On May 28, 2018, Canada introduced Bill C‑82 (“Bill “), which, if passed, will bring into force the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”). The Bill passed the first reading in the House of Commons on June 20.
The objective of the MLI is to implement measures to counter base erosion and profit shifting (“BEPS “) without requiring each party to a bilateral tax treaty to enter into a bilateral negotiation process. BEPS refers to tax planning strategies that take advantage of tax rules to artificially transfer a company’s profits to jurisdictions with low tax rates and where the company has no substantial activity. Canada’s introduction of the Bill brings the country one step closer to the implementation of the MLI into Canadian law. Read our detailed note on the steps to the implementation of the MLI: Canada’s adoption of the multilateral instrument – timing clarified, impact still uncertain.
The MLI will modify up to 75 of Canada ‘s bilateral tax treaties (also known as Covered Tax Agreements or ‘CTAs’). Read our detailed note on Canada’s participation at the MLI’s signing ceremony for a full list of Canada’s CTAs modified by the MLI: Hot off the Presses: Canada signs the Multilateral Instrument.
Canada had initially taken a very conservative approach to the MLI. At the time Canada signed the MLI, on June 7, 2017, it chose only to adopt the minimum standards with respect to treaty abuse – the new tax treaty preamble and the substantive anti-treaty shopping technical rule (currently set to be the default Principal Purpose Test (‘PPT’)) – and the mandatory binding arbitration provision. Canada ‘s approach to the MLI recently shifted as it expressed its intent, in the backgrounder published by the Department of Finance accompanying the introduction of the Bill, to withdraw certain of its reservations on optional provisions pertaining to dividends (Article 8), capital gains (Article 9), dual residency tie-breaker rules (Article 4) and relief from double taxation (Article 5). We discuss these changes below.
Of note, Canada has not removed its reservation on Article 7(4) of the MLI which would allow treaty benefits that would otherwise be denied under the PPT to be granted by the competent authorities in appropriate circumstances. The PPT denies treaty benefits when one of the principal purposes of the structure was to obtain a given treaty benefit in circumstances where the granting of the benefit is not in accordance with the object or purpose of the relevant provision of the CTA. In the case of certain private equity or other collective investment vehicles that benefit from a given treaty benefit (assume, for example, a 5% withholding tax rate on dividends) it may be the case that the investors themselves would also have benefited from a treaty benefit (assume, for example, a 15% dividend withholding tax for an investor that is an individual) had they made a direct investment into Canada. In such cases, it may be unjust to subject the dividend to a 25% domestic dividend withholding tax. However, by not removing the reservation, Canada denies taxpayers any remedy in such cases.
Treaty benefits: Reduced dividend withholding rates
Canada removed its reservation on Article 8 of the MLI, the reduced withholding tax on dividends article. This article addresses the reduction of the 25% domestic dividend withholding rate under most CTAs to 5% where the dividend is paid to a corporation that, at the time of the payment, owns, holds or controls directly (and in certain CTAs, indirectly) at least 10% of votes (or in certain cases holds more than 10% of the shares) of the dividend payor. Article 8 will deny the reduced treaty withholding tax rate unless the applicable ownership conditions are met throughout a 365-day period that includes the day of the payment of the dividends. For this purpose, ownership changes resulting from corporate reorganizations (e.g. amalgamations) of the dividend payor or shareholder are ignored. This 365-day holding period is meant to ensure that non-resident companies that engage in certain short-term share acquisitions will not benefit from the lower treaty dividend withholding tax rates.
The application of the hold period rule will be problematic in practice because the 365-day period can straddle the transaction date. Where the holding period test has not been met at the transaction time, the corporate dividend payor has a difficult choice to make. If it withholds at the lower rate, it exposes itself to the risk that the shareholder will not meet the holding period test and, therefore, the payor will be liable for the additional withholding tax and penalties. Alternatively, if it withholds on the dividend at the domestic rate, and the test is met, the shareholder will then need to apply for a refund of the excess withholding, which will engender additional costs and delays. Presumably, related parties may be in a position to share information such that the hold period rule can operate smoothly. However, a dividend payor, particularly one that is unrelated to the dividend recipient, may wish to obtain guarantees of continued shareholding and indemnification from the shareholder in order to withhold at the treaty rate in such cases.
