Canada: Reducing Barriers To Foreign Investment In Canada?

The authors would like to thank Fred Purkey of Davies Ward Phillips & Vineberg LLP for his helpful suggestions respecting this piece.

Reprinted from Tax Notes Int'l, March 10, 2008, p. 885 VOLUME 49, NUMBER 10 MARCH 10, 2008

A nonresident of Canada is subject to Canadian mainstream tax on a disposition of some types of Canadian-nexus property, called taxable Canadian property (TCP), unless a treaty exemption is available. To ensure the collection of the tax from nonresidents, section 116 of the Income Tax Act (Canada)1 provides a set of compliance requirements applicable to the vendor and purchaser of TCP. This section 116 certificate procedure has been besetting foreign investors in Canada for more than 35 years, and discontent with it has been festering since the recent advent of megabuck cross-border private equity acquisitions. 2

It is ironic that issues with the section 116 certificate requirements saw both their most egregious manifestation and an initiative for a favorable resolution within the past six weeks. The ostensible solution comes, unexpectedly, from the Canadian federal government's February 26, 2008, budget proposals.

The budget proposals seek to limit, beginning in 2009, the application of the section 116 certificate requirements and tax return filing obligations of nonresidents disposing of TCP, to reflect the benefits offered to residents of countries with which Canada has tax treaties. Unfortunately, the initial design of the proposals may be inadequate to achieve the stated aims.

I. Nonresidents Disposing of TCP

Substantive Rules

Under the ITA, a nonresident of Canada is subject to Canadian mainstream income tax when either that person has been employed in Canada, has carried on business in Canada, or has disposed of TCP. 3 This entails tax being imposed on net income at the fairly substantial rates of tax applicable to Canadian corporations and individuals. 4

Considering this paradigm, when a nonresident of Canada disposes of property and realizes a gain, a determination must be made of whether the profit is ordinary business income or a capital gain: The distinction, rooted in case law, is fundamental because business income is fully taxable whereas only one-half of capital gains are taxable. If the profit is ordinary income, regardless of the location or nature of the property, if the gain is derived from carrying on a business in Canada,5 the net profit therefrom would be subject to Canadian tax. If the gain is considered a capital gain, Canadian tax will arise only when the property sold meets the definition in subsection 248(1) of TCP.

Contrary to the more limited approach of many countries, including the United States and the United Kingdom, nexus to the Canadian tax system, through the term "taxable Canadian property,'' encompasses a broad list of properties, including:

  • real property situated in Canada;
  • property used in a business carried on in Canada;
  • a share of a private Canadian company or unlisted share of a publicly traded Canadian company;
  • a share of a private nonresident company if, at any particular time during the previous 60-month period, (i) the fair market value of all of the properties of the corporation each of which was a TCP, a Canadian resource property, a timber resource property, an income interest in a trust resident in Canada, or an interest in or option in respect of such property was greater than 50 percent of the FMV of all of its properties, and (ii) more than 50 percent of the FMV of the share was derived directly or indirectly from one or any combination of real property situated in Canada, Canadian resource properties, and timber resource properties;
  • a listed share (that otherwise meets the criteria of the previous two items) of a public company if at any time during the previous 60-month period the taxpayer or persons with whom the taxpayer did not deal at arm's length owned 25 percent or more of the issued shares of any class of the capital stock of the corporation; and
  • an interest in a partnership if, at any particular time during the last 60 months, the FMV of all of the properties of the partnership each of which was a TCP, a Canadian resource property, a timber resource property, an income interest in a trust resident in Canada, or an interest in or option in respect of the above properties was greater than 50 percent of the FMV of all of its properties.

Under paragraphs 2(3)(c) and 115(1)(b), when a nonresident has a capital gain from selling TCP, half the gain would be taxed in Canada.

The Canadian tax charged under paragraphs 2(3)(c) and 115(1)(b) may be relieved under one of Canada's tax treaties. Canada has entered into more than 80 tax treaties. Of course, one of the purposes - if not the main purpose - of these treaties is the avoidance of double taxation that might otherwise result in the circumstances contemplated by subsection 2(3).

