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Michael McLaren and Michael Colborne
Thorsteinssons
Canada

Michael McLaren and Michael Colborne at Thorsteinssons comment on new developments in Canada's international tax laws that include statutory amendments and the implications of the fifth protocol to the Canada-US tax treaty

The past year witnessed developments in Canadian laws that have been met with mixed reaction from the Canadian tax and business community. That is, developments were made that garnered a positive reaction from taxpayers, while others have been met with strong resistance.

Certain developments in Canadian tax laws are relevant to foreign inbound and outbound direct investment:

• statutory amendments to the Income Tax Act (Canada);
• jurisprudence regarding the concept of beneficial ownership in Canada's tax treaties, the application of Canada's general anti-avoidance rule and the status of transfer pricing appeals;
• the report of the Advisory Panel on Canada's System of International Taxation (the panel); and
• the Canada-United States Income Tax Convention (the treaty).

Statutory amendments

While there were many technical amendments made to the Income Tax Act (Canada) in the past year, two developments are noteworthy. First, legislation introduced in 2008 that would limit the deductibility of borrowing costs commencing in 2012 was repealed. Second, progress was made by the Canadian government in negotiating tax information exchange agreements with a number of countries.

Repeal of interest deduction limitation

In 2008 the Government of Canada introduced a statutory mechanism, effective in 2012, which would have disallowed the deduction of interest and other financing costs incurred by Canadian-resident corporations for borrowed funds used directly or indirectly for the purpose of funding certain intra-group loans which, ultimately, would result in a double-dip financing structure.

After considerable resistance from the Canadian tax and business community and a specific recommendation for repeal made by the panel, the Canadian government repealed this legislation.

Tax information exchange agreement negotiations

The technical rules for the application of Canada's exemption system (that is, the exempt surplus regime) and accrual system (that is, the foreign accrual property income or FAPI regime) were significantly changed as a result of statutory amendments made in 2008.

Specifically, commencing in 2009 Canada's exempt surplus system was expanded to include the concept of a tax information exchange agreement (TIEA) such that active business income earned by a foreign affiliate through a permanent establishment located in a country with which Canada has a TIEA (a TIEA country) will constitute exempt surplus if the affiliate is resident in such a country or a country with which Canada has concluded a tax treaty (a treaty country). The FAPI regime was also expanded to include active business income earned by a foreign affiliate through a permanent establishment located in a non-treaty country if Canada offers to negotiate a TIEA with that country and a TIEA is not concluded within five years.

In the last year the Government of Canada announced the commencement of TIEA negotiations with a number of countries including Anguilla, Aruba, Bahamas, Bahrain, Bermuda, British Virgin Islands, Cayman Islands, Gibraltar, Guernsey, Isle of Man, the Netherlands Antilles, Jersey, Saint Kitts and Nevis, Saint Lucia and Turks and Caicos. The TIEA with the Netherlands Antilles was signed on August 29 2009.

The Government of Canada has not confirmed news reports that Canada has concluded a TIEA with Bermuda. Depending on the result of the negotiations with these countries Canadian-based multinationals may be able to expand their offshore structures and continue to enjoy the benefits of Canada's exemption system.

Jurisprudence

Beneficial ownership

In the similar article in World Tax 2009 we reported that Canada's first beneficial ownership case was decided in favour of the taxpayer by the Tax Court of Canada in Prévost Car Inc v The Queen. The government appealed the decision to the Federal Court of Appeal. In finding for the taxpayer, the Federal Court of Appeal adopted the reasoning of the Tax Court of Canada and agreed that the beneficial owner of dividends is the person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. In coming to this conclusion the Court noted that it is inappropriate to pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of the relevant funds.

The Government of Canada has acknowledged that it accepts the definition of beneficial ownership adopted by the Federal Court of Appeal in Prévost and that, in the future, it will challenge beneficial ownership if an intermediary is a conduit for a payment. An example of such a challenge is apparent in Velcro Canada Inc v The Queen which is held in abeyance at the Tax Court of Canada.

Velcro will be Canada's second case concerning beneficial ownership and will specifically deal with royalty payments made in respect of the licensing of intellectual property. In the case, Velcro Canada, a Canadian-resident corporation, which manufactured and sold Velcro fasteners had entered into a licence agreement with Velcro Industries, a resident of the Netherlands, which owned the relevant intellectual property. The licence agreement gave Velcro Canada the right to manufacture and sell Velcro Industries's products in Canada.

Two months before Velcro Industries migrated to the Netherlands-Antilles, Velcro Industries assigned its rights under the licence agreement to grant licences and to receive the royalty payments to Velcro Holdings, a resident of the Netherlands, who was the exclusive sublicensor of the Velcro technology in certain jurisdictions. Pursuant to that assignment agreement, Velcro Holdings agreed to pay royalties to Velcro Industries. Under the assignment agreement, Velcro Industries was an express third-party beneficiary and was entitled, at its sole discretion, to exercise the rights of Velcro Holdings and to enforce the obligations of Velcro Canada.

The Government of Canada asserted that Velcro Industries was the beneficial owner of the assigned royalty payments and that Velcro Holdings acted as Velcro Industries's agent when it collected the royalties. Consequently, in the government's view Velcro Canada should have withheld tax on the royalty payments at the 25% domestic rate (the Netherlands Antilles does not have a tax treaty with Canada) and not the reduced treaty rate applicable to royalty payments made by a resident of Canada to a resident of the Netherlands, which was argued to be 0% in Velcro.

