Decision is the first to apply the General Anti-Avoidance Rule to a tax treaty
The old saying “you can’t have your cake and eat it too” may be what the Supreme Court of Canada majority had in mind today when it ruled against the Crown in finding that a foreign company which had a tax treaty with Canada would not have to pay taxes in two jurisdictions.
In a 6/3 decision in Canada v. Alta Energy Luxembourg S.A.R.L., the majority of the Supreme Court upheld the Federal Court of Appeal’s ruling in finding that the Luxembourg company could benefit from a Canadian tax exemption it had claimed for the sale of assets in Canada, since the existing tax treaty – which benefits Canada by encouraging foreign investment in the country – allows this.
The decision is the first to apply the Income Tax Act’s General Anti-Avoidance Rule (GAAR) to a tax treaty, says counsel for the respondent Matthew Williams, a partner in Thorsteinssons LLP in Toronto.
“I suspect [that] played a large role in leave being granted, because it was a first in that regard,” Williams says, adding that there have been fewer than a half-dozen Supreme Court decisions issued that concern the GAAR, the last being in 2011.
The case deals with the GAAR as it applies to Canadian tax treaties, whereas other cases have applied it simply to the Canadian Income Tax Act. “So that was unique, to have to apply this Canadian provision [the GAAR] to a bilateral contract,” Williams told Canadian Lawyer. "The majority were very aware of ensuring that the bargain that was struck between those parties was upheld and wasn't disturbed by an application of the GAAR.”
The General Anti-Avoidance Rule -- section 245 of the Income Tax Act -- empowers the Canada Revenue Authority to deny tax benefits resulting from a tax avoidance transaction that constitutes abuse.
In this case the Supreme Court was asked to consider whether the Federal Court of Appeal erred in law and in fact in concluding that the avoidance transactions used by Alta Luxembourg did not result in an abuse of the relevant provisions: Canada’s Income Tax Act, and the tax treaty between Canada and Luxembourg (Convention between the Government of Canada and the Government of the Grand Duchy of Luxembourg for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital).
“In raising the GAAR, Canada is now seeking to revisit its bargain in order to secure both foreign investments and tax revenues,” wrote Justice Suzanne Côté in her reasons for the majority. “But if the GAAR is to remain a robust tool, it cannot be used to judicially amend or renegotiate a treaty.”
The tax treaty between the two countries exempts Luxembourg companies that profit from selling shares in Canada from paying Canadian taxes, provided that the shares relate to buildings and lands in Canada where the company conducts business. In this case, Alta Luxembourg, an unconventional oil and gas company, had sold its shares in its Canadian subsidiary, Alta Canada, in 2013 at a profit of $380 million, on which it paid taxes in Luxembourg. Alta Luxembourg claimed a tax exemption on its Canadian tax return on the basis that the profit was not “taxable income earned in Canada,” as the company is based in Luxembourg.
The Minister of National Revenue denied the treaty exemption, arguing that the business property exemption of the Treaty did not apply and, in the alternative, if the shares did qualify as treaty‑protected property, that the GAAR should apply.
Under art. 4 of the treaty, “residence” is based on liability to tax in one or both of the contracting states by reason of domicile, residence, place of management, or other similar criterion.
“In the context of corporations, the ‘liable to tax’ requirement is met under the Treaty where the domestic law of a contracting state exposes the corporation to full tax liability on its worldwide income because it has its residence in that state,” wrote Justice Côté for the majority.
“Aside from the ‘liable to tax’ requirement, the purpose of art. 4(1) is not to establish specific standards for defining residence,” and the provision “expressly states that residence is to be defined by the laws of the contracting state of which the person claims to be a resident.”
Luxembourg law grants resident status to corporations having either their legal seat or their central management in Luxembourg, which is consistent with international practice, she wrote.
Application of GAAR
The court defined the application of the GAAR as a three‑part process to determine: (1) whether there is a tax benefit arising from a transaction; (2) whether the transaction is an avoidance transaction; and (3) whether the avoidance transaction is abusive.
To determine the latter, the court established a two‑step inquiry. The first step is to interpret the object, spirit and purpose of the treaty and the true intention of the contracting parties. The second step is to make a factual analysis of whether the avoidance transaction frustrates the object, spirit or purpose of the provisions.
