TAX UPDATE. A report on cross-border developments in Canadian tax law. Relief for Non-Residents of Canada on Canadian Property Dispositions

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1 April 2010 TAX UPDATE A report on cross-border developments in Canadian tax law Relief for Non-Residents of Canada on Canadian Property Dispositions By Gabrielle M. R. Richards Budget 2010 proposes significant changes to Canada s international tax rules. Effective for dispositions after March 4, 2010, the liability for Canadian tax on gains from the disposition of Canadian investments will be eliminated in many cases, together with the reporting and withholding requirements, enhancing the ability of Canadian businesses to attract foreign venture capital. Subject to the provisions of applicable tax treaties, Canada currently taxes non-residents on their income and gains from the disposition of taxable Canadian property. A purchaser acquiring such property from a non-resident is required to withhold part of the purchase price and remit such funds to the government on account of the non-resident vendor s potential Canadian tax liability, unless the non-resident vendor obtains a clearance certificate from the Canada Revenue Agency (CRA) or unless the property is excluded property, such as shares of Canadian corporations listed on a recognized stock exchange. To obtain a clearance certificate, a non-resident vendor must remit an amount to the CRA on account of the nonresident s potential Canadian tax liability, post security, or satisfy the CRA that no tax will be due. Nonresident investors were frustrated with the need to obtain such certificates, which were generally delayed In This Issue One Three Five Relief for Non-Residents of Canada on Canadian Property Dispositions US LLCs Limited Opportunity? OECD Releases Report on Improving Procedures for Tax Relief for Cross-Border Investors

2 many months, and the need to file Canadian income tax returns, particularly where no Canadian tax was ultimately payable on any gains due to a treaty exemption. For example, gains from the disposition of shares of a Canadian resident corporation are ordinarily exempt from Canadian taxation under most treaties, provided that such shares do not derive their value principally (more than 50 per cent) from real or immovable property situated in Canada. Budget 2010 proposes an important relieving measure to exclude from the definition of taxable Canadian property shares of corporations, and certain other trust and partnership interests, that do not at any time during the 60-month period prior to the determination time derive their value principally (more than 50 per cent) from one or any combination of (i) real or immovable property situated in Canada, (ii) Canadian resource property, (iii) timber resource property, or (iv) options or interests in respect of the foregoing. Certain property is deemed to be taxable Canadian property in certain circumstances (e.g., under the reorganization provisions where the exchanged property was taxable Canadian property). Budget 2010 will amend these provisions such that the deeming rule will apply only for 60 months after the relevant disposition. These amendments will align the Canadian rules more closely with Canada s tax treaties and the domestic rules of various OECD (Organisation for Economic Development) countries including the United States. This measure also builds upon recent changes introduced in Budget 2008 that eased compliance requirements on the disposition by a non-resident of taxable Canadian property where treaty exemptions were applicable, particularly in the case of non-arm s-length dispositions. These changes have been welcomed by foreign private equity and venture capital firms as removing a barrier to directly investing in Canadian technology, bioscience and other private corporations. Previously, to avoid the need to obtain clearance certificates on behalf of each of many investors in a venture or private equity fund, especially if structured as a limited partnership, an offshore blocker entity such as a Luxembourg subsidiary was used to make the Canadian investment. As a result of the changes, such costly and complex legal structures can be eliminated. The CRA has stated that it will apply these proposed changes after March 4, 2010, notwithstanding that the Budget 2010 proposals are not yet enacted. Two

