Canada is a signatory to the Multilateral Convention to Implement Tax Related Measures to Prevent Base Erosion and Profit Shifting (the "MLI"), and with a provision aimed at targeting treaty shopping, taxpayers may need to rethink their tax planning strategies when seeking a treaty-based tax benefit.
Until now, Canada's GAAR has had somewhat limited effectiveness against treaty shopping. In late 2018, the Tax Court published its reasons in Alta Energy Luxembourg SARL, part of a decade-long line of treaty shopping cases stating that such activity is not per se abusive under the GAAR. Compliments of a generous treaty-based tax exemption, Luxembourg-based Alta Energy Luxembourg S.A.R.L. ("Alta Energy") avoided paying any capital gains on the share sale of its subsidiary partly owing to the absence of a strong anti-treaty shopping provision in the relevant treaty, and because the Tax Court refused to apply the GAAR. Such decisions may become rarer once the MLI is ratified.
Under Article 7 – Prevention of Treaty Abuse of the MLI, treaty shopping, and the attendant tax benefits, may be invalidated when an arrangement or transaction has as one of its principal purposes the obtaining of the tax benefit. This is assessed under the principal purpose test ("PPT").
The MLI applies to 75 bilateral agreements Canada has entered with other jurisdictions (as of the time of signature, May 30, 2017) and represents an explicit and concerted multilateral effort to curb treaty shopping as an activity to avoid taxation. This will give the CRA a more express tool (albeit broadly worded) for dealing with the activity. Were Alta Energy Luxembourg SARL to be heard under the MLI, and according to the PPT, the decision may have resulted in the tax benefit being denied to Alta Energy. Until ratification, however, taxpayers may still be able to seek tax benefits under treaties without falling afoul of the GAAR.
The limited success of applying the GAAR to treaty shopping
The Tax Court of Canada had previously outlined the limited reach of GAAR in invalidating transactions involving treaty shopping in Canada v. MIL (Investments) S.A. The GAAR requires that three elements be satisfied for a finding of tax abuse: (1) the identification of a tax benefit; (2) the identification of an avoidance transaction; and (3) a finding of misuse or abuse of legislative provisions. An avoidance transaction lacks a bona fide purpose other than to obtain the tax benefit.Under this test, treaty shopping is not per se abusive where the activity merely offends vague tax policy principles announced in the relevant treaty. Instead, a purposive and contextual reading of the treaty provision, in consideration of the Income Tax Act, is the preferred approach. If the purpose of the provision is not offended, the GAAR does not apply.
This position was upheld in Garron Family Trust v. The Queen, and Antle v. The Queen, two later cases dealing with the Canada and Barbados tax treaty addressing double taxation and fiscal avoidance. All three cases affirm the proposition that treaty shopping is not abusive for the reason alone that no tax is applied to the transaction on account of tax treaty benefits. The Tax Court of Canada expects Canada's negotiators to know when a partner jurisdiction is and is not taxing its residents and to negotiate its tax treaties accordingly. Absent legislation, the court won't second guess the government's actions.
MLI and the principal purpose test (PPT): a new potential tool for tax authorities
The PPT under the MLI will, however, offer a new tool to the CRA in capturing these precise circumstances. Contained in Article 7 of the MLI, the PPT will operate to deny a tax benefit where it is reasonable to conclude, regarding all the circumstances, that one of the principal purposes of the transaction was to obtain the benefit. The benefit may be denied unless it is established that granting it accords with the object and purpose of the relevant provision. In the Luxembourg Treaty, for example, the rationale underlying the provision was the exempting of residents of Luxembourg from taxation on capital gains with respect to the type of property involved.
In Alta Energy Luxembourg SARL, Alta Energy objected to the alleged abusiveness of the transaction, but it conceded there was a tax benefit and an avoidance transaction. Under the PPT, such concessions may need to be rethought. Given that the stated purpose of Article 7 is to prevent treaty shopping, Alta Energy would need to show that obtaining the treaty benefit was not a primary purpose of any of the transaction. It remains to be seen who will bear the burden of proving what the purpose of the relevant treaty provision is. Arguably, this could fall to the CRA. As the government's representative, it will be better positioned to assert what Canada's intention was with respect to the provision.
Other questions arise regarding how the GAAR and the PPT will interact. Both resort to a reasonableness test and look at all the relevant facts. Were a taxpayer to be assessed under the PPT, a finding that obtaining the tax benefit was not a primary purpose may preclude assessment under GAAR. This is because the absence of a primary purpose in obtaining a tax benefit would strongly suggest a bona fide purpose to the transaction.
A further policy-based support for this idea is that defending against two separate general avoidance tests burdens taxpayers with two defences. Given the comprehensiveness of the PPT, its focus on treaty shopping and the availability of OECD commentary on the provision, the CRA might consider reserving the GAAR for other instances of alleged tax avoidance.
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