Regarding gains on the disposition (alienation) of property, Canada's tax treaties generally reflect the following principles:

  • Gains derived by a resident of a contracting state from the alienation of immovable property situated in the other contracting state may be taxed in that other state.
  • Gains from the alienation of business property of a permanent establishment that an enterprise of a contracting state has in the other contracting state, including gains from the alienation of a PE, may be taxed in that other state.
  • Gains derived by a resident of a contracting state from the alienation of shares or other corporate rights in a company, the value of which is derived principally from immovable property situated in the other contracting state, or an interest in a partnership or a trust, the value of which is derived principally from immovable property situated in that state, may be taxed in that state. 6
  • Other gains are taxable only in the contracting state of which the alienator is a resident; that is, they are exempt from taxation in the source state.

The focus of this article is mainly on dispositions by nonresidents of TCP that comprise shares of Canadian resident corporations that would be exempt from Canadian taxation under a tax treaty. The particular procedural issues and the intended ameliorating effects of the February 26 budget are considered next.

The Section 116 Certificate Procedure

The most problematic aspect of the regime applicable to nonresidents disposing of TCP (aside from its overbroad substantive ambit) is the compliance procedures contained in section 116, which have often served to delay, frustrate, and sometimes even derail cross-border merger and acquisition transactions.7 The section 116 certificate requirements are particularly troublesome because they apply even when the disposition of the TCP does not give rise to a gain because it is eligible for a domestic rollover treatment8 or is exempt under a tax treaty.

Section 116 applies to any nonresident person, 9 whether or not that person previously resided in Canada, who disposes or proposes to dispose of some types of TCP and to any purchaser of such property from a nonresident person. Specifically, subsections 116(1) to (5) set out rules respecting notification requirements and a purchaser's liability resulting from the disposition by a nonresident of TCP other than property described in subsection 116(5.2) 10 or "excluded property'' (defined in subsection 116(6)).

When a nonresident person proposes to dispose of TCP other than excluded property, the nonresident may, at any time before the disposition, send a notice to the Canada Revenue Agency setting forth the name and address of the proposed purchaser, a description of the property sufficient to identify it, the estimated proceeds of disposition, and the adjusted cost base to the nonresident of the property at the time the notice is sent. 11 In practice, the optional notice under subsection 116(1) is rarely used.

Once a disposition actually materializes, however, within 10 days the nonresident must send a notice to the CRA. 12 As stated above, the notice must be given by the nonresident regardless of whether the property is disposed of at a gain, and regardless of whether the nonresident is exempt from Canadian tax by virtue of the provisions of a tax treaty. A notice filed by a nonresident person under subsection 116(3) should be accompanied by a payment to the Receiver General equal to 25 percent of the amount, 13 if any, by which the proceeds of disposition of the property exceed its adjusted cost base immediately before the disposition. 14 The amount so paid will not necessarily correspond to the nonresident person's tax liability regarding the disposition, and it is only on filing a tax return for the year under section 150 that the nonresident will be able to claim, or will be obliged to pay, as the case may be, the difference between the amount paid under paragraph 116(4)(a) and the actual amount of his tax liability for the year.

To ensure compliance with the notice and payment requirements of subsection 116(4), the following coercive measures are provided for in the ITA:

  • A late notice results in a penalty of at least $100 but not exceeding $2,500. 15
  • A vendor who has failed to comply with the notice requirement of subsection 116(3) is guilty of an offense and is liable on summary conviction to a fine of not less than $1,000 and not more than $25,000, or to both a fine and imprisonment for a term of not more than 12 months. 16

Unless exonerated under the "reasonably inquiry'' safe harbor, 17 the purchaser of TCP other than excluded property is liable to withhold and remit to the CRA, on behalf of the nonresident, 25 percent18 of the amount, if any, by which the cost to the purchaser of the acquired property exceeds the certificate limit fixed by the certificate, if any, issued under subsection 116(2). Therefore, usually the 25 percent withholding is applied on the gross proceeds from the sale. The purchaser withholds this amount at the time of sale and, if a certificate is not furnished by the vendor within 30 days from the end of the month in which the sale occurs, remits the amount to the CRA by the end of that period, unless (security) arrangements acceptable to the CRA have been made.

The frustration with the section 116 certificate requirements arises mainly with the operation of the purchaser withholding rule in subsection 116(5). A combination of an increased number of transactions, 19 greater amounts at issue, an understaffed CRA, and closer scrutiny applied to most transactions has resulted in extremely lengthy delays (usually one year and even as long as two years) for issuing clearance certificates.

