Canada: Unsuccessful Crown Attempt To Apply GAAR To The Canada–Luxembourg Tax Treaty

Last Updated: November 2 2007

Article by Kathleen Penny, © 2007, Blake, Cassels & Graydon LLP

Originally Published in Blakes Bulletin on Tax, October 2007

Taxpayers have greater certainty regarding their ability to enjoy the benefits of Canada’s tax treaties following the recent release of the Federal Court of Appeal decision in the case of The Queen v. MIL (Investments) S.A. The Court confirmed that the general anti-avoidance rule did not apply to deny the exemption from capital gains tax granted by a tax treaty, and that there was no misuse or abuse of any provision of the treaty or the Income Tax Act (Canada) (the Act). This was the finding of the Federal Court of Appeal even based on a purposive and contextual interpretation of the treaty provisions.

The taxpayer had taken steps to continue as a Luxembourg corporation and to reduce the level of ownership of shares of a Canadian public corporation by MIL and related persons. The shares were "taxable Canadian property" of MIL for purposes of the Act, and derived their value principally from Canadian immovable property. When the Canadian shares were later sold, MIL was taxable on the gain under the provisions of the Act unless there was a treaty exemption. MIL claimed exemption from Canadian tax on the gain under the Canada-Luxembourg treaty. The requirements for claiming the treaty exemption were that MIL was a resident of Luxembourg (this was not questioned), and that the Luxembourg resident together with related persons owned less than 10% of the shares of the Canadian corporation at the time of the sale. These requirements were all met based on a straightforward reading of the treaty as applied to the facts.

The Minister of National Revenue argued that the treaty had been misused or abused and that the general anti-avoidance rule should be applied. An important part of the earlier Tax Court of Canada decision in favour of MIL had been the factual finding that the sale of the Canadian shares was not part of the same "series of transactions" as the prior steps taken to continue MIL into Luxembourg and reduce the shareholding below the 10% maximum.

If this had been the only reason given by the Tax Court for the decision in the taxpayer’s favour, this would have been a narrow fact-based decision with little precedential value in terms of the application of anti-avoidance principles to tax treaties in other situations. However, the Tax Court of Canada also expressed its views on the non-application of anti-avoidance principles even in the event the sale was part of the same series of transactions.

The Federal Court of Appeal did not determine whether the sale and the preceding steps and transactions were part of the same series, but preferred to express its strong views on the anti-avoidance issues even in the event that all steps and transactions were part of the same series. The Court stated that it was unable to see in the specific provisions of the Act and the treaty, interpreted purposively and contextually, any support for the argument that the tax benefit obtained by MIL resulted in an abuse or misuse of the object and purpose of any of these provisions.

The Minister had argued that the 10% test in the treaty should not be read too literally and that the object or purpose of the threshold was that the Luxembourg taxpayer and its affiliates should not have de facto control over the Canadian corporation – in other words, the treaty exemption should be limited to portfolio investments or "non-controlling" interests.

The Court refused to depart from the plain words or read into the treaty provisions a requirement that was not there (but that could easily have been included if the treaty negotiators had so chosen). This offers taxpayers additional comfort that treaties will likely be interpreted in a straightforward way based on their actual wording. While the text of a treaty is to be interpreted in a contextual and purposive way, this cannot result in the reading in of an additional requirement for access to a treaty exemption that is not apparent on the face of the treaty.

There was also some brief discussion by the Federal Court of Appeal about the appropriateness of "double non-taxation". The Minister had argued that the purpose of tax treaties is to relieve against double taxation, not to encourage double non-taxation. In the MIL case, Luxembourg apparently did not impose capital gains tax on the share sale transaction although the treaty would have permitted Luxembourg to do so. If the treaty applied to preclude Canada from imposing capital gains tax, the result was that neither Canadian nor Luxembourg tax applied to the capital gain. The Federal Court of Appeal was not troubled by this result and stated merely that "the issue raised by GAAR is the incidence of Canadian taxation, not the foregoing of revenues by the Luxembourg fiscal authorities".

It seems clear that tax planning designed to access the benefits of Canada’s tax treaties is alive and well. If the Minister wishes to pursue the application of anti-avoidance principles to treaties, it may be possible to achieve this only by re-negotiation of individual treaties to add limitations on benefits or other specific anti-avoidance provisions. This is essentially the approach that the United States has pursued with its network of tax treaties. The Crown has decided not to seek leave to appeal the decision to the Supreme Court of Canada.

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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