Canada: Canadian Tax @ Gowlings – July 2007

Last Updated: August 21 2007

Edited by Vince Imerti

  • Treaty Shopping and the GAAR Revisited
  • Update of Canadian Interest Deductibility Proposals
  • Canadian Immigration Trusts

Treaty Shopping and the GAAR Revisited

We recently reported (see Volume 3, Number 3 of this publication) on a decision of the Tax Court of Canada in the case of MIL (Investments) S.A. relating to an attempt by the Canada Revenue Agency ("CRA") to apply the so-called "general anti-avoidance rule" or "GAAR" to a case of alleged abusive treaty shopping. The decision of the Federal Court of Appeal in the appeal by the CRA of the Tax Court of Canada decision was recently released.

As reported earlier, the Canadian courts have consistently held that in order for the GAAR to be applicable to deny a "tax benefit" that arises from a transaction or series of transactions, a number of tests must be satisfied including, in general terms, that the impugned transaction or transactions give rise to a misuse of the provisions of the Canadian tax act or an abuse having regard to the provisions of that act read as a whole. The decision of the Federal Court of Appeal was direct and succinct in this regard. The Court stated that it was "unable to see in the specific provisions of the [Canadian Tax Act] and the [Luxembourg-Canada] Tax Treaty…any support for the argument by the [Canada Revenue Agency] that the tax benefit obtained by the [taxpayer] was an abuse or a misuse of the object and spirit of any of those dispositions". The Court went on to say that "[the CRA] urged us to look behind this textual compliance with the relevant provisions to find an object or purpose whose abuse would justify our departure from the plain words of the disposition. We are unable to find such an object or purpose".

It seems that in what can fairly be described as an extremely brief and clear judgment, the Federal Court of Appeal has confirmed that it will be extremely difficult for the CRA to try to successfully apply the GAAR to what it might perceive to be abusive treaty shopping.
By: Tim Wach

Update of Canadian Interest Deductibility Proposals

In the 2007 Federal Budget (delivered March 19, 2007) the Minister of Finance announced that new legislation would be introduced to restrict the deductibility of interest on funds borrowed by a Canadian corporation to finance a "foreign affiliate". The concern, according to the Minister, was that corporations should not be able to deduct interest on money used to earn income that is effectively exempt through Canada's form of participation exemption.

Under the original Budget proposal, corporatins would have been denied a current interest deduction for interest paid on money borrowed to finance foreign affiliates to earn "exempt dividends" ("exempt dividends" are those paid out of a foreign affiliate's "exempt surplus", which includes in particular active business income of the foreign affiliate from a country with which Canada has concluded a double taxation treaty). This deduction was to be replaced with a carry-forward amount that could be deducted in future years to the extent that the foreign affiliate generates non-exempt income for the Canadian corporation (in other words, income, including capital gains, other than exempt dividends received out of the exempt surplus). The new proposal was to take effect on a staggered basis between 2007 and 2009.

The original announcement was ill conceived and generated a storm of protest from business and from tax professionals. As a result, on May 14 the Minister of Finance announced changes to the original proposal. The substituted proposal is more targeted than in the Budget but also more arbitrary, denying a deduction only for an amount referred to as "double dip" income. This requires a calculation of the foreign affiliate's income "attributable to" certain specified debts owing to the foreign affiliate, and will vary according to the amount of foreign income taxes paid in respect of that income. Furthermore, the proposal will now apply only to taxation years beginning in 2012.

The changes, while welcome, were accompanied by justifications that backtracked significantly from the rationales originally advanced by Finance to support the proposal. Instead, the stated purpose of the revised proposals is an attack on "double-dip" and so-called "tower structures" designed to generate interest deductions in offshore jurisdictions as well as in Canada. It is our understanding, from our conversations with various interested parties, that Finance's primary concern is so-called "second-tier financing" structures in which Canadian subsidiaries of foreign parents borrow to further finance other entities in the corporate group. Although we feel that (for various reasons) the attack on "double-dip" and "tower structures" is without policy merit, Finance appears to be digging in its heels to preserve some sort of proposal, even if it has little in common with the original proposal.