In that context, to reduce the costs and complications associated with remittance to the government of the amounts withheld, the CRA has adopted the administrative practice of issuing comfort letters allowing the purchaser to retain (in escrow) the amounts withheld without interest or penalty pending the issue by CRA of the clearance certificate. Nonetheless, considering the delays, in many cases, the purchaser's withholding on the gross proceeds is very harsh. 20

Significantly, no notice must be given to the CRA under subsections 116(3) or (5.2) for property that is excluded property, and the purchaser of property that is excluded property will have no liability under subsections 116(5) or (5.3). An excluded property is defined in subsection 116(6) and includes:

  • a property (other than real property situated in Canada, a Canadian resource property, or a timber resource property) described in the inventory of a business carried on in Canada by the nonresident;
  • a share of a class of the capital stock of a corporation that is listed on a designated or recognized stock exchange; 21 and
  • a unit of a mutual fund trust (defined in subsection 132(6)).

Nowhere do the section 116 rules specifically address a vendor that is a partnership (with nonresident members). However, the CRA has long taken the position that the rules do apply on a look-through basis. Given the potential punitive results under section 116, that position is invariably observed by parties to a deal. 22

II. Issues for Private Equity Funds

The horizon for the hold period of a target of a private equity group renders the foregoing rules and issues particularly pertinent. The very nature of private equity investment structures (at least in the case of those that do not - as may now be emerging - entail publicly traded entities23) sees a finite life of the private equity fund, and, as a result, an overall plan of acquisition and investment generally includes structuring elements relevant to an eventual divestiture.24

That private equity focus in the case of Canada as a target country of a foreign-based private equity group always makes applicable the divestiture tax issues discussed herein. In contrast, they are not necessarily encountered when a foreign industry buyer is involved. 25

And the Canadian-type issues do not arise in those countries that do not generally tax foreign sellers of domestic company stock. These countries include the United States (in general terms in a non-real-estate or resource sector), Australia (regarding recent legislative changes, again in the non-real-estate or resource sector), Belgium, and the United Kingdom. 26

The section 116 compliance rules particularly complicate cross-border acquisitions of Canadian targets by foreign-based private equity groups that are structured in partnership format. Either the substantive or procedural factor may lead a private equity group to undertake structuring complexities - involving treaty country-based arrangements - which have their own costs and challenges. 27

In that context, a court decision in June 2007 boded well for those groups that incorporate, in their acquisition or investment structures, holding companies based in countries that have tax treaties with Canada (for example, Barbados, Luxembourg, and the Netherlands) as a means of ameliorating the substantive or procedural divestiture-related issues noted. On June 13, 2007, the Federal Court of Appeal (FCA)28 upheld the August 2006 lower court (Tax Court of Canada, or TCC) decision in favor of the taxpayer in Canada's first treaty shopping case. This entailed a claim for exemption, under the Canada-Luxembourg treaty, from Canadian tax on a gain of C $425 million realized by the taxpayer (MIL), a Luxembourg resident company, on selling its shares of Diamond Fields Resource Ltd. (a Canadian corporation that had discovered one of the world's largest nickel mines at Voisey Bay, Newfoundland) on the 1996 takeover of Diamond Fields by the Canadian mining giant Inco (itself acquired last year by CVRD of Brazil). MIL was owned by a thirdcountry individual and had originally been incorporated in the Cayman Islands and subsequently migrated to Luxembourg.

Although each situation must be evaluated on its own facts and circumstances - and those arising in MIL would be expected to be quite different from a typical private equity group deal - it is significant that the effect of both the FCA and TCC judgments in MIL was to reject claims by the government that treaty shopping should be struck down either (1) as abusive avoidance under Canada's general antiavoidance rule in section 245 as interpreted by the Supreme Court in two 2005 decisions, 29 or (2) as being subject (at least in the case of a pre-2003 treaty, such as the Luxembourg treaty) to the 2003 OECD model treaty commentary advocating an inherent anti-treaty-shopping rule. This may well have played a role in the February 26 budget initiative.

III. The Proposed Fix

The February 26, 2008, Canadian federal budget proposes two changes, effective 2009, intended to simplify the rules that apply to dispositions by nonresidents of TCP and improve the interaction between Canada's domestic tax rules and the rules contained in Canada's income tax treaties. These changes may, at least in part, substantially reduce the compliance burden on foreign investors in Canada.