3 US LLCs Limited Opportunity? By Gabrielle M. R. Richards The April 8, 2010 decision of the Tax Court of Canada in TD Securities (USA) LLC v. R. ( (IT)G) has reversed a long-standing position of the Canada Revenue Agency (CRA) that US limited liability companies (LLCs) are not entitled to the benefits of the Canada-US Income Tax Convention (Treaty) before the recent amendments made in the Fifth Protocol to the Treaty. While we expect the case will be appealed, US LLCs that have not claimed the benefit of the Treaty for past years may wish in the meantime to file amended returns for branch tax or capital gains tax or to file claims for refunds of withholding tax on dividends, interest, royalties and management fees for past years. Applications for refunds of amounts withheld must be made no later than two years after the calendar year in which the amount was withheld and remitted. Facts TD Securities (USA) LLC (TD LLC) is a Delaware LLC, the sole member of which is TD Holdings II Inc. (Holdings), a Delaware corporation indirectly wholly owned by The Toronto-Dominion Bank, a Canadian chartered bank. TD LLC is a US broker-dealer that has a Canadian branch in Canada to serve its US customers. TD LLC is a disregarded entity for US tax purposes such that its income is included in that of its sole member, Holdings. The Canadian branch profits of TD LLC for 2005 and 2006 were reported by TD LLC in its Canadian tax returns. Under Part XIV of the Income Tax Act (Canada), an additional 25 per cent branch tax is imposed on non-residents carrying on business in Canada, subject to reduction under an applicable treaty. TD LLC claimed the reduced rate of five per cent on its Canadian branch profits on the basis that the Treaty applied. Holdings also included the Canadian branch profits of TD LLC in its income under the US Code. The CRA argued that, although an LLC is a person, it is not liable to tax in the US, such that it could not meet the definition of resident in Article IV of the Treaty (i.e., any person that, under the laws of that State, is liable to tax therein by reason of that person s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature ). Accordingly, TD LLC was not entitled to the benefits of the reduced rate of branch tax under the Treaty. Decision The Tax Court of Canada held that TD LLC was entitled to the benefits of the Treaty, as the evidence was overwhelming that the object and purpose of the Treaty would be frustrated if the Canadian-sourced income of TD LLC that is fully taxed in the US in the hands of its member does not enjoy the benefits of the Treaty. As stated by Boyle, J.: It makes little sense to think that treaty entitlement should be affected by a US LLC s exercise of its right under the US Code to elect to have its income taxed in its hands or flowed through and taxed in the hands of its US-resident members. Three

4 This was stated to be consistent with the OECD Model Treaty and related reports and commentaries, in particular those dealing with partnerships. It was also consistent with the CRA s position that the Treaty applied to not-for-profit entities and government entities, notwithstanding that they are not generally liable to tax under the US Code, and S corporations, notwithstanding that their income is flowed through to their shareholders. Further, it was consistent with the CRA s position that the Treaty applied to foreign partnerships, notwithstanding that their income is flowed through to partners, and treaty benefits determined and enjoyed at the partner level. In the Court s view, the treatment of foreign partnerships and LLCs should be analogous. Finally, the Fifth Protocol, although not treating an LLC as a resident yet applying the Treaty as if the LLC were a resident, was further evidence that the Treaty prior to the Fifth Protocol should extend to LLCs. Comments It will be interesting to see how the CRA will interpret the Fifth Protocol in light of this case and the difficult interpretative issues that the Fifth Protocol provisions dealing with LLCs and other fiscally transparent entities already present and that we have discussed in earlier Notes. 1, 2 The February 10, 2010 CRA Technical Interpretation C6, which contains the official answer to a CRA Round Table question at the Canadian Tax Foundation s 2009 annual conference on the application of the Fifth Protocol to LLCs, may require reconsideration in particular in respect of interest and dividends paid to a US LLC before It is also interesting to consider whether the result in the case would have been different if TD LLC had two members, one of which was not resident in a treaty country. A similar reversal recently occurred in the February 22, 2010 decision of the UK First-Tier Tribunal in Mr. Swift v. Commissioners, [2010] UKFTT 88 (TC). In this case, a UK resident who was a member of a US LLC was held to be entitled to claim a UK foreign tax credit for the US federal and state taxes on his share of the profits of the LLC against his UK tax on the distributions from the LLC. The UK tax authority s long-standing position had been that the LLC is a corporate entity that paid the equivalent of a dividend to its members (i.e., not fiscally transparent) so that the UK resident had not been taxed on the same income in the UK for which relief from double taxation would be available with a foreign tax credit. In both recent cases dealing with the treatment of LLCs, the decisions were expressly stated to be limited to the particular facts and circumstances; however, practically they have wider potential application. 1 Planning for the Entry into Force of Treaty Changes Affecting Hybrid Entities on January 1, Canada-US Tax Treaty: Important CRA Guidance on Scope of Article IV(7)(b) Four