Treaty benefits: Exempting capital gains from source country taxation
Canada has removed its reservation on Article 9(1) of the MLI, which specifies when capital gains on shares, and interests in partnerships and trusts, can be taxed in the source country.
Under Canadian domestic law, a capital gain on a share (or a partnership or a trust interest) is taxable if, at any time during the 60-month period that ends at the time of the disposition, the share (unit or interest) derives more than 50% of its value (directly or indirectly) from real property interests in Canada. However, Canada ‘s CTAs narrow this by using a point-in-time test at the moment of disposition of the share (unit or interest). Therefore, under the current rules, a non-resident shareholder of a Canadian corporation holding real property that exceeds the value threshold could avoid Canadian capital gain tax on the portion of the value of the shares that was not derived from the real property. It could do this by causing the Canadian corporation to dispose of the property shortly before the sale of the shares by the non-resident. In such a case, the sale of the real property by the Canadian corporation would still be subject to capital gains tax in Canada but the gain might itself be reduced or eliminated depending on the tax attributes of the Canadian corporation. As a result of the application of Article 9 of the MLI, the shareholder of the corporation in this example would still be subject to full capital gains tax in Canada as the capital gains exemption test period under CTAs is now extended to the 365-day period preceding the disposition of the shares.
Resolving dual-residency issues
Canada has removed its reservation on Article 4 of the MLI. This article provides a mechanism for taxpayers (such as corporations), other than individuals, to resolve dual-residency cases. Under this provision, the competent authorities of Canada and the other contracting jurisdiction to a CTA must determine by mutual agreement in which jurisdiction a dual resident will be deemed to be a resident for the purposes of the CTA. To make that decision, Article 4 of the MLI prescribes that the competent authority should take into account the following factors: the person ‘s place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of an agreement, the article provides that the person shall not be entitled to any relief or exemption from tax provided by the CTA except if it is agreed otherwise by the competent authorities.
By not imposing a bright-line tie-breaker rule but rather giving the competent authorities a series of factors to consider, the MLI dual-resident provision will work differently than the tie-breaker rules found in some of Canada ‘s treaties. For example, Article 4(3)(a) of the Canada-US treaty provides a bright-line tie-breaker rule for situations where an entity is a dual resident, for example because it is incorporated in one jurisdiction but has its mind and management in another; such entity is considered resident only in the jurisdiction where it was created. Although Article 4 of the MLI also includes among its guiding criteria for the competent authorities the place where a person was incorporated or otherwise constituted, it is open to the competent authority to give more weight to other factors such as the place of effective management, especially if other relevant criteria can be identified, in determining the country of residence of the taxpayer.
Elimination of double taxation
Canada has also removed its reservation on Article 5 of the MLI, regarding methods of eliminating double taxation through either an exemption or credit system. Article 5 allows signatories to choose between adopting one of three options for eliminating double taxation, but also allows them to choose to adopt none of the options. Canada has not specified which of the three options it will adopt. Where Canada chooses a different option from a CTA partner, the option chosen by each country would apply to its own residents only.
The three options set out in Article 5 can be summarized as follows:
A – No exemption in country A where country B applies the bilateral treaty to exempt income from tax or apply tax at a reduced rate; country A shall offer a foreign tax credit in respect of the tax paid to country B. This is intended to address situations of double non-taxation of income.
B – No exemption in countryA for dividends that are deductible to the payer in country B. Country A shall instead offer a foreign tax credit.
This is intended to combat hybrid instruments. For example, an instrument that is considered debt in country B such that the payer is entitled to a deduction for the payment of interest, while countryA treats the instrument as equity such that the recipient is treated as receiving an exempt dividend.
C – If income is taxed under the treaty in country B, country A shall offer a foreign tax credit on the basis of net income. If income is exempt from tax in country A, country A may still offer a foreign tax credit for taxes paid in country B.
By Laura Gheorghiu, Gowling WLG