The majority noted that the “object, spirit, and purpose” of the business property exemption provided for under the treaty “are to foster international investment by exempting residents of a contracting state from taxes in the source state on capital gains realized on the disposition of immovable property in which a business was carried on, or on the disposition of shares whose value is derived principally from such immovable property.
“The fact that the capital gains may not be taxed in Luxembourg, leading to double non‑taxation, and the fact that conduit corporations can take advantage of the carve-out are tax planning outcomes consistent with the bargain struck between Canada and Luxembourg,” Justice Côté wrote.
Treaty shopping and tax avoidance
In dissenting reasons, Justices Malcolm Rowe and Sheilah Martin, also writing for Chief Justice Richard Wagner, found that there was abusive tax avoidance because, it said, Alta Luxembourg (itself a subsidiary of an American oil and gas company) had no genuine economic Luxembourg connection. They therefore found that Alta Luxembourg did not meet the residency requirement as a “conduit corporation,” and because of that the company’s Canadian tax exemption frustrated the purpose of the bilateral treaty, even if it did not contradict its strict wording.
“The dissent correctly pointed out that offshore/international tax arrangements, tax planning can be rife with abuse, and it does need to be dealt with,” says Roy Berg of Roy Berg International Tax in Calgary. “They wanted to deal with it under domestic law, essentially overriding the treaty,” he says. ”I think the better place for combating international tax abuse is through the treaty systems.”
The case is really a treaty-shopping case, says Williams, in which the majority of the court “clearly said there is nothing inherently improper in trying to structure your affairs in a way to takes advantage of Canada's tax treaties. Instead, you have to look at what was done to determine whether there was an abuse, not just the intention to try and be tax-efficient.”
Tax avoidance is not tax evasion, Justice Côté pointed out; further, she wrote, “it is also important to distinguish what is immoral from what is abusive.” In the Supreme Court’s decision in Copthorne Holdings Ltd. v. Canada, she noted, Justice Marshall Rothstein observed that courts should not infuse the abuse analysis with “a value judgment of what is right or wrong nor with theories about what tax law ought to be or ought to do.”
“Taxpayers are allowed to minimize their tax liability to the full extent of the law and to engage in ‘creative’ tax avoidance planning, insofar as it is not abusive within the meaning of the GAAR,” she wrote. “Therefore, even though one may consider treaty shopping in tax havens to be immoral, this is not determinative of a finding of abuse.”
One key takeaway from Friday’s decision is “the Supreme Court has indicated that treaties have the effect of law, and they will be respected if appropriately followed,” says Berg. “It gives us certainty, and comfort that you can rely on the treaty.”
A second takeaway he says, the decision “may be another blow [for the government] against applying GAAR” against treaties, and may “show continued weakening of the GAAR standard. However, I think the overriding concern of the court was the supremacy of the treaty,” he adds, it would be “a mistake, as practitioners and taxpayers, to read too much into the loss on GAAR.”
Friday’s decision affirms that “tax planning is not bad,” says Williams. “Tax avoidance is not the same as tax evasion.” The decision is important to taxpayers in general, he adds, since legislators write the law on which taxpayers must rely. The GAAR must therefore have an objective role, “one that taxpayers can objectively discern, rather than rely[ing] on the subjective views of people who may change from time to time to time.”
Interestingly, Berg notes, Luxembourg – a country with only 600,000 or so residents but attractive tax laws -- is Canada’s fourth largest direct investor behind the United States, the Netherlands and the United Kingdom.
“This is the consequence of treaties,” he says, “and so long as you're following the rules, and following the treaty to the letter, you should be able to expect the tax consequences that result.”
A spokesman for Justice Canada said in a statement to Canadian Lawyer that “The decision affirms the importance of the mutual intentions of the two contracting states in determining the object, spirit, and purpose of a bilateral tax treaty. Those intentions must be ascertained at the time the treaty is entered into.
“Going forward, Canada, Luxembourg, and other Organization for Economic Cooperation and Development member states will be subject to the Principal Purpose Test in the Multilateral Instrument,” the statement read.
“That multilateral treaty amended thousands of bilateral tax treaties at the same time to include both a recognition that tax treaties are not intended to facilitate tax avoidance and tax base erosion, as well as additional tools for preventing abusive tax avoidance. Those tools include the principal purpose test (PPT), as well as options for negotiating specific limitation-on-benefit clauses. Canada is pursuing both approaches to protect its tax base from aggressive international tax avoidance.”