On December 9, 2009, the Organisation of Economic Co-operation and Development (OECD) released a Report containing proposed changes to the Commentary on the OECD Model Tax Convention dealing with the question of the extent to which collective investment vehicles (CIVs or, in Canadian terms, mutual funds) or their investors are entitled to treaty benefits on income received by the CIVs. This note summarizes the Report and its significance to Canadian mutual funds.

For the purposes of the Report, a CIV is a fund that is widely held, invests in a diversified portfolio of securities, and is subject to investor-protection regulation in the country in which it is established. The term includes "fund of funds" that achieve diversification by investing in other CIVs; it does not include private equity funds, hedge funds and REITs. One example of a CIV is a Canadian mutual fund governed by National Instrument 81-102 of the Canadian securities administrators.

The Model Tax Convention is the basis on which approximately 3,000 bilateral tax treaties have been negotiated worldwide. It contains provisions that address the allocation of taxing authority between the Contracting State in which income (interest, dividends and gains) arise and the Contracting State in which the owner of that income is resident (for example, by restricting the rate of withholding tax on interest and dividends imposed by the country in which the income arises).

The Model Tax Convention does not contain specific rules applicable to CIVs. Therefore, as a general rule, under a tax convention that is based on the Model Tax Convention, a CIV will only be entitled to treaty benefits if it is considered to be a "person" that is a "resident of a Contracting State" and, in the case of interest and dividends, the "beneficial owner" of such income. It is the position of the Canadian mutual fund industry that a Canadian mutual fund trust or mutual fund corporation satisfies each of these requirements and should be entitled to treaty benefits. That is, a trust or corporation is a "person," is liable to tax on its worldwide income under the Income Tax Act (Canada)(ITA), although as a practical matter it generally pays no tax by reason of provisions of the ITA permitting refunds if appropriate distributions are made to investors, and it is the beneficial owner of such income. In the past, some European countries have taken the position that some or all of these conditions are not satisfied by Canadian mutual funds, although the outcome of bilateral discussions has generally been favourable. The position of Canadian mutual funds can be contrasted with the position of certain European funds (e.g., fonds communs de placement in Luxembourg) that are contractual arrangements under which the condition that the CIV be a "person" is not met and with the position of other structures where the CIV is exempt from tax (and cannot be treated as a "resident of" a Contracting State). From a policy perspective, this is an inappropriate result as economically similar CIVs are afforded different tax treatment.

A complication that arises with respect to the treatment of CIVs is the concern that investors resident in a third country that does not have a treaty with the state in which the income arises will access treaty benefits by investing in a CIV that is resident in a country that does have such a treaty. This would generally not be of concern where the country in which the CIV is resident imposes a material withholding tax on distributions to non-resident investors (as would be the case in the United States, and perhaps to a lesser extent, in Canada) but would be of concern where the country in which the CIV is resident does not impose such a tax (Luxembourg, for example).

The Report proposes additions to the Commentary to the Model Tax Convention to address these concerns.

It contemplates that treaty negotiators expressly address the treatment of CIVs even where it is clear that CIVs of both Contracting States would be entitled to benefits. In such a case, the treaty or an exchange of notes could acknowledge the entitlement of CIVs to treaty benefits.

In other cases, if treaty entitlement would not technically be available, the negotiators should include an express provision in the treaty that a CIV established in a Contracting State be treated, for the purposes of applying the treaty, as if it were an individual resident in the country in which it is established and as if it were the beneficial owner of its income - but only to the extent that "equivalent beneficiaries" are owners of the shares or units of the CIV. "Equivalent beneficiaries" are residents of the country in which the CIV is established, or residents of other countries with which the country in which the income arises has a tax treaty providing for a withholding rate at least as low as that in the treaty under consideration. Countries would need to agree on methods by which the relevant percentages of shares or units of the CIV owned by equivalent beneficiaries could be determined. It is anticipated that further guidance will be forthcoming from the OECD in this regard. The recognition of equivalent beneficiaries is particularly significant for Luxembourg, Ireland and, to a lesser extent, the United Kingdom, which have significant numbers of third-country investors in their funds.

The Report recognizes that as treaties are bilateral, rather than multi-lateral, some countries would limit benefits to owners of the relevant income that are residents of the country in which the CIV is established rather than adopt the equivalent beneficiary concept.

The Report also contemplates that, if an agreed percentage of interests are owned by equivalent beneficiaries, the Contracting States may agree that the CIV should be entitled to full benefits under the treaty rather than proportional benefits.

In other cases, the Report contemplates that countries may wish to permit CIVs to make claims for treaty relief on behalf of investors that are entitled to such benefits. This could be the case where investors are pension funds that, if they had invested directly, would have been entitled a zero rate of withholding on interest and dividends. It is noted that "transparency" could also be achieved in many cases by using an appropriate investment vehicle such as a limited partnership.

Finally, the Report contemplates that a CIV be treated as entitled to full treaty benefits if the principal class of shares or units of the CIV is listed and regularly traded on a regulated stock exchange in the Contracting State in which the CIV is established. This would address exchange-traded funds.

If adopted, the changes to the Model Tax Convention and resulting changes flowing therefrom should be helpful, or at least not harmful, for the entitlement of Canadian mutual funds to treaty benefits. An interesting question is whether, if Canada’s treaty negotiators include an express provision in new treaties addressing CIVs, any negative inferences might arise about earlier treaties that are silent in this regard. We think not, but it is an issue to be considered.

The Report is available on the OECD website. Interested parties are invited to send their comments on the Report electronically (in Word format) to jeffrey.owens@oecd.org before January 31, 2010.