This Update concerns a measure proposed in Canada’s federal budget for 2014, tabled by the Minister of Finance on February 11, 2014 (Budget 2014), relating to treaty shopping that may affect private equity (PE) funds investing in Canada through treaty-based holding companies. Set out below is a summary of the treaty-shopping proposal, which opts for and elaborates upon one of the potential measures outlined in the August 12, 2013 consultation paper regarding treaty shopping (see the August 22, 2013 Osler Update relating to the implications for PE investors of a potential Canadian anti-treaty-shopping rule). The following general points should be noted:
Budget 2014 only outlines a proposed approach. There is no draft legislation.
The approach outlined in Budget 2014 may be impacted by the recommendations of the Organisation for Economic Co-operation and Development (OECD) relating to the treaty-shopping part of the base erosion and profit shifting (BEPS) project, which are scheduled to be released in September 2014.
The approach involves a unilateral change to Canadian law as opposed to a bilateral or multilateral approach with Canada’s treaty partners.
The rule would only apply in the first year after the year in which the final legislation is enacted.
Budget 2014 does not provide for any grandfathering or transitional rule although the government does request comments “as to whether transitional relief would be appropriate.” (The fact that the government is still thinking about this suggests it has not decided whether transitional relief should be available.)
The government is seeking comments within 60 days on the approach outlined in Budget 2014.
Put in its simplest terms, the proposed rule, if enacted, may apply where one or more persons not entitled to the benefits of a particular tax treaty with Canada use an entity that is a resident of a country with which Canada has concluded a tax treaty in order to obtain Canadian treaty benefits. For example, this could include a Luxembourg or Netherlands holding company used to reduce or eliminate tax on Canadian investments by a PE fund whose investors are themselves not resident in such treaty country. The intention is that the proposed rule would deny the treaty benefits sought through such an arrangement.
In greater detail, the proposed approach to preventing treaty shopping outlined in Budget 2014 contains the following elements:
Main purpose provision: The test for the application of the anti-treaty-shopping rule is a “one of the main purposes” test, which is supported by positive and negative presumptions as to whether the test is satisfied. More particularly, Budget 2014 provides that, “subject to the relieving provision, a benefit would not be provided under a tax treaty to a person in respect of an amount of income, profit or gain (‘relevant treaty income’) 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, that results in the benefit, was for the person to obtain the benefit.” Domestically, “one of the main purposes” tests have generally not been interpreted as imposing a high threshold.
Conduit presumption: It would be presumed that the “one of the main purposes” test is satisfied “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 or persons that would not have been entitled to an equivalent or more favourable benefit had the other person or persons received the relevant treaty income directly.” This presumption could be rebutted if the taxpayer provided sufficient proof to the contrary. There are two examples provided of the application of this rule. One suggests that if less than 50% of the relevant treaty income is not flowed-through outside the holding company treaty jurisdiction (e.g., the Netherlands or Luxembourg), the conduit presumption would not be applied. However, the “one of the main purposes” test could still be satisfied as a factual matter. The other example is described below under the heading “Example – Payment of Dividends.”
Safe harbour presumption: Subject to the conduit presumption, it would be presumed that none of the main purposes was to obtain a treaty benefit if:
the person receiving the relevant treaty income (or a related person) carries on an active business (other than managing investments) in the treaty country in which such income is derived and the active business is substantial compared with the activity carried on in Canada giving rise to the relevant treaty income;
the person is not controlled (legally or factually) by another person or persons that would not have been entitled to an equivalent or more favourable benefit had the other person or persons 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.
As with the conduit presumption, this presumption can be overridden by proof to the contrary.
Relieving provision: If the main purpose provision applies in respect of a benefit under a tax treaty, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.
Budget 2014 provides examples of how the proposed approach will apply in five specific scenarios. Two of these scenarios are particularly relevant to PE funds and are described in detail below.
Example – Payment of Dividends
This example involves a scenario where an investment into Canada made by ACo (a resident of State A) and Cco (a resident of State C) is structured using a holding company (Holdco), a resident of State B. Holdco holds all the shares of a Canadian resident company (Canco). Canada has tax treaties with each of State A, State B and State C. However, Canada’s tax treaties with State A and State C provide a higher rate of withholding tax on dividends than is the rate under Canada’s tax treaty with State B.
The example indicates that such a structure under the proposed new rule would be caught by the conduit presumption (subject to providing sufficient proof to the contrary, as described above) such that the withholding tax rate under the treaty with State B would be denied. In this case, the relieving provision may apply, “to the extent ... reasonable having regard to all the circumstances,” so as to prevent an increase in the withholding rate on dividends to the full 25% non-treaty rate. In determining what would be reasonable in the circumstances, a relevant consideration would be whether Aco and Cco would be taxable on the dividend paid by Holdco in their respective tax jurisdictions.
The above example may be relevant to PE fund investments in Canada because it describes a structure that, in abstract terms, is not unlike a typical PE fund investment structure – where a PE fund that is a partnership (with investors in multiple jurisdictions that each may have different treaty dividend withholding rates with Canada) invests in Canada through a treaty-based holding company.
Example – Change of Residence
This example involves a corporation (Aco) resident in State A, which owns shares of a corporation resident in Canada (Canco). ACo is contemplating selling the shares of Canco, which would trigger a capital gain that would be taxable in Canada (i.e., the shares of Canco are taxable Canadian property). Canada does not have a tax treaty with State A. However, shortly before selling the shares of Canco, Aco shifts its residence to State B. Canada does have a tax treaty with State B and such treaty provides an exemption from tax for capital gains on shares of a Canadian corporation disposed of by residents of State B. ACo sells the shares of Canco, retains the proceeds of disposition and claims the capital gains exemption available under the tax treaty. Since this example assumes that the taxpayer retains the sale proceeds, the conduit presumption does not apply. However, the example concludes that the treaty benefit would be denied on the basis of the main purpose provision.
The above example may be contrasted with a PE fund that does not conduct such a residence shift and, nevertheless, could in addition to seeking a treaty exemption from Canadian tax on capital gains have other reasons for centralizing its investments through a non-U.S., non-Canadian treaty jurisdiction. The example provides a further scenario that may be more relevant for consideration by PE funds investing in Canada. If, instead of becoming a resident of State B shortly before the sale, Aco was resident of State B at the time of the initial acquisition of the shares of Canco, Aco’s eligibility for treaty benefit would require a consideration of all relevant circumstances in order to determine whether it is reasonable to conclude that one of the main purposes for the establishment of Aco as a resident of State B was to obtain the relevant capital gains exemption. The example states that such consideration of relevant circumstances may include the lapse of time between the establishment of Aco in State B and the realization of the capital gains, and any other intervening events.
The proposals set out in Budget 2014 could have significant impacts on PE funds invested in, or proposing to invest in, Canada. However, since Budget 2014 merely provides proposals relating to anti-treaty-shopping measures, there is still time for a potentially affected PE fund to consider taking mitigating steps to proactively avoid the application of these proposals (in the event such proposals are enacted in the form proposed) and/or make comments to the government on the proposed approach (as outlined above – especially in respect of transitional relief).