It was also proposed that a committee of Government officials and tax professionals study this matter further. However, given some of our recent experience with new and sweeping legislation dealing with international tax concepts in Canada, it may be that these amendments (which do not yet even have the form of draft legislation) will never see the light of day in the current proposed form. At the very least, further thinking and further amendments will almost certainly be needed.
By: Craig Burley

Canadian Immigration Trusts

Like many other jurisdictions, Canada has a set of tax rules aimed at taking the tax advantage for Canadian taxpayers out of holding passive investments through offshore or "non-resident" trusts. As previously discussed in this publication, Canadian non-resident trust rules are the subject of a set of recently enacted (but not yet proclaimed or in force) amendments to the Income Tax Act that intended to broaden their application. However, it is significant to note that the "Immigration Trust", long a feature of the Canadian tax system, will continue to be available as a tax-planning device.

The Immigration Trust was originally intended to provide relief to foreign executives transferred to Canada on a temporary basis. Because Canada taxes residents on their world-wide income, a foreign executive transferred to Canada, even on a temporary basis would, in most cases, be subject to Canadian tax on income from all sources, including from passive investments in their home jurisdiction. A properly structured Immigration Trust (and there are many technical "traps" that must be avoided) provides relief from this impact for up to five years being, effectively, the maximum period that such trusts are exempted from the former and the new non-resident trust rules.

The benefits of an Immigration Trust are not limited to foreign executives, however, and can be of benefit to anyone emigrating to Canada, including individuals moving here permanently. The essential elements of Immigration Trust planning are as follows:

  • There must be a trust settlement by the immigrating individual at some time that is prior to the expiry of the first 60-months of residence in Canada. The settlement of the trust should typically occur prior to the immigrating person taking up Canadian residence. Although the trust can be settled at any time within the first 60-months of residence, if it is settled while the immigrating person is a resident of Canada, the settlement itself will be a realization for Canadian tax purposes and any capital gains that have accrued since the date of immigration will be taxable in Canada.
  • The trust must be, under normal principles, a non-resident of Canada. This means, at the least, that the majority of trustees is not resident and that the trust is not otherwise controlled by residents of Canada. The trust residence should be established in a jurisdiction that itself does not tax the trust income. The tests for establishing the residence of a trust under Canadian tax law are somewhat fluid; care should therefore be taken in the design of the trust's governance to avoid the argument by the Canada Revenue Agency that the persons who truly control the trust, and therefore the trust itself, are resident in Canada.
  • The beneficial interests in the trust should generally be discretionary. Further, to avoid Canadian taxation altogether, only trust capital should be paid to Canadian resident beneficiaries since any trust income they receive will be taxable to them in the year it is paid or payable to them.
  • Proper planning is required to avoid the application of the attribution rules contained in the Income Tax Act. These rules can apply to attribute the income and the capital gains of at trust to the person who has gifted or loaned property to the trust in various situations, including situations where the beneficiaries of the trust are the person's spouse, their children under the age of 18 and other persons who are not at arm's length to them. These attribution rules are of general application and could, in the absence of proper planning, apply to defeat the point of the immigration trust.
  • The trust may invest its property anywhere. If it invests in Canadian investments, however, it will be liable to pay Part XIII withholding tax on the investment income from Canadian sources.
  • If the trust can be considered to be carrying on business in Canada or to be disposing of taxable Canadian property, it will also be subject to Part I tax.
  • Prior to the end of the 60-month period, the trust should consider changing its residence to Canada. This can be done simply by changing the trustees to Canadian resident trustees. For Canadian tax purposes, the trust will have a non-taxable deemed disposition of all of its property and obtain a step-up of the cost base of its property. If there is trust property with inherent losses, consideration should be given to distributing the property to Canadian resident beneficiaries in order to preserve the losses for later realization.
  • The trust will be treated under Canadian income tax law as a non-resident trust. Canadian resident contributors and beneficiaries are therefore subject to the foreign property reporting rules.

Clearly, anyone contemplating a move to Canada, whether on a temporary basis or a permanent basis, should consider establishing an Immigration Trust.
By: David Stevens

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