Global Tax Alert (News from Americas Tax Center) | 17 April 2014

Canada’s proposed treaty shopping framework could affect private equity investments

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In the Federal Budget tabled on 11 February 2014, the Canadian Government suggested certain measures it might implement to curtail “treaty shopping” by nonresidents investing in Canada, and announced a new (second) round of consultations in relation to the proposed measures. In the 2013 Budget, the Government had announced the first round of treaty shopping consultations, and its specific comments in the 2014 Budget reflected the public input received. Based on the direction the Government appears to be heading, these measures could affect private equity investments in Canadian real property, such as interests in oil and gas exploration and production companies. To further advance the consultation process and discussions, the Department of Finance set out the main elements of a proposed rule to address treaty shopping. While the announcement did not include draft legislation, the Government did provide insights on possible direction of future legislation.

The Canadian Government's specific comments about what a Canadian treaty shopping rule might look like have garnered widespread discussion throughout the private equity and international investment community. The Government's comments are focused on the prevention of what it perceives to be the improper use of treaties by nonresidents who invest in Canada. Although the Government did not specifically address private equity holding company structures, the framework is sufficiently broad to potentially negatively affect those structures.

For example, if Canada introduces anti-treaty shopping provisions that apply to deny treaty benefits when a holding company disposes of taxable Canadian property (TCP), then 50% of any such capital gain would be taxed at a rate of 25%. This tax would be collected by the purchaser through a specific Canadian withholding process for dispositions of TCP.

Below is a summary of the proposed conceptual framework for the anti-treaty shopping rule, followed by certain practical implications to consider when evaluating holding company structuring alternatives for investments into Canada on a go-forward basis.

Budget 2014 implications

After a first round of comments, the 2014 Budget proposal appears to signal the Canadian Government's intention to move forward with a general, domestic anti-treaty shopping rule, as opposed to attempting to renegotiate some or all of Canada's income tax treaties. The 2014 Budget proposal concludes that a specific rule (such as a US-style limitation of benefits provision) would not capture “all forms of treaty shopping,” and that a treaty-based approach would not be as effective as a domestic law rule (presumably because of the inability to renegotiate treaties in a reasonable period).

The main elements of the proposed anti-treaty shopping framework are as follows:

  • Main purpose provision: Subject to the relieving provision (see below), a treaty benefit would not be provided to a person for an amount of income, profit or gain if it is reasonable to conclude that “one of the main purposes” for undertaking the transaction, or a transaction that is part of a series (e.g., use of a holdco), that results in a benefit for the person, was for the person to obtain the benefit.
  • Conduit presumption: It would be presumed, in the absence of proof to the contrary, that one of the main purposes for undertaking a transaction resulting in a treaty benefit (or that is part of a series resulting in the benefit) was for a person to obtain the benefit if the relevant treaty income is primarily used to pay, distribute or otherwise transfer, directly or indirectly, at any time or in any form, an amount to another person or persons that would not have been entitled to an equivalent or more favorable benefit had the person or persons received the relevant treaty income directly.
  • Safe harbor provision: Subject to the conduit provision, it would be presumed, in the absence of proof to the contrary, that none of the main purposes for undertaking a transaction was for a person to obtain a treaty benefit if:
  • The person (or a related person) carries on an active business (not including investment activities) in the relevant treaty jurisdiction that is substantial in relation to the activity carried on in Canada giving rise to the relevant treaty income;
  • The person is not controlled, directly or indirectly in any manner whatever, by another person or persons that would not have been entitled to an equivalent or more favorable benefit had the person or persons received the relevant treaty income directly; or
  • The person is a corporation or a trust, the shares or units of which are regularly traded on a recognized stock exchange.
  • Relieving provision: If the main purpose provision applies in respect of a benefit under a tax treaty, the benefit is to be provided, in whole or in part, to the extent that is reasonable under the circumstances.

