Tax-efficient holding structures commonly used by multinational enterprises and private equity firms investing in the Canadian resource sector could soon become subject to anti-treaty shopping measures contained in the "Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting" (the "MLI").
The MLI was negotiated in November 2016 by over 100 member countries in the Organisation for Economic Co-operation and Development (OECD), with the intention of swiftly implementing a series of tax treaty measures to lessen the opportunity for tax avoidance by multinational entities. The MLI does not override or amend existing bilateral tax treaties, but is applied alongside the treaties, modifying their application as necessary. To date, 87 countries have either signed the MLI or expressed an intention to sign, including Canada and most economically developed countries (excluding the United States).
The most significant treaty modifications implemented through the MLI are the so-called "minimum standards" which create a new tax treaty preamble and a substantive anti-avoidance rule. The preamble generally provides that tax treaties are intended to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. The "minimum standards" also impose a broad anti-avoidance rule, referred to as the "principal purpose test", which generally disallows a treaty benefit where obtaining the benefit was one of the principal purposes of undertaking a particular transaction or arrangement, unless granting the benefit would be in accordance with the object and purpose of the treaty.
Many multinational enterprises and private equity firms that invest in the Canadian resource sector commonly hold their investment through an intermediary corporation resident in the Netherlands or Luxembourg. These structures generally benefit from tax-exempt capital gains on shares of a Canadian company that derive their value principally from "immovable property" situated in Canada (including resource property) used in connection with business operations. The effectiveness of such structures was most recently affirmed by the Tax Court of Canada in Alta Energy Luxembourg SARL v R, 2018 TCC 152 (currently under appeal). When the MLI becomes effective, the "principal purpose test" could significantly limit the availability of this exemption. In particular, the exemption will likely be denied for Netherlands and Luxembourg holding companies that have little economic substance and are interposed to obtain tax benefits.
The MLI will modify a particular bilateral tax treaty only after both treaty partners enact implementing domestic legislation and deliver a ratification instrument to the OECD. On February 14, 2019, and March 5, 2019, respectively, Luxembourg and the Netherlands each concluded their domestic ratification procedures. The Netherlands deposited its ratification instrument with the OECD on March 29, 2019. While Luxembourg has not yet deposited a ratification instrument with the OECD, it is expected to do so in the near term.
As a result, the MLI will enter into force with respect to the Canada-Netherlands and Canada-Luxembourg tax treaties on the first day of the month beginning three months after Canada ratifies the MLI and delivers a ratification instrument to the OECD. With respect to withholding taxes, the MLI will be effective at the start of the first calendar year beginning on or after the date the MLI enters into force. With respect to other taxes, including capital gains, the MLI will be effective for tax years beginning six months after the MLI enters into force.
For example, if Canada ratifies the MLI in July 2019, the MLI would enter into force with respect to the Canada-Netherlands and Canada-Luxembourg tax treaties on November 1, 2019. The MLI would then be effective with respect to withholding taxes on January 1, 2020, and, with respect to other taxes including capital gains, for tax years beginning on or after May 1, 2020.
In May 2018, the Canadian Government introduced legislation to implement the MLI (Bill C-82). First and second reading occurred in 2018. The Standing Committee on Finance recently concluded its study of the Bill and reported the Bill back to the House of Commons without amendment. The third reading at the House of Commons, the Senate approval process, and the delivery of a ratification instrument to the OECD, still remain. In the March 2019 Federal Budget, the Government confirmed its intention to complete the ratification of the MLI, but provided no indication with respect to timing. It is also unclear whether upcoming federal elections in the fall of 2019 will affect this process.
Multinational enterprises and private equity firms investing in Canada through a Netherlands or Luxembourg holding structure should pay close attention to Canada's ratification of the MLI. Planning should already be underway to ensure future compliance with the "principal purpose test" or to take advantage of current structures before the MLI becomes effective (e.g., through implementation of "step-up" transactions). In addition, an affected holding company that intends to dispose of the shares of its Canadian operating company should carefully consider the selection of its Canadian taxation year (which may differ from its Netherlands/Luxembourg fiscal year) to determine if it can commence prior to the time the MLI becomes effective. It will also be imperative to consider the impact of the MLI on new investments in the Canadian resource sector.