Canada
Michael McLaren, Michael Colborne and Mark Barbour
Thorsteinssons
Canada
Michael McLaren, Michael Colborne and Mark Barbour of Thorsteinssons discuss Canadian legal developments impacting international investment
Many developments occurred over the past year in Canadian law governing foreign inbound and outbound direct investment. Of particular interest are various statutory developments, the expansion of Canada's income tax convention and tax information exchange network and the evolution of Canadian jurisprudence on anti-avoidance, transfer pricing, reverse hybrid partnerships, trust residence, and non-discrimination.
Statutory developments
A number of technical amendments to the Income Tax Act (the Act) were made, or were proposed by the Government of Canada in its June 6, 2011 Federal Budget to be made, over the past year. Of particular relevance to international investment were proposals to expand Canada's withholding tax regime as it applies to interest payments, eliminate corporate tax deferral using partnerships and revise Canada's foreign affiliate rules.
Withholding tax on interest payments
The Act imposes withholding tax on interest payments that a payer resident in Canada makes to a non-resident recipient with whom the payer does not deal at arm's-length if the interest is not in respect of certain debt obligations such as Canadian government bonds (referred to as "fully exempt interest").
On March 16 2011, the government of Canada announced proposals to amend the Act to impose withholding tax on interest that, in addition to not being fully exempt interest, is paid or payable to either a non-resident recipient with whom the payer does not deal at arm's-length or a non-resident recipient (whether arm's-length or not) if the interest is paid or payable on a debt obligation owed by the payer to a non-resident with whom the payer does not deal at arm's-length.
In principle, the proposed amendment was intended to curtail coupon-stripping and represents a statutory response to the Federal Court of Appeal decision in Lehigh Cement Limited where the court held that Canada's general anti-avoidance rule did not apply to a coupon-strip undertaken by a taxpayer in a manner that resulted in interest payments made by a Canadian-resident entity being exempt from withholding tax pursuant to former legislation.
Elimination of partnership deferral
The Act includes in a taxpayer's income for a taxation year income allocated to the taxpayer from a partnership where the partnership's fiscal period ends in the taxpayer's taxation year. Deferral may be achieved if the partnership's fiscal period ends after the taxpayer's taxation year end. The Act was amended in 1995 to prevent individuals from deferring tax on business or property income in such a manner; however, certain Canadian corporations continued to be able to benefit from this opportunity. Given the corporate rate reductions adopted by the Government of Canada, this deferral opportunity also provided absolute tax savings.
On August 16, 2011 the Government of Canada announced proposals to amend the Act to eliminate this tax-deferral strategy.
Canada's Foreign Affiliate Rules
On August 19, 2011 the Government of Canada announced proposals to amend the Act to change a number of aspects of the foreign affiliate rules and abandon previous proposals. The changes are far reaching: of particular interest is that inbound loans from foreign affiliates to Canadian-resident taxpayers may be included in the taxpayer's income in certain circumstances.
Reporting of avoidance transactions
In World Tax 2011 we discussed the announcement by the Government of Canada in its March 4, 2010 Federal Budget of draft proposals to require the reporting of certain tax avoidance transactions. Though draft legislation to implement the draft proposals has been released, it is our understanding that the consultation process is not complete.
Tax information exchange and treaty developments
Tax information exchange agreement negotiations
In World Tax 2010 we discussed the technical rules for the application of Canada's exemption system (the exempt surplus regime) and accrual system (the foreign accrual property income regime) and the interaction between those detailed technical rules and tax information exchange agreements (TIEA) concluded between Canada and other countries.
TIEAs have entered into force with Bermuda, the Cayman Islands and the Netherlands Antilles; have been signed with Anguilla, Bahamas, Costa Rica, Dominica, Guernsey, Isle of Man, Jersey, Saint Lucia, San Marino, St. Kitts and Nevis, St Vincent and the Grenadines, and the Turks and Caicos Islands; and are under negotiation with Antigua and Barbuda, Aruba, Bahrain, Belize, the British Virgin Islands, Brunei, the Cook Islands, Gibraltar, Grenada, Liberia, Liechtenstein, Montserrat, Uruguay and Vanuatu.
