Canada: Canadian Tax @ Gowlings - November 15, 2011 - Special Bulletin

Last Updated: November 21 2011
Article by Jim Wilson, Pierre G. Alary, Gary Edwards and Timothy S. Wach

Edited by Laura L. Monteith and Henry Chong

New Protocol to Canada-Barbados Treaty - Barbados Regains Advantage Over TIEA Countries

A new protocol amending the Canada-Barbados Income Tax Agreement1 ("Protocol" and "Treaty") was signed by the contracting states on November 8, 2011. If the Protocol is implemented by Canada and Barbados, the main changes to the existing Treaty, which were well anticipated, will be the introduction of a modernized exchange of information article and the expansion of the list of persons currently covered by the limitation of benefit provision in Article XXX(3) ("LOB Provision")2. The LOB Provision as it currently reads only precludes the application of the Treaty to companies that are entitled to special benefits under the Barbados International Business Companies Act ("IBCs") or to companies entitled to any special tax benefit under any similar law enacted by Barbados. While the expansion of the LOB Provision to a broader class of persons and entities is significant, especially certain Barbados trusts, no less significant are several subtle changes to the Treaty that if adopted (and there is no reason to believe they won't be) will likely mean that Barbados will continue to be the more attractive destination for Canadian outbound structures over other low or no tax jurisdictions that have recently entered into Tax Information Exchange Agreements ("TIEAs") with Canada.

The changes we are referring to above are the introduction of a new corporate dual resident tie-breaker rule in Article IV(3) of the Treaty3 and a slight, but important, revision to the existing language of the LOB Provision. The new LOB Provision provides that Articles VI to XXIV of the Treaty shall not apply to IBCs or any other entity described within that provision. Under the existing LOB Provision, IBCs are excluded from the benefits of the Treaty in its entirety. Accordingly, one of the consequences of the amendments to the LOB Provision is that Articles IV (Residence) and XXVII (Mutual Agreement Procedure ("MAP")) of the Treaty will apply to IBCs where those companies would otherwise be considered residents of Barbados pursuant to Article IV(1).

This means that, for example, an IBC that would otherwise be a resident of Barbados for purposes of Article IV(1) and that is challenged4 by the Canada Revenue Agency ("CRA") as having its central management and control in Canada, and thus is a resident of Canada,5 would now be entitled, as a dual resident corporation, to the benefits of the new corporate dual resident tie-breaker rule. Consequently, in a situation where an IBC that has filed tax returns in Barbados on the premise that its central management and control is in Barbados and both the taxpayer (i.e., the IBC) and the Barbados tax authorities consider it to be a resident of Barbados for domestic tax purposes, the IBC should be either entitled to the automatic application of the tie-breaker rule or at least to the benefits of the MAP Article which would ensure a competent authority review of the so-called dual residence matter.

There is some confusion resulting from the apparent requirement under the Barbados domestic tax laws that the IBC's central management and control must be in Barbados in order to be considered a resident of that country for domestic tax purposes. This is why some IBCs, in order to avoid the 2.5% tax rate, intentionally establish central management and control outside Barbados and do not file Barbados tax returns as Barbadian residents. That scenario, however, is quite different from the more common Canadian structures where the IBCs are filing tax returns in Barbados as domestic tax residents and voluntarily paying the Barbados taxes based on their view, and presumably the view of the Barbadian tax authorities, that their central management and control is in Barbados. In those situations where there is a dispute between the two contracting states as to the true location of the IBC's central management and control, the application of either the tie-breaker rule or the MAP Article should now be of significant relevance. After all, the spirit and object of a dual resident treaty tie-breaker rule6 is to deal precisely with those situations where the two contracting states assert full domestic taxation rights based on their interpretation of the criteria described in Article IV(1).7 

Corporate Residence – Central Management and Control

For Canadian common law purposes, the corporate residence of IBCs, or any other corporate entity for that matter, is generally determined by identifying the location of the central management and control of the IBC. The test generally applied in respect of corporate residence is the one enunciated by the House of Lords in the De Beers case.8 A corporation's central management and control, in broad terms, is generally intended to be directed at the highest level of control of the business of the company (i.e., the highest level of corporate control). The location of a corporation's highest level of control is generally understood to be the place where the company's board of directors meets, as opposed to the location of the personal residence of the directors. CRA auditors, when auditing offshore companies located in low or no tax jurisdictions, have always been fairly aggressive in challenging the corporate residence of such companies, particularly for those companies that have been careless in ensuring that their mind and management is effectively carried out in that foreign jurisdiction. However, with the proposed changes in the Protocol, it may no longer be worth the effort and audit resources of the CRA to challenge the residency of an IBC. That said, a determination by CRA of the IBC's central management and control being in Canada still presents a problem to the IBC from the perspective of its ability to distribute profits to a Canadian related corporation on a tax free basis9. This problem applies equally to entities in TIEA countries.