5 OECD Releases Report on Improving Procedures for Tax Relief for Cross-Border Investors By Nigel Johnston Introduction On February 8, 2010, the Organisation for Economic Co-Operation and Development (OECD) released a public discussion draft of a report entitled Possible Improvements to Procedures for Tax Relief for Cross- Border Investors: Implementation Package. The Report, prepared by the Pilot Group on Improving Procedures for Cross-Border Investors, provides draft documentation (Implementation Package) for implementing a streamlined procedure pursuant to which portfolio investors, including collective investment vehicles (CIVs, or in Canadian terminology, mutual funds), may claim reductions in withholding rates pursuant to tax treaties or the domestic law in the source country. The Pilot Group included representatives from the tax administrations of a number of OECD member states, including Canada, as well as representatives from the financial services industries representing, among others, managers and distributors of CIVs and global custodians. For the purposes of the Report, a CIV is a fund that is widely held, invests in a diversified portfolio of securities, and is subject to investor-protection regulation in the country in which it is established. The term includes fund of funds that achieve diversification by investing in other CIVs; it does not include private equity funds, hedge funds or REITs. By way of background, in 2008, the OECD established an Informal Consultative Group on the Taxation of Collective Investment Vehicles and Procedures for Tax-Relief for Cross-Border Investors (ICG). The ICG prepared two reports released in early 2009, one relating to accessing treaty benefits by CIVs and the second relating to claims for treaty benefits more generally in intermediated structures. A mo dified version of the first report of the ICG, which proposed changes to the commentary to the OECD Model Tax Convention, the basis on which approximately 3,000 bilateral tax treaties have been negotiated worldwide, was released by the OECD for public comment in December 2009 and was the subject of an article in McCarthy Tétrault s Tax Update (Volume 2, Issue 1). It envisaged additional documentation relating to claims for treaty relief by CIVs, including Model Mutual Agreements (MOUs) to be entered into by Contracting States to address the entitlement of CIVs established in each Contracting State to claim treaty benefits and, where appropriate, to determine the basis on which proportionate benefits would be granted to CIVs not entitled to treaty relief in their own right. The Model MOUs are included in the Implementation Package. The second report of the ICG envisaged a system for claiming treaty benefits that allows certain intermediaries those that have entered into agreements with a source country to make claims for treaty benefits on behalf of portfolio investors on a pooled basis in respect of income arising in the source country. Under these arrangements, an intermediary that participates in the system (an authorized intermediary) and deals directly with an investor would, if it obtains appropriate documentation and performs appropriate due diligence, be able to make a claim for treaty benefits (or reduced withholding pursuant to the source country s domestic law) on behalf of the investor, including by passing certain information to the next intermediary in the chain, without identifying the investor. Intermediaries participating in the system would report investor-specific information to the source country. It was Five