The first, and potentially most significant, proposal is intended to limit the circumstances when the section 116 requirements apply to a disposition of TCP. This change will not affect a nonresident's substantive Canadian tax exposure, but will restrict or eliminate the section 116 requirements in a way that matches the protection afforded by an applicable tax treaty. This objective is intended to be met by adding a new item, called "treaty-exempt property,'' to the list of excluded properties in subsection 116(6). 30 If that proposal operates properly, it would both dissolve obstacles to closing deals and eliminate the necessity of having part of the divestiture proceeds or collateral security tied up with either the buyer or the government.

Under new subsection 116(6.1), a property will be a treaty-exempt property at the time of the nonresident person's disposition of the property if at that time it is a treaty-protected property (a concept in the current law) and, in the case of a disposition between related persons, the purchaser sends to the CRA, within 30 days after the date of the disposition, a notice to be provided for in new subsection 116(5.02) setting out basic information about the transaction and the vendor.

The key notion, treaty-protected property, is defined in subsection 248(1) 31 as property any income or gain from the disposition of which by the taxpayer would, because of a tax treaty with another country, be exempt from tax under Part I. There are two requirements for a nonresident person to be exempt from Canadian tax under a tax treaty: One pertains to the status of the person as a resident of the treaty country that is eligible for treaty benefits; the other is that the transaction must meet the conditions of an exemption provided for in the treaty.

First, the person must be considered a resident of a contracting state for the purposes of the relevant treaty. Typically, to be a resident of a contracting state, the operative residence article requires that a person be "liable to tax'' in that state by virtue of a specified criterion. Canadian case law has given meaning to the notion of being considered liable to tax in the treaty country. In particular, the Supreme Court of Canada set forth the concept that a person be subject to the most comprehensive form of taxation as exists in the relevant country. 32 The CRA has its own (nonbinding) views on this: It will generally accept that the person is a resident of the other contracting state "unless the arrangement is abusive (e.g. treaty shopping where the person is in fact only a 'resident of convenience').'' 33 This administrative position signals that the CRA may challenge a nonresident's treaty residence based either on Canada's domestic GAAR or on an inherent treaty antiabuse rule. 34

Second, even if a person meets the treaty residence test, it must be determined that the person is not denied the benefits of the exemptions or other relief provided by the treaty by reason of a restriction arising under either the type of limitation on benefit rules spawned by the United States in its 1993 treaty with the Netherlands, and now the hallmark of all of its treaties since, or specific rules related to residents of the treaty country who benefit from special tax regimes in such country. Indeed, the LOB approach was adopted by Canada for the first time in the September 21, 2007, fifth protocol to the Canada-U.S. tax treaty. 35 Under this rule a U.S. resident may be denied benefits of the treaty, including some exemption from Canadian tax on selling shares of Canadian companies. The new LOB provision is exceedingly complex, and treaty benefits under the amended Canada-U.S. tax treaty may often be uncertain.

Arguably, by using the word "would,'' the definition of treaty-protected property does not require that the treaty exemption be certain. To that extent, compliance with the mechanical residence requirements of the particular treaty, as evidenced by a residence certificate or a tax return provided by the seller, should suffice for a qualification as treaty-protected property without a necessity of exploring the possibility of a residence or LOB challenge by the CRA.

Separately, even if there is no doubt respecting the status-related eligibility of the seller for treaty benefits, there may be uncertainty about whether an exemption applies to the particular disposition of TCP. For example, consider the situation of a U.S.-formed corporation that is listed on the New York Stock Exchange36 that sells all of the shares of a Canadian corporation that is a fast-food franchiser operating through corporate-owned storefronts. Assume the price for the shares is $100 million cash (the price established by an earnings multiple) with the target having liabilities of $40 million at the point of the transaction, so that the total price-related value of the target's assets is $140 million. Because the price is based on an earnings multiple, an allocation of the $140 million as between the real estate (the stores) of the target and all of the other non-real-property assets can be made only on a theoretical basis. Assume the buyer has obtained a valuation of the real property at $65 million so that apparently the non-real-property assets have a value of $75 million.

Based on that valuation, the shares would be eligible for exemption under Article XIII(4) of the Canada-U.S. tax treaty and, therefore, would constitute treatyprotected property in the hands of the seller. Based on this analysis, the shares of the Canadian corporation should be excluded property37 and the requirements of section 116 would not apply. However, the buyer may be concerned about the valuation factor noted above and may believe that this puts it at risk, because the CRA or a court could conclude that the value of the real property is not $65 million, but is greater than $70 million, which would disqualify the gain from exemption under Article XIII(4) of the treaty by reason of Article XIII(3). If that were to happen, the shares would not be excluded property and the buyer would be exposed to the subsection 116(5) obligations. There is no cure, under the current budget proposals, for this exposure.

