Velcro Canada Inc. v. The Queen: Riding Prévost Car to Victory... 1

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1 In This Issue Velcro Canada Inc. v. The Queen: Riding Prévost Car to Victory... 1 More on FATCA and More to Come: The Internal Revenue Service and Treasury Department Release Proposed Regulations... 4 Changes to Rules for Canadian Property Dispositions by Non-Residents A report on cross-border developments in Canadian tax law / March 2012

2 1 Velcro Canada Inc. v. The Queen: Riding Prévost Car to Victory By: John C. Yuan In the tax world, treaty-shopping occurs when a person resident in Country A organizes a legal entity in, and directs income through, Country B, solely to secure benefits under a tax treaty between Countries B and C that would not be available to a resident of Country A, typically preferential tax treatment for income sourced from Country C. In recent years, tax administrations around the world, including Canada, have addressed this concern by adding limitation of benefits articles to existing tax treaties to deny treaty benefits when certain criteria are met. However, when a tax treaty does not include a limitation of benefits clause, the primary tool for challenging treaty shopping in the context of non-resident withholding tax is to assert that the person claiming the treaty benefits is not the beneficial owner of the relevant income, as preferential withholding tax rates under tax treaties that follow the OECD Model Convention typically only apply where the income recipient is also the beneficial owner of such income. In Canada, Prévost Car Inc. v. The Queen, 1 (Prévost Car) was the first case to consider whether tax treaty benefits should be denied on the basis that the non-resident recipient of the Canadian-sourced income was not the beneficial owner. In Prévost Car, the income consisted of dividends paid on shares of a Canadian corporation to a Dutch holding company established and jointly owned by an English corporation and a Swedish corporation. In 2008, the Federal Court of Appeal (FCA) affirmed the Tax Court of Canada s decision to afford the Dutch holding company the benefits of the reduced withholding rates on Canadian-sourced dividend income under the Canada-Netherlands tax treaty, even though the shareholders of the Dutch holding company had established an operating structure that had ensured at least 80% of the Dutch holding company s income was distributed as a dividend to shareholders and where the favourable Canada-Netherlands tax treaty was a factor in establishing the Dutch holding company in the Netherlands. A key feature of the Tax Court s decision in Prévost Car was its conclusion that the relevant question with respect to beneficial ownership is whether the dividend recipient is the person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. The Prévost Car case provided judicial guidance on how the beneficial ownership question would be resolved with respect to dividends. Undeterred, the minister of national revenue (Minister) then chose to litigate the same issue in a royalty context in Velcro Canada Inc. v. The Queen, 2 (Velcro Canada), which was recently decided by the Tax Court of Canada in the taxpayer s favour. In the Velcro Canada case, intellectual property owned by a Dutch company (IPco) in the Velcro worldwide group of companies was licensed to Velcro Canada Inc., commencing in The license provided that IPco was to receive a specified percentage of Velcro Canada s net sales. Initially, the percentage depended on whether the sales were attributable to products using established technology (5%) or new technology (7.5%), but the royalty entitlement was amended in 2003 to reflect a flat 5% rate. In 1995, as part of a strategic worldwide reorganization of the Velcro group, IPco migrated from the Netherlands to the Netherlands Antilles. Prior to its migration, IPco assigned its rights under the license agreement with Velcro Canada, a Dutch holding company (Dutchco) and gave Dutchco the right to grant licenses in respect of IPco-owned intellectual property. 1 Prévost Car Inc. v. The Queen, 2008 TCC 231, aff d 2009 FCA 57 2 Velcro Canada Inc. v. The Queen, 2012 TCC 57, released February 24, 2012

