10/19/2006

News / Canada-U.S. Tax Convention-What It Was Then and What It is Now

Gowlings National Tax Practice Group Adds to Its Tax Dispute Resolution Team

The Gowlings National Tax Practice Group is pleased to announce that Steve Novoselac has joined the team in the Toronto office. Steve brings to the Gowlings' tax team extensive experience in resolving tax disputes with the Canada Revenue Agency, as well as provincial and other taxation authorities. Steve has represented taxpayers at all levels of Canadian courts, from the Tax Court of Canada all the way to the Supreme Court of Canada.

The Canadian General Anti-Avoidance Rule and Treaty Shopping

The subject of so-called limitation of benefits provisions and the Canada Revenue Agency's ("CRA") position on the potential application of Canada's "general anti-avoidance rule" ("GAAR") to perceived abuses of Canada's bilateral tax treaties was the subject of a previous article in Canadian Tax @ Gowlings (see Volume 1, Number 2). This topic received its first judicial consideration in the very recent Tax Court of Canada decision in MIL (Investments) S.A. v. The Queen, 2006 T.C.C. 460. In the MIL case the Tax Court of Canada allowed a taxpayer's claim of treaty protection under the Canada-Luxembourg Tax Convention ("Treaty") in respect of the disposition of shares of a Canadian mining corporation. In very general terms, an individual, Mr. Boulle ("Boulle"), and his wholly-owned corporation incorporated in the Cayman Islands, MIL (Investments) S.A. ("MIL"), initially held more than 12% of a Canadian public corporation named Diamond Field Resources Ltd. ("DFR"). In June of 1995, MIL sold some of the DFR shares to another Canadian corporation, Inco Limited ("Inco"), on a tax-deferred share exchange rollover basis, with the result that the aggregate DFR shareholding by Boulle and MIL was reduced to less than 10%. MIL was then continued into Luxembourg, a jurisdiction with which Canada has entered into a tax treaty. Within a few months of the continuance and after several offers from Inco and another corporation, MIL entered into an agreement with Inco to sell the remaining DFR shares ("Sale") and realized a capital gain of approximately $425 million. MIL claimed protection under the Treaty from Canadian tax on the gain realized on the Sale. The CRA disagreed with the position of MIL.

Under paragraph 4 of Article 13 of the Treaty, capital gains derived by a resident of Luxembourg from the disposition of shares forming part of a substantial interest in the capital stock of a company the value of which shares is derived principally from immovable property situated in Canada is taxable in Canada. A substantial interest exists when the resident and related persons own 10% or more of the shares of any class or the capital stock of a company. Accordingly, as MIL and Boulle (related persons) did not have a substantial interest in DFR, the capital gains arising from the disposition were not taxable in Canada pursuant to the capital gains exemption under paragraph 4 of Article 13 of the Treaty.

The CRA challenged the availability of the capital gains exemption under the Treaty on the basis that the GAAR under section 245 of the Income Tax Act (Canada) applied to deny the benefits of the Treaty. In the alternative, the CRA argued that an anti-abuse rule inherent in the Treaty itself would deny the exemption. In general terms, the application of GAAR as set out by the Supreme Court of Canada in the leading case of Canada Truscto v. Canada depends on the following three tests: (i) the existence of a tax benefit arising from the impugned transaction or series of transactions; (ii) the determination that the transaction, or series of transactions, may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit ("avoidance transaction"); and (iii) the determination that the avoidance transaction is abusive. MIL conceded that the application of the Treaty gave rise to a tax benefit. However, the Court denied the application of GAAR on the basis that the share exchange and continuance into Luxembourg were not part of the same series of transactions as the Sale, stating that "the Sale cannot be included in that series because of a mere possibility [at the time of the exchange and continuance] of a future potential sale of any shares". As a result, the Sale could not be an avoidance transaction and therefore, GAAR could not be applied to it.

Having concluded that there were no avoidance transactions, the Court did not have to consider whether the transaction was abusive. However, the Court went on to state that "the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive", and that if Canada is concerned with the preferable tax rates of any of its treaty partners, it should seek recourse by attempting to renegotiate selected tax treaties rather than to apply the GAAR.

With respect to CRA's alternative argument that the Treaty should be read to include an "inherit" anti-abuse rule that would deny the treaty exemption, the CRA argued that this was the case in light of the lack of an explicit reference to anti-avoidance rules in the Treaty and that the OECD commentary should be interpreted without reference to revision subsequent to the signing of the Treaty. The Court was unimpressed with these arguments and found that there was no ambiguity in the Treaty permitting it to be construed as containing an inherent anti-abuse rule. Therefore, the ordinary meaning of the Treaty allowing MIL to claim protection from capital gains taxation had to be respected.

On the basis of the Court's decision, it might be argued that a non-resident of Canada, resident in a particular jurisdiction, can structure its investment in shares in Canadian corporations through a holding corporation resident in a different jurisdiction to take advantage of that other jurisdiction's tax treaty with Canada and to avoid Canadian taxes on capital gains. However, given that the comments of the Court in respect of treaty shopping were not part of the reasons on which the disposition of the case depended (in other words, they were obiter dicta), one should be cautious in this regard. Clearly, we have not heard the last word on this issue.

