Base Erosion and Profit Shifting
Base erosion and profit shifting (“BEPS”) is the term used to refer to tax planning arrangements undertaken by multinational enterprises (“MNEs”) that exploit the interaction between domestic and international tax rules to minimize taxes. Typically, BEPS involves an effective transfer of income from a higher tax jurisdiction to low or no-tax jurisdictions.
The Organization for Economic Cooperation and Development (the “OECD”) has worked on guidelines for countering BEPS for a number of years, releasing an initial BEPS report in 2013 at the request of the governments of The Group of Twenty (the “G20”). On October 5, 2015, the OECD presented a final package of the OECD/G20 BEPS project’s 15 point action plan (“BEPS Project”), which includes finalized guidance on transfer pricing, neutralizing the effects of hybrid mismatch arrangements, preventing the granting of treaty benefits in inappropriate circumstances and developing a multilateral instrument to modify bilateral tax treaties.
Canada is committed to the BEPS Project and will continue to work with the international community to ensure a coherernt and consistent response to BEPS. The Budget encompasses a number of counter-BEPS initiatives, as set out below.
Transfer Pricing Documentation – Country-by-Country Reporting
Transfer pricing refers to the pricing of goods, services and intangibles that are traded across international borders between persons who do not deal with each other at arm’s length. In order to ensure that taxable income in each jurisdiction reflects the market value of the relevant activity, many countries’ tax rules generally require MNEs’ transfer pricing to be on an arm’s length basis. These rules also typically require MNEs to prepare transfer pricing documentation to describe their intra-group transactions and the methodologies they applied to determine the transfer pricing.
The OECD has provided transfer pricing guidelines since 1995. The BEPS Project recommends new standards for transfer pricing documentation and for the interpretation of the arm’s length principle.
Recommendations for transfer pricing documentation aim to help tax administrations to have better information in administering tax compliance. These recommendations include a country-by-country report, which large MNEs will generally be required to file with the tax administration of the country in which the MNE’s ultimate parent entity resides. A country-by-country report will include a country-by-country allocation of the key variables for the MNE, including its revenue, profit, tax paid, stated capital, accumulated earnings, number of employees, tangible assets and the main activities of each of its subsidiaries.
Pursuant to the new country-by-country reporting requirements, a jurisdiction that receives a country-by-country report from a member of an MNE will automatically exchange the report with other jurisdictions in which the MNE operates, provided that, in each case, the other jurisdiction has implemented country-by-country reporting requirements, the two jurisdictions have a legal framework in place for automatic exchange of information, and they have entered into a competent authority agreement relating to country-by-country reporting.
The Budget proposes to implement country-by-country reporting in Canada. Notably, this measure will apply only to MNEs with total annual consolidated group revenue of EURO 750 million (approximately CAD 1.1 billion) or more. Where such an MNE has an ultimate parent or subsidiary entity that is resident in Canada, it will be required to file a country-by-country report with the Canada Revenue Agency within one year of the end of the fiscal year to which the report relates. First exchanges between jurisdictions of country-by-country reports are expected to occur by June 2018. Before any exchange with another jurisdiction, the Canada Revenue Agency will formalize an exchange arrangement with the other applicable jurisdiction and will ensure that it has appropriate safeguards in place to protect the confidentiality of the reports.
Country-by-country reporting will be required for the applicable MNEs for taxation years that begin after 2015.
Revised Transfer Pricing Guidelines
Transfer pricing requirements are generally legislated in many countries’ domestic tax legislation and/or bilateral tax treaties. In Canada, the arm’s length principle is primarily governed by section 247 of the Tax Act. OECD’s Transfer Pricing Guidelines are not expressly incorporated into Canada’s legislation, however, they are used by the Canada Revenue Agency and the courts for interpreting and applying section 247 of the Tax Act.
The BEPS Project’s revisions of the OECD’s Transfer Pricing Guidelines aim to provide an improved interpretation of the arm’s length principle and a better alignment of the economic activities and profits of MNEs for tax purposes. The Budget materials say that these revisions generally support the Canada Revenue Agency’s current interpretation and application of the arm’s length principle, which is reflected in its audit and assessment practices. These revisions are therefore being applied by the Canada Revenue Agency as they are said to be consistent with current practices.
