The new law has set its sights on holding or shell companies set up principally to take advantage of a double taxation treaty
Foreigners looking to Canada as a tax haven and Canadians seeking havens abroad will have to deal with a whole new set of rules when the Organisation for Economic Co-operation and Development’s Multilateral Instrument (MLI) comes into force on December 1.
“Foreign investors will have to rethink the extent to which their investments will be subject to Canadian tax and the extent to which it affects their return on investments and on their disposition,” says Darren Hueppelsheuser, a tax lawyer in Norton Rose Fulbright Canada LLP’s Calgary office.
“A lot of opportunities for tax-advantageous structuring will no longer be available to foreign investors in Canada — and for that matter, to Canadian companies investing abroad in the countries who have adopted the MLI.”
The MLI requires participating countries who have signed the agreement to include the minimum standards against treaty shopping and abuse found in the OECD’s Base Erosion and Profit Shifting (BEPS) project in “covered tax agreements (CTA)”— those where both countries to a double taxation treaty have ratified the MLI and notified the OECD that their agreement is covered.
Most significantly, the MIL modifies all CTAs by incorporating a broad anti-avoidance rule known as the principle purpose test (PPT). The PPT provides that treaty benefits may be denied where it’s reasonable to conclude that a key reason for any transaction was to obtain such a benefit.
The most obvious example involves the use of tax avoidance structures or arrangements such as holding or shell companies set up “principally” to take advantage of a double taxation treaty.
“The PPT may disproportionately apply to holding companies or other entities that do not have significant substance in a jurisdiction since it is likely that tax authorities may form the view that granting treaty benefits to such companies may not be in accordance with the object and purpose of the relevant treaty provisions,” says Patrick Marley, a tax lawyer in Osler, Hoskin & Harcourt LLP’s Toronto office. “As a result, there is a greater likelihood that disputes involving such companies may need to be resolved by the court.”
To date, some 89 jurisdictions who are parties to more than 1,400 double taxation treaties have signed the MLI, and 26 — including Canada — have formally ratified them.
Five of Canada’s most important trade partners in 2018 — China, the United Kingdom, Japan, Mexico, and South Korea — have signed the treaty although only the U.K. and Japan are the only ones to have ratified so far.
Canada has advised the OECD that it is amenable to having 84 of its 93 double taxation treaties subject to the MLI when and if the various countries involved also ratify them and designate them as CTAs.
Notable exceptions are the United States, Germany and Switzerland, with whom Canada has double taxation treaties but who have not signed the MLI. However, Canada has engaged these countries in bilateral treaty negotiations that are expected to mirror the convention’s provisions.
Ecuador, Guyana, Kyrgyzstan, Taiwan, Uzbekistan and Venezuela are the other countries who have treaties with Canada but are not MLI signatories.
The MLI will, as of January 1, affect withholding taxes under Canada’s tax treaties with countries that have ratified the MLI. It will impact other taxes, including capital gains taxes, for the tax year beginning on or after June 1, 2020. Additional treaties will be affected as Canada’s partners ratify the MLI.
What is certain is that the impact on withholding taxes could be significant.
“If the treaty benefits don’t apply because of the PPT test, the withholding tax in the case of dividends could rise from as little as five per cent to 25 per cent,” Hueppelsheuser says. “So in some cases it may be better for investors to structure their investments to produce an interest stream rather than a dividend stream.”
According to the lawyer, foreign investors with inherent gains who may be caught by the MLI should at least look into selling their interests before the convention takes effect.
“While the MLI is not retroactive, it does capture the entirety of the gain on the date of disposition,” Hueppelsheuser says.
But the biggest issue may be the uncertainty created by the PPT.
“It’s not at all clear how Canadian courts will deal with PPT and its effect on our GAAR (general anti-avoidance rule), which our courts have interpreted for decades and whose approach we understand,” says Marley. “There’s also some concern about how Canadian courts will deal with foreign decisions interpreting the MLI, because the identical rule will be found in many treaties.”
What’s apparent is that the MLI is already in the Canada Revenue Agency’s (CRA) crosshairs.
“When Canadian businesses receive tax advice, (they) should take the potential application of the MLI into consideration,” the CRA stated in an email responding to questions from the Financial Post.
With regard to the interplay of GAAR and PPT, the CRA points out that Canadian GAAR applies to “any benefit” provided under a tax treaty.
“In appropriate circumstances, the principal purpose test in the MLI and the Canadian GAAR could apply as alternative assessing positions to a given transaction or arrangement,” the Agency states. “The CRA has not yet had to consider the application of the principal purpose test in the MLI in conjunction with the Canadian GAAR. Such a determination will depend on the specifics of the case.”
Marley believes that’s not the right approach.
“The PPT rule as drafted is not too different from the Canadian rule, so we hope that they will be interpreted by the courts in a consistent manner,” he says. “And if the two are consistent, there is no reason for the courts to apply both at the same time”.
Meanwhile, Hueppelsheuser suggests that taxpayers relying on a Canadian bilateral tax treaty should consider which treaties they rely upon; which provisions of the MLI are applicable; the extent of the new withholding obligations; whether proactive steps such as restructuring or reorganization can improve tax efficiency after the MLI’s effective date; and monitor the status of CTAs “as these will continue to change and may have future impact.”