Recent Developments in International Taxation: Canada

Transcription

1 Recent Developments in International Taxation: Canada Stephanie A. Wong July 15, 2003 TABLE OF CONTENTS 1. Recent Legislative Developments...3 (a) (b) (a) Outbound Planning...3 (i) Proposed Amendments to Canada s Foreign Affiliate Rules...3 (ii) Amendments to Section 17 Loans to Non-Residents...7 (iii) Foreign Investment Entity ( FIE ) and Non-Resident Trust Rules...8 (1) FIE Rules...8 (2) Non-Resident Trust Rules...9 (3) Cross-Border Share-for-Share Exchanges...10 Inbound Planning...11 (i) End of the Non-Resident-Owned Investment Corporation Regime...11 (ii) Phase-Out of Federal Capital Tax on Large Corporations...11 General...12 (i) Upcoming Changes to Interest Deductibility Rules Judicial and Administrative Developments...13 (a) General Anti-Avoidance Rule...13 (i) Jabin Investments...14 (ii) Canada Trustco...15 (iii) Mathew...20 (b) Partnerships...21 (c) Interpretation of the New FIE Rules...23 C ALGARY M ONTRÉAL O TTAWA T ORONTO V ANCOUVER is an Ontario Limited Liability Partnership.

2 3. Tax Treaty Developments...25 (a) (b) New Protocol to the Canada-United Kingdom Income Tax Convention..25 Other Developments...26 (c) Current Status of Canada s Bilateral Income Tax Conventions...27 (d) Tax Treaty Interpretation...27 (i) Beame...27 (ii) Pacific Network Services Ltd (iii) Cheek Recent Transfer Pricing Developments...30 (a) General CCRA Commentary...31 (b) Downward Transfer Pricing Adjustments...32 (c) Referrals to the Transfer Pricing Review Committee...33 (d) (e) Repatriation of Funds by Non-Residents...34 Pacific Association of Tax Administrators ( PATA ) Transfer Pricing Documentation Package...35 Appendix

3 1. Recent Legislative Developments (a) Outbound Planning (i) Proposed Amendments to Canada s Foreign Affiliate Rules While the foreign affiliate rules contained in the Income Tax Act (Canada) 1 (the Act ) affect primarily outbound planning by Canadian multinationals with foreign subsidiaries, they can also have a significant impact on major U.S. multinationals as excess cash planning with respect to these multinationals often involves the use of dividend flows from investment in a Canadian holding company. A foreign affiliate of a Canadian taxpayer is generally a non-resident corporation where (i) at least 1% of the shares of any class of the non-resident corporation are owned by the Canadian taxpayer, and (ii) at least 10% of the shares of any class of the nonresident corporation are owned either by the Canadian taxpayer alone or by the Canadian taxpayer together with related persons. Canada s foreign affiliate system is comprised of an exemption regime, a credit regime and a foreign accrual property income ( FAPI ) regime. The exemption regime operates in respect of active business income earned by a foreign affiliate resident in a designated treaty country from a business carried on in a designated treaty country. Such active business income is included in the foreign affiliate s exempt surplus account and dividends paid out of such exempt surplus by the foreign affiliate to its Canadian parent are not subject to Canadian income tax. The credit regime operates in respect of active business income earned by a foreign affiliate where either the foreign affiliate is not resident in a designated treaty country or the foreign affiliate earns the active business outside of a designated treaty country. Such active business income is included the foreign affiliate s taxable surplus account and dividends paid out of such taxable surplus by the foreign affiliate to its Canadian parent is subject to Canadian income tax, but a deduction from taxable income is available for foreign taxes attributable to such taxable surplus. Third, FAPI (essentially passive income) earned by 1 R.S.C. 1985, c.1 (5th Supplement), as amended. 3

