INSIGHT: The MLI and its Impact on Canada’s Bilateral Tax Treaties

The Organization for Economic Co-operation and Development (OECD) Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) was intended to provide an efficient means to implement tax treaty measures that were contained in the OECD/G-20 Base Erosion and Profit Shifting (BEPS) project, and will modify a very large number of existing bilateral tax treaties (covered tax agreements).

The MLI applies to a covered tax agreement (CTA) where both parties have signed the MLI and notified the OECD that the MLI applies to such treaty.

Procedural Status of the MLI

Canada signed the MLI in June 2017, and listed 75 of its 93 tax treaties as CTAs. The number of CTAs is expected to increase when Canada deposits its instrument of ratification with the OECD. Other signatories to the MLI include most of Canada’s significant trading partners except the U.S.

Canadian legislation to ratify the MLI received royal assent on June 21, 2019, and Canada is expected to deposit its instrument of ratification with the OECD in the near future.

As of June 28, 2019, 29 signatories have deposited their respective instruments of ratification with the OECD, including Australia, Singapore, France, Ireland, Luxembourg, Netherlands, and the U.K.

The MLI will enter into force for Canada on the first day of the month beginning three months after Canada deposits its instrument of ratification with the OECD. Where the MLI is already in force for the counterparty to a CTA, the MLI will then enter into effect for that CTA for:

• withholding taxes, on the first day of the first calendar year that begins on or after the date of entry into force for Canada; and
• for other taxes (such as taxes on capital gains), for tax years beginning six months after the MLI enters into force for Canada.

For example, if Canada deposits its instrument of ratification with the OECD in September 2019 and the MLI is already in force for a counterparty to a CTA, the MLI will enter into effect for that agreement:

• on January 1, 2020 for withholding taxes; and
• for other taxes, for tax years beginning on or after July 1, 2020 (which for calendar year taxpayers would be January 1, 2021).

The MLI will not affect Canada’s tax treaties with the U.S. and with Germany and Switzerland (with which Canada has announced bilateral treaty negotiations).

Mandatory Provisions

All signatories to the MLI, including Canada, must agree to certain minimum standards on treaty abuse and improving dispute resolution.

The minimum standard to address treaty abuse consists of two aspects:

• an amended preamble, stating that the applicable CTA is intended to eliminate double taxation “without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance” (including through certain treaty-shopping arrangements); and
• a broad anti-avoidance rule, referred to as the principal purpose test (PPT), as discussed in further detail below.

In addition, Canada has agreed to implement the MLI’s minimum standard with respect to the dispute resolution features of its tax treaties, and has also agreed to adopt mandatory binding arbitration to assist in resolving treaty-based disputes in a timely manner.

Application of the PPT—Interaction with the GAAR

Under the PPT, a treaty benefit may be denied where it is reasonable to conclude that one of the principal purposes of any arrangement or transaction was to obtain such benefit, unless it is established that granting the benefit would be in accordance with the object and purposes of the relevant provisions of the treaty.

There are certain structural similarities between the PPT and the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (Canada) (the Act).

Both provisions require:

• the presence of a tax benefit (including under a tax treaty);
• a determination of the primary or principal purposes behind a transaction or arrangement; and
• a determination of whether the tax benefit or transaction is consistent with the object and purpose of provisions in either the Act or a tax treaty.

Since the GAAR may apply to any tax benefit provided under a tax treaty (as a result of section 4.1 of the Income Tax Conventions Interpretation Act), there is significant overlap between the scope of the PPT and the GAAR.

In general, the Canadian tax consequences of a transaction must first be determined under the Act, before any tax reduction under a tax treaty is applied. For example, where a Canadian corporation pays a dividend to a nonresident taxpayer, the Act generally imposes withholding tax at a rate of 25% (see subsection 212(2) of the Act).

Next, the taxpayer must determine whether any tax treaty applies to, for example reduce the applicable withholding tax rate. If the PPT applies to the transaction, no benefit under the relevant treaty would be available and the applicable withholding tax rate would remain at 25%, and it would be unnecessary for the GAAR to apply. On the other hand, if the PPT does not apply and a treaty benefit is available to a taxpayer, the GAAR should not apply either, given the similarities of the two rules.

Although the Canada Revenue Agency (CRA) suggested at the 2017 CTF Annual Tax Conference Roundtable that it may seek to apply both the PPT and the GAAR as alternate assessing positions, such an approach is likely to create significant and, for the reasons described above, unnecessary additional litigation costs for all parties without any revenue benefit to the CRA.