General anti-avoidance rule

The Supreme Court of Canada has provided the analytical framework to be applied when considering the application of Canada's general anti-avoidance rule (the GAAR). Without going into the peculiarities of the rule, a transaction (or series of transactions) that is structured for the primary purpose of obtaining a tax benefit will result in the application of the GAAR if the transaction (or the series of which such transaction is a part) constitutes an abuse of the Income Tax Act (Canada). To find an abuse a Court must ground its reasoning in an analysis of specific statutory provisions that were either used or avoided.

The recent application of the GAAR analytical framework by the Tax Court of Canada in Lehigh Cement Limited v R (Disclosure: Thorsteinssons represents Lehigh in this case) is relevant given that it illustrates just one of many examples of the Court's willingness to stray from the wording of the specific statutory provisions at issue and adopt a general policy-based analysis. This type of analysis is contrary to the instructions of the Supreme Court of Canada.

In Lehigh certain transactions were undertaken to restructure inter-corporate debt in a manner that would result in interest payments made by a Canadian-resident entity being exempt from withholding tax pursuant to former legislation. In concept, a Belgian creditor sold the coupon on a debt owed by a related Canadian-resident debtor to an arm's-length Belgian financial institution in consideration for fair market value proceeds. Pursuant to Canadian law applicable at the time, the interest payments made to the arm's-length financial institution were exempt from Canadian withholding tax. In addition, the proceeds realised on the sale of the coupon were not subject to Canadian tax.

The Tax Court of Canada found that the restructuring transactions abused the Canadian statutory withholding tax exemption and, therefore, that the GAAR applied to ensure that the exemption was not available. In the result, interest payments would be subject to withholding tax. The taxpayer has appealed the decision to the Federal Court of Appeal.

Transfer pricing

In World Tax 2009 we reported that Canada's much anticipated transfer pricing case, GlaxoSmithKline Inc v R, was decided by the Tax Court of Canada in favour of the Canadian government. The taxpayer has appealed the decision of the Tax Court to the Federal Court of Appeal.

In addition, the Tax Court of Canada has recently heard the appeal in General Electric Capital Canada Inc v The Queen, which considered the extent to which a guarantee fee paid by a Canadian-resident subsidiary to its foreign parent is justified and not subject to transfer pricing adjustment. The Tax Court's decision has not yet been released. The Tax Court is expected to hear a similar matter in HSBC Bank Canada v The Queen.

The Advisory Panel on Canada's System of International Taxation

In 2008 the Government of Canada appointed the panel to study the competitiveness, efficiency and fairness of Canada's international tax regime and to make recommendations that would improve the Canadian system having regard to those three areas of study.

The panel released its report in December 2008 and made a number of recommendations. These are some of the more substantive recommendations:

• Expand Canada's exemption system to include all foreign-source active business income earned by foreign affiliates; and capital gains and losses realised on the disposition of foreign affiliate shares where the shares derive their value from active business assets.
• Eliminate the expansion of the accrual regime referred to above.
• Reduce withholding tax in future tax treaties and protocols.
• Reduce the thin-capitalisation debt: equity ratio from 2:1 to 1.5:1 and expand the scope of the thin-capitalisation rules to partnerships, trusts and Canadian branches of non-resident corporations.
• Adopt specific, targeted legislation to prohibit debt-dumping transactions within related corporate groups.

Overall, the panel provided a balanced set of recommendations. That being said, as can be expected, the Canadian tax and business community welcomed the outbound investment recommendations more warmly than their inbound counterparts.

The fifth protocol to the treaty

The fifth protocol to the treaty entered into force on December 15 2008. Three items are worthy of comment.

First, while interest paid or credited by a resident of Canada to an arm's-length resident of the US on or after January 1 2008 is exempt from Canadian withholding tax pursuant to Canadian domestic law, the treaty must be relied on to provide relief for interest paid or credited by a resident of Canada to a related resident of the US. In this regard, interest paid or credited by a resident of Canada to a related resident of the US: (i) on or after January 1 2008 and before January 1 2009 will be subject to 7% Canadian withholding tax; (ii) on or after January 1 2009 and before January 1 2010 will be subject to 4% Canadian withholding tax; and (iii) on or after January 1, 2010 will be exempt from Canadian withholding tax.

Second, from January 1 2010 inbound investment into Canada from the US through a Canadian-resident unlimited liability company (ULC) that is fiscally transparent for US tax purposes will produce adverse results. Specifically, dividends and interest paid by ULC to a US shareholder will be ineligible for reduced withholding rates under the treaty. American taxpayers who own shares of a Canadian-resident ULC should consider restructuring their affairs. During the restructuring process consideration must also be given to the proposals released by the US Department of the Treasury in May 2009.

Finally, from January 1 2009 income, profit or gain of a US limited liability company (LLC) that is fiscally transparent for US tax purposes arising from a Canadian source will be considered income, profit or gain of the members of the LLC for the purposes of the treaty.

Michael McLaren (mhmclaren@thor.ca) and Michael Colborne (mwcolborne@thor.ca) are tax lawyers at Thorsteinssons.