6 envisaged that source countries could provide information to the investor s country of residence pursuant to exchange of information arrangements. The proposed arrangements have some similarities to the current US qualified intermediary regime (QI), including the concept of financial intermediaries entering into contractual or other arrangements with the tax administration of a source country. There are important differences, including reporting to the source country of payments to non-residents rather than, in the case of a QI, reporting of US-source payments made to US accountholders. There are also important differences with the US regime contemplated by the Foreign Account Tax Compliance provisions (FATCA) under which foreign financial intermediaries that enter into an agreement with the IRS will be required to report to the IRS with respect to payments to US accountholders. The Report is over 100 pages in length and includes the form of application by a financial intermediary to become an authorized intermediary, the form of agreement between the financial intermediary and the tax administration, forms to be used under the agreement, procedures for independent reviews and procedures for authorized intermediaries that accept primary withholding responsibilities. As noted, it also includes Model MOUs in relation to treaty entitlement of CIVs. In a note such as this, it is not possible to comment on all aspects of the Implementation Package and only a number of highlights will be identified. The Implementation Package requires close study by financial intermediaries because, even though the views and best practices reflected in the Implementation Package are not the views of OECD member states, they are clearly indicative of the direction that tax administrations are heading as a result of the recent financial crisis. Moreover, the Implementation Package reflects certain compromises that business may not be willing to support. For example, as noted below, the issue of liability where an intermediary has followed all necessary steps but has nonetheless under-withheld tax on a payment to a non-resident may need to be considered. There is a lengthy comment period in relation to the Report, ending August 31, In addition, if there is sufficient interest, the McCarthy Tétrault Tax Group will put on a presentation to outline the Implementation Package in more detail to interested persons. Please indicate your interest in such a presentation by to njohnston@mccarthy.ca. Authorized Intermediary Regime Authorized Intermediary The Implementation Package contemplates that an intermediary, being a person acting on behalf of others, such as a custodian, broker, nominee or other agent, will apply to the Competent Authority of a source country to become an authorized intermediary in relation to payments of dividends and interest arising in the source country. If the Competent Authority approves, it will enter into an agreement with that intermediary (AI Agreement) under which the intermediary becomes an authorized intermediary, is assigned an identification number, and agrees to follow certain procedures set out as an appendix to the agreement (Procedures). It is expected that the Procedures will be identical under all AI Agreements entered into by all source countries modifications to the procedures will be made in the agreement itself. Six

7 The AI agreement will define eligible countries, which are those countries in respect of whose residents the source country is prepared to have the reduced withholding procedures apply. They will be countries that the source country considers to have effective exchange of information relationships with the source country, adequate know-your-customer rules, and membership in a multi-lateral organization or grouping of countries that adopt common standardized approaches to issues of tax compliance including mutual assistance (such as the EU and OECD). Know-your-customer rules (KYC Rules) are defined to mean customer and due diligence requirements relating to the opening and maintenance of accounts with financial services firms that are based on the relevant principles established by the Financial Action Task Force, including in particular Recommendations 4-11 of the 40 Recommendations relating to measures to prevent money laundering and terrorist financing and the 9 Special Recommendations relating to terrorist financing as they relate to financial institutions found at Investor Self-Declaration The AI Agreement and the Procedures contemplate that an AI will obtain an investor Self-Declaration from each direct accountholder as part of the account-opening procedure. A direct accountholder is any person, including another intermediary, who has an account directly with the AI and in respect of which the AI is acting in its capacity as an authorized intermediary. The concept of designating accounts allows the AI to elect that only certain accounts are in the system. The Self-Declaration, in a specified form, will contain mandated information. For example, for an individual, the required information includes the individual s name, address, taxpayer ID in his or her country of residence (if the country of residence issues taxpayer ID numbers); a certification that the individual is resident in the country of residence, is not acting as an agent, nominee or conduit with respect to income of the designated account, and is the beneficial owner thereof. The Self-Declaration includes a specific authorization to the AI to provide a copy of the form and additional information to any relevant tax authority and an acknowledgement that information relating to income paid or credited to the investor will be reported to the tax authority of the source state that may provide the information to the tax authority of the state in which the individual is resident. These express consents to disclosure should prevent assertions that disclosure is in breach of applicable privacy rules. The form also includes an undertaking to make the AI whole for any under-withholding and to update the Self-Declaration within 30 days of a change in circumstances. The Self-Declaration for entities is similar but requires classification of the entity into certain categories, including government, pension fund, charity, international organization and partnership. The Procedures contemplate that the AI will review the Self-Declaration and other information in its possession, including information obtained as part of the account-opening process and application of KYC Rules, in order to determine if the Self-Declaration is unreliable or incorrect. An AI may not make claims on the basis of a Self-Declaration that the AI knows, or should have known, that the information or statements contained [therein] are unreliable or incorrect. The Procedures provide a non-exhaustive list of circumstances in which the AI is considered to have reason to know that a Self-Declaration is unreliable or incorrect, such as where the AI has other information that is inconsistent with the investor s claim. A Self- Declaration is to expire on December 31 of the fifth year following the year in which it is signed. An AI must institute procedures to ensure that changes in an investor s account information (e.g., change of address) that could affect the validity of the investor s Self-Declaration, trigger a review and an updating if required. Seven