As we have previously noted, Canada's rapidly expanding network of TIEAs should be welcome news to Canadian-based multinationals that are looking to expand and refine their offshore structures in a manner that will provide access to Canada's exemption system.
Tax treaty status
In the last year, the Government of Canada signed income tax conventions with Switzerland and entered into income tax convention negotiations with Hong Kong and negotiations to update the treaty with China. Previously signed income tax conventions with Turkey and the Hellenic Republic entered into force. In addition, the Government of Canada signed a protocol with Switzerland to amend the Canada-Switzerland tax treaty to include the standard developed by the OECD for the exchange of tax information.
Jurisprudence developments
General anti-avoidance rule
At issue in Collins & Aikman Products Co. was a surplus strip transaction that resulted in a Canadian corporation having sufficient paid-up capital that it could make a substantial return of capital to a non-resident shareholder without triggering Canadian non-resident withholding tax. The Crown applied the general anti-avoidance rule to reduce the corporation's paid-up capital and then assessed on the basis that withholding tax was payable on the distribution to the non-resident shareholder.
The Tax Court of Canada held that the surplus strip transaction did not misuse or abuse the provisions of the Act and therefore the general anti-avoidance rule did not apply. This decision was upheld by the Federal Court of Appeal. Collins & Aikman confirms that the Crown cannot rely on a general policy against surplus striping in order to establish abusive tax avoidance under the general anti-avoidance rule.
In January 2011, the Supreme Court of Canada heard an appeal from the Federal Court of Appeal's decision in Copthorne Holdings Ltd., another case in which the Crown applied the general anti-avoidance rule to reduce a corporation's paid-up capital on a distribution to a non-resident shareholder. It is hoped that the court will provide further guidance on the application of the general anti-avoidance rule and on the circumstances in which a transaction will be considered to form part of a series of transactions, a concept that is fundamental to the application of the general anti-avoidance rule.
Transfer pricing
In World Tax 2010 we reported that the Tax Court of Canada heard the appeal in General Electric Capital Canada. That case considered the extent to which a 1% guarantee fee paid by a Canadian-resident subsidiary to its foreign parent was justified. In finding that the guarantee fee was justified, the Tax Court of Canada held that all economic considerations-including implicit credit support from a parent corporation-must be taken into account to determine the appropriate transfer price. The court concluded that the taxpayer's stand-alone credit rating (i.e. without the guarantee of its foreign parent) would have resulted in an increased interest cost on debt of 1.83%. Since the guarantee fee paid was less than the hypothetical increased interest cost, the 1% fee was justified. The Federal Court of Appeal dismissed the Crown's appeal. A similar matter is now before the Tax Court of Canada in HSBC Bank Canada.
In Alberta Printed Circuits Ltd. the Tax Court of Canada considered fees paid by a Canadian-resident corporation (Canco) to its subsidiary incorporated under the laws of Barbados (Barbco). Barbco was responsible for the development, supply, and maintenance of database systems software, the manufacturing of circuit boards and the development and maintenance of the taxpayer's website. Barbco's only customer was Canco and its remuneration was based on the manufacturing charges made by Canco to its customers (with no markup by Canco), plus fees for all other work.
The Tax Court's decision in Alberta Printed Circuits Ltd. is noteworthy because it demonstrates the continued adoption by Canadian courts of the OECD transfer pricing guidelines. The court noted that the comparable uncontrolled price (CUP) method is the most reliable method and that, where available, transactional profit methods are less reliable than traditional transaction methods. To that end, the court emphasized that the transfer pricing rules require an attempt to be made to obtain comparables using the CUP method regardless of whether it is difficult to do so and also require that every attempt be made to distinguish differences through adjustments. The court accepted expert-opinion evidence to the effect that prices charged by Canco to its arm's-length customers were internal comparables for the prices charged by Barbco to Canco in respect of the manufacturing services.