Application of the PPT—Determining Object and Purpose

Similar to the “misuse and abuse” stage of the GAAR analysis, the application of the PPT requires a determination of the object and purpose of relevant provisions in the treaty. In Alta Energy Luxembourg S.A.R.L. v. R (Alta Energy), the Tax Court of Canada considered the object and purpose of an exempting provision in the Canada–Luxembourg tax treaty (Luxembourg Treaty) in the context of the GAAR (the decision is currently under appeal to the Federal Court of Appeal).

In Alta Energy, the taxpayer (a resident of Luxembourg) disposed of shares of a wholly-owned Canadian subsidiary which were “taxable Canadian property,” and claimed an exemption from Canadian income tax on the resulting capital gain under the Luxembourg Treaty (Gain Exemption). Although the value of shares of the Canadian subsidiary was derived principally from immovable property in Canada (which would ordinarily allow Canada to impose income tax on the resulting gain under Article 13(4) of the Luxembourg Treaty), the court found that the Canadian subsidiary’s business was carried on in such immovable property, which entitled the taxpayer to qualify for the “Excluded Property” exception from Article 13(4).

Among other things, the Tax Court of Canada found that the GAAR did not apply to deny the benefit of the Luxembourg Treaty to the taxpayer since the relevant transactions (which involved the formation of the taxpayer and the taxpayer’s acquisition of shares of the Canadian subsidiary) did not involve a misuse or abuse of either the Act or the Luxembourg Treaty.

The court in Alta Energy found that the preamble of the Luxembourg Treaty, which referenced “the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes,” indicated the general purpose of the treaty but was vague regarding the application of specific articles (see Alta Energy, para. 77).

Since parties to a tax treaty are presumed to know the other country’s tax system when negotiating a tax treaty (including the fact that Luxembourg does not tax capital gains where the conditions of the Luxembourg participation exemption are met), the court concluded that Canada could have insisted on a narrower Gain Exemption if it wished to limit the Gain Exemption to scenarios of potential double-taxation (see Alta Energy, para. 85).

The court also found that there was nothing in the Luxembourg Treaty which suggests that a single-purpose holding corporation cannot avail itself of benefits under the treaty, or that a corporation resident in Luxembourg could not access benefits under the treaty simply because its shareholders were not residents of Luxembourg (see Alta Energy, para. 91). The court made a comparison to the Canada-U.S. tax treaty, which included a detailed “limitation-on-benefits” clause (in Article XXIX-B) that was not present in the Luxembourg Treaty (see Alta Energy, para. 94).

According to the court, the purpose of the “Excluded Property” exception in Article 13(4) of the Luxembourg Treaty is to exempt residents of Luxembourg from Canadian taxation where there is an investment in immovable property used in a business, and the taxpayer’s transactions were consistent with this purpose (see Alta Energy, para. 100).

It is unclear to what extent a Canadian court’s view of the object and spirit of a CTA will change after the MLI is in effect for that agreement.

As amended by the MLI, the preamble of all CTAs will proclaim an intention not to create opportunities for “non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs […] for the indirect benefits of third jurisdictions).” (see Article 6(1) of the MLI).

This language is more specific than the preamble language considered by the court in Alta Energy, and may be considered relevant to the object and purpose of a CTA for purposes of the PPT. In the context of statutory interpretation, commentators have observed that “the primary … function of preambles is an articulation of the mischief or purpose of the legislation” (see K. Roach, “The Uses and Audiences of Preambles in Legislation”, 2001, 47 McGill LJ 129. See also, R. Sullivan, ed., Driedger on the Construction of Statutes, 3d ed. (Toronto: Butterworths, 1994) at 259 to 261).

On the other hand, courts often tend to give greater weight to specific provisions within legislation than to preambles, consistent with the court’s judgment in Alta Energy.

One could persuasively argue that the MLI-modified preamble may not accurately reflect the object and spirit of more specific provisions (such as the Gain Exemption in the Luxembourg Treaty), and should therefore be given limited weight when applying the PPT.

The tension between the modified preamble and pre-existing treaty provisions is highlighted by the fact that pre-existing provisions may have been negotiated many years before the modified preamble entered into effect, particularly if such treaty provisions were not otherwise amended as a result of the MLI’s implementation.

The CRA has not generally been successful in using the GAAR to challenge what it considers to be “treaty-shopping” arrangements (see R v. MIL (Investments) S.A., 2007 FCA 236). It is uncertain whether similar challenges by the CRA will be more successful under the PPT, which requires analyzing many of the same issues as under the GAAR.

In some of Canada’s CTAs, the relative uncertainty of the PPT may be replaced or supplemented with a more objective test. Canada’s Department of Finance announced in May 2018 that it intends where possible to adopt a limitation-on-benefits provision (in addition to or in replacement of the PPT) through bilateral negotiations.

Optional Provisions

In addition to the mandatory provisions described above, Canada has also announced its intent to adopt some of the optional MLI provisions, by removing its provisional reservations against these provisions. An optional provision will modify a CTA if neither party to the agreement registers a reservation against such provision.

