Canada: The Deferral of the Gain!!! Article XIII(8) of the Canada-U.S. Tax Convention What It Was Then And What It Is Now

Last Updated: July 14 2006
Article by Dale Hill

In 2005, foreign direct investment in Canada rose $10.0 billion to $398.4 billion at the end of the fourth quarter. This increase came mostly from acquisitions of Canadian firms by foreign investors and largely from overseas countries. In addition, by the end of the third-quarter of 2005, there were 296 cross-border merger and acquisition ("M&A") transactions involving Canadian businesses totalling $74.8 billion, which represented 73% of total deal value and 36% of total deal volume.

A substantial proportion of international M&A activity in Canada involves transactions between Canadian and U.S. business enterprises. Due to the divergence of domestic tax legislation in the two countries, cross-border corporate or other reorganizations, amalgamations, or similar transactions that are otherwise tax-deferred in the U.S., can result in the recognition of profit, gains or income in Canada under the Income Tax Act (Canada) (the "Act") in respect of dispositions or deemed dispositions of Canadian subsidiaries, assets or business operations of a U.S. resident. In many instances, the Canada–U.S. Tax Convention (1980) (the "Convention") will not preclude Canadian taxation of such profits, gains or income at the time of these dispositions or deemed dispositions. If there are dispositions or deemed dispositions that are not taxable in the U.S. in the same taxation year as they are in Canada, a timing mismatch occurs, and foreign tax credit relief for the Canadian taxes may not be available in the U.S. in that year or a future year, potentially giving rise to double taxation.

Canada's bi-lateral income tax treaties, including the Convention, designate the Minister of National Revenue as the Canadian Competent Authority responsible for providing relief to taxpayers from double taxation or otherwise from situations where they are subject to taxation, either in Canada or in another contracting state, that is not in accordance with the provisions of the relevant tax treaty. Administratively, the Canadian Competent Authority function is split between the International and Large Business Directorate and the Legislative Policy Directorate of the Canada Revenue Agency ("CRA").

Article XIII(8) of the Convention attempts to harmonize Canadian and U.S. tax rules applying to corporate or other reorganizations, amalgamations, or similar transactions, and allows for a deferral of recognition of the profit, gain or income resulting from the disposition of property for Canadian income tax purposes. If requested by the acquirer of the property, the Canadian Competent Authority may enter into an agreement with the acquirer to defer the recognition of the profit, gain or income in accordance with Article XIII(8) of the Convention and section 115.1 of the Act. However, allowing such a deferral is entirely at the discretion of the Competent Authority.

The Canadian Competent Authority will only consider agreeing to a deferral where, inter alia : (1) there is evidence that the purpose of the reorganization is commercially motivated; (2) a deferral is required to avoid potential double taxation; (3) a deferral would be available if the acquirer and vendor were residents of Canada; (4) there is no applicable deferral provision in the Act that may be used; (5) the transaction for which a deferral is sought is not specifically prohibited or precluded for non-residents on a deferred basis under the Act; (6) in the opinion of the Canadian Competent Authority, no component of the reorganization or other transaction would be subject to the general anti-avoidance rule in Section 245 of the Act; and (7) the Canadian Competent Authority can administer the agreement. However, this is not the complete list of conditions as described in paragraphs 72-85 of the CRA's Information Circular ("IC") 17-R5.

Prior agreements concluded by the Canadian Competent Authority were subject to a number of terms and conditions, some of which were better described as triggering events. Among these triggering events were the immediate recognition of the deferred profit, gain or income in Canada: if there were changes to the Convention or U.S. income tax law that would negatively impact the subsequent Canadian taxation of the disposition if the acquirer ceases to be a United States resident; or if a property ceases to meet the definition of real property situated in Canada pursuant to a transaction to which Section 245 of the Act applies. In previous years, the Canadian Competent Authority typically required that the taxpayer provide a letter of confirmation from the Internal Revenue Service ("IRS") that the transaction in question met the non-recognition test under the Internal Revenue Code . In addition, agreements often included a condition that the shares of any corporation involved in the transaction could not be transferred, exchanged, encumbered or otherwise dealt with in any manner for a period of two years without the permission of the CRA.

The Canadian Competent Authority has recently undertaken a significant policy review of Article XIII(8). Consequently, some terms and conditions that may have been used in prior Article XIII(8) agreements have been removed, and certain new terms and conditions, including some new triggering events, have been introduced, depending on the particular facts and circumstances of each case. For instance, once a taxpayer provides a description of the transactions concerned, and an explanation of their purpose and intent, confirmation from the IRS regarding the non-recognition of the transactions for U.S. tax purposes is no longer required. Instead, taxpayers will generally only be required to provide an opinion letter from U.S. counsel attesting to the non-recognition status of the transactions. This is a welcomed, and positive step toward improving the expediency of an Article XIII(8) deferral request. However, should the taxpayer's description of the U.S. tax implications be incorrect, the agreement would be null and void.

On the other hand, although Competent Authority has now removed the two-year limitation period on share transfers from its Article XIII(8) deferral agreements, it has now added new terms and conditions, including some new triggering events, that attempt to prevent taxpayers from using Article XIII(8) for tax planning purposes. Generally speaking, upon the occurrence of any triggering event listed in an agreement, a U.S. resident taxpayer will be required to include any taxable gain that has otherwise qualified for deferral under the agreement in its income.

In addition to the old triggering events, the nature of the new triggering events now being listed in Article XIII(8) deferral agreements are controversial, and will likely prove to be highly burdensome for taxpayers. For example, assume that a U.S. company ("US Vendor") has sold the shares of its Canadian subsidiary ("CanSub") to a another U.S. company ("US Acquiror") in a transaction that is a non-recognition event for U.S. tax purposes (the "Initial Disposition"), and has concluded an Article XIII(8) deferral agreement with the Canadian Competent Authority in respect of any taxable gain in Canada. By virtue of the triggering events now being included in these agreements, US Vendor may become subject to tax on the Initial Disposition if at anytime in the future CanSub pays (or is deemed to pay) a dividend to US Acquiror in contemplation of a sale of its shares by its US Acquiror to an arm's length party.

While I expected most of the recent changes to the Competent Authority's policy regarding Article XIII(8) deferral requests, it is regrettable that these changes have entailed such cumbersome conditions as are currently being imposed on taxpayers. However, the alternative would be to pay the tax on the gain that is legislated in the Act, which would create a different set of issues.

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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