Notably, the BEPS project is finalizing its work on the threshold of low value-added services and the definition of risk-free and risk-adjusted returns for minimally functional entities (often referred to as “cash boxes”). The Canada Revenue Agency will not be adjusting its administrative practices with respect to these measures until the OECD’s work on them is more complete.
The BEPS project identifies treaty abuse, and, in particular, treaty shopping, as one of the most important sources of BEPS concerns. Treaty shopping occurs, for example, where a third-country resident creates an intermediary holding company in a treaty country, which effectively extends tax treaty benefits that were not intended and without any reciprocal benefits accruing to Canadian investors or to Canada.
The BEPS treaty abuse minimum standard requires countries to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. In addition, the treaty abuse minimum standard requires countries to implement this common intention by adopting in their tax treaties 1 of 2 approaches to treaty anti-abuse rules: (i) a principal purpose test – which is a general anti-abuse rule that uses the criterion of whether one of the principal purposes of an arrangement or transaction was to obtain treaty benefits in a way that is not in accordance with the object and purpose of the relevant treaty provisions; and (ii) a limitation on benefits rule – which is a more mechanical and specific anti-abuse rule that requires satisfaction of a series of tests in order to qualify for treaty benefits.
The Budget confirms the Government’s commitment to address treaty abuse in accordance with the BEPS treaty abuse minimum standard. Canada currently has 1 treaty that has adopted a limitation-on-benefits approach (the Canada-U.S. tax treaty) and several treaties that have adopted a limited principal purpose test. Going forward, Canada will consider either minimum standard approach, depending on the particular circumstances and discussions with Canada’s tax treaty partners. Amendments to Canada’s tax treaties to include a treaty anti-abuse rule could be achieved through bilateral negotiations, a multilateral instrument recommended by the OECD that will be developed in 2016, or a combination of the two.
Spontaneous Exchange of Tax Rulings
Another area of concern identified by the BEPS Project was a lack of transparency in connection with certain tax rulings provided by tax administrations. This lack of transparency can give rise to mismatches in cross-border tax treatment and instances of double non-taxation.
The BEPS Project recommends a framework for the spontaneous exchange of certain tax rulings that could give rise to BEPS concerns in the absence of such exchanges. The framework covers 6 categories of rulings: (i) rulings related to preferential regimes; (ii) cross-border unilateral advance pricing arrangements; (iii) rulings giving a downward adjustment to profits; (iv) permanent establishment rulings; (v) conduit rulings; and (vi) any other type of ruling agreed to in the future.
Canada already has an established exchange of information program through its tax treaties, tax information exchange agreements and the multilateral Convention on Mutual Administrative Assistance in Tax Matters.
The Budget confirms the Government’s commitment to the OECD’s BEPS-related recommendations for the spontaneous exchange of certain tax rulings. The Canada Revenue Agency will commence the exchange of tax rulings with other jurisdictions, that have committed to these OECD recommendations, in 2016.
Cross-Border Surplus Stripping
The paid-up capital (“PUC”) of the shares of a Canadian corporation generally represents the amount of share capital that has been contributed to the corporation by its shareholders, which can be returned to shareholders free of tax, even in the cross-border setting. Retained earnings in excess of PUC that are distributed to shareholders are normally treated as taxable dividends that are, for nonresident shareholders, subject to a 25% withholding tax (unless reduced under an applicable tax treaty).
The Tax Act contains an “anti-surplus-stripping” rule in section 212.1 that is intended to prevent a non-resident shareholder from entering into a transaction to extract free of tax (or “strip”) a Canadian corporation’s retained earnings (or “surplus”) in excess of the PUC of its shares or to artificially increase the PUC of the shares. When applicable, the anti-surplus-stripping rule results in a deemed dividend to the non-resident or a suppression of the PUC of the shares that would otherwise have been increased as a result of the transaction.
An exception to this anti-surplus-stripping rule is found in subsection 212.1(4), which, if met, disables the rule in section 212.1. The exception in subsection 212.1(4) applies where a Canadian corporation holds shares of a non-resident corporation that itself owns shares of a Canadian corporation – that is, where the non-resident is “sandwiched” between the two Canadian corporations – and the non-resident disposes of shares of the lower-tier Canadian corporation to the Canadian parent corporation (“Canadian Purchaser Corporation”) in order to unwind the sandwich structure. The Budget materials say that some non-resident corporations with Canadian subsidiaries have misused this exception by reorganizing the group into a sandwich structure with a view to artificially increasing the PUC of shares of their Canadian subsidiaries.