To deal with any uncertainty respecting the first element (residency) of the treaty-protected-property status of the TCP being disposed of, but not necessarily with the second (LOBs) and clearly not the third (eligibility of the transaction for a treaty exemption), the budget proposes to ensure that the purchaser of property from a nonresident vendor need not withhold, under an exclusion under new paragraph 116(5)(a.1), if the following requirements, contained in new subsection 116(5.01), are met:

  • the purchaser concludes after reasonable inquiry that under a tax treaty that Canada has with a particular country, the vendor is resident in that country;
  • the property would be treaty-protected property of the vendor under the tax treaty referred to above if the vendor were resident in the particular country; and
  • within 30 days after the date of the disposition, the purchaser sends to the CRA the notice provided for in new subsection 116(5.02) setting out basic information about the transaction and the vendor.

The rule that a reasonable inquiry safe harbor38 applies to the vendor's residence in a treaty country under a tax treaty that Canada has with that particular country essentially allows the purchaser to assume that the vendor is resident in the treaty country represented, unless there is glaring evidence to the contrary. 39 It may be expected that purchasers will routinely consider filing the subsection 116(5.02) notice to try to protect themselves, but that alone will not completely protect them. 40

This is because subsection 116(5.01) does not provide a safe harbor for the determination of the other elements underlying the notion of treaty-protectedproperty status. For example, it would not provide any protection in the illustration above. In that example, for the buyer to get relief by reason of these proposals, the buyer would have to answer the same question that precluded it from relying on section 116(6), namely whether the shares in fact qualify for an exemption. If the valuation is wrong, for the same reason that there is no certainty of excluded property status for section 116(6), there would be no certainty and thus no relief under the reasonable inquiry provisions that are supposed to provide relief when there is doubt that the property disposed of is excluded property.

In summary, if in the above example it turns out the valuation was correct, there is no subsection 116(5) requirement by reason of the excluded property exception, and there is no need to rely on new subsection 116(5.01). If the valuation is wrong (and the real property is worth more than $70 million), subsection 116(5) obligations do apply and there is no exception under any of the proposals. The buyer in this illustration might decide it has no choice but to insist on receiving a section 116 certificate, the very exercise that this government initiative is supposed to eliminate.

The budget's second change is a proposed exemption from filing a Canadian income tax return for dispositions of TCP.

Currently, a nonresident must file a Canadian income tax return for any tax year in which the nonresident disposes of a TCP, even if the nonresident can claim tax treaty benefits or no Canadian income tax is actually payable. The budget proposes to exempt nonresidents from filing Canadian income tax returns for any tax year in which the nonresident satisfies all of the following criteria contained in the definition of the term "excluded disposition'' in new subsection 150(5):

  • no tax is payable under Part I of the ITA by the nonresident for the tax year;
  • the nonresident is not currently liable to pay any amount under the ITA for any previous tax year (other than an amount for which the CRA has accepted, and holds, adequate security under section 116 or 220 of the ITA); and
  • each TCP disposed of by the nonresident in the year is excluded property for section 116 purposes, or a property regarding the disposition of which the CRA has issued to the nonresident a certificate under section 116 of the ITA.

Given that in most cases the purchaser either will have satisfied itself that the shares being sold are excluded property or will have demanded a section 116 certificate (the third possibility of proceeding under section 116(5)(a.1) being unlikely for the reasons stated above), all of these conditions will generally be readily complied with by a bona fide treaty resident, not subject to an LOB or similar limitation, when the substantive requirements of a treaty exemption are met. Ostensibly, however, if the transaction has proceeded without a certificate under paragraph 116(5)(a.1), the seller seems to be required to file a return.

IV. Concluding Comments

The current substantive Canadian rules for taxing nonresidents who sell shares of Canadian (and some foreign) companies, when either the shares are unlisted or when they are listed and there is or has been a 25 percent or greater interest in any class of stock of the listed corporation, raise potential liability to Canadian tax (subject to treaty relief, if any) and in the case of unlisted shares the onerous procedural rules of section 116. In either case, there are tax return filing obligations.