Reverse hybrid partnerships
In 4145356 Canada Limited, the Tax Court of Canada considered the availability of the Canadian foreign tax credit in a classic "foreign tax credit generator" structure entered into between the Royal Bank of Canada and the Bank of America. Without going into the technical complexities regarding such structures, it is sufficient for this purpose to note that the structure involved a partnership that checked-the-box to be treated as a C-corporation for the purposes of the Internal Revenue Code and, in the end, resulted in the Royal Bank of Canada receiving Canadian tax credits in respect of foreign taxes paid by the partnership on an amount of income where there was no (or very little) net tax paid in the United States in respect of the income because of an offsetting deduction or credit.
While the government of Canada has proposed legislation to prevent the use of such structures, the decision of the court is important since it recognized the partnership as a partnership under Canadian law regardless of its treatment under the laws of the United States. Specifically, the Court held that there is no distinction in Canadian law between partnerships which, under the laws under which the partnership was formed, are separate legal entities, and those that are not separate legal entities. This case is now under appeal to the Federal Court of Appeal.
Trust residence
In St. Michael Trust Corp, the Federal Court of Appeal upheld the Tax Court of Canada's decision regarding the proper test for determining the residence of a trust. In St. Michael Trust, the share capital of an automotive parts manufacturer was reorganized to implement estate planning objectives of the two principals of the business. As part of the reorganization, two trusts were settled with St. Michael Trust Corp., a trust company resident in Barbados. The two trusts acquired shares of Canadian holding corporations, the value of which would increase if there was any increase in the value of the underlying automotive parts business. These shares were eventually sold at a gain and St. Michael Trust Corp. claimed an exemption from Canadian tax on the basis that the trusts were resident in Barbados, and not Canada, for the purposes of the Canada-Barbados tax treaty.
Before this case, the generally-accepted view was that the residence of a trust was determined by reference to the residence of its trustee. However, the Tax Court of Canada and the Federal Court of Appeal departed from this approach and instead held that the residence of a trust should be determined using the central management and control test developed to determine corporate residence. Applying this test to the facts in St. Michael Trust, the trusts were found to be resident in Canada on the basis that the powers and discretions of the trusts were, in fact, exercised in Canada by the Canadian-resident beneficiaries.
This case is under appeal to the Supreme Court of Canada. If it is upheld, it could have implications for offshore trust structures. Moreover, it could signal a shift in the application of the central management and control test relevant to determining corporate residence.
Non-discrimination
In Saipem UK Limited, the Tax Court of Canada considered the application of the non-discrimination provision in the Canada-UK tax treaty. At issue was whether the non-discrimination provision in the treaty applied on the basis that a UK corporation cannot wind up a subsidiary with a permanent establishment in Canada and then access the subsidiary's non-capital losses in the same manner as a Canadian corporation with a Canadian subsidiary. The taxpayer argued that this distinction results in discrimination for the purposes of the treaty, based either on nationality or on permanent establishment status. The Tax Court of Canada disagreed and held that the non-discrimination provision did not apply. In coming to this conclusion, the Court reasoned that the relevant domestic provision distinguished between taxpayers on the basis of residence, not nationality, and that doing so is not discriminatory.
This is Canada's first case dealing with a non-discrimination provision in a tax treaty. The case is now under appeal to the Federal Court of Appeal.
Beneficial ownership
In World Tax 2010 and World Tax 2011 we reported that Velcro Canada Inc. v. The Queen will be Canada's second case concerning beneficial ownership-the first being Prevost Car Inc. v. The Queen. Velcro was heard by the Tax Court of Canada on May 18, 2011 and the decision was reserved.