In the March 2013 Federal Budget, the Department of Finance indicated that it intended to initiate a consultation process on certain "treaty shopping" practices. On August 12, 2013, the government released a consultation paper entitled Treaty Shopping - The Problem and Possible Solutions in which it invites stakeholders to comment on possible approaches to curtail treaty shopping. The government released the consultation paper amidst a broad international review of the potential abuses of tax treaties. On July 19, 2013, the Organization for Economic Cooperation and Development (OECD) published its highly anticipated Action Plan on Base Erosion and Profit Shifting, which was subsequently endorsed by the G20 Finance Ministers and Central Bank Governors in Moscow on July 20, 2013.
This update provides a brief summary of the consultation paper and highlights issues that stakeholders, including multinational enterprises with Canadian inbound investment and financing structures, may wish to consider, including providing submissions to the government regarding developing an appropriate approach to treaty shopping.
Treaty Shopping in Canada
Treaty shopping in the Canadian context refers to a situation where an enterprise not directly entitled to the benefits of a tax treaty with Canada uses an intermediary entity resident in a country with which Canada has entered into a tax treaty to hold or finance its investment into Canada thereby earning income or realizing gains without Canadian tax or at a reduced treaty rate that might not otherwise apply had the intermediary entity not been used. In the consultation paper, the government indicates that it considers the following circumstances as hallmarks of treaty shopping: (1) the intermediary entity is owned or controlled primarily by residents of another country which are not entitled to the same treaty benefits; (2) the intermediary entity pays little or no taxes in its country of residence on the income earned in Canada; and (3) the intermediary entity does not carry on "real and substantial business activities" (other than managing investment income) in its country of residence.
The government's position on treaty shopping is that it is inappropriate to indirectly access tax treaty benefits through the use of an intermediary resident in a country with favourable tax treaty terms for the following reasons: (1) the benefits of the reduction in Canadian tax realized by the third country residents are not necessarily reciprocated to Canadians investing in that country; (2) it denies Canada the opportunity to negotiate terms that reflect the tax system of the third country as well as the ability to determine the countries with which Canada is willing to negotiate bilateral tax treaties for political or other reasons; and (3) Canada's intention to reduce Canadian taxation of non-residents is implemented by amendments to the Income Tax Act (Canada) and not by indirectly accepting structures which implement treaty shopping.
To date the Minister of National Revenue has been largely unsuccessful in challenging treaty shopping in court. In MIL (Investments) S.A. v The Queen, the corporate taxpayer, which was resident in the Cayman Islands, a jurisdiction with which Canada has no treaty, continued into Luxembourg prior to claiming an exemption under the Canada-Luxembourg Treaty in respect of capital gains realized on the subsequent disposition of taxable Canadian property. The Crown alleged that the taxpayer was involved in abusive treaty shopping and the exemption should be denied. However, the Federal Court of Appeal held that the textual provisions of the treaty supported the availability of the exemption and rejected the Minister's argument that treaty shopping was against the object and purpose of the treaty. More recently, in Prévost Car Inc. v The Queen and Velcro Canada Inc. v The Queen, the Minister argued unsuccessfully that favourable treaty withholdings rates on dividends and royalties, respectively, should be denied because the intermediate entity receiving payments from Canada was not the "beneficial owner" of the payments. In light of being unsuccessful in the courts, the government is now attempting to develop a workable legislative approach to prevent what it perceives as abusive treaty shopping.
Approaches to Anti-Treaty Shopping
The purpose of the consultation paper is to discuss the relative merits of a number of possible approaches to preventing treaty shopping into Canada in an attempt to find a workable solution. The paper indicates that the government is not only committed to ensuring that the purposes of Canada's tax treaties are achieved, but also ensuring that Canada remains an attractive destination for foreign investors.
As a threshold matter, Canada must decide whether to incorporate anti-treaty shopping rules into its domestic tax laws or its bilateral tax treaties. Although the consultation paper recognizes that negotiating effective anti-treaty shopping provisions in Canada's tax treaties might ultimately produce the most comprehensive and effective measures, that approach could take decades to implement as it would depend on the amount of resources dedicated to treaty negotiations and would require consent from treaty partners. The consultation paper appears to favour the domestic law approach, which could be implemented consistently across Canada's treaty network in a timely manner. As a potential drawback, the paper notes that the government's ability to draft effective domestic legislation might be constrained by potential conflicts with Canada's existing treaty obligations.
The consultation paper also provides a discussion of the range of legislative approaches to curtailing treaty shopping, from general to specific anti-treaty shopping rules. The paper discusses a number of approaches, including the U.S.-style "limitation on benefits" article, similar to Article XXIX-A of the Canada-US Treaty, as well as a general anti-abuse rule that would apply only to specific types of income, such as dividends, interest and royalties. There are a number of factors to consider in weighing the appropriate response to treaty shopping. A general approach may be over-inclusive, and accordingly, may expose businesses to compliance risk. A general approach may also impose a significant administrative burden on the Canada Revenue Agency in terms of developing guidance, responding to administrative ruling requests, and carrying out enforcement. Specific rules, on the other hand, have the advantage of greater certainty for taxpayers, although they are generally more complex and may produce inappropriate results in the absence of effective discretionary authority.
While encouraging discussion on all aspects of the consultation paper, the government is asking stakeholders to submit comments by December 13, 2013, on seven specific questions, each of which deals with different approaches to preventing treaty shopping:
Comment on the advantages and disadvantages of a domestic law approach, a treaty-based approach, or a combination of both.
Comment on the relevant merits of the various approaches to treaty shopping identified by the OECD as well as whether there are other approaches and types of rules that should be considered in Canada in evaluating how best to address the problem of treaty shopping.
Provide views on whether a general approach is preferred over a relatively more specific and objective approach.
Provide views on whether a main purpose test, if enacted in domestic tax laws, would be effective in preventing treaty shopping and achieve an acceptable level of certainty for taxpayers.
Provide input on 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 stakeholders who favour a more specific approach over a main purpose approach, provide input on the design of the conditions and exceptions (e.g., the substantive business operations and derivative benefits exceptions) under a more specific approach as well as any other exceptions that should be considered under this approach with a view to ensuring the measure is effective and applies in a reasonably straightforward manner with predictable outcomes.
Comment on whether or not a domestic anti-treaty shopping rule should apply if a tax treaty contains a comprehensive anti-treaty shopping rule.
The government's approach to treaty shopping is a matter of concern for any multinational enterprise that has, or is intending to have, an intermediary entity in its corporate structure. It appears clear from the consultation paper that the government intends to introduce anti-treaty shopping rules, and it may simply be a matter of determining when they will be implemented and in what form. While the consultation paper does not address how these rules will impact current structures, it is clear that they will impact many Canadian businesses that rely on foreign investment. The government has stated that one of the purposes of the consultation paper is to ensure that Canada remains an attractive destination for foreign investors. As such, interested stakeholders that are considering making submissions on the consultation paper are encouraged to consider the following:
presenting their preferred approach to treaty shopping in light of their business operations and capital structure and highlighting the business risks associated with the different approaches to anti-treaty shopping rules;
requesting exemptions that would be appropriate for businesses that are not using intermediary entities primarily to access treaty benefits;
providing information about the various business reasons for using intermediary entities other than obtaining a tax benefit; and
requesting transitional rules for existing structures.