In any of these situations, the issues are amplified when foreign private equity partnerships are involved because of the flow-through application of these substantive and procedural requirements for each member of the partnership. That, particularly, has raised the matter to the level of an imbroglio that has attracted high-profile protests (apart from attracting or inducing strategies to avoid or minimize the issues through third-country treaty arrangements). Obviously, the imbroglio has been of sufficient concern to the government as to prompt it, in its February 26 budget, to announce measures to try to redress at least the procedural side of the issue.

The government's initiative is certainly welcome and laudatory. The challenge to the legislative drafters has been daunting in light of the patently conflicting interests to be reconciled. In this context, the government's initial proposals are to be commended.

Unfortunately, it appears that the first cut at specific rules to implement the government's clearly stated objective41 has some built-in limitations. These limitations may well impair the objective of providing a broadbased procedural relief to foreign sellers (whether industry players, private equity groups, or institutional investors) that are exempted by treaty from the necessity of obtaining section 116 certificates.

In this context, further thought to the design of the rules would be appropriate. For example, consideration might be given to whether there would be effective relief if the rules included time limitations on the exposure of buyers to obligations under subsection 116(5). This might see a buyer who proceeds to close a sale on the basis that withholding and remittance to the government is not required (by reason of the proposals respecting subsection 116(5) as discussed above) being exposed for only a limited period of time to a contrary determination by the CRA (and resultant liability under subsection 116(5)). With the time limitation (say, one or two years after the deal closes) there might be room for commercially viable arrangements that see the parties proceed by way of a time-limited guarantee by seller to buyer and accessory collateral security arrangements as they consider appropriate and required in the circumstances.

Perhaps, more fundamentally, the government should give thought to extending the reasonable inquiry defense to all elements underlying a treaty exemption, not just the residence-related element. And, separately, at minimum there should be no section 116 requirements when a domestic rollover rule governs the transaction.

Finally, the proposed curtailment of tax return filing requirements should bode well in most circumstances. However, only a repeal of the broad-based taxation of foreign sellers of Canadian corporate shares would fully eliminate the tax obstacles to foreign investment in Canada.


1 R.S.C. 1985, c. 1 (5th Supp.) as amended (ITA). Unless otherwise indicated, section references in this article are to the ITA.

2 See Nathan Boidman, "Private Equity International Acquisitions . A Paradigm Shift?'' Tax Notes Int'l, Sept. 10, 2007, p. 983.

3 Subsection 2(3) and section 115. Canada's mainstream income tax is contained in Part I of the ITA. Separately, a nonresident of Canada may be subject to final withholding tax under Part XIII of the ITA at the rate of 25 percent (subject to treaty reduction) on a variety of passive types of income (such as dividends, interest, and royalties), unless the item of income can be considered to be derived from the conduct of business in Canada (through a domestically defined permanent establishment), in which case it is taxed in accordance with the rules in Part I for income from carrying on business in Canada. In the case of rents from real property, an option is available to avoid the 25 percent withholding tax on gross income by electing, under section 216 of the ITA, to be taxed under Part I on a net basis. The section 216 election is akin to that available in the United States for foreign persons regarding U.S. real property rents. See sections 871(d) and 882(d) of the Internal Revenue Code of 1986 as amended.

4 For 2008 the top combined federal-provincial marginal rate applicable to individuals varies between 39 percent in Alberta and 48.22 percent in Quebec. For 2008 the general combined federal-provincial corporate tax rate varies between 29.5 percent in Alberta and 35.5 percent in Nova Scotia and Prince Edward Island. When a nonresident sells TCP, provincial tax should not apply, but instead a grossed up individual tax rate (top marginal rate of 42.92 percent) and the unabated federal corporate tax rate (29.5 percent) would apply. Some anomalous double taxation may arise on TCP situated in some provinces that administer their own individual or corporate tax system (for example, Quebec).

5 Subsection 248(1) defines a business to include a profession, calling, trade, manufacture, or undertaking of any kind whatever, and an adventure or concern in the nature of trade. The expression "carrying on business'' is generally not defined in the ITA except for a deeming provision in section 253.

6 There is significant variation among Canada's tax treaties regarding the wording of this provision, and may exclude real property in which a non-real-estate business is carried on.

