In November, the SCC rejected Ottawa’s claim that the taxpayer, a Luxembourg resident, should be denied the benefit of the Canada-Luxembourg tax treaty because it engaged in treaty shopping and its economic ties to Luxembourg were insufficient. In its decision, the SCC ruled that the federal government cannot use the general anti-avoidance provisions (GAAR) of the Income Tax Act to displace the tax benefits contemplated by the international treaty.
“The court made it clear that treaty shopping, even if regarded as morally reprehensible, does not constitute abusive tax planning,” said David Rotfleisch of Toronto tax boutique Rotfleisch & Samulovitch P.C.
The decision involved large capital gains arising from Alta Energy Luxembourg SARL’s sale of the shares of its wholly-owned Canadian subsidary, Alta Energy Partners Canada Ltd., a shale oil developer in Northern Alberta.
The Luxembourg-resident parent claimed an exemption from Canadian income tax under the Canada-Luxembourg Tax Convention 1999. But the Canada Revenue Agency maintained that GAAR operated to deny the exemption: because the parent’s ties to Luxembourg were insufficiently substantive and the company had engaged in treaty shopping, CRA argued, resort to the exemption was an “abuse” or “misuse” that triggered the anti-avoidance provisions.
But a majority of six judges on the nine-member court rejected the CRA’s argument.
“The court recognized that the treaty was a deliberate policy decision reached after negotiation between two sovereign nations and that the CRA should not expect judges to stomp on everything the Agency deemed objectionable,” Rotfleisch said.
As the majority saw it, GAAR was applicable only if the court ascertained that what the taxpayer had done was abusive in the sense of inconsistent with the treaty’s terms.
“The court reiterated that, short of abusive behaviour, taxpayers are allowed to minimize their tax liabilities,” said Steve Suarez, a tax partner in Borden Ladner Gervais LLP’s Toronto office. “What that means is that even a transaction that is entirely tax-motivated is not necessarily abusive, and that it is not the role of the court to make morality judgments.”
Here, the intentions of the treaty partners were clear from the text and context of the treaty. It would not be appropriate, in the majority’s view, to allow Canada to “revisit its bargain” with Luxembourg in a way that precluded certain residents — including those with allegedly insufficient ties to Luxembourg — from treaty benefits. What was appropriate was to respect the way in which the parties defined the requirement of residency under their domestic law. From the latter perspective, the parent company was undeniably a Luxembourg resident.
GAAR, the majority added, was intended to apply to unforeseen tax planning strategies. Alta Luxembourg’s use of a conduit corporation, however, was not unforeseen when the treaties were negotiated and could have been —but was not — addressed through a variety of additional anti-avoidance provisions.
“Indeed, in agreeing to include the carve-out in the Treaty , Canada sought to encourage investments by Luxembourg residents in business assets embodied in immovable property located in Canada (e.g. mines, hotels, or oil shales) and to reap the ensuing economic benefits,” the majority wrote. “This incentive was never intended to be limited to Luxembourg residents with ‘sufficient substantive economic connections’ to Luxembourg. Internationally, residency typically does not depend on the existence of such connections; formal criteria for residency are just as well accepted as factual criteria.”
According to Suarez, Ottawa was asking the SCC to do something that it wouldn’t do for itself.
“At no point did Ottawa pass a domestic law to combat treaty shopping, which is something it considered in 2014 and abandoned,” he said. “Nor has it published any technical explanation as to how treaties should be interpreted, like the one that exists for the Canada-U.S. treaty.”
More recently, 96 countries, including Canada and many of its treaty partners (but not the U.S.) have signed and ratified the OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), which came into force in 2018. The MLI introduces the principal purpose test (PPT), which discourages treaty shopping by denying benefits where the principle purpose of an arrangement or transaction is to secure the benefit, unless granting the benefit would accord with the object and purpose of the treaty.
But William Innes, a veteran Toronto tax lawyer, is highly critical of the SCC ruling.
“The case illustrates that, with the departure of Chief Justice Beverley McLachlin and Justice Marshall Rothstein, there’s no judge on the court with a significant background in tax,” he said. “The majority’s reasoning is a very brittle, kind of ‘gotcha’ approach, and harkens back to the way courts interpreted tax treaties in the eighties by disregarding, among other things, the economic reality that the parent company was nothing more than a file in the office of some company registrar.”
However that may be, Innes expects that the feds will likely attempt to negate the ruling with an amendment to the Tax Convention Interpretation Act, a course they proposed but did not pursue in 2013.
“After all, the Tax Convention Act was originally passed to reverse a 1982 SCC tax decision holding that guarantee fees weren’t interest and therefore not subject to withholding tax under Canada’s tax treaty with Germany.”