose test focusing on avoidance transactions. To provide more certainty and predictability for taxpayers, Finance indicates that the rule would contain specific provisions that would attempt to set out the scope of how the provision would apply.
The proposed rule includes:
- Main purpose provision – This provision would deny treaty benefits (subject to the relieving provision) if it is reasonable to conclude that one of the main purposes for undertaking a transaction (or a transaction that is part of a series of transactions or events) was to obtain the treaty benefit
- Conduit presumption – A rebuttable presumption that the main purpose provision applies if the relevant treaty income is primarily used to pay, distribute, or otherwise transfer, directly or indirectly, at any time or in any form, an amount to another person that would not have been entitled to an equivalent or more favourable benefit had the other person received the relevant treaty income directly
- Safe harbor presumption – A rebuttable presumption (subject to the conduit presumption) that the main purpose provision will not apply if one of the following conditions is met:
- The person (or a related person) carries on an active business (other than managing investments), in the state with which Canada has concluded the tax treaty, that is substantial compared to the activity carried on in Canada giving rise to the relevant treaty income
- The person is not controlled (directly or indirectly in any manner whatever) by another person or persons that would not have been entitled to an equivalent or more favourable benefit had the other person received the relevant treaty income directly, or
- The person is a corporation or a trust, the shares or units of which are regularly traded on a recognized stock exchange.
- Relieving provision – If the main purpose provision applies, treaty benefits may still be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.
An anti-treaty shopping rule, if adopted, would be included in the Income Tax Conventions Interpretation Act so that it would apply in respect of all of Canada's tax treaties. The rule would be prospective (applying to taxation years that commence after enactment) and may include transitional relief.
While Finance has opted to implement a domestic treaty shopping rule, it appears that the proposed “safe harbor” element resembles several of the elements of a limitations of benefits (LOB) rule that would commonly be found within tax treaties (for example, in the Canada-U.S. tax treaty).
Although Finance has indicated that the proposed rule would not apply to ordinary commercial transactions solely because obtaining a treaty benefit was one of the considerations for making an investment, it is still not clear how these provisions and presumptions will operate in practice. The provisions could have a very broad application and could adversely affect any inbound investment into Canada. For example, the conduit presumption seems to be an overriding presumption, even if the safe harbour presumption would otherwise apply. Further, it is not clear how or when the relieving provision might apply in practice, but it appears to provide the CRA with the discretion to allow certain treaty benefits even if the anti-treaty shopping rule would otherwise apply.
Observations on Finance's examples
The budget documents provide examples that outline when the proposed rule may apply to deny treaty benefits. The first three examples are based on Canadian court cases won by the taxpayer. P resumably, the facts of these court cases are the focus of the proposed anti-treaty shopping rule and easily fit into the realm of the conduit presumption. As such, the provided examples may not be relevant for actual business transactions undertaken by taxpayers.
Example 1 – Assignment of income
In the first example, the interposition of a treaty-resident subsidiary corporation (TreatyCo) between a non-treaty resident parent company (Non-Treaty Parent) and a Canadian company (Canco) results in a denial of treaty benefits under the conduit presumption. Non-Treaty Parent assigns its right to receive royalty payments from Canco to TreatyCo. In exchange, TreatyCo agrees to remit 80% of the royalties received to Non-Treaty Parent within 30 days of receipt.
Under the conduit presumption, it would be presumed, in the absence of proof to the contrary, that one of the main purposes for the assignment of the royalty license is for TreatyCo to obtain the benefit of the treaty-based withholding tax reduction. Therefore, the main purpose provision would deny treaty benefits for the royalty payments. The relieving provision may be allowed for the royalty payments that are not used by TreatyCo to pay an amount to Non-Treaty Parent.
This example is based on Velcro Canada Inc. v. The Queen (2012 TCC 57), in which the CRA lost its argument for the denial of treaty benefits. In this case, the Tax Court of Canada found that the Canadian-resident company could rely on the provisions of the Canada-Netherlands treaty for withholding tax on royalty payments, as the Netherlands recipient was the beneficial owner of the sublicensed royalty income. This case illustrates the problems faced by the CRA in trying to argue against beneficial ownership for treaty purposes, and is likely a catalyst for the introduction of a domestic anti-treaty shopping rule.
Interestingly, the example notes that if, instead, only 45% of the royalties received by TreatyCo were used to pay an amount to Non-Treaty Parent, the conduit presumption would not apply, and it would be a question of fact whether the main purpose provision would apply. Presumably this is because the “primarily” requirement in the conduit presumption would not be satisfied. It is not clear how the main purpose provision would factor into this situation or whether the conduit presumption would once again apply when the profits are ultimately repatriated to the parent company.
Example 2 – Payment of dividends
In this example, a treaty-resident subsidiary (TreatyCo) is required to immediately distribute all dividends received from a Canadian corporation (Canco) to its two parent companies (Non-Treaty Parent1 and Non-Treaty Parent2) that are resident in jurisdictions with less favourable treaty withholding tax rates than TreatyCo.
Under the conduit presumption, it would be presumed, in the absence of proof to the contrary, that one of the main purposes for the establishment of TreatyCo is to obtain the benefit of the more favourable treaty-based withholding tax rate. The main purpose provision would, subject to the relieving provision, therefore apply to deny treaty benefits for the dividend payments. The benefits of the less favourable treaty may be provided under the relieving provision in certain circumstances.