The Budget proposes to amend the exception in subsection 212.1(4). In particular, it will be clarified that, consistent with the policy of the anti-surplus-stripping rule, the exception does not apply where a non-resident both (i) owns, directly or indirectly, shares of the Canadian Purchaser Corporation, and (ii) does not deal at arm’s length with the Canadian Purchaser Corporation.
The Canada Revenue Agency has already challenged transactions that purportedly misuse the existing subsection 212.1(4), including by way of the general anti-avoidance rule. These challenges will continue with respect to transactions that occurred prior to Budget Day.
To address the possibility of situations where it may be uncertain whether consideration has been received by a non-resident from the Canadian purchaser corporation in respect of the disposition by the non-resident of shares of the lower-tier Canadian corporation, the Budget also proposes a specific rule to deem the non-resident to receive non-share consideration from the Canadian purchaser corporation in such situations. The amount of this deemed consideration will be determined by reference to the fair market value of the shares of the lower-tier Canadian corporation received by the Canadian purchaser corporation.
This change to subsection 212.1(4) should be considered in relation to cross-border acquisitions and reorganizations to ensure that the adverse application of this proposal is not inadvertently triggered.
Extension of the Back-to-Back Rules
The Tax Act currently contains back-to-back rules that can apply to interest payments for withholding tax purposes. These rules apply when an intermediary is interposed between a Canadian resident debtor and a foreign creditor in an attempt to reduce the withholding tax rate that would otherwise apply if interest were paid directly. There are also similar back-to-back rules for the thin capitalization rules in the Tax Act.
When the existing back-to-back withholding tax rules apply, the Canadian resident debtor is deemed to have paid a specified amount of interest to the ultimate foreign creditor. The result is that the Canadian withholding tax rate is determined based on the country of residence and status of the ultimate foreign creditor rather than the intermediary (assuming that withholding tax rate is higher).
The Budget introduces similar back-to-back rules for rents, royalties and similar payments. This is a significant and important change. Canada has an increasing number of double tax treaties that provide a complete withholding tax exemption for payments for the use or right to use certain intellectual property, including software in some cases. If a Canadian resident were to make such a payment to a resident of a country with which Canada does not have a double tax treaty, the Canadian withholding tax rate would be 25%. Under some of Canada’s double tax treaties, the withholding tax rate is reduced but there is no exemption.
Some taxpayers may be motivated to establish an intermediary in a country where the double tax treaty has a complete withholding tax exemption and license the intellectual property into Canada from there. The back-to-back rules proposed by the Budget target this type of arrangement.
Canada’s tax treaties generally say that the treaty reduced withholding tax rate is only available where the recipient of the royalty is a resident of the other treaty country and is the beneficial owner of the royalty in question. The Canada Revenue Agency has challenged beneficial ownership for treaty purposes in the Canadian tax courts, but has to date been unsuccessful. See, for example, Velcro Canada Inc. vs. The Queen 2012 TCC 57. The proposed back-to-back rules may, in part, be a legislative response to these court decisions.
Where they apply, the proposed back-to-back rules for royalties deem the Canadian-resident payor to have made a royalty payment directly to the ultimate non-resident recipient. The Canadian withholding tax will be payable on the deemed royalty based on the country of residence of the ultimate non-resident recipient rather than the intermediary (assuming that withholding tax rate is higher).
The proposed rules deem connected arrangements to be a back-to-back royalty arrangement if:
- a Canadian-resident person makes a royalty payment in respect of a particular lease, licence or similar agreement (the “Canadian Leg”) to a person or entity resident in a country with which Canada has a tax treaty (the “Intermediary”);
- the Intermediary (or a person or partnership that does not deal at arm’s length with the intermediary) has an obligation to pay an amount to another non-resident person in respect of a lease, licence or similar agreement, an assignment or an instalment sale (the “Second Leg”); and
- one of the following conditions is met:the amount the Intermediary is obliged to pay under the Second Leg is established, in whole or in part, by reference to the royalty payment made by, or the royalty payment obligation of, the Canadian-resident person in the Canadian Leg or the fair market value of property, any revenue, profits, income, or cash flow from property or any other similar criteria in respect of property, where a right to use the property is granted under the Canadian Leg; or
- it can reasonably be concluded based upon all the facts and circumstances that the Canadian Leg was entered into or permitted to remain in effect because the Second Leg was, or was anticipated to be, entered into. In this regard, the fact that the Canadian Leg and the Second Leg are in respect of the same property will generally not be considered sufficient on its own to conclude that this condition has been met.