8 The AI Agreement contemplates that an AI will provide Tax Rate Information to a Payor. A Payor is a person that makes a covered payment, generally any payment of interest or dividends arising in the source country received by the AI with respect to an account that has been designated by the AI as one for which it is acting as an AI. Tax Rate Information is pooled information provided by the AI with respect to the withholding rate to be applied to a payment. For example, if the AI has valid Self-Declarations from investors entitled to 40 per cent of a dividend payment at a 10 per cent withholding rate, the AI would advise the Payor to withhold at a 10 per cent rate from 40 per cent of the payment. The AI would not be required to provide copies of the investor Self-Declarations to the Payor nor the identity of the investors. Where an AI is itself an accountholder with another upper-tier AI, the lower-tier AI is entitled to pass pooled information to the upper-tier AI that can combine this information with that relating to its own direct accountholders from which it has received Self-Declarations. The lower-tier AI must provide an appropriate declaration to the upper-tier AI. The Self-Declaration procedures can be contrasted with current and proposed Canadian procedures. Information Circular 76-12R6, published by the Canada Revenue Agency (CRA), sets out procedures to be followed by persons paying or crediting amounts subject to Canadian withholding tax under Part XIII of the Income Tax Act (Canada) (ITA) to residents in countries with which Canada has a tax treaty. Under these procedures, it is not necessary to obtain a certificate or declaration from the payee in all cases. In particular, the payor can accept the name and address of the payee as being that of the beneficial owner unless there is reasonable cause to question whether the payee is the beneficial owner. A non-exhaustive list of circumstances in which there is reasonable cause to question whether the payee is the beneficial owner includes: (a) the payee is known to act, even occasionally, as an agent or nominee (other than agents or nominees residing in Switzerland, which are subject to special arrangements); (b) the payee is reported as in care of another person, or in trust ; and (c) the mailing address provided for payment of interest or dividends is different from the registered address of the owner. In doubtful cases, a certificate must be obtained from the payee. A sample certificate is provided by way of example. Where the payee is the beneficial owner, the recipient is required to certify that the payee is a resident of the relevant country, taxable in that country if required by the relevant treaty and the beneficial owner of the income from the property registered in the payee s name. The payee also undertakes to advise the payor of any change in the payee s country of residence. In the case of an agent or nominee that provides financial intermediary service as part of its business, the agent must certify that the income from the property is, and will continue to be, held solely for the beneficial ownership of persons resident of and, if required by the relevant tax treaty, taxable in countries with which Canada has a tax treaty that provides for a specified Canadian withholding tax rate. The nominee also undertakes to replace the certificate should there be a change in the country of residence or holdings affecting the withholding requirements for a subsequent payment and to provide to the CRA, on request, such information as may be necessary to substantiate the accuracy of the information in the Eight