4 a controlled foreign affiliate of a Canadian resident is taxable to the Canadian shareholder annually on an accrual basis. Canada s Department of Finance released a detailed package of technical amendments to the Canadian foreign affiliate rules contained in the Act on December 20, Many of the proposed amendments address issues that have been raised by practitioners with the Department of Finance since 1995, when the last significant changes to the foreign affiliate system were made. Several of the proposed technical amendments are aimed at addressing specific problems that were identified in the application of the current rules. For example, certain amendments clarify the tax treatment of gains and losses arising under currency hedging arrangements entered into by a foreign affiliate of a Canadian taxpayer. These amendments are intended to ensure that such gains and losses are not treated as FAPI or a foreign accrual property loss in specified circumstances such as where the hedge is in respect of an amount receivable on the disposition of excluded property, an amount that is deemed to be active business under the Act or a debt used to acquire excluded property or to earn active business income. Another example of a specific amendment to the foreign affiliate rules in the Act is the amendment to the deemed active business income provision in the foreign affiliate rules which is being made in response to representations made in respect of investments in U.S. limited liability companies ( LLCs ). Under the current deemed active business income provision, interest income earned by a foreign affiliate on a loan to another foreign affiliate (U.S. Holdco) to acquire all of the shares of a U.S. LLC that carries on an active business outside Canada would not be deemed to be active business income under the Act as the U.S. LLC would be treated as a flow-through entity for U.S. income tax purposes and would therefore not be subject to income taxation in the U.S. From a tax policy viewpoint, tax planners have argued that where a U.S. Holdco is the sole shareholder of the U.S. LLC, all of the income of the U.S. LLC would subject to tax in the U.S. and therefore the scope of the deemed active business income provision should be expanded to apply to such a situation. In response, the Department of Finance has proposed changes to the deemed active business income provision intended to specifically address this type of situation. 4

5 The specific changes and the issues they are intended to address are the subject of a series of comfort letters that were made public by the government prior to the introduction of the technical bill and were intended to have a relieving impact on taxpayers. However, also included in the technical bill are proposed changes relating to the disposition of foreign affiliates and of property held by foreign affiliates. These proposals, if enacted as currently proposed, may have a significant impact on transactions occurring after December 20, A number of potential problems have been identified with respect to these and other proposed amendments and it is hoped that they will be addressed before the proposed amendments are released in final form and enacted. A key feature of the proposed amendments is the general section 95 election. This election permits a taxpayer to have a proposed relieving provision apply retroactively to a taxation year commencing after 1994, which is when the current foreign affiliate system was introduced. However, once the election is made, all of the proposed amendments included in the general section 95 election package will apply to taxation years of all foreign affiliates of the electing taxpayer that begin after This all or nothing approach has been the subject of much public commentary but the federal government has so far not been persuaded to remove it from the proposals. The decision as to whether to make the election will involve substantial review and analysis by taxpayers and their advisers. Discussions are currently ongoing between the government, taxpayers and their representatives in regard to several of the proposed amendments. A taxpayer wishing to make the election will be required to do so by the due date for filing its tax return that includes the date when the legislation receives Royal Assent. It is uncertain, at this point, whether Royal Assent will be granted in Where the election is made, the normal reassessment periods will not apply to the extent required to give effect to the election. It appears that as the proposed amendments are currently drafted, the government has an unlimited time to review returns and to make adjustments, both positive and negative, to the extent that the general election has application. The technical bill also proposes a second election, the fresh start election. The 1995 amendments to the foreign affiliate system impacted on many foreign businesses of 5