The proposed rules for royalties will apply to a back-to-back arrangement where the withholding tax that is payable on a royalty payment to the Intermediary is less than the withholding tax that would be payable on a direct payment by the Canadian resident payor to the ultimate non-resident recipient.
These proposed back-to-back royalty rules will apply to royalty payments made after 2016.
Character Substitution Rules
The Budget proposes to supplement the existing withholding back-to-back rules for interest and the proposed withholding back-to-back rules for royalties to prevent their avoidance through the substitution of economically similar arrangements where the payment from the intermediary to the ultimate non-resident recipient has a different character than the payment from the Canadian resident to the intermediary.
The proposed character substitution rules could apply where:
- interest is paid by a Canadian-resident to an intermediary and the intermediary pays royalties to another non-resident;
- royalties are paid by a Canadian-resident to an intermediary and the intermediary pays interest to another non-resident; or
- interest or royalties are paid by a Canadian-resident to an intermediary and a non-resident person holds shares of the intermediary that include certain obligations to pay dividends or that satisfy certain other conditions (e.g., they are redeemable or cancellable).
Where character substitution rules apply, the Canadian-resident will be deemed to have made a payment to the ultimate non-resident recipient with the same character (i.e., interest or royalty) as the payment from the Canadian resident to the intermediary.
The Budget says the proposed character substitution rules will apply where a sufficient connection is established between the arrangement under which a Canadian resident pays interest or royalty to the intermediary and the arrangement between the intermediary and the other non-resident. Whether such a connection exists will be determined by applying tests similar to those used for back-to-back loans and back-to-back royalty arrangements. Further detail is not provided in the Budget materials. Presumably, the legislation, when enacted, will say that a sufficient connection will exist where the amount of the payment from the intermediary to the other non-resident is determined by reference to the payment from Canadian resident to the intermediary or it can reasonably be concluded that the arrangement between the Canadian resident and the intermediary was entered into or was permitted to remain in effect because the arrangement between the intermediary and the other non-resident was, or was anticipated to be, entered into.
The proposed character substitution rules will apply to interest and royalty payments made after 2016.
Multiple Intermediary Structures
The existing withholding back-to-back rules for interest as written appear to address financing structures that involve a single intermediary.
The Budget proposes to clarify the application of the existing withholding back-to-back rules for interest and the proposed withholding back-to-back rules for royalties to arrangements involving multiple intermediaries. Under this proposal, the back-to-back rules will apply to all arrangements that are sufficiently connected to the arrangement under which a Canadian resident makes a cross-border payment of interest or royalties to an intermediary (using similar criteria as with single intermediary arrangements). Where the back-to-back rules apply to multiple intermediary arrangements, the Canadian resident payor will be deemed to have made a payment to the ultimate non-resident recipient in the chain of connected arrangements of the same character as the payment to the first intermediary.
The Budget also proposes to include rules addressing multiple-intermediary arrangements within the proposed back-to-back shareholder loan rules.
This proposal will apply to payments of interest or royalties made after 2016 and to shareholder debts as of January 1, 2017.
Back-to-Back Shareholder Loan Rules
Section 15 of the Tax Act contains rules to ensure that corporate surplus cannot be made available to an individual shareholder and certain others indefinitely by way of loan or other indebtedness.
In particular, subsection 15(2) of the Tax Act provides that if a shareholder of a corporation or a connected person (generally a person or partnership that does not deal at arm’s length with or is affiliated with the shareholder and certain other specified persons) is indebted to the corporation, a related corporation or a partnership of which the corporation or a related corporation is a partner, then (subject to a number of exceptions) the amount of the debt is included in the debtor’s income. Where the debtor is a non-resident of Canada, the amount of the debt is deemed to be a dividend subject to withholding tax.
