In the tax world, "treaty-shopping" occurs when a person resident in Country A organizes a legal entity in, and directs income through, Country B, solely to secure benefits under a tax treaty between Countries B and C that would not be available to a resident of Country A, typically preferential tax treatment for income sourced from Country C.
In recent years, tax administrations around the world, including Canada, have addressed this concern by adding limitation of benefits articles to existing tax treaties to deny treaty benefits when certain criteria are met. However, when a tax treaty does not include a limitation of benefits clause, the primary tool for challenging treaty shopping in the context of non-resident withholding tax is to assert that the person claiming the treaty benefits is not the "beneficial owner" of the relevant income, as preferential withholding tax rates under tax treaties that follow the OECD Model Convention typically only apply where the income recipient is also the beneficial owner of such income.
In Canada, Prévost Car Inc. v. The Queen,1 (Prévost Car) was the first case to consider whether tax treaty benefits should be denied on the basis that the non-resident recipient of the Canadian-sourced income was not the beneficial owner. In Prévost Car, the income consisted of dividends paid on shares of a Canadian corporation to a Dutch holding company established and jointly owned by an English corporation and a Swedish corporation. In 2008, the Federal Court of Appeal (FCA) affirmed the Tax Court of Canada's decision to afford the Dutch holding company the benefits of the reduced withholding rates on Canadian-sourced dividend income under the Canada-Netherlands tax treaty, even though the shareholders of the Dutch holding company had established an operating structure that had ensured at least 80% of the Dutch holding company's income was distributed as a dividend to shareholders and where the favourable Canada-Netherlands tax treaty was a factor in establishing the Dutch holding company in the Netherlands.
A key feature of the Tax Court's decision in Prévost Car was its conclusion that the relevant question with respect to beneficial ownership is whether the dividend recipient is the "person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received."
The Prévost Car case provided judicial guidance on how the beneficial ownership question would be resolved with respect to dividends. Undeterred, the minister of national revenue (Minister) then chose to litigate the same issue in a royalty context in Velcro Canada Inc. v. The Queen,2 (Velcro Canada), which was recently decided by the Tax Court of Canada in the taxpayer's favour.
In the Velcro Canada case, intellectual property owned by a Dutch company (IPco) in the Velcro worldwide group of companies was licensed to Velcro Canada Inc., commencing in 1987. The license provided that IPco was to receive a specified percentage of Velcro Canada's "net sales." Initially, the percentage depended on whether the sales were attributable to products using established technology (5%) or new technology (7.5%), but the royalty entitlement was amended in 2003 to reflect a flat 5% rate.
In 1995, as part of a strategic worldwide reorganization of the Velcro group, IPco migrated from the Netherlands to the Netherlands Antilles. Prior to its migration, IPco assigned its rights under the license agreement with Velcro Canada, a Dutch holding company (Dutchco) and gave Dutchco the right to grant licenses in respect of IPco-owned intellectual property.
Under the agreements effecting the assignment, IPco was entitled to receive royalties from Dutchco computed similarly to royalties payable under the license with Velcro Canada; until 2003, IPco received an "arm's length percentage" of Velcro Canada's net sales (as defined under the assigned Velcro Canada license) and, beginning in 2003, IPco received the royalties that Dutchco collected under the Velcro Canada license, less the amount approved by the Dutch tax authorities to cover Dutchco's costs related to its obligations under the assignment agreement.
Over the period that the assignment was in place, IPco received approximately 90% of the royalties that Dutchco collected under the Velcro Canada license.
The assignment of the royalty stream by IPco to Dutchco in 1995 did not reduce the Canadian withholding tax from the situation before IPco's migration. However, IPco's assignment of the Velcro Canada license to Dutchco allowed the Canadian-source royalty stream to continue enjoying the benefits of the Canada-Netherlands treaty despite IPco's migration to a jurisdiction that did not have a tax treaty with Canada (i.e., Netherlands Antilles).