7 Quebec has an equivalent set of provisions in sections 1094ff. of the Quebec Taxation Act (QTA).

8 This means, in U.S. parlance, "nonrecognition'' treatment. The egregiousness of the section 116 rules and their administration by the CRA referred to above became (once again) obvious when on December 17, 2007, the CRA issued its amended interpretation bulletin IT-474R2, "Amalgamations of Canadian Corporations,'' whereby it reversed its previous position, which was that on a tax-deferred amalgamation, the section 116 requirements do not apply to shares held by a nonresident that are converted on the amalgamation. Following an outcry from the tax community, the CRA reverted to its old position in a corrected version of the bulletin dated January 8, 2008.

9 A "person'' is defined in subsection 248(1) in the broadest of terms. When a flow-through partnership that is not a person, such as a private equity partnership fund comprising hundreds or thousands of separate investors, disposes of TCP, the section 116 procedures are especially obstructive since they potentially expose each investor to the compliance requirements. Separately (and generally of no direct application to foreign investment funds or entities) under recent legislation specified income flowthrough (SIFT) partnerships are effectively taxed as though they are persons.

10 Subsections 116(5.2) and (5.3) set out similar rules when the property disposed of is a Canadian resource property or depreciable taxable Canadian property.

11 Subsection 116(1). A notice filed by a nonresident person under this subsection should be accompanied by supporting documentation and a payment to the Receiver General equal to 25 percent of the amount, if any, by which the proceeds of disposition of the property exceed its adjusted cost base immediately before the disposition. A certificate provided by the CRA under subsection 116(2) stipulates a "certificate limit'' equal to the proposed purchase price. This certificate limit may not reflect the purchase price ultimately agreed upon.

12 Subsection 116(3).

13 Subsections 116(5.2) and (5.3) provide a 50 percent rate on depreciable taxable Canadian property. The general rate applicable in Quebec is 12 percent (section 1098 and 1100 QTA), and the Quebec rate applicable to depreciable property is 30 percent (section 1102.2).

14 Alternatively, the nonresident may furnish security acceptable to the CRA regarding the disposition.

15 Recently the CRA has been enforcing the penalty. A corresponding penalty is provided for in the QTA.

16 Subsection 238(1). To the authors' knowledge, the fine and prison sentence has not been enforced in respect of subsection 116(3).

17 The purchaser would be exonerated either if after having made reasonable inquiry, the purchaser had no reason to believe that the vendor was not resident in Canada, or if the Minister has issued to the purchaser a certificate under subsection 116(4) with respect to the disposition.

18 It is 12 percent in Quebec.

19 The problem is not simply closer scrutiny of the proposed transaction, but clearly inappropriate use or exploitation of the section 116 requirements to effectuate audit compliance with unrelated taxation matters (including sales taxes) that may apply to a proposed seller of TCP.

20 For example, assume a nonresident disposes of a substantial investment (say $1 million) with a very small gain (say $10). The purchaser must withhold $370,003.70, or 25 percent federally and 12 percent for Quebec for a total of 37 percent on the gross proceeds of $1,000,010. If it takes one year to obtain the certificate, the vendor loses the use of $370,003.70 of his capital for that period. At 5 percent this yields $18,500 of interest lost. To deal with this issue, sale and purchase agreements are usually drafted to provide for the deposit of the withheld amount in an interest-earning account.

21 Recently enacted Bill C-28 substitutes these terms for the preexisting "prescribed stock exchange'' notion.

22 The only comparable provision in the United States appears to be the much more narrowly focused withholding and compliance procedures under Code section 1445 respecting foreign sellers of U.S. real property interests.

23 For a discussion, see Boidman, supra note 2, at note 15.

24 A recent OECD study ("The Implications of Alternative Investment Vehicles for Corporate Governance: A Synthesis of Research About Private Equity Firms and 'Activist Hedge Funds,''' issued by the OECD Steering Group on Corporate Governance, July 2007; and appendix, "The Implications of Alternative Investment Vehicles for Corporate Governance: A Survey of Empirical Research'') put the matter as follows: Private equity firms are under significant pressure to achieve their target returns and hence work toward a timely exit from their investment. Exits have been running at the rate of around 300 a year in the U.K. and 200 in Continental Europe. However, with the recent surge in deals, some concerns have been expressed about a potential oversupply of exits over four to six years.

25 An industry acquirer scenario generally provides a firm basis, with clear parameters, on which to consider the operation of target-country domestic inbound international tax rules and the treaty network overlay, as well as those of the acquirer's country. If the discussion involves a target country's tax treatment of a future divestiture by the acquiring party, it would not be necessary, in the case of an industry buyer, to consider uncertainties under target country domestic or treaty law, which might arise when partnerships or other flow-through entities are involved.