3 2 Under the agreements effecting the assignment, IPco was entitled to receive royalties from Dutchco computed similarly to royalties payable under the license with Velcro Canada; until 2003, IPco received an arm s length percentage of Velcro Canada s net sales (as defined under the assigned Velcro Canada license) and, beginning in 2003, IPco received the royalties that Dutchco collected under the Velcro Canada license, less the amount approved by the Dutch tax authorities to cover Dutchco s costs related to its obligations under the assignment agreement. Over the period that the assignment was in place, IPco received approximately 90% of the royalties that Dutchco collected under the Velcro Canada license. The assignment of the royalty stream by IPco to Dutchco in 1995 did not reduce the Canadian withholding tax from the situation before IPco s migration. However, IPco s assignment of the Velcro Canada license to Dutchco allowed the Canadian-source royalty stream to continue enjoying the benefits of the Canada-Netherlands treaty despite IPco s migration to a jurisdiction that did not have a tax treaty with Canada (i.e., Netherlands Antilles). The Tax Court framed its analysis in the Velcro Canada case using the concept of beneficial ownership that had been previously expressed in Prévost Car. It went so far as to start with dictionary definitions of the four key words in the judge-made test: possession, use, risk, and control. The Tax Court then went on to consider whether Dutchco had enjoyed the incidents of beneficial ownership under the Prévost Car standard. With respect to possession and use, Dutchco did not simply collect and immediately forward to IPco a 90% share of the royalties collected from Velcro Canada. Rather, the funds were comingled with Dutchco s funds from other sources and sometimes converted into a different currency. Amounts that Dutchco held in its accounts earned interest income for Dutchco s benefit and were applied to pay Dutchco s expenses. In light of those facts, it was clear to the Tax Court that Dutchco had both possession and use of the Velcro Canada royalties based on a strict tracing analysis. With respect to risk, the Tax Court noted that Dutchco had assumed some conventional commercial risks with respect to the royalties. Since the assignment agreement did not provide Dutchco with indemnification from IPco for those risks, it was clear to the Tax Court that Dutchco was exposed to risk in relation to the Velcro Canada royalties. Having come to the view that Dutchco had had possession and use of the funds and had been exposed to commercial risk in respect thereof, the Tax Court concluded that Dutchco also had control over the collected Velcro Canada royalties and therefore each of the four criteria from the Prévost Car formulation of beneficial ownership had been met. The Tax Court then quickly dismissed the Minister s arguments that Dutchco was merely IPco s agent, nominee or conduit to flow the royalties from Velcro Canada to IPco. In the end, it would appear that the Prévost Car and Velcro Canada cases establish a fairly high threshold for the Minister to meet in order to successfully deny treaty benefits on the basis that the recipient of dividends and royalties is not the beneficial owner of these amounts. In the absence of a fact situation in which the flow of funds (on a direct tracing basis) is pre-determined and the recipient of the funds has no discretion whatsoever on how the funds are handled or applied, it is difficult to see how a court could find in favour of the Minister on future beneficial ownership cases. Perhaps the practical outcome of this case is that Canadian tax authorities will shift their focus from trying to use the courts to challenge structures that offend its view of when tax treaty benefits will apply and instead focus on ensuring that the language in Canada s bilateral tax treaties more clearly describes the circumstances under which treaty benefits would not be available. This is the approach that the Canadian government adopted when it renegotiated the Canada-U.S. tax treaty, which now contains a limitation of benefits article.

4 3 It should be noted that both Prévost Car and Velcro Canada discussed in some detail the OECD Model Convention (upon which the Canada-Netherlands tax treaty is based) and the Commentary thereon with respect to beneficial ownership and conduits. 3 In Prévost Car, the FCA noted that the Minister s position on beneficial ownership in that case was, in effect, asking the Court to adopt a pejorative view of holding companies which neither Canadian domestic law, the international community nor the Canadian government through the process of objection to the OECD Model Convention have adopted. The OECD has recently 4 issued proposed changes to the Commentary on beneficial ownership, aiming to clarify the interpretation that should be given to that concept in the OECD Model Convention and, in particular, whether the interpretation should reflect what beneficial ownership has meant historically or a broader anti-abuse concept. Based on recent comments by the U.S. delegate, consensus among the OECD members on this issue has been a challenge to date. 5 3 Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital (1977) and 2003 Commentary, as well as the OECD Conduit Companies Report (1986) 4 Clarification of the Meaning of Beneficial Ownership in the OECD Model Convention, discussion draft dated 29 April 2011 to 15 July Jesse Eggert on March 1, 2012 at the International Fiscal Association USA 2012 annual conference, as summarized in Tax Analysts, March 2, 2012