The 2014 Budget proposal notes that the Organisation for Economic Co-operation and Development (OECD) is expected to issue recommendations on treaty shopping in September 2014, as part of its Base Erosion and Profit Shifting (BEPS) Action Plan initiative, and that these recommendations will be relevant in developing a Canadian approach to address treaty shopping. Therefore, the timing may be linked with the BEPS timeline, and it is possible that the Canadian Government will not move forward with a specific treaty shopping rule prior to considering the OECD recommendations in this regard.

Practical implications for private equity investors

The 2014 Budget proposal is merely a conceptual framework and the Department of Finance has not yet released draft legislation. Private equity investors will generally be interested in how the “main purpose test” and “conduit provision” will apply in practice. In particular, will the Canadian tax authorities conclude that having a valid business purpose is sufficient “proof to the contrary” that “one of the main purposes” for using a super-holding company was not to obtain the benefits of a particular treaty, notwithstanding the jurisdiction of the holding company? Further, even if the conduit presumption is not satisfied, it is not clear whether the holding company can rely on the safe harbor provision because of the uncertainty regarding whether the holding company may be viewed as being controlled by the general partner, notwithstanding its limited indirect economic interest in the holding company.

Notwithstanding the foregoing, the increased scrutiny that Canada and other jurisdictions are placing on holding company structures reinforces the need to bolster and provide substance for recommended super-holding company structures (e.g., Luxembourg or Netherlands holdcos that are managed and controlled in their country of incorporation and own multiple investments in multiple jurisdictions). With respect to Canada, the following reflects an understanding of certain key points of Canada's potential anti-treaty shopping provisions:

  • Existing holding company structures into Canada are not expected to be “grandfathered,” meaning that any change in law or approach could apply to new or existing holding company structures. In particular, the Canadian Government indicated the new rule would apply to tax years commencing after enactment of the new rule. However, it also requested comments as to whether transitional relief would be appropriate.
  • It appears as though Canada may not introduce any actual draft legislation before the OECD's BEPS plan is released in September.
  • The genesis of the proposed anti-treaty shopping provisions appears to be a focus on two primary sets of circumstances:
  • Treaty benefits related to the disposition (directly or indirectly) of taxable Canadian property
  • Treaty benefits related to interest and dividends

Despite the likelihood of the introduction of a Canadian treaty shopping rule with the elements discussed above, it is hoped that many recommended investment structures will continue to be viable if properly structured, implemented and maintained for investments into Canada. This remains to be seen. The proposals do, however, strengthen the need for recommended leading practices to be followed and maintained (substance of super-holding companies, as well as non-tax reasons for international holding companies – governance, location of key employees/technical resources, multiple jurisdictional holdings, mitigating the administrative burdens and compliance filing requirement of funds' partners), as well as consideration to be given to flexibility and possible unwinds in the event of adverse legislation. If the framework ultimately moves towards enactment and such provisions negatively affect an existing holding company structure, funds could consider the viability of a look-through approach or substantive strategies to crystallize any inherent gain and/or evaluate basis strategies.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (Canada), Calgary
  • Warren W. Pashkowich, Energy Segment Market Tax Leader
    +1 403 206 5168
  • Karen R. Nixon, International Tax Services
    +1 403 206 5326
  • Dean W. Radomsky, Canadian Tax Services
    +1 403 206 5180
Ernst & Young LLP (Canada), Toronto
  • Heather Kerr, FS Tax Leader
    +1 416 943 3162
Ernst & Young LLP, New York
  • Jeffrey L. Hecht, Americas Private Equity Tax Leader
    +1 212 773 2339
  • Gerald E. Whelan, Jr., Private Equity Tax
    +1 212 773 2747
Ernst & Young LLP, New York, Houston
  • Deborah L. Byers, Energy Market Segment Tax Leader
    +1 713 750 8138
  • Greg M. Matlock, Transaction Tax
    +1 713 750 8133

EYG no. CM4358