26 For more information, see the past installments of the TNI Forum on International Mergers and Acquisitions (Boidman, supra note 2, and the accompanying Introductory Note in Tax Notes Int'l, Sept. 10, 2007, p. 981, which summarizes the previous 13 installments).

27 For a work advocating a repeal of these rules, see Stephen A. Hurwitz and Louis J. Marett, "Financing Canadian Innovation,'' C.D. Howe Institute Commentary, no. 244, February 2007.

28 MIL (Investments) S.A. v. Her Majesty the Queen, 2007 FCA 236.

29 Canada Trustco Mortgage Co. v. Canada, 2005 DTC 5523 and Mathew v. Canada, 2005 DTC 5523, and Mathew v. Canada, 2005 DTC 5538. See Nathan Boidman and Francois Barette, "Canadian Supreme Court's Message on Tax Avoidance Transcends Canada,'' Tax Notes Int'l, Nov. 28, 2005, p. 813.

30 As noted above, under the current rules, a sale of excluded property (e.g., most significantly a listed share) is not subject to the section 116 procedures.

31 The definition of treaty-protected property was added to subsection 248(1) by S.C. 1999, c. 22, subsection 80(12), applicable to 1998 et seq.

32 The Queen v. Crown Forest Industries Ltd., 95 DTC 5389 (SCC).

33Income Tax Technical News, no. 35 (February 26, 2007).

34 But, as discussed above, the MIL decision demonstrates the difficulties for the CRA in asserting the position.

35 Canada, but not the United States, has already completed domestic ratification procedures to implement the protocol. For detailed discussions, see Nathan Boidman, Peter Glicklich, Michael Kandev, and Abraham Leitner, "How the New Canada- U.S. Treaty Protocol Affects Business Enterprises,'' Tax Management International Journal, vol. 36, no. 2, Dec. 14, 2007, and Nathan Boidman and Michael Kandev, "Fifth Protocol to the Canada-United States Tax Treaty,'' Bulletin for International Fiscal Documentation (forthcoming in March 2008).

36 Perhaps the only entity that is a resident of the United States under Article IV of the Canada-U.S. treaty and that would be clearly and totally excluded from the LOB provisions (as revised by the protocol) is a U.S.-formed corporation the shares of which are listed on an exchange such as the New York Stock Exchange.

37 It is assumed in this illustration that the seller and buyer are totally unrelated and deal at arm's length.

38 As mentioned in note 17, section 116 currently contains a safe harbor provision for a vendor who is a resident of Canada.

39 The McCarthy Tetrault 2008 Federal Budget Commentary (Toronto: Carswell, 2008) notes, at pp. 1-5: Does a reasonable inquiry require a purchaser to obtain a certificate from the seller as to certain factual matters and possibly an opinion on the residence of the seller under the relevant treaty? It is noted that the requirement in paragraph (a) would be satisfied by making reasonable inquiries even if the purchaser's conclusion were incorrect.

40 A purchaser will certainly require representations and warranties from the vendor that the various criteria for "excluded property'' have been met.

41 The budget paper states the following:

Cross-Border Business and Investment.

Where a "taxable Canadian property'' (TCP) . that is, a property the nonresident's income or gain from the disposition of which may be taxable in Canada . is disposed of by a nonresident, generally the purchaser must withhold a portion of the amount paid, and remit it to the Government on account of the nonresident vendor's possible Canadian tax liability. However, the purchaser's obligation to withhold does not apply if the nonresident vendor obtains a "clearance certificate'' from the CRA or the property is "excluded property'' (most business inventory, listed shares, mutual fund trust units, etc.). To obtain a clearance certificate, the nonresident vendor needs to remit an amount, post security, or satisfy the CRA that no tax will be owing. These rules are contained in section 116 of the Income Tax Act (the Act).

Most tax treaties allow Canada to tax capital gains only on Canadian real and resource properties and on shares of companies that derive most of their value from such properties. (The otherwise taxable properties the income or gains on which a treaty prevents Canada from taxing are called "treaty-protected properties''.)

Currently, section 116 of the Act and its associated rules take no account of the effect of tax treaties. Accordingly, Budget 2008 proposes three changes to streamline and simplify the rules that apply to nonresidents' dispositions of TCP. These changes will make the section 116 process more efficient.

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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