This example is based on The Queen v. Prevost Car Inc. (2009 FCA 57 affirming 2008 TCC 231), in which the CRA lost its argument for the denial of treaty benefits. In this case, the Federal Court of Appeal confirmed that a Netherlands holding company was considered the beneficial owner of dividends paid by a Canadian-resident corporation rather than the holding company's Swedish and U.K. shareholders. As a result, the Canadian corporation was entitled to withhold tax at the low rate in the Canada-Netherlands treaty.
It is not clear how far the conduit presumption might extend to variations of this example. The rule could possibly apply even if TreatyCo was not required to immediately distribute the entire dividend. The conduit presumption has no built-in time limit, and only requires that the relevant treaty income be distributed “at any time and in any form” to another person. If TreatyCo ultimately distributes more than 50% of the dividends received, it would seem that the conduit presumption could deny treaty benefits (subject to the relieving provision).
Example 3 – Change of residence
In this example, a parent company resident in a non-treaty jurisdiction (Non-TreatyCo) owns shares of a Canadian company (Canco) which it intends to sell. The capital gain realized on the sale of the Canco shares would be subject to tax in Canada, presumably because the shares meet the definition of taxable Canadian property. Non-TreatyCo continues to a jurisdiction with which Canada has a treaty that provides an exemption from Canadian tax on such a disposition.
This example is based on The Queen v. MIL (Investments) SA (2007 FCA 236 affirming 2006 TCC 460), in which the CRA lost its argument for the denial of treaty benefits. In this case, a Luxembourg-resident corporation disposed of shares in a Canadian public corporation, which resulted in a capital gain that was exempt from Canadian tax under the Canada-Luxembourg treaty. Before the disposition of the shares, the corporation had been incorporated and resident in the Cayman Islands, and had continued to Luxembourg.
In this example, Finance notes that, had the company been a treaty resident before acquiring the shares of the Canadian company, the main purpose test might still apply depending on the facts. As a result, certain holding structures could be caught under the proposed rule unless it could be argued that the choice of treaty jurisdiction in which the company was incorporated was based on commercial facts and circumstances.
Example 4 – Bona fide investments
In this example, a widely held trust is resident in a jurisdiction with which Canada has a tax treaty. The trust manages a diversified portfolio of investments and holds 10% of its portfolio in shares of Canadian companies, for which it receives dividends. Under the treaty with Canada, a reduced rate of withholding tax applies to the dividends. The trust distributes all of its income to its investors annually. The majority of the investors in the trust are residents of countries with which Canada does not have a tax treaty.
Because the dividends are primarily used to distribute income to persons that are not entitled to treaty benefits, the conduit presumption would apply to presume that one of the main purposes for the investments by the investors in the trust and the trust in the Canadian companies was to obtain the treaty benefits. However, as investors' decisions to invest in the trust are not driven by any particular investments made by the trust, and the trust's investment strategy is not driven by the tax position of its investors, there should be sufficient facts to rebut the conduit presumption and to argue that the main purpose provision should not apply to deny treaty benefits.
While this example of a situation where the conduit presumption is not met is welcome, it may not provide practical guidance for other common commercial arrangements. In particular, this example does not provide any comfort to investors, such as private equity investors, that may make investments in Canada through a common holding company located in a third jurisdiction. In such structures there are generally a number of business reasons for using a specific jurisdiction for the main investment entity, including ease of tax compliance and investment vehicle options. It would seem such structures should not be subject to treaty shopping rules.
Example 5 – Safe harbour (active business)
A corporation resident in a country with which Canada does not have a treaty (Non-Treaty Parent) owns all the shares of a financing company that is resident in a country that has a treaty with Canada (Treaty Finance Co). Treaty Finance Co finances Non-Treaty Co's wholly owned subsidiaries, including a Canadian company (Canco) and a company that is resident in the same country as Treaty Finance Co (TreatyCo). The active business carried on by TreatyCo is substantial in comparison to the activities carried on by Canco. Non-Treaty Parent's other treaty subsidiaries are residents of countries that provide equivalent benefits for withholding tax on interest as those provided under the treaty between Canada and Treaty Finance Co's country of residence. Treaty Finance Co reinvests its profits from the interest payments received from the various subsidiaries.
Because Treaty Finance Co reinvests the interest payments received from Canco, these payments are primarily used to pay amounts to persons that would have been entitled to equivalent benefits. Therefore, the conduit presumption should not apply.
Since TreatyCo carries on a substantial active business and is related to Treaty Finance Co, it would be presumed under the safe harbor presumption, in the absence of proof to the contrary, that none of the main purposes for Treaty Finance Co to undertake the investment in Canada was to obtain treaty benefits not otherwise available to Non-Treaty Parent.
The potential reach of the proposed safe-harbour presumption remains unclear. Specifically, it is not certain whether a financing company can ever pay dividends to its non-treaty parent. If it does, it is not yet known whether the CRA would seek to trace the source of those dividends to interest payments received by the financing company from the Canadian company, such that the conduit presumption would be triggered to retroactively deny treaty benefits.
While these examples illustrate how the proposed anti-treaty shopping rule might apply to obvious examples, the application of the rule to real commercial and other transactions still remains unclear.
Coming into force provisions uncertain
There is also uncertainty about when an anti-treaty shopping rule might be implemented and whether there will be any grandfathering relief for arrangements already in place. Therefore, any non-residents with investments or arrangements with Canada that obtain treaty relief through a third jurisdiction need to proactively consider the possible implications of a future anti-treaty shopping measure to their current arrangements, and understanding what future steps may be required to mitigate any potential future adverse implications.
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We can help
Your KPMG adviser can help you assess the potential impact of the proposed 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 Jodi Kelleher, Leader of KPMG in Canada's International Corporate Tax practice, at firstname.lastname@example.org .