Treaty Shopping: An Update

Cross-border tax structures periodically optimize available tax

treaty benefits having regard to the differences between various

bilateral tax treaties. Structures that take advantage of such

differences in bilateral treaties (e.g., holding companies situated

in advantageous jurisdictions) may, however, be susceptible to

attack under treaty shopping principles.

This article will discuss both Canadian and international

jurisprudence that has considered such principles.

There is no widely recognized definition of treaty shopping;

however, the Canada Revenue Agency (CRA) has commented that it

considers treaty shopping to include transactions that involve the

establishment of entities or residency in a particular jurisdiction

to permit a taxpayer to avail itself of the benefits of a treaty

with the particular jurisdiction for tax avoidance

purposes.1

Treaty shopping has developed a high profile, and the CRA has

indicated that it will target treaty shopping

structures.2 The CRA typically seeks to challenge treaty

shopping on the basis of one or more of the following

principles:

specific limitation on benefit (LOB) rules;

the general anti-avoidance rule (GAAR);

an abuse of treaties principle;

residency requirements; and/or

beneficial ownership requirements.

1. Limitation On Benefit (LOB) Rules

Unlike many US treaties, Canada's bilateral tax treaties do

not generally contain detailed "limitations of benefits"

or "LOB" provisions, which are expressly designed to

counteract treaty shopping.

The notable exception is the current Canada-United States Income

Tax Convention (Canada-US Treaty).3 On December 15,

2008, the Fifth Protocol to the Canada-US Treaty came into force.

The provisions of this Protocol substantially amended the Canada-US

Treaty in a number of important respects, including the amendments

to Article XXIX-A of the Canada-US Treaty to create a reciprocal

LOB rule that denies the benefits of the Canada-US Treaty to

certain US residents where they have an insufficient nexus with the

United States. While the LOB rules are highly complex, the general

role of the LOB provision is that only a "qualifying

person" will be entitled to all of the benefits of the

Canada-US Treaty and, except as expressly provided, persons other

than "qualifying persons" will not be entitled to treaty

benefits.

Very generally, "qualifying persons" include natural

persons, certain governmental bodies, companies (or trusts) the

shares or units of which are primarily and regularly traded on a

recognized stock exchange, certain other companies satisfying an

indirect publicly traded test, and companies (or trusts) satisfying

a combined ownership and "base erosion" test.

Persons other than qualifying persons may nevertheless access

treaty benefits in relation to (i) income connected with or

incidental to an active trade or business; (ii) dividends, interest

and royalties received by a company where the ultimate owners of a

defined percentage of the votes and value of the affected company

are resident in a country that has a tax treaty with Canada, and

where such treaty provides the same or lower withholding tax rate

than the Canada-US Treaty on the relevant payment; and (iii)

certain amounts where the competent authority permits treaty

benefits to be applied. The LOB provision applies in respect of

withholding taxes for amounts paid or credited after February 1,

2009, and in respect of other taxes for taxation years commencing

after 2008.

Due to the short time during which such provisions have been in

force, we are not aware of the CRA having challenged any structures

on the basis of such rules. However, such LOB provisions will be

extremely important going forward, and the introduction of LOB

provisions in the Canada-US Treaty may foreshadow the introduction

of similar LOB provisions in other bilateral Canadian tax

treaties.

2. General Anti-Avoidance Rule (GAAR)

The retroactive change to the GAAR, which was introduced

following the 2004 federal Budget, eliminated any debate over

whether the GAAR applied to tax treaties as the GAAR now expressly

refers to tax treaties.4

The Supreme Court of Canada has most recently provided guidance

on the application of the GAAR in Lipson v. The

Queen.5

The Lipson decision did not involve alleged treaty

shopping, but rather involved interest deductibility on a borrowing

of funds that had permitted a home to be purchased as part of the

same series of transactions as the borrowing. Justice LeBel, for

the majority, largely applied the framework and principles set

forth in prior GAAR jurisprudence that requires the following three

elements to be satisfied:

a tax benefit results from a transaction or a series of

transactions;

the transaction is an avoidance transaction (i.e., it cannot be

reasonably viewed as having been undertaken primarily for a bona

fide non-tax purpose); and

there was abusive tax avoidance in the sense that it cannot be

reasonably concluded that a tax benefit would be consistent with

the object, spirit or purpose of the provisions relied upon by the

taxpayer.

Justice LeBel also made certain comments relevant to tax

planning and the GAAR risk:

The Duke of Westminster principle, which states that a taxpayer

is entitled to arrange his or her affairs to minimize taxes

payable, remains valid but was circumscribed by the GAAR to limit

avoidance transactions while maintaining certainty for

taxpayers.

The entire series of transactions should be considered in

determining whether individual transactions within the series

result in abuse of the Income Tax Act (Canada), although

it is not the purpose or motivation for the transaction that

determines abuse, but rather the result.

The GAAR is a residual provision that can apply even if the

transactions fall outside the scope of more specific anti-avoidance

rules.

The burden was on the Minister to prove, on the balance of

probabilities, that the transactions had resulted in abuse

— this may represent a softening of the prior GAAR

jurisprudence, which held that the GAAR may only be invoked where

the abuse is clear.

For the CRA to succeed on the GAAR in the treaty shopping

context, it will have to demonstrate that a particular transaction

defeats the object, spirit and purpose of a particular provision of

a treaty. This may be difficult for CRA to establish in light of

rules in most of Canada's treaties, which already create a

framework addressing who may benefit from such treaties:

Most of Canada's tax treaties are drafted based upon the

OECD Model Convention, and specifically address who is entitled to

the benefits of the treaty. Article 1 typically provides that the

treaty shall apply to persons who are residents of one or both of

the contracting states, and Article 4 defines who is a resident of

the contracting state for purposes of the convention.

A number of Canada's treaties specifically deny the

benefits of the treaty to certain types of

residents.6

Other Canadian bilateral treaties more directly address the

treaty shopping issue through express LOB provisions.

The residency and beneficial ownership requirements may be

considered stand-alone anti-avoidance measures.

Canadian courts have addressed the GAAR in the treaty shopping

context. The decision in MIL (Investments) S.A. v. The

Queen7 related to a capital gains exemption claimed

under the Canada-Luxembourg Tax Convention (Luxembourg

Treaty) in respect of the disposition of shares of

mining companies. The crown challenged the availability of such

exemption based inter alia on the GAAR. MIL held over 29

per cent of the shares of a Canadian mining company, Diamond Fields

Resources. Initially, MIL was a Cayman Islands company, a

jurisdiction with which Canada does not have a tax treaty. Diamond

Fields discovered the Voisey Bay nickel find, following which

another Canadian mining company, Inco, agreed to acquire Diamond

Fields. Inco effected a share exchange on a rollover basis with

MIL, so that MIL held less than 10 per cent of the shares of

Diamond Fields. MIL then continued into Luxembourg and subsequently

sold its Inco and Diamond Fields shares, realizing a gain of almost

$500 million. MIL claimed a treaty exemption under the Luxembourg

Treaty on the basis that it was a resident of Luxembourg and it

(and related persons) held less than 10 per cent of the shares,

such that the exemption applied even though the shares derived

their value from immovable property situated in Canada.

The Tax Court concluded that the GAAR did not apply on the...