TIEAs

TIEAs are bilateral agreements used to promote international co-operation in tax matters through the exchange of information. TIEAs are beneficial when a country does not have or is not considering the negotiation of a comprehensive tax treaty with Canada. TIEA countries have become attractive targets for Canadian corporations looking to expand their operations. The main advantage of incorporating in a TIEA country is that Canada's exempt surplus system is extended to these countries. Therefore, the active or deemed active business profits of a corporation based in a TIEA country may be repatriated to a Canadian parent corporation by way of a tax-free dividend. Despite the recent popularity of TIEA countries for Canadian corporations looking to expand their operations, the Protocol appears to give a significant advantage back to Barbados. Other advantages would include the access to the MAP Article for disputes concerning tax in contravention of the Treaty.

Conclusions

The advantages of expanding a corporation's operations in Barbados are many. The tax rate for an IBC is 2.5% on up to the first US$5 million of income of the IBC for a year. The rate then drops by 0.5% for each successive US$5 million of income of the IBC for the year until it hits 1% for income in excess of US$15 million for the IBC for the year. Barbados has developed an excellent reputation with respect to its economic, political and social stability. In addition, Barbados has long been known to be investor-friendly while offering a favorable tax environment, a strong legal system and a stable financial sector. In this regard, the treaty network developed by Barbados is sophisticated and extensive, which offers stability and peace of mind to multinational entities. However, once the active business profits earned by an IBC get material, many Canadian companies prefer a structure utilizing a TIEA country that has a zero tax rate.

The Protocol, once implemented, clearly provides some degree of protection or right to dispute resolution for IBCs against CRA corporate residence audits and should give IBCs another advantage over offshore entities formed in TIEA countries. This type of CRA audit action is a real and legitimate concern to taxpayers and their tax advisors when planning effective tax structures. Accordingly, regardless of the factors that need to be taken into consideration when choosing the best country to set up foreign operations, the changes proposed under the Protocol clearly improve Barbados' ranking on the list of favored destinations for Canadian outbound structures. It is unclear to us whether it was the intention of the Canadian negotiators to introduce a tie-breaker rule that would hinder an effective CRA audit technique against IBCs. Regardless, the Protocol will be welcomed by Canadian-based multinational entities that want to reduce their exposure to at least one CRA audit approach on the review of its offshore entities.

Footnotes

1. Agreement between Canada and Barbados for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on capital.

2. Article XXX(3), which currently applies to "companies", has been expanded to "any person or other entity" entitled to any special tax benefit in Barbados under "the International Business Companies Act, the Exempt Insurance Act, the Insurance Act, the International Financial Services Act, the Society With Restricted Liability Act, or the International Trust Act, or any substantially similar law subsequently enacted".

3. The corporate dual resident tie-breaker rule in the existing Treaty, which basically allowed the tie to be settled by the competent authorities of each state, was never an issue regarding IBCs because those entities were carved out of the Treaty, in its entirety, under the existing LOB Provision. However, the new corporate tie-breaker rule, which goes to the state in which the company is a national (i.e., generally where it is incorporated or created), now provides a clear and certain tie-breaker mechanism.

4. When an IBC's central management and control is challenged by CRA, it is usually based on CRA's opinion of the facts (i.e., the true location of the IBC's senior decision making process) which is a fairly subjective evaluation which can vary from the conclusions reached by both the taxpayer and the Barbados tax authorities.

5. Where CRA has successfully challenged an offshore corporation as having its central management and control in Canada, subject to subsection 250(5) of the Income Tax Act, the company will be taxed in Canada on its world income and the Canadian tax deferral objective of the structure will be defeated.

6. It should be noted that the new tie-breaker rule in Article IV(3) is an automatic rule not subject to competent authority agreement. Therefore, in those situations where CRA ignored their obligations under the Treaty, taxpayers will have recourse to CRA Appeals and the courts regarding the interpretation of Article IV(3) as well as the competent authority process through the MAP Article.

7. One only needs to consider Union Corporation Ltd v IRC (1953) 34 TC 207, which appears to accept the notion that a corporation can have dual residence under central management and control.

8. De Beers Consolidated Mines, Ltd. v. Howe (1906), 5 TC 190 (HL).

9. In the 1996 Corporate Management Tax Conference CRA Q&A, CRA stated that "The term "resident in a designated treaty country" is not defined. Therefore general Canadian common law principles apply in determining whether a foreign affiliate is otherwise resident in a designated treaty country. Draft Regulation 5907(11.2) deems a foreign affiliate not to be resident in a designated treaty country unless one of paragraphs 5907(11.2)(a), (b), (c) or (d) is satisfied. The test is therefore a two-pronged test. As well, the references to "that country" found in draft Regulation 5907(11.2) are to the country that the affiliate is otherwise resident under Canadian common law. Therefore the affiliate must be resident in the same country under both tests in order to be considered "resident in a designated treaty country".

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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