6 Canadian taxpayers. Businesses that had previously been considered to be active businesses were reclassified as investment businesses or as inactive businesses. At that time, the federal government proposed a series of fresh start rules intended to provide for the deemed disposition of property of the reclassified business and the deemed reacquisition of that property. These original fresh start rules were problematic in many respects. The December 20, 2002 technical bill provides for a new fresh start election intended to solve these problems. This election, while subject to the same compliance and timing as the general election, is separate from it. An important feature of the new fresh start rules is that they will apply in situations where a business that was an inactive business or an investment business is reclassified in a year to be an active business. The proposed amendments will deem a disposition of the property of the foreign affiliate to take place, resulting in the inclusion of all accrued income and gains on that property in FAPI which is subject to taxation annually on an accrual basis. As mentioned above, amendments have also been proposed in respect of the rules relating to dispositions of foreign affiliates and of property held by foreign affiliates. These proposed new rules are not retroactive and are not included in the general section 95 election package. The first of the proposed amendments will apply to transfers of shares of a foreign affiliate within a non-arm s length group. The proposal will deem shares that are transferred outside existing specific tax deferral provisions not to be excluded property. The result is that any gain realised by a foreign affiliate on the disposition of shares (in excess of amounts eligible for a deemed dividend) would give rise to FAPI in the hands of the Canadian shareholder if the affiliate is a controlled foreign affiliate. If no consideration is paid for the shares by the transferee, the transferor will be deemed to receive proceeds equal to the fair market value of the shares. The intended purpose of the proposal, as stated by the federal government, is to prevent doubling of surplus accounts or increases in the tax basis of shares on internal group transfers. However, the proposals appear to have broader consequences. The second proposal will extend rules that currently prevent recognition of surplus where active business capital property is transferred from one foreign affiliate to another affiliate. One of the concerns with respect to the new rule is its potential application to 6

7 the sale of an affiliate by a holding company to an unrelated purchaser. Any gain on the sale would not be included in the holding company s income from an active business and would therefore not generate exempt or taxable surplus. Any amounts returned to the Canadian shareholder would therefore reduce tax basis, and to the extent tax basis was exceeded, would give rise to a capital gain (not reduced by foreign tax paid, if any) to the Canadian shareholder. Another issue relates to U.S. LLCs. No surplus can be recognized on the disposition by the LLC of excluded property in the course of the LLC s business as it is not taxable in respect of its earnings. Both these concerns are currently being discussed with the federal government and changes to the proposed rules may result. In the interim, taxpayers are being advised to consider whether, given the uncertainty, commonly effected transfers should be deferred. (ii) Amendments to Section 17 Loans to Non-Residents The December 20, 2002 technical bill also proposed changes to section 17 of the Act. Section 17 deals with outbound loans and generally imputes interest income to a Canadian resident corporation where an amount owing by a non-resident to the Canadian resident corporation remains outstanding for more than one year and a reasonable rate of interest has not otherwise been included in computing the Canadian resident corporation s income for the year under the Act. Section 17 was substantially revised in 1998 to address the federal government s increasing sensitivity over the use by foreign multinationals of Canadian subsidiaries to fund financing structures with related non-residents, thereby generating interest deductions in Canada and exempt surplus in non-resident subsidiaries that could be repatriated tax-free to Canada. Under the current rules, the loan by the Canadian corporation must fit within one of the specified exceptions to the interest imputation rule, such as where the loan is made to a controlled foreign affiliate ( CFA ) of the Canadian corporation and the amount was used by the CFA for the purpose of earning income from the CFA s active business or to loan to another CFA of the Canadian corporation to be used in that CFA s active business (subsection 17(8) of the Act). The technical bill proposes to add subsections 17(8.1) and (8.2) to the Act. These two proposed provisions essentially work together to create additional exceptions to the interest imputation rule where the CFA uses the amount owing to the Canadian resident 7

