The Canada-United States Tax Treaty (the “Tax Treaty”) is unique among Canada’s tax treaties in its approach to prevent “treaty shopping”. Treaty shopping generally refers to the acquisition and enjoyment of treaty benefits under a given tax treaty by persons who are not bona fide tax residents of one of the countries that is a party to the particular treaty.
The Tax Treaty is unique in that it contains a “limitation on benefits” (“LOB”) provision (Article XXIX A) which is unlike the anti-treaty shopping provisions in Canada’s treaties with other countries. Although the LOB article in the Tax Treaty has existed for some time, prior to the introduction of the Fifth Protocol to the Tax Treaty in 2008, the LOB article applied only in respect of U.S. taxes. With the introduction of the Fifth Protocol, the LOB article now applies with respect to both U.S. and Canadian taxes. As a result, any inbound investment into Canada that involves reliance on the benefits of the Tax Treaty must be carefully considered in light of the LOB rules.
Canada’s other tax treaties generally contain other provisions aimed at preventing treaty shopping, including reliance on Canada’s general anti-avoidance rule in section 245 of the Income Tax Act (Canada) (the “Act”) and on the requirement that the recipient of treaty benefits must be the “beneficial owner” of the relevant income sought to be taxed by the source country. For example, Canada’s recently signed tax treaty with Hong Kong specifically states in Article 26(2) that nothing in the treaty shall prevent a party from “applying the provisions of its law which are designed to prevent tax avoidance, including measures relating to thin capitalization”. Treaty benefits relating to dividends, interest and royalties are also denied in Articles 10(7), 11(9) and 12(7) of the tax treaty with Hong Kong, respectively, in a broadly-worded set of situations which generally involve an analysis of the purposes of any assignment or transfer of the income or the creation, assignment or transfer of shares, debt-claim or other rights related thereto.
The LOB article under the Tax Treaty, in contrast, is relatively specific and focussed as to the persons (referred to as “qualifying persons”) who are entitled to treaty benefits, and those who are not. Although the provisions are relatively complex, their specificity generally allows for a greater degree of certainty as to whether or not a given person will be entitled benefits under the Tax Treaty. The following is a brief overview of the main components of the LOB article in the Tax Treaty.
Qualifying and Non-Qualifying Persons
“Qualifying persons” are entitled to all of the benefits under the Tax Treaty, and are defined as residents of either Canada or the U.S. who are one of the following:
- a natural person;
- a specified government body (e.g. federal, provincial or other government bodies of a contracting state);
- a publicly-traded company or trust (subject to certain qualifications);
- a corporate subsidiary of qualifying publicly-traded company(ies) or trust(s) (subject to certain qualifications);
- a company or trust that meets the ownership and “base-erosion” tests under the Tax Treaty;
- an estate;
- a not-for-profit organization (subject to certain qualifications); or
- a tax-exempt organization (subject to certain qualifications).
Persons who are not qualifying persons under one of the categories above may nonetheless be entitled to certain benefits under the Tax Treaty under the “active trade or business” test in Article XXIX-A(3), the “derivative benefits” test in Article XXIX-A(4), or through a request to the applicable Competent Authority (the Internal Revenue Service or the Canada Revenue Agency) in accordance with Article XXIX-A(6).
Ownership and Base Erosion Tests
Corporations that meet both the ownership test and the base-erosion test are qualifying persons entitled to all of the benefits under the Tax Treaty. While there are numerous interpretive issues with both tests that are beyond the scope of this article, the tests as applicable to corporations may generally be described as follows. A similar test also applies to trusts.
The ownership test generally requires that 50% or more of the aggregate vote and value of the corporation’s shares, as well as 50% or more of the vote and value of each disproportionate class of shares must not be owned, directly or indirectly, by persons other than qualifying persons. A disproportionate class of shares generally refers to any class of shares of a corporation entitling a holder resident in one country to disproportionately higher participation, through dividends, redemption payments of otherwise, in the earnings generated by the corporation in the other country.
In applying the ownership test, one must look-through the chain of ownership to ensure that non-qualifying persons in the chain do not own, directly or indirectly, 50% or more of the above-noted shares of the particular corporation. The exception to this rule is that it is not necessary to look-through the chain of ownership above any qualifying publicly-traded corporations or trusts.
The base erosion test generally requires that the amount of the expenses deductible from gross income (as determined pursuant to the laws of the relevant corporation’s state of residence) that are paid or payable by the corporation for its preceding fiscal period, directly or indirectly, to persons that are not qualifying persons must be less than 50% of the corporation’s gross income for that period. The Canadian tax authorities have taken the view that payments will be considered to be made indirectly to non-qualifying persons where there is a sufficient link between the initial payment to a qualifying person and a subsequent payment by such qualifying person to a non-qualifying person.
Active Trade or Business Test
A non-qualifying person who is a resident of the U.S. or Canada, as applicable, and engaged in the active conduct of a trade or business in the person’s country of residence (other than the business of making or managing investments, unless those activities are carried on with customers in the ordinary course of business by a bank, an insurance company, a registered securities dealer or a deposit-taking institution) will be entitled to claim all benefits under the Tax Treaty with respect to any income derived in the other country in connection with or incidental to the trade or business carried on in the country of residence.
For the purposes of applying this test from a Canadian tax perspective, the Canadian tax authorities have taken the position that Canadian-source income shall be considered derived “in connection with” a trade or business carried on in the U.S. if the income is derived from an activity in Canada that is part of, or complementary to, the activity carried on in the U.S. Activities in Canada will generally be considered “part of” a trade or business in the U.S. where such trade or business is upstream, downstream or parallel to the activity in Canada, and will be “complementary to” a trade or business in the U.S. if they are part of the same industry or are interdependent (i.e. the success or failure of one would tend to result in the success of failure of the other).
To meet this test, the trade or business carried on in the country of residence must also be “substantial” in relation to the activity carried on in the other country. The Canadian tax authorities have steadfastly declined to provide guidance as to a particular percentage or ratio that will constitute “substantial” activity, stating only that the activity in the country of residence must be more than “a very small percentage” of the activity carried on in the other country.
Derivative Benefits Test
A corporation resident in Canada or the U.S. (as applicable) that is a non-qualifying person will be entitled to benefits under the Tax Treaty in respect of dividends, interest and royalties if it meets the derivative benefits tests (comprised of both an ownership and base erosion test). In order to meet the ownership test, more than 90% of the aggregate vote and value of all the shares of the corporation, and at least 50% of the vote and value of any disproportionate class of shares, must be owned, directly or indirectly, by qualifying persons or persons: (i) resident in a third country which has a comprehensive income tax treaty with Canada or the U.S. (as applicable) (referred to herein as “third country tax treaty”) and is entitled to all the benefits provided by Canada or the U.S. (as applicable) under the third country tax treaty; (ii) would be a qualifying person under the Tax Treaty or would meet the active trade or business test in the Tax Treaty, if that person were a resident of Canada or the U.S. (as applicable), and in the case of the active trade or business test, if the business it carried on in the third country were carried on in Canada or the U.S. (as applicable); and (iii) would be entitled to a tax rate under the third country tax treaty in respect of dividends, interest or royalties, as applicable, that is at least as low as the rate applicable under the Tax Treaty.
The corporation must also meet a base-erosion test that is identical in its application as the base erosion test described above.
The application of the LOB article to inbound investments into Canada is complex and requires careful planning in order to ensure entitlement to benefits under the Tax Treaty. Despite its complexities, proper planning can often provide taxpayers with a relatively high degree of certainty as to their eligibility for benefits under the Tax Treaty.