5 4 More on FATCA and More to Come: The Internal Revenue Service and Treasury Department Release Proposed Regulations By: Nigel Johnston Introduction In 2010, the United States amended the Internal Revenue Code of 1986 to add provisions relating to foreign account tax compliance (FATCA). Intended to combat international tax evasion by U.S. persons, these amendments were a mere 10 pages long, but they contemplated a comprehensive worldwide system of information gathering, reporting and withholding (see New, Far-Reaching US Tax Requirements Under FATCA Canadian Pension Plans may Even Be Caught, dated December 17, 2010). Since then, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) have issued several releases intended to provide guidance with respect to the manner in which the system is to operate. They have also engaged in extensive consultations with affected persons. This process culminated with the release, on February 8, 2012, of approximately 400 pages of proposed regulations and explanatory material. Comments on the proposed regulations may be submitted until April 30, The proposed regulations do not provide any further delay of the phase-in of FATCA withholding and reporting requirements from the scheduled start date of January 1, The deadline for a foreign financial institution (FFI) to enter into an agreement with the IRS to avoid withholding tax remains June 30, At the same time as the release of the proposed regulations, Treasury and the governments of five European countries (France, Germany, Italy, Spain and the United Kingdom) released a Joint Statement indicating that the United States and each of their governments had agreed to explore a common approach to FATCA implementation through domestic reporting and reciprocal automatic exchange, based on existing bilateral tax treaties. It is understood that an acceptable approach, if one can be determined, would serve as a template for arrangements with other countries. Such an approach would address concerns raised in the consultation process that requirements imposed on financial institutions to report account holder information to the IRS would contravene applicable privacy laws. Canada was not a party to the Joint Statement, but it is understood that there are ongoing discussions between Canada and the United States relating to the application of FATCA, having regard to: the relatively large number of U.S. individuals who reside in Canada; the fact that Canada is not a low-tax jurisdiction; and the fact that the Canada Revenue Agency (CRA) already automatically exchanges information with the IRS with respect to certain payments made to persons with U.S. addresses. Publicly available documents indicate that the CRA automatically exchanges details of payments made to U.S. addresses and reported on Canadian NR4 forms such as dividends, interest and trust distributions. However, as U.S. taxpayer ID numbers are not collected in Canada, the information provided is not associated with U.S. taxpayer ID numbers that would facilitate matching. It is also understood that there is no exchange of information relating to proceeds from the sale or other disposition of property. In addition, payments to entities in third countries that may be owned by U.S. persons are not reported. This update provides a high-level overview of the FATCA regime, followed by a discussion of some of the proposed exceptions to full FATCA compliance that might be available to certain Canadian entities. As FATCA is U.S. law, readers requiring legal advice should consult with U.S. counsel.

6 5 Broad Scope of FATCA FATCA is intended to address tax evasion by U.S. persons, including U.S. citizens, who maintain accounts in an FFI or who own substantial interests in other foreign entities, i.e., non-financial foreign entities (NFFEs). The objective is for the IRS to be provided with information about these U.S. persons. The sanction is an obligation on the part of a person making a withholdable payment to a non-compliant FFI or NFFE to deduct 30% withholding tax on that payment. An FFI is defined to include a non-u.s. entity which: is a bank; holds, as a substantial portion of its business, financial assets for the account(s) of others (e.g., a custodian or a broker); or is engaged primarily in the business of investing, reinvesting or trading in securities, partnership interests, commodities or any interest (including a futures or forward contract or option) in such securities, partnership interests or commodities (an Investment Undertaking). A Canadian investment fund, pension plan or profit-sharing plan may be considered to be engaged in an Investment Undertaking. FATCA requires an FFI to enter into an agreement with the IRS (FI Agreement). Under the FI Agreement, the FFI is required to: obtain information from each account holder to determine whether the account holder is a U.S. person; comply with verification and due diligence procedures required by the IRS for the identification of U.S. accounts ; make annual reports to the IRS with respect to each U.S. account (including the name, address and taxpayer identification number of the holder, the account number and its balance or value, and gross receipts and gross withdrawals or payments from the account); deduct a 30% withholding tax on certain payments to recalcitrant account holders (i.e., account holders where the FFI cannot determine if they are, or are not, U.S. persons); and comply with requests for information from the IRS. Although a draft form of FI Agreement has yet to be released, the proposed regulations outline in considerable detail what it will contain. Absent an exemption, a Canadian investment fund, pension plan or project-sharing plan that is an FFI would have to comply with procedures to identify security holders or beneficiaries that are U.S. persons. If an FFI does not enter into an FI Agreement, then beginning January 1, 2014, a person making a withholdable payment must withhold 30% of the payment. Broadly defined, a withholdable payment includes U.S. source dividends, interest and other fixed or determinable annual or periodic income (FDAP income) as well as gross proceeds from the sale or other disposition of property that produce interest or dividends that are U.S.-source FDAP income. Withholding on gross proceeds is required, beginning January 1, An FFI that enters into an FI Agreement is required to withhold a tax equal to 30% of any passthru payment made to a recalcitrant accountholder or another FFI that has not entered into an FI Agreement. A passthru payment is: any withholdable payment; or any other payment to the extent attributable to a withholdable payment. This is particularly problematic. For example, how would an investment fund receiving income from U.S. and foreign sources determine the percentage of a distribution attributable to withholdable payments and made to a recalcitrant account holder? Similarly, how would it determine what amount of

