In the Canadian Federal Budget released on February 11, 2014, the Department of Finance signaled its intention to enact a domestic treaty-shopping rule, generally allowing the Canada Revenue Agency (CRA) to deny treaty benefits when the "main purpose" of a particular transaction is to obtain treaty benefits. This new rule could come into force in the first taxation year after the year in which the final legislation is enacted. The potential for transitional relief is still an open issue. As the government works towards developing draft legislation, it has given stakeholders 60 days to comment on its proposed approach.
This update provides a brief summary of the Budget 2014 announcement and highlights further steps that stakeholders, including multinational enterprises and private equity firms with Canadian inbound investment and financing structures, should consider as this anti-treaty-shopping proposal unfolds.
Road to the 2014 Budget
The government first raised concerns on the issue of treaty shopping in Budget 2013, describing it as an arrangement under which a person not entitled to the benefits of a particular tax treaty with Canada uses an entity that is resident of a state with which Canada has concluded a tax treaty to obtain Canadian tax benefits. The government expressed its concern that Canada's existing anti-abuse provisions were not sufficient to counter these practices, particularly given recent rulings from the tax courts.
In August 2013, the government released a consultation paper wherein it invited stakeholders to comment on the relative merits of various approaches to treaty shopping by December 13, 2013 (See our review of the consultation paper in Department of Finance Releases Consultation Paper on Anti-Treaty Shopping Measures from September 2013). In particular, stakeholders were asked to address the benefits of a general approach relative to a more specific approach, as well as the advantages and disadvantages of a domestic law approach, a treaty-based approach, or a combination of the two. The proposed rule and discussion provided by the government in Budget 2014 highlights the progress since this consultation.
While no draft legislation has been released, Budget 2014 provides a detailed examination of the government's proposed anti-treaty-shopping rule, including its potential application in five common scenarios. The proposed rule will focus on avoidance transactions by considering whether one of the main purposes of a transaction is to obtain treaty benefits. The government also provides some certainty and predictability for taxpayers by building in several positive and negative presumptions to inform the main-purpose analysis. The main elements of the proposal are as follows:
- Main-Purpose Provision: Subject to the relieving provision described below, treaty benefits will be denied where it is reasonable to conclude that one of the main purposes of undertaking a transaction was to obtain a treaty benefit. Of note, other tests in the Income Tax Act (Canada) using similar language (i.e., "one of the main purposes") generally do not have a high threshold.
- Conduit Presumption: A presumption will arise that one of the main purposes of a transaction was to obtain a treaty benefit where the relevant treaty income is primarily (i.e., at least 50 percent) used to pay, distribute, or transfer an amount to another person who would otherwise not be entitled to the same treaty benefits had the person received the treaty income directly. The presumption can be overcome with evidence to the contrary.
- Safe-Harbour Presumption: Subject to the conduit presumption, a presumption will arise that the main purpose for undertaking a transaction was not to obtain treaty benefits where:
- the person (or a related person) carries on an active business (other than managing investments) in a state with which Canada has concluded a tax treaty and, where the relevant treaty income is derived from a related person in Canada, the active business is substantial compared to the activity carried on in Canada giving rise to the treaty income. Notably, this relief appears to be similar to the active-trade-or-business test currently provided in the limitation on benefits provision of the Canada-U.S. Tax Treaty (Article XXIX-A(3));
- the person is not controlled by another person that would not have been entitled to equivalent treaty benefits had that person received the 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.
- Relieving Provision: Where the main purpose of a transaction is to obtain treaty benefits, the benefit will be provided to the extent that it is reasonable having regard to all of the circumstances.
In developing its proposal, the government has recognized the important objective of tax treaties to encourage trade and investment and, therefore, continues to acknowledge that treaty benefits are a relevant consideration for a non-resident deciding whether to invest in Canada. On this point, the government added that the proposed rule "… would not apply in respect of an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations in making an investment." It remains to be seen whether the government will adopt standalone relief for ordinary commercial transactions and what this relief might look like.
Basis of Proposals
Contrary to the preference of numerous stakeholders for a treaty-based approach, expressed during the August 2013 consultation process, the government has adopted a domestic rule. It states that a domestic rule could be compatible with existing treaties on the basis that there are no implicit treaty obligations to provide benefits in respect of abusive arrangements. The government noted that this view was shared by both the Organization for Economic Cooperation and Development (OECD) and the United Nations, and highlighted similar domestic legislation enacted in other countries.
The government concluded that a domestic law approach would generally be more effective and suggested that its proposed rule would be added to the Income Tax Conventions Interpretation Act, such that it would apply in respect of all of Canada's tax treaties.
A number of stakeholders also expressed preference for the adoption of a specific rule, such as the limitation-on-benefits provision included in U.S. tax treaties. While the government acknowledged that rules of this nature provide a high level of certainty, it stressed that they do not capture all forms of treaty shopping. Accordingly, the government has favoured a general approach to prevent a wider range of treaty-shopping arrangements. The government added that a general rule, based on a main-purpose provision, has already been included in several of Canada's tax treaties and is relatively familiar to Canadian taxpayers, tax professionals, and Canada's tax treaty partners.
Moving to the second phase of its consultation process, the government has requested further comments from interested parties on its proposed approach to prevent treaty shopping. In particular, the government has sought comments on the potential application of its proposal to five transactional scenarios set out in the Budget. The first three scenarios parallel the facts of several treaty-shopping cases which the CRA unsuccessfully challenged in the past: MIL (Investments) SA v The Queen; Prévost Car Inc v The Queen, and Velcro Canada Inc v The Queen, all of which may now be caught by the proposed rule. In addition, while indicating that its proposed rule would likely apply to taxation years commencing after enactment, the government requested specific comments on whether transitional relief (i.e., grandfathering provisions) would be appropriate. The consultation period ends just 60 days from the Budget announcement (April 12, 2014), suggesting that any comments received may not result in significant alterations to the proposals.
The government has not specified a timeline for the release of draft legislation, however, the Budget suggests that this may not occur until late 2014 or early 2015. In 2013, the OECD issued an Action Plan to address international tax planning by multinational enterprises which, in part, calls for the development of "model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances." The Budget notes that the OECD model provisions and recommendations, which are not expected to be released until September 2014, will be relevant in formulating Canada's approach.
The continued progression towards Canadian anti-treaty shopping legislation will be an important issue to watch in 2014. If enacted as described in the Budget, the government's proposals will have a dramatic impact on multinational enterprises and private equity firms with Canadian inbound investment and financing structures. The proposed rule may apply wherever an enterprise or investor 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 (such as Luxembourg or the Netherlands) 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.
While still in the early stages of development, the proposals in Budget 2014 offer sufficient guidance for those potentially affected to assess the viability of their existing and planned structures. Given that the rules may be effective immediately or shortly after enactment (based on the commencement of a taxpayer's next taxation year), affected taxpayers may find themselves in need of immediate restructuring. These taxpayers should consider taking proactive steps to mitigate the impact of the rules, including making submissions to the government for a reasonable transition time and some form of valuation-day relief with respect to existing gains that would be exempt from tax under an existing treaty.
If you would like assistance responding to the Budget announcement or have questions or concerns about the potential impact of the proposed rule on your corporate structure or international tax planning, please contact any member of our tax department.