9 certificate. The agent or nominee will provide the certificate based on a review of names and addresses of its accountholders and, where it determines to question whether its accountholder is a beneficial owner, a certificate. The Information Circular expressly contemplates providing pooled information to the payor of dividends and interest. In early 2009, the CRA released for public comment draft certificates of residence for withholding tax purposes. The draft certificates were far more detailed but, again, use of the forms is not to be mandatory. Revised forms of certificate have not yet been released. Contractual Intermediaries The Procedures contemplate a second category of intermediaries that do not enter into AI Agreements with a source country. Such intermediaries are referred to as contractual intermediaries. In order to be a contractual intermediary, the AI with which the intermediary deals must have received a valid intermediary declaration certifying that the intermediary is subject to KYC Rules, authorizing disclosure of the declaration to the relevant tax authorities and agreeing to procedures for the recovery of under-withheld tax. Contractual intermediaries will collect Self-Declarations from their own accountholders. However, a contractual intermediary cannot pass pooled information up the chain to an upper-tier intermediary. If the upper-tier intermediary is an AI, it can pool information provided by the contractual intermediary with other information if the contractual intermediary provides copies of the Self-Declarations for its accountholders in respect of which it seeks reduced withholding. The accountholder of the contractual intermediary will be treated as an indirect account holder of the AI. The AI is considered to know that relevant information or statements contained in documentation are unreliable or incorrect if a reasonably prudent person in the position of the AI would question the claims made. Unless the accountholder with the contractual intermediary is an accountholder with the AI, the AI will not have other information its possession and presumably will be required to make sure that the copy of the Self- Declaration provided to it is regular on its face. Excluded Intermediaries A third category of intermediary is the excluded intermediary. No entity in the chain can rely on information originating with an excluded intermediary. An excluded intermediary is an intermediary that the Competent Authority of the source country determines, in its discretion, is likely to provide information that is by definition unreliable. The Procedures state that the determination should be based on objective evidence that information provided by the intermediary has repeatedly been unreliable or incorrect and has resulted in material under-withholding of tax that has not been promptly corrected. The source country may look at the intermediary s conduct with respect to AI agreements that the intermediary has with other countries. In the case of a contractual intermediary, there should be objective evidence of failure to fulfill significant procedural obligations. Finally, if an AI Agreement is terminated for cause by the Competent Authority, the intermediary will normally be treated as an excluded intermediary for five years. The Competent Authority will make available to any person the name and address of any intermediaries designated as excluded intermediaries and may, if it chooses, publish that information. Note that in the AI Agreement, the intermediary agrees that the Competent Authority may disclose its status as an AI and, if applicable, its status as an excluded intermediary, or make such information publicly available. Nine

10 Reporting to Source Country An AI will be required to provide to the Competent Authority of the source country detailed information regarding payments paid, directly or through one or more contractual intermediaries, to its accountholders (direct and indirect) that are investors and other AIs during the calendar year. The report is due by April 30 of the following year. The report will include: the name, address and identification number of the AI; the name, address and taxpayer ID number of the accountholder (or other combination of information used by a Competent Authority to identify its residents) and country of residence; and information regarding the reportable payment, the date it was paid or credited to the accountholder, details of the securities in respect of which the payment was made and the amount of tax withheld. In the case of a payment to another AI, the same information is required except that the taxpayer ID number is to be the AI s AI identification number. Information provided to the Competent Authority of the source country can be provided to the Competent Authority of the accountholder s country of residence on request or pursuant to automatic information exchange depending on the information exchange relationships in place. Readers will note that it is conceivable that the proposed system could evolve to require reporting by an AI to the Competent Authorities of countries in which accountholders are resident. Adjustments for Over- and Under-Withholding The Procedures provide for adjustments to be made if an AI discovers that Tax Rate Information that has been provided to a payor, or withholding by the payor, was incorrect. Independent Review and Compliance The Procedures contemplate that an Independent Reviewer will be appointed although the Competent Authority retains the right to review directly the AI s compliance with the Procedures and the AI Agreement. The initial Independent Reviewer will be named in the AI Agreement. The Competent Authority may require the delivery of an Independent Reviewer s Report that will review the AI s processing of covered payments including the application of withholding tax in accordance with the AI Agreement, the documentation secured (or to be secured) pursuant to the Procedures, and reporting to source country. The review procedures are set out in an Annex to the Procedures. The AI is to have the Independent Reviewer prepare an Independent Reviewer s Report for the first full calendar year that the AI has in effect an AI Agreement with any country pursuant to which it acts as an AI in accordance with the Procedures. Thereafter, an Independent Reviewer s Report is to be prepared only upon request by a Competent Authority under an AI Agreement, which shall be no more than every third year unless a Competent Authority has good cause for requesting a more frequent review. The request for a review must be delivered by the Competent Authority not later than December 31 of the year that is to be reviewed. If a review identifies failures by the AI for the year under review, the Competent Authority may require previous years that have not been reviewed to be reviewed if the AI would be liable for any under-withholding (i.e., a limitation period has not expired). If an intermediary is an AI with one source country and enters into an AI Agreement with a second source country, the AI is to provide the Competent Authority of the second source country with a copy of its most recent Independent Reviewer s Report prepared for the first (or other) source country. If the first year of the AI Agreement with the second source country is not a year for which another independent review would be Ten

