Treaty shopping

By Trent Henry & Jennifer Smith
Illustration: Mike Constable

Court findings show it’s becoming acceptable in the context of structuring crossborder investments

The Tax Court of Canada rendered its much-anticipated decision in MIL (Investments) S.A. v. The Queen, 2006 TCC 460 on August 18, 2006. This is the first case to consider the application of the general anti-avoidance rule in Section 245 of the Income Tax Act to a “treaty shopping” transaction. The taxpayer was successful in convincing Justice R.D. Bell of the Tax Court of Canada that the GAAR did not apply. The Crown has appealed the tax court’s decision. If the approach taken by the court is accepted by the Federal Court of Appeal, the GAAR will have proven to be an ineffective tool for attacking treaty shopping transactions.

By way of background, the Canada Revenue Agency has consistently taken the position that the GAAR can be applied to deny a treaty benefit to a nonresident of Canada who “enters into a series of transactions designed primarily to secure an exemption or reduction from Canadian tax under an income tax convention that Canada has with another country” (Revenue Canada Round Table: Canada-US and International Issues, in Tax Planning for Canada-US and International Transactions, 1993 Corporate Management Tax Conference [Toronto: Canadian Tax Foundation, 1994], 22:1-32, question 11, at 22:9). However, the case of Rousseau–Houle v. The Queen 2001 DTC 250 (TCC) cast serious doubt on whether the GAAR could be applied to treaty benefits. The government responded in the 2004 federal budget by amending Section 245 retroactively to specifically apply to treaty benefits. The pleadings in the MIL case were already drafted at the time of the 2004 amendment to the GAAR, but the tax court nevertheless had to consider it. It is well established that courts must give effect to retroactive legislation contained in tax statutes if it is clearly intended to have retroactive effect.

The taxpayer in the MIL case, a nonresident of Canada, was assessed under the act in respect of a capital gain in the approximate amount of $426 million that was realized on the disposition of shares in the capital stock of Diamond Fields Resources Inc. (DFR), a public company incorporated in Canada and traded on the Toronto Stock Exchange. The taxpayer claimed an exemption from tax under the provisions of the Canada-Luxembourg Income Tax Convention, 1989. Article 13(4) of this treaty exempts the capital gain on immovable property from which a business is carried on and the right to tax immovable property in which the taxpayer owns less than a 10% interest. The Minister dis-allowed the exemption, relying on the general anti-avoidance rule.

The taxpayer was originally a Cayman Islands company and held an 11% interest in DFR. The taxpayer undertook the following transactions:

• June 1995: the taxpayer sold some of its shares in DFR to Inco Ltd. in exchange for Inco shares (tax deferred under Section 85.1). This brought the taxpayer’s interest in DFR to less than 10%.
• July 1995: the taxpayer was continued in Luxembourg. No disposition was triggered on the continuation.
• August 1995: the taxpayer sold the Inco shares it had acquired in June 1995 and claimed exemption from Canadian tax on the $65-million capital gain under Article 13 of the treaty. (The taxpayer was not reassessed in Canada on that gain and paid no tax in Luxembourg because the cost base of the shares for Luxembourg tax purposes was the value at the time of the continuance.)
• May 1996: Inco made a successful takeover bid for DFR. As a result, the taxpayer disposed of all of its remaining DFR shares to Inco in August of 1996.

This final sale to Inco generated the $426-million capital gain that was the subject of the GAAR reassessment. Although the existence of a tax benefit was admitted, the court found there was no avoidance transaction and no abusive tax avoidance. In its analysis, the court went through the orderly three-pronged analysis provided by the Supreme Court of Canada in the Canada Trustco and Mathew cases reviewing whether there was a tax benefit that resulted from an avoidance transaction that resulted in abusive tax avoidance.

On the evidence, the court found that the sale of the shares to Inco was arranged primarily for a bona fide purpose other than to obtain a tax benefit. The court was of the view that the sale of the shares in a tax effective manner did not make the transaction an avoidance transaction.