Article XIII(8) of the Canada??“U.S. Tax Convention??“What It Was Then and What It is Now

A substantial proportion of international M&A activity in Canada involves transactions between Canadian and U.S. business enterprises. Due to the divergence of domestic tax legislation in the two countries, cross-border corporate reorganizations, or similar transactions that are otherwise tax-deferred in the U.S., can result in the recognition of profit, gains or income in Canada under the Income Tax Act (Canada) (the "Act") in respect of dispositions or deemed dispositions of Canadian subsidiaries, assets or business operations of a U.S. resident. In many instances, the Canada??“U.S. Tax Convention (1980) (the "Convention") will not preclude Canadian taxation of such profits, gains or income at the time of these dispositions or deemed dispositions. If a disposition or deemed disposition is not taxable in the U.S. in the same taxation year as they are in Canada, a timing mismatch occurs, and foreign tax credit relief for the Canadian taxes may not be available in the U.S. in that year or a future year, potentially giving rise to double taxation.

Article XIII(8) of the Convention attempts to harmonize Canadian and U.S. tax rules applying to corporate reorganizations, or similar transactions, and allows for a deferral of the recognition of the profit, gain or income resulting from the disposition of property for Canadian income tax purposes. If requested by the acquirer of the property, the Canadian Competent Authority may enter into an agreement with the acquirer to defer the recognition of the profit, gain or income in accordance with Article XIII(8) of the Convention and section 115.1 of the Act. However, allowing such a deferral is entirely at the discretion of the Competent Authority.

The Canadian Competent Authority will only consider agreeing to a deferral where, among other requirements: (1) there is evidence that the purpose of the reorganization is commercially motivated; (2) a deferral is required to avoid potential double taxation; (3) a deferral would be available if the acquirer and vendor were residents of Canada; (4) there is no applicable deferral provision in the Act that may be used; (5) the transaction for which a deferral is sought is not specifically prohibited or precluded for non-residents on a deferred basis under the Act; (6) in the opinion of the Canadian Competent Authority, no component of the reorganization or other transaction would be subject to the general anti-avoidance rule in section 245 of the Act; and (7) the Canadian Competent Authority can administer the agreement.

Past Practice

Prior agreements concluded by the Canadian Competent Authority were subject to a number of terms and conditions, some of which referred to "triggering events". The occurrence of a triggering event would result in the immediate recognition of the deferred profit, gain or income in Canada. In the past, these triggering events included changes to the Convention or U.S. income tax law that would negatively impact the subsequent Canadian taxation of the disposition if the acquirer ceases to be a United States resident, and when a property ceases to meet the definition of real property situated in Canada pursuant to a transaction to which section 245 of the Act applies. In addition, agreements often included a condition that the shares of any corporation involved in the transaction could not be transferred, exchanged, encumbered or otherwise dealt with in any manner for a period of two years without the permission of the CRA.

As well, previously, the Canadian Competent Authority typically required that the taxpayer provide a letter of confirmation from the Internal Revenue Service ("IRS") that the transaction in question qualified for non-recognition treatment under the Internal Revenue Code.

Recent Changes

The Canadian Competent Authority has recently undertaken a significant policy review of Article XIII(8). Consequently, some terms and conditions that may have been used in prior Article XIII(8) agreements have been removed, and certain new terms and conditions, including certain new triggering events, have been introduced. For instance, once a taxpayer provides a description of the transactions concerned, and an explanation of their purpose and intent, confirmation from the IRS regarding the non-recognition treatment of the transactions for U.S. tax purposes is no longer required. Instead, taxpayers will generally only be required to provide an opinion letter from U.S. counsel attesting to the non-recognition status of the transactions. This is a welcomed step toward improving the timing of an Article XIII(8) deferral request.

On the other hand, the nature of the new triggering events now listed in Article XIII(8) deferral agreements are more restrictive and more extensive, and will likely prove to be highly burdensome for taxpayers. As an example of one of the new triggering events, assume that a U.S. company ("US Vendor") has sold the shares of its Canadian subsidiary ("CanSub") to another U.S. company ("US Acquiror") in a transaction that is a non-recognition event for U.S. tax purposes (the "Initial Disposition"), and has concluded an Article XIII(8) deferral agreement with the Canadian Competent Authority in respect of any taxable gain in Canada. By virtue of the triggering events now being included in these agreements, US Vendor may become subject to tax on the Initial Disposition if at anytime in the future CanSub pays (or is deemed to pay) a dividend to US Acquiror in contemplation of a sale of its shares by its US Acquiror to an arm's length party.

While we expected most of the recent changes to the Competent Authority's policy regarding Article XIII(8) deferral requests, it is regrettable that these changes have entailed such cumbersome conditions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Edited by Vince F. Imerti

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