The tax policy behind this rule is that monies which cannot be paid by a corporation tax-free to an individual shareholder as a repayment of a loan owing or the shareholder or as a return of paid-up capital should, when paid, generally be treated as taxable distributions of corporate surplus.
The exceptions include indebtedness that is repaid (otherwise than as part of a series of loans and repayments) within 1 year after the end of the taxation year of the creditor to whom the indebtedness is owing and certain indebtedness on which the debtor pays interest at a prescribed rate, e.g., pertinent loan or indebtedness (“PLOI”).
The Tax Act currently contains “back-to-back loan” rules that can apply for withholding tax purposes when an intermediary is interposed between a Canadian resident debtor and a foreign creditor in an attempt to reduce the withholding tax rate that would otherwise apply if interest were paid directly.
The Budget proposes to add back-to-back rules to section 15 of the Tax Act that are similar to the existing withholding tax back-to-back rules. The purpose of this change is to prevent individuals from circumventing the shareholder loan rules in section 15 through the use of an intermediary debtor. For example, a corporation might loan monies to an arm’s length party on condition that the arm’s length party make a loan to an individual shareholder of the corporation. On a strict reading of the existing provisions, subsection 15(2) would not apply to such an arrangement.
The Budget says these new back-to-back rules will apply with respect to indebtedness owing to a Canadian-resident corporation. Indebtedness owing to a non-resident corporation does not appear to be covered by the proposal.
If the proposed rules apply, then the ultimate debtor is deemed to be indebted directly to the Canadian-resident corporation creditor. If direct indebtedness would have resulted in an income inclusion for a Canadian resident debtor or withholding tax for a non-resident debtor, this will also be the result under the back-to-back rules.
The Budget refers to the targeted arrangements as “back-to-back shareholder loan arrangements”. In fact, these back-to-back rules will apply to loans and all other forms of indebtedness, e.g., unpaid purchase price.
The Budget describes a “back-to-back shareholder loan arrangement” as an arrangement where a person to whom subsection 15(2) could apply in relation to a Canadian-resident corporation (e.g., a shareholder or a non-arm’s length person) is indebted (the “Shareholder Debt”) to a person or partnership (the “Intermediary”) that is not connected with the shareholder (i.e., someone to whom subsection 15(2) would not apply) and one of the following two conditions is met:
- the Intermediary owes an amount (the “Intermediary Debt”) to the Canadian-resident corporation and either: (i) creditor recourse on the Intermediary Debt is limited in whole or in part to amounts recovered by the Intermediary on the Shareholder Debt, or (ii) it can reasonably be concluded that the Shareholder Debt became owing or was permitted to remain owing because the Intermediary Debt was, or was anticipated to be, entered into; or
- the Intermediary has a “specified right” in respect of a particular property that was granted by the Canadian-resident corporation and either the existence of the specified right is required under the terms of the Shareholder Debt or it can reasonably be concluded that the Shareholder Debt became owing or was permitted to remain owing because the specified right was, or was anticipated to be, granted. “Specified right” has the meaning given in existing subsection 18(5) of the Tax Act.
If a back-to-back shareholder loan arrangement exists, the shareholder is deemed to be indebted to the Canadian-resident corporation in an amount that is equal to the lesser of:
- the amount of the Shareholder Debt; and
- the amount of the Intermediary Debt plus the fair market value of property over which the Intermediary was granted a specified right.
Presumably, if the direct indebtedness between the Canadian-resident corporation and the shareholder would have been excepted from the adverse application of subsection 15(2), then the deemed indebtedness will also be excepted. This could be the case, for example, if the Intermediary Debt were repaid (otherwise than as part of a series of loans and repayments) within one year after the end of the taxation year of the Canadian-resident corporation to whom the Intermediary Debt is owed. It is hard to see, however, how the PLOI exception could be available for the deemed debt. It may be appropriate to provide something like a PLOI exception for the deemed debt if adequate interest is paid on the Intermediary Debt, but there is no mention of anything like this in the Budget materials.
If the deemed debt subsequently increases or decreases, there will an additional amount of deemed debt or a reduction of the deemed debt, as the case may be. Reductions are deemed to repay the deemed debt on a first-in, first-out basis.
These new back-to-back shareholder loan rules apply as of Budget Day. For back-to-back shareholder loan arrangements in existence on Budget Day, the deemed debt is deemed to have become owing on Budget Day.