7 6 redemption proceeds paid to the recalcitrant accountholder is attributable to a withholdable payment? Although one could say that recalcitrant account holders are the authors of their own misfortunes, the proposed regulations will defer withholding on passthru payments that are not withholdable payments until at least January 1, Treasury and the IRS specifically request comments on approaches to reduce the administrative burden associated with determining passthru payment percentages. FATCA also contains provisions applicable to an NFFE. In general terms, a person making a withholdable payment to an NFFE must withhold 30%, unless the NFFE certifies that it does not have any substantial U.S. owners or provides the person with the name, address and taxpayer identification number of each substantial U.S. owner. A substantial U.S. owner of an NFFE is, subject to certain exceptions, generally: if the NFFE is a corporation: a U.S. person who owns, directly or indirectly, more than 10% of the stock (by votes or value) of the NFFE; if the NFFE is a partnership: a U.S. person who owns, directly or indirectly, more than 10% of the profits or capital interests; and if the NFFE is a trust: a U.S. person who owns, directly or indirectly, more than 10% of the beneficial interests. However, the regime applicable to FFIs will not apply to the extent that the beneficial owner of the relevant payment is of a class of persons identified by the Secretary of the Treasury (Secretary) as posing a low risk of tax evasion. In addition, the Secretary may identify classes of persons that are not subject to the rules applicable to NFFEs. Some Potential Carve-Outs Canadian Investment Funds, Pension Plans and Retirement Accounts The proposed regulations contemplate that registered deemed compliant FFIs and certified deemed compliant FFIs do not have to enter into an FFI Agreement in order to avoid FATCA withholding. As the name suggests, a registered deemed compliant FFI must register with the IRS and will be provided with an identification number. A certified deemed compliant FFI need not register with the IRS, but does need to certify its status to a person making a witholdable payment to it. Registered Deemed Compliant FFIs In the investment fund context, there are two potentially relevant categories of registered deemed compliant FFIs qualified collective investment vehicles and restricted funds. A qualified collective investment vehicle must meet the following requirements: It must be an FFI solely because it is engaged in an Investment Undertaking. Each holder of record of units or shares (units) must be a participating FFI, a registered deemed compliant FFI or certain enumerated U.S. persons, including: a corporation which has stock regularly traded on one or more established securities markets; a real estate investment trust; a regulated investment company; or any entity registered with the Securities Exchange Commission under the Investment Company Act of If it is part of an expanded affiliated group, all other FFIs in the group must be participating FFIs or registered deemed compliant FFIs. A restricted fund must meet the following requirements: It must be an FFI solely because it is engaged in an Investment Undertaking.