Somewhat surprisingly the court found that the final sale to Inco could not be included in the series of transactions that began with the first sale of shares to Inco, the transaction that brought its interest in DFR to less than the requisite 10% ownership. It accepted the taxpayer’s arguments that the sale to Inco was not pre-ordained or contemplated at the time. These terms were the ones used by the Supreme Court of Canada in the Canada Trustco case to determine a series of transactions. In Justice Bell’s view: “There must be a strong nexus between transactions in order for them to be included in a series of transactions. In broadening the word ‘contemplation’ to be read in the sense of ‘because of’ or ‘in relation to the series,’ the Supreme Court cannot have meant mere possibility, which would include an extreme degree of remoteness. Otherwise, legitimate tax planning would be jeopardized, thereby running afoul of that court’s clearly expressed goals of achieving consistency, predictability and fairness.”

The court accepted the taxpayer’s evidence that at the time of the first sale and the continuation, DFR had no desire to allow itself to be sold to any buyer. Moreover the sale to Inco could not be included as part of the series because of a mere possibility of a future potential sale of shares at the time of the continuation. The court accepted the taxpayer’s suggestion, among other matters, that the proceeds from the initial sale of shares were needed to repay a $1-million line of credit. It was not swayed by the fact the initial sale generated $65 million of which only $1 million was used to repay that debt.

Having found that there was no avoidance transaction, it wasn’t necessary for the tax court to consider whether the transaction or series of transactions was abusive under subsection 245(4). However, the court indicated, in obiter, that it did not consider the transactions to be abusive, noting there is nothing inherently proper or improper in selecting one foreign regime over another. While the selection of a low tax jurisdiction may speak persuasively as evidence of a tax purpose for an alleged avoidance transaction, the shopping or selection of a treaty to minimize tax on its own can’t be viewed as being abusive. It is the use of the selected treaty that must be examined.

The court also found that, in drafting the exemptions found in Article 13(4) of the treaty, it must be presumed that Canada had a valid reason to allow Luxembourg to retain the right to tax capital gains in those specific circumstances, e.g., the desire to encourage foreign investment in Canadian property. The taxpayer’s reliance upon a treaty provision as agreed upon by both Canada and Luxembourg cannot be viewed as being a misuse or abuse. The court further suggested that Canada, if concerned with the preferable tax rates of any of its treaty partners, instead of applying Section 245, should seek recourse by attempting to renegotiate selected tax treaties.

Finally, the court made some important comments with respect to the so-called inherent abuse rule in the treaty. The Crown presented the following argument: even if the GAAR does not apply to deny the treaty benefit in this case, it is still possible to deny the treaty based on the anti-abuse rule inherent within the treaty itself.

The Crown presented an expert witness, Prof. Alain Steichen, who was qualified as an expert in Luxembourg tax law and income tax treaties to which Luxembourg is a party. The court found Prof. Steichen’s theory that a specific treaty benefit may be denied in situations where both Canadian and Luxembourg domestic anti-avoidance rules would deny the benefit to be “not substantively convincing.” During cross-examination Steichen conceded that “if you want an anti-avoidance rule in the treaty, you should put it in the treaty.” The court went on, “I find there is no ambiguity in the Treaty permitting it to be construed as containing an inherent anti-abuse rule. Simply put, the ordinary meaning of the Treaty allowing the Appellant to claim the exemption must be respected.”

The Crown is obviously dissatisfied with the outcome in this case. In its appeal, it is challenging the court’s conclusion that GAAR does not apply. Specifically it stated the trial judge erred in law in several respects: first, the transactions were not avoidance transactions or part of a series of transactions that resulted in a tax benefit; and second with the court’s views that treaty shopping does not constitute abusive avoidance. It is also challenging the court’s finding that there is no anti-abuse rule inherent in the treaty.

Finally, it included the following rather provocative statement: “The trial judge, in the analysis with respect to Section 245 of the act, based his decision on several erroneous findings of fact made in a perverse and capricious manner and with regard to the material before the court.”

The findings of the court in MIL continue to support treaty shopping as acceptable planning in the context of structuring crossborder investments. Whether this leads to the Canadian tax authorities considering more limitation of benefit type clauses when renegotiating treaties is unknown at this point but rest assured, there will be more developments to report on treaty shopping.

Jennifer Smith, LLB, is a principal with Ernst & Young in Ottawa.

Trent Henry, CA, is leader of international tax services with Ernst & Young in Toronto. He is Technical editor for Taxation