11 performed, the Competent Authority of the second source country may require such a review but on a limited basis in general, limited to reviewing two covered payments arising in the source country. As noted, the Competent Authority retains the right to review directly the AI s compliance with the Procedures and the AI Agreement. Such review may take the form of spot checks pursuant to which the Competent Authority would request information regarding a certain percentage or number of accountholders receiving a specific payment to determine if the amount of withholding and any information required to be reported was correct. The Competent Authority may also cross-check with the Competent Authority of another country that an accountholder that asserts that it is resident in the other country is in fact resident in that country. More expansive examinations are also permitted. Liability of the AI for Under-Withholding While the Procedures contemplate specific steps to be taken by an AI, the risk of under-withholding of tax in relation to an investor remains with the AI. However, if the relevant payment is through a chain of intermediaries that includes more than one AI, it is the AI closest to the investor that is liable for any under-withholding. In contrast, under the ITA, each entity in the chain of intermediaries would be liable for any under-withholding of tax. The CRA states in Information Circular IC 76-12R6 that it is the payor s responsibility to withhold and remit Part XIII tax at the appropriate rate and the payor is liable to the Crown for any deficiency. Following the procedures set forth in the Information Circular therefore technically does not afford a due diligence defence if there is an under-withholding. Termination An AI Agreement is for an indefinite term subject to the termination provisions contemplated by the Procedures. Either party may terminate the agreement on notice. However, the Competent Authority may not give notice of termination for seven years unless there is a significant change in circumstances or there is an event of default and the resolution procedures in the Procedures have been followed. The sevenyear term is intended to recognize the substantial investment in systems and other costs to be incurred by an AI to participate in the system. The resolution procedures contemplate that the Competent Authority will deliver a notice specifying an event of default that has occurred and proposing a date within 45 days for a meeting with the AI and, if necessary, the Independent Reviewer. The purpose of the meeting is to clarify and resolve the issues leading to the default. If the Competent Authority and the AI cannot reach a satisfactory resolution, or agree to continue discussions, the Competent Authority may deliver a notice of termination. Given the business consequences of termination, the Competent Authority will have extraordinary leverage in these discussions. If the Competent Authority is proposing to designate the AI as an excluded intermediary, the meeting must be held within 15 days of the notice. If an AI Agreement is terminated for cause by the Competent Authority, the intermediary will normally be treated as an excluded intermediary for five years and cannot participate in the system. If the Independent Reviewer s report identifies a default and the steps that the AI has taken to cure the default, the Competent Authority may decide that the cure is adequate, or, if not, issue a notice of default. Eleven

12 Issues for Business to Consider in Relation to the Authorized Intermediary Regime As noted, there is a lengthy comment period in relation to the Report, ending August 31, Issues that should be considered by business include the following: 1. If an authorized intermediary complies with the Procedures but there is nonetheless an underwithholding of tax, should the AI be liable for the deficiency? In other words, should there be a due diligence defence? Arguments can be made for and against the strict liability contemplated by the Procedures. In the Canadian context, Canada operates a system that is not dissimilar to the proposed system and has a strict liability regime in the ITA. 2. The AI Agreement contemplates that one or more affiliates of an applicant for authorized intermediary status can, together with the applicant, be treated as authorized intermediaries. It is important to note that, as drafted, a reference to the AI in the Procedures means the applicant and its affiliates designated as authorized intermediaries in the AI Agreement of which the procedures form part. This has a number of consequences. For example, the determination of whether an AI knows or should have known that a Self-Declaration is unreliable or incorrect will be made taking into account all of the information that the AI has in its possession. Therefore, if a parent corporation and subsidiary are designated as authorized intermediaries in the AI Agreement, each is treated as if it has in its possession the information held by the other even if there are privacy or other legal constraints on sharing that information. Business may want to argue again that only information actually in the possession of the entity is relevant. The issue might be finessed by having the applicant and each affiliate file separate applications and enter into separate agreements with a Competent Authority, but the Competent Authority could readily frustrate this planning by insisting on one agreement. If the AI were to operate by way of separate branches, any particular branch would be treated as possessing the information of all other branches. 3. The system contemplates that Self-Declarations will be obtained from all investors that want to claim treaty relief. Should there be a transitional period in respect of existing investors? Should the duration of a Self-Declaration be limited to five years following the year it is signed? 4. Should there be an affirmative obligation on a Competent Authority to publish lists of Authorized Intermediaries and excluded intermediaries on websites? 5. Should there be additional limits on the ability of a Competent Authority to request Independent Reviews? Twelve