8 7 It must be regulated as an investment fund under the laws of its country of incorporation or organization; this country must be Financial Action Task Force compliant. Units may only be sold through certain permitted distributors (i.e., a participating FFI, a registered deemed compliant FFI, a non-registering local bank or a restricted distributor) or redeemed by the fund. Each distribution agreement with a permitted distributor must prohibit the sale of units to U.S. persons, non-participating FFIs or passive NFFEs with one or more substantial U.S. owners (other than units which are both distributed by and held through a participating FFI). The fund s prospectus and all marketing materials must indicate that sales of units to the foregoing are prohibited. Each distribution agreement with a permitted distributor must require the distributor to notify the fund if it ceases to be a permitted distributor. The FFI must certify to the IRS that it will terminate the distribution agreement within 90 days notice of the change in status and redeem or acquire within six months all units distributed through that distributor. With respect to any pre-existing direct accounts (i.e., accounts held directly by the ultimate investors), the fund must generally review them in accordance with prescribed procedures to identify any U.S. account or account held by a non-participating FFI. The fund must implement prescribed policies and procedures with respect to direct account holders to ensure that it either: does not open or maintain an account for a U.S. person (with certain exceptions), a non-participating FFI or a passive NFFE with one or more substantial U.S. owners; or closes any such account within 90 days after it is opened or the FFI had reason to know the account holder was such a person, or withholds and reports on such account as if it were a participating FFI. If it is part of an expanded affiliated group, all other FFIs in this group must be participating FFIs or registered deemed compliant FFIs. A qualified collective investment vehicle and a restricted fund may apply to become a registered deemed compliant FFI. In order to do so, its chief compliance officer or equivalent person must certify to the IRS that the relevant requirements are satisfied. The IRS will confirm registration and issue a federal tax identification number (FFI-EIN). Certification must be renewed every three years. In broad terms, it appears that the definition of qualified collective investment vehicle is intended to exclude from the definition of FFI a fund where the necessary information will be provided by other entities closer to investors. In the case of a restricted fund, the goal appears to be to exclude from FATCA a fund that, through its distribution arrangements, excludes U.S. persons as investors. The requirement that a restricted fund must be regulated as an investment fund under the laws of its country of incorporation or organization is not clear. Presumably, a Canadian mutual fund offered by prospectus and compliant with National Instrument of the Canadian securities regulators (which imposes investment diversification and other requirements) would meet this requirement. On the other hand, would a pooled fund offered to accredited investors pursuant to exemptions from prospectus requirements and not subject to government-mandated investment restrictions qualify? Certified Deemed Compliant FFIs A certified deemed compliant FFI is not required to register with the IRS. It must provide, to a withholding agent that is making a payment to it, certain prescribed information applicable to the relevant deemed compliant category. A retirement fund may qualify for certified deemed compliant status if it meets the following requirements: I t is organized for the provision of retirement or pension benefits under the laws of the country in which it is established or operates.

9 8 All contributions to the fund (other than certain transfers from other plans) are employer, government or employee contributions limited by reference to earned income. No single beneficiary has a right to more than 5% of the fund s assets. Under the laws of the jurisdiction in which the fund is established or operates: contributions to the fund are deductible or excluded from gross income of the beneficiary; the taxation of investment income to the beneficiary is deferred; or 50% or more of total contributions to the fund (other than transfers from certain plans) are from the government and the employer. An initial review of these requirements suggests that most Canadian registered pension plans would satisfy them. A retirement fund may also qualify for certified deemed compliant status if it meets the following conditions: It is organized for the provision of retirement or pension benefits under the laws of the country in which it is established or operates. It has fewer than 20 participants. It is sponsored by an employer that is not an FFI engaged in an Investment Undertaking or a passive NFFE. Contributions to the fund (other than certain permitted transfers) are limited by reference to earned income. Participants that are not residents of the country in which the fund is organized are not entitled to more than 20% of the fund s assets. No participant that is not resident in the country in which the fund is organized is entitled to more than $250,000 of the fund s assets. A withholding agent will be entitled to treat a retirement fund as having deemed compliant status if it has a valid withholding certificate from the payee, in which the payee certifies that it meets the requirements and that its organizational documents generally support the payee s claim. An organizational document will generally support the payee s claim if it indicates that the payee qualifies as a retirement plan under the laws of the jurisdiction in which it is organized. The organizational document does not have to specify that the payee meets all of the requirements, but it cannot contain information that contradicts the payee s claim to qualify. Exclusions From the Definition of Financial Account A financial account is generally a depository or custodial account maintained by a financial institution or an interest in a financial institution engaged in an Investment Undertaking. A U.S. account is a financial account held by one or more specified U.S. persons or U.S.-owned foreign entities. Under an FI Agreement, the FFI must comply with verification and due diligence procedures required by the IRS for the identification of United States accounts. The FFI s compliance burden may be reduced, to the extent that categories of account are excluded from the definition of financial account. A retirement fund that meets the requirements to qualify for certified deemed compliant status will also be excluded from the definition of financial account. Given the significant amount of savings held by Canadian investors in registered accounts such as registered retirement savings plans (RRSPs), it would ease Canadian financial institutions compliance burdens if such registered accounts were also excluded. A personal retirement account will be excluded from the definition of financial account if it is subject to regulation as a personal retirement account or is registered or regulated as an account for the provision of retirement or pension benefits under the laws of the country in which the FFI that maintains the account is established or in which it operates and meets the following conditions:

