On August 12, 2013, Canada’s Department of Finance released a Consultation Paper on Treaty Shopping – The Problem and Possible Solutions. The paper outlines a number of possible measures for combating perceived tax treaty abuse. If followed, the measures could have a broad impact on inbound investment into Canada. In particular, the measures could negatively affect investment in Canadian companies – particularly those in the resource sector – by foreign private equity funds, governments and state-owned enterprises. The measures could also negatively affect certain holding company structures established by multinational enterprises. This Update provides a brief summary of the consultation paper, which follows through on the government’s announcement in the 2013 federal budget of its intention to study treaty shopping (discussed in our Budget Briefing 2013).
The current work of the Canadian government takes place against the backdrop of a broad international review of the uses and potential abuses of bilateral tax treaties: the consultation paper was released less than a month after the OECD provided its Action Plan on Base Erosion and Profit Shifting to the G20, one of whose action items was the development, by September 2014, of model treaty provisions and recommendations for the design of domestic rules to prevent the granting of treaty benefits in inappropriate situations (see our Update on the OECD Action Plan).
The Consultation Paper
The Perceived Abuse
The paper defines treaty shopping as a situation in which a person who is not entitled to the benefits of a tax treaty uses an intermediary entity that is entitled to such benefits in order to indirectly obtain those benefits. The paper cites both anecdotal and (indirect) empirical evidence that foreign taxpayers make such use of intermediary entities based in treaty countries. Hallmarks of treaty-shopping arrangements include the intermediary entity paying little or no tax on the income stream from Canada in its country of residence, and the intermediary entity not carrying on “real and substantial” business activities (other than managing investment income). The paper takes the position that making use of such an entity to obtain the benefits of a tax treaty is “improper,” because it runs counter to the basis on which Canada agrees with a treaty partner to tax income at a lower rate – namely, that the other country as the residence country would tax the income and that the persons obtaining benefits of the treaty from Canada would in fact be residents of that country (not third-country investors in a passive intermediary entity).
The paper notes that the Canada Revenue Agency has been generally unsuccessful in attacking treaty shopping in the courts, even though Canada’s general anti-abuse rule (GAAR) applies to misuses or abuses of Canada’s tax treaties. The position taken by the courts has generally been that the selection of a treaty jurisdiction by third-country residents is not inherently abusive and/or occurred in circumstances in which the intermediary entity was the true “beneficial owner” of the relevant Canadian source income. In this judicial climate, the paper concludes, “the courts in Canada require clearer legislative direction to the effect that treaty shopping is an improper use of Canada’s tax treaties.”
It is clear from the paper’s analysis of treaty shopping that the government is not consulting the public on whether Canada should act to curb treaty shopping but how. The paper raises seven questions for consultation, each of which deals with different approaches to prevent treaty shopping.
On the threshold question of whether an anti-treaty-shopping rule should be contained in domestic law or in each of Canada’s bilateral treaties, the paper notes that the latter approach would be inefficient and slow since it would require the renegotiation of most Canadian tax treaties, which in turn would require consent from treaty partners. In contrast, a domestic law approach could be implemented in less time and would have immediate effect across Canada’s entire tax treaty network. Although the paper asks for public consultation on the matter, the government seems to favour the domestic approach, which would entail amendments to Canadian law that would apply to – and override anything to the contrary in – each of Canada’s existing and future tax treaties. The paper does not address the potential for a multilateral agreement, which is one of the action items under consideration in the OECD Action Plan.
The paper proposes a series of different types of rules that could be enacted to prevent treaty shopping. The rules range from general rules, expressed in brief, loosely worded terms, to more detailed and technical rules, including a U.S.-style comprehensive limitation on benefits provision. Each of the various rules would seek to limit treaty benefits for intermediary entities that are owned or controlled by residents of one or more third countries where certain other hallmarks of treaty shopping exist. Strengths and weaknesses of the different variants are noted – for instance, the paper acknowledges that some anti-treaty-shopping rules can be over-inclusive and lead to unintended denial of treaty benefits. Stakeholders are generally being asked to evaluate the different proposals, but are urged to be mindful that the stated objective of the consultation process is for the government to receive input for discussions on finding a “workable solution to the problem of treaty shopping.”
Reflections on the Consultation Paper
The government’s deliberations, as reflected in the consultation paper, are of immediate relevance to taxpayers that have in place, or are planning to put in place, treaty-based intermediary entities with the objective of obtaining access to reduced rates of – or exemptions from – Canadian taxation. This will have an especially significant impact on foreign direct investment in Canadian companies (particularly mining and oil and gas companies), because private equity and other investors in these companies often invest through holding companies in jurisdictions that have a tax treaty with Canada. Canadian capital markets have been successful in attracting listings of resource companies, in many cases with most of their operations and a substantial part of their investors being overseas. Some of that foreign inbound investment has already been adversely affected by the recent introduction of Canada’s foreign affiliate dumping rules. The consultation paper does not address how access to international capital would be affected by the introduction of the types of measures discussed.
In many cases there are a variety of reasons for investing though an intermediary company (including use of a common jurisdiction for multiple investors, limiting tax reporting and filing requirements for multiple investors, access to bilateral investment treaties and use of a common entity for multiple investments). From a Canadian tax perspective, use of intermediary holding companies could also provide access to reductions in withholding tax rates on interest, dividends and royalties, or access to capital gains exemptions. If adopted, an anti-treaty-shopping rule could deny treaty benefits to companies established for a number of purposes – perhaps, but not necessarily – including accessing favourable Canadian treaty rates or exemptions.
The consultation process outlined in the paper gives taxpayers an opportunity to make suggestions regarding Canada’s approach to treaty shopping. The government invites stakeholders to comment on the questions and proposals in the paper by December 13, 2013. Taxpayers and others with a stake in the outcome may wish to address such matters as the following:
the economic justification for acting against treaty shopping – which could involve asking whether the government has studied the potential impact on foreign direct investment of an anti-treaty-shopping rule and how this compares with the estimated cost to Canada’s tax revenues of treaty shopping;
the design of Canada’s approach to treaty shopping;
the need for and design of exemptions for investments in which obtaining benefits under a tax treaty with Canada was not the principal purpose for making the investment; and
the need to consider a grandfathering period for existing investments (a matter on which the consultation paper is silent).