13 Model Mutual Agreements The Report includes four Model MOUs that could be used under existing or future income tax conventions to allow CIVs established in a Contracting State to claim benefits with respect to income arising in the other Contracting State. They contemplate the following scenarios: (a) Bilateral-Residents. This model contemplates a CIV established in a Contracting State that derives income from the other Contracting State and that provides relief in relation to residents of the Contracting State in which the CIV is established. (b) Bilateral-Equivalent Beneficiaries. This model contemplates a CIV established in a Contracting State that derives income from the other Contracting State and relief is provided in relation to residents of the Contracting State in which the CIV is established and to investors (equivalent beneficiaries) who are residents of other States that would be entitled to a rate of tax in respect of an item of income that, under the source country s domestic law or a treaty that the source country has with the relevant investor s country of residence if the income were not received through the CIV, is at least as low as the rate provided in the treaty between the two Contracting States. The Model MOUs also consider two analogous multilateral scenarios. Each Model MOU contemplates that the competent authorities will agree that a CIV established in a Contracting State that is of a particular legal form is: (a) Entitled to claim treaty benefits without regard to ownership of its shares or units (units) as a resident of the Contracting State in which it is established and is to be treated as the beneficial owner of such income. This treatment is subject to three principal caveats: (i) if the CIV would not be treated as a resident of the Contracting State because of a generally applicable limitation on benefits clause, no treaty benefits will be available; (ii) whether the lower rate of withholding tax on dividends where the recipient holds more than a stated percentage of the payor corporation s shares applies is to be agreed between the Contracting States; and (iii) the CIV will not be treated as a beneficial owner if a resident of the Contracting State that received the income in the same circumstances would not be regarded as the beneficial owner. (b) Entitled to claim treaty benefits on a proportionate basis, having regard to the residence of investors. This claim is subject to the second and third caveat in (a) above. It is also contemplated that a CIV with separate classes of units may claim benefits as if the class were a separate CIV. The Contracting States may also agree that if the proportion of units held by investors entitled to treaty benefits exceeds a threshold amount, the CIV will be entitled to claim full treaty benefits; or Thirteen

14 (c) Entitled to claim benefits at the rate applicable to owners of units in lieu of the owners claiming such deductions. An abbreviated form of Self-Declaration is to be used by holders of units. The CIV itself would provide a Self-Declaration to an Authorized Intermediary or contractual intermediary setting out its status. The Model MOUs contemplate that Contracting States can agree that a CIV may make certain assumptions in determining the ownership of its units: (a) The annual determination for a year can be made based on an average of the proportion of units held by eligible investors at the end of the four quarters ending before the end of the preceding year. (b) If distribution agreements between the CIV and distributors limit the distribution of units of the CIV, or of a class of units, to particular countries, the CIV can assume that units distributed by those distributors are held by residents of those countries provided that the units are not freely transferable. Similar assumptions can be made if units of a CIV (or class) may only be distributed to certain types of investor (such as pension funds). Issues for Business to Consider in Relation to the Model MOUs From a Canadian perspective, most widely held mutual funds (including those governed by National Instrument NI of the Canadian securities regulators) should be treated as CIVs entitled to claim benefits as a resident of Canada under the relevant treaty. It is not obvious that a CIV that is not treated as a resident of a Contracting State because of a generally applicable limitation of benefits provision should not be treated as entitled to benefits on a proportionate basis. Fourteen

15 McCarthy Tétrault Tax Group Contacts National Practice Group Leader and Ontario Regional Contact Douglas Cannon British Columbia Regional Contact Edwin G. Kroft, Q.C Alberta Regional Contact Doug S. Ewens, Q.C Québec Regional Contact Frédéric Harvey 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.