10 9 a. The account is tax-favoured in the jurisdiction within which it is maintained. b. All contributions to the plan are employer, government or employee contributions that are limited by reference to earned income under the law of the jurisdiction in which the account is maintained. c. Annual contributions (other than certain transfers) are limited to $50,000 or less, and limits or penalties apply, according to the law of the jurisdiction in which the account is maintained, to withdrawals made before reaching a specified retirement age and to annual contributions not exceeding $50,000 (other than certain permitted transfers). An account that is tax-favoured in the jurisdiction in which it is maintained and subject to government regulation as a savings vehicle for purposes other than retirement will be exempt from the definition of financial account if it meets the following conditions: a. Contributions are limited by reference to earned income. b. Annual contributions are limited to $50,000 or less. c. Limits or penalties apply on withdrawals made before specific criteria are met under the law of the jurisdiction in which the account is maintained. d. Limits or penalties apply to excess contributions. It is not apparent that all Canadian registered accounts would qualify for exclusion: With respect to an RRSP, unless the funds in the RRSP are locked-in because they are locked-in pension funds that have been transferred to the RRSP, the annuitant of the RRSP is entitled to withdraw amounts from the RRSP subject to terms of the plan. In most cases, the amount withdrawn must be included in income. Is such an income inclusion a penalty for a withdrawal made prior to maturity? With respect to a registered retirement income fund (RRIF), property is generally transferred to the RRIF from an RRSP. Presumably, one would argue that as RRSP contributions are limited by reference to earned income, contributions to an RRIF from an RRSP are similarly limited, particularly as transfers are contemplated by (c) of the personal retirement account exclusion above. A tax-free savings account would not qualify, since contributions are limited to $5,000 per year regardless of earned income. A deferred profit sharing plan might qualify under the personal retirement account exclusion above, depending on how one interprets the penalty for the early withdrawal requirement. As noted, the proposed regulations are not country-specific. Given the large number of registered accounts in Canada, it would be helpful for the IRS to issue additional guidance confirming which Canadian registered accounts qualify Conclusion This update provides a brief overview of FATCA and a close examination of a few issues regarding its application to Canadian investment funds, pension plans and registered accounts. The complexity of the law in this narrow area alone is an example of the enormous complexity of the FATCA regime. One hopes that the governments of Canada and the United States are able to simplify the application of FATCA to Canadian residents. We reiterate that affected persons should engage U.S. counsel and consider making additional submissions as part of the comment process applicable to the proposed regulations.