The Tax Court framed its analysis in the Velcro Canada case using the concept of beneficial ownership that had been previously expressed in Prévost Car. It went so far as to start with dictionary definitions of the four key words in the judge-made test: "possession," "use," "risk," and "control". The Tax Court then went on to consider whether Dutchco had enjoyed the incidents of beneficial ownership under the Prévost Car standard.
With respect to possession and use, Dutchco did not simply collect and immediately forward to IPco a 90% share of the royalties collected from Velcro Canada. Rather, the funds were comingled with Dutchco's funds from other sources and sometimes converted into a different currency. Amounts that Dutchco held in its accounts earned interest income for Dutchco's benefit and were applied to pay Dutchco's expenses. In light of those facts, it was clear to the Tax Court that Dutchco had both possession and use of the Velcro Canada royalties based on a strict tracing analysis.
With respect to risk, the Tax Court noted that Dutchco had assumed some conventional commercial risks with respect to the royalties. Since the assignment agreement did not provide Dutchco with indemnification from IPco for those risks, it was clear to the Tax Court that Dutchco was exposed to risk in relation to the Velcro Canada royalties.
Having come to the view that Dutchco had had possession and use of the funds and had been exposed to commercial risk in respect thereof, the Tax Court concluded that Dutchco also had control over the collected Velcro Canada royalties and therefore each of the four criteria from the Prévost Car formulation of beneficial ownership had been met.
The Tax Court then quickly dismissed the Minister's arguments that Dutchco was merely IPco's agent, nominee or conduit to flow the royalties from Velcro Canada to IPco.
In the end, it would appear that the Prévost Car and Velcro Canada cases establish a fairly high threshold for the Minister to meet in order to successfully deny treaty benefits on the basis that the recipient of dividends and royalties is not the beneficial owner of these amounts.
In the absence of a fact situation in which the flow of funds (on a direct tracing basis) is pre-determined and the recipient of the funds has no discretion whatsoever on how the funds are handled or applied, it is difficult to see how a court could find in favour of the Minister on future beneficial ownership cases.
Perhaps the practical outcome of this case is that Canadian tax authorities will shift their focus from trying to use the courts to challenge structures that offend its view of when tax treaty benefits will apply and instead focus on ensuring that the language in Canada's bilateral tax treaties more clearly describes the circumstances under which treaty benefits would not be available. This is the approach that the Canadian government adopted when it renegotiated the Canada-U.S. tax treaty, which now contains a limitation of benefits article.
It should be noted that both Prévost Car and Velcro Canada discussed in some detail the OECD Model Convention (upon which the Canada-Netherlands tax treaty is based) and the Commentary thereon with respect to beneficial ownership and conduits.3 In Prévost Car, the FCA noted that the Minister's position on beneficial ownership in that case was, in effect, asking the Court to adopt a pejorative view of holding companies which neither Canadian domestic law, the international community nor the Canadian government through the process of objection to the OECD Model Convention have adopted.
The OECD has recently4 issued proposed changes to the Commentary on beneficial ownership, aiming to clarify the interpretation that should be given to that concept in the OECD Model Convention and, in particular, whether the interpretation should reflect what beneficial ownership has meant historically or a broader anti-abuse concept. Based on recent comments by the U.S. delegate, consensus among the OECD members on this issue has been a challenge to date.5
1 Prévost Car Inc. v. The Queen, 2008 TCC 231, aff'd 2009 FCA 57
2 Velcro Canada Inc. v. The Queen, 2012 TCC 57, released February 24, 2012
3 Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital (1977) and 2003 Commentary, as well as the OECD Conduit Companies Report (1986)
4 Clarification of the Meaning of "Beneficial Ownership" in the OECD Model Convention, discussion draft dated 29 April 2011 to 15 July 2011
5 Jesse Eggert on March 1, 2012 at the International Fiscal Association USA 2012 annual conference, as summarized in Tax Analysts, March 2, 2012
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.