Additional Provisions to be Adopted

Canada intends to adopt Article 8(1) of the MLI, which adds a one-year holding period requirement to treaty-based dividend withholding tax reductions that depend on levels of ownership. One representative example of this type of reduction, commonly found in Canada’s tax treaties, is Article 10(2)(a) of the Canada–Netherlands tax treaty, which generally limits withholding rates on dividends to 5% if the beneficial owner of the dividend is a company which owns at least 25% of the capital, or controls at least 10% of the voting power, of the dividend payer (if this ownership threshold is not met, the withholding rate is only reduced to 15% under Article 10(2)(b)).

Article 8(1) of the MLI would cause the 5% rate described above to apply only where the dividend recipient satisfies the 10% ownership requirement throughout a 365-day period that includes the date of the dividend payment (such 365-day period can include periods both before and after the dividend payment).

The second optional provision would add a one-year look-back testing period when determining whether capital gains on a sale of equity interests (including shares) should be exempt from source country taxation.

Although Canada’s domestic “taxable Canadian property” rules impose a five-year look-back period for determining whether shares and equity interests derive their value principally from Canadian real or resource properties (and are therefore “taxable Canadian property”), many of Canada’s tax treaties exempt gains from being taxed in Canada where the equity interests sold by a resident of the other state do not derive their value principally from immovable property in Canada at the time of disposition.

Article 9(1) of the MLI, which Canada proposes to adopt, will allow the source country to tax such gains if the relevant value threshold is exceeded at any time during the 365 days preceding the disposition. The same provision also ensures that CTAs allow source countries to tax the disposition of both shares and other comparable interests (such as interests in partnerships and trusts) where the relevant immovable property threshold is met, although this is already a feature of most of Canada’s tax treaties.

Canada has also agreed to adopt Article 4(1) of the MLI, which adds certain factors that competent authorities should take into account when resolving dual resident entity cases—including “place of effective management, place where the entity is incorporated or otherwise constituted and any other relevant factors.” In addition, Canada intends to adopt a provision that allows treaty partners to move from an exemption system as their method of relieving double taxation to a foreign tax credit system—although the general trend for many years has been for countries (including Canada) to provide an exemption system rather than a foreign tax credit system.

Potential for Future Changes

Unfortunately, Canada has not announced an intention to remove its reservation on Article 7(4) of the MLI—which would allow treaty benefits that would otherwise be denied under the PPT to be granted in full or in part by the competent authorities in appropriate circumstances.

For example, assume that an investor would be entitled to a 15% withholding tax rate on dividends had it made a direct investment into Canada, but instead invests into Canada through an intermediary that would have been entitled to a 10% withholding tax rate absent the PPT. A denial of treaty benefits under the PPT could lead to a 25% withholding tax rate on dividends to the investor.

However, Article 7(4) would provide a specific mechanism to allow the investor to access the 15% rate notwithstanding the application of the PPT—if the CRA determines that the 15% rate would have applied had the investor invested into Canada directly. This provision is particularly important for ensuring that the tax consequences of any application of the PPT are reasonable and not unduly punitive towards private equity and other collective investors that may be resident in multiple jurisdictions. We hope that in the near future, Canada will remove its reservation to Article 7(4).

Reservations against optional provisions in the MLI can generally be removed with an Order-in-Council and without Parliamentary consent. Therefore, Canada has the flexibility to adopt additional MLI provisions at a later date. Canada may also make further modifications to its provisional reservations (beyond those discussed above) when depositing its instrument of ratification with the OECD, but to date there have been no indications of any further modifications from the Department of Finance.

We note that certain MLI provisions which would expand the permanent establishment (PE) threshold (in Articles 10, 12, and 13) may have significant impacts on both taxpayers and Canada’s taxing rights if adopted, since any expansion of source country taxing rights (through a lower PE threshold) would require the resident jurisdiction to provide additional relief from double taxation. We hope that Canada exercises caution when considering the removal of its reservations against these PE-related provisions.

Conclusion

The MLI is expected to result in significant changes to a majority of Canada’s tax treaties, likely as soon as January 1, 2020 (for withholding taxes).

Some of these changes are technical in nature (such as in the case of new holding period tests to qualify for withholding tax reductions on dividends and exemptions on capital gains), while other changes, such as the introduction of the PPT, may create significant uncertainty for the application of Canada’s tax treaties.

Matias Milet is a Partner and Taylor Cao is an Associate at Osler, Hoskin & Harcourt LLP, Toronto.

The authors would like to thank Patrick Marley, Kaitlin Gray and Joe Stonehouse of Osler for their comments and assistance in the preparation of this article.