11 10 Changes to Rules for Canadian Property Dispositions by Non-Residents By: Gabrielle M.R. Richards Canada taxes non-residents on their gains from the disposition of taxable Canadian property (TCP). Recent amendments have aligned Canada s rules more closely with Canada s tax treaties, thereby eliminating Canadian tax on gains from the disposition of Canadian investments in many cases and enhancing the ability of Canadian business to attract foreign investors (see Relief for Non-Residents of Canada on Canadian Property Dispositions, dated April 26, 2010). In particular, unlisted shares of most corporations or interests in a partnership or trust will be considered TCP at a particular time only if, at any time during the preceding 60 months, more than 50% of the shares fair market value was derived directly or indirectly from a combination of: real or immovable property situated in Canada; Canadian resource properties; timber resource property and options; and/or interests or civil law rights therein (i.e., look-through rule). 1 This definition of TCP is consistent with a general international tax principle that the country in which immovable property is located should have the right to tax the gains from the disposition of such property. 2 For example, the OECD 3 Model Tax Convention on Income and on Capital (OECD Model Convention) provides that gains from the alienation of shares deriving more than 50% of their value directly or indirectly from immovable property situated in a country may be taxed in that country. 4 Two recent changes to the rules and their application should be noted. 1. Valuation Method The Canada Revenue Agency (CRA) has announced a change in its administrative policy for determining whether shares of a corporation derive their value principally from Canadian property. 5 Previously and in the context of treaties, when determining whether a share of a company derives its value principally from real or immovable property situated in Canada, the CRA has permitted a taxpayer to use the gross asset value method, the net asset value method or any other method appropriate in the circumstances. Moreover, the CRA has stated that for this purpose, it will accept a valuation method that assigns the debt of a corporation to the assets to which the debt reasonably relates. The CRA took this position even though the Commentary to the OECD Model Convention 6 provides that one will normally conduct the test by referring to the value of the property of the corporation, without taking into account its debts or other liabilities. The CRA has now determined that its approach in the context of treaties and when interpreting the definition of TCP should be in line with the Commentary to the OECD Model Convention. This means that the determination as to whether a share of a corporation derives its value principally from real or immovable property situated in Canada should be made by reference to the value of the properties of the corporation without taking into account its debts or other liabilities (i.e., the gross asset value method). 1 Paragraph (d) of the definition of TCP in subsection 248(1) of the Income Tax Act (Canada) (ITA) 2 The explanatory notes in the March 4, 2010 budget indicate that the TCP definition changes were in part to make the domestic rules more consistent with Canada s tax treaties. 3 Organization for Economic Co-Operation and Development 4 Article 13(4) of Model Tax Convention on Income and on Capital (Paris: OECD, 2010) 5 At the 63rd Annual Conference of the Canadian Tax Foundation, November 29, Paragraph 28.4 of the Commentary

12 11 The CRA s new restrictive position will initially be applied only with respect to dispositions of properties acquired after Non-resident taxpayers disposing of property already held by them in 2011 will continue to be able to choose any valuation method they wish, provided that the sale takes place before For sales of property that take place after December 31, 2012, the CRA will follow the gross asset value method in respect of all property dispositions. In light of these changes to the CRA administrative position, non-residents holding Canadian investments where the net asset value method results in less Canadian tax payable may wish to restructure their ownership during Relief From Look-Through Draft legislation released August 27, 2010 prevents the indirect look-through to the property of a corporation, trust or partnership, where the shares of the corporation or interest in the trust or partnership would not themselves be TCP. 7 For example, a non-resident may own, through a private holding corporation, shares of a Canadian public corporation that derive most of their value from real or immovable property situated in Canada. In such circumstances, it is possible that the shares of the private holding corporation could otherwise be TCP by virtue of the look-through to the real property, even though a direct holding by the non-resident of the public corporation shares might not be TCP. This amendment is intended to ensure that in these circumstances the look-through rules do not apply where the public corporation shares are not themselves TCP. 8 The CRA has confirmed 9 that if the draft legislation amending the definition of TCP is enacted as proposed, it will take this new rule into account in the determination of whether shares of a corporation derive their value principally from real or immovable property situated in Canada. This is particularly relevant where the shares of a corporation (Subsidiary) are held by another corporation (Parent) and would not themselves be TCP. According to this new rule, the full value of the shares of the Subsidiary owned by the Parent will be viewed as property other than real or immovable property situated in Canada in the determination of whether the shares of the Parent derive their value principally from real or immovable property situated in Canada. 7 Proposed amendment to paragraph (d) of the definition of TCP in subsection 248(1) of the ITA 8 The September 12, 2010 explanatory notes to the August 27, 2010 draft legislation set out this example and comment. 9 See supra note 5 Every effort has been made to ensure the accuracy of this publication, but the comments are necessarily of a general nature, are for information purposes only and do not constitute legal advice in any manner whatsoever. Clients are urged to seek specific advice on matters of concern and not rely solely on the text of this publication.

13 12 Key Contacts in Our Tax Group National Practice Group Leader and Ontario Regional Contact Douglas Cannon British Columbia Rosemarie Wertschek, QC Alberta Ron Mar Québec Frédéric Harvey