8 corporation (i) to replace funds that were previously borrowed by it for use in its active business; (ii) to replace funds that were previously borrowed by it to loan to another CFA for use in its active business; or (iii) to retire debt incurred by it to acquire property for use by it in its active business, as long as the previous borrowing was incurred after the non-resident became a CFA of the Canadian corporation or, in the case of an amount owing on an acquisition of property, the original acquisition debt was incurred after the purchaser became a CFA or the property acquired by the CCRA has at all times been used principally to earn active business income. These proposed amendments provide a welcome clarification of the non-application of the interest imputation rule in the context of repaying borrowings in the circumstances described above and are intended to apply retroactively to taxation years beginning after February 23, 1988, the date upon which the substantially revised regime in section 17 originally became effective. (iii) Foreign Investment Entity ( FIE ) and Non-Resident Trust Rules The new FIE rules in section 94.1 of the Act and non-resident trust rules in subsection 94(1) of the Act, though not yet formally enacted into law, have become applicable to Canadian taxpayers for taxation years beginning after The original drafts of these rules, which were released on June 22, 2000, were revised and re-released first on August 2, 2001 and then again on October 11, The application of the new rules was twice delayed, from an original application date of January 1, 2001 to the current application date of January 2003, in order to continue the lengthy process of public discussion on various aspects of the proposed rules. The new rules, which are very complex and broadly worded, are aimed at preventing tax avoidance through foreign investment and replace much simpler rules that were perceived by the Canadian government to be ineffective. (1) FIE Rules The basic purpose of the FIE rules is to tax Canadian investors on an annual basis in respect of their participating interests in a foreign investment entity (FIE). In the case of investment in a corporation, the FIE rules parallel the foreign affiliate rules and apply to situations where the Canadian investor s investment in the non-resident corporation is not subject to the FAPI rules contained within the foreign affiliate system. 8

9 Generally, an FIE is a non-resident entity the total carrying value of the investment property of which is greater than 50% of the total carrying value of all of its property at the end of the year. Essentially, the rules are intended to catch foreign investment vehicles accumulating foreign income and capital gains that is either not taxed or taxed at low rates in the foreign jurisdiction. A participating interest in a foreign investment entity is very broadly defined and means a share of a corporation or an interest in a trust or other non-resident entity, and a property that is convertible into, exchangeable for, or confers a right to acquire, directly or indirectly, an interest in the non-resident entity or a property the fair market value of which is determined primarily by reference to the fair market value of an interest in the non-resident entity. Where the FIE rules apply, an investor with a participating interest in an FIE is required to include in computing the investor s income, for each taxation year in which the investment is held and no exception to the application of the rules applies, a prescribed rate of return on the investment, regardless of whether any amounts in respect of the investment are payable to the investor. The prescribed rate of return method imputes an amount of income to the investor on a monthly basis equal to the applicable prescribed rate of interest (adjusted for the month) multiplied by the designated cost of the taxpayer s participating interest in the FIE at the end of that month. Alternatively, the investor may elect to be taxed on a mark-to-market basis where the investment meets certain requirements and the investor has sufficient information about the investments made by the FIE to compute taxable income. The mark-to-market method requires investors to take into account the annual increase or decrease in the fair market value of their interests in FIEs in computing their income for Canadian tax purposes. The potentially wide scope of these rules is indicated by a recent technical interpretation issued by the Canada Customs and Revenue Agency (the CCRA ), discussed below under Judicial and Administrative Developments. (2) Non-Resident Trust Rules The basic purpose of the new non-resident trust rules is to prevent Canadian residents from using non-resident trusts to reduce or defer Canadian income tax. The new rules, which replace existing rules in section 94 of the Act, apply to a non-resident trust where 9

10 at the end of any year there is either (i) a Canadian resident contributor to the trust or (ii) a Canadian resident beneficiary and a connected contributor has made a contribution to the trust in certain circumstances. There are specified exceptions to the application of the rules: for example, certain arm s length transfers to a non-resident trust will not trigger the application of the rules and immigration trusts are exempted from the application of the rules for a period of five years. A non-resident trust that is subject to the rules will be deemed to be resident in Canada for purposes of computing income under the Act. As a result, the non-resident trust will be liable for Canadian income tax in a taxation year to the extent that amounts are not paid out of the trust to beneficiaries during the year. Furthermore, a Canadian resident contributor or Canadian resident beneficiary is jointly and severally liable with the trust for any tax, interest and penalties owing by the trust under the Act, subject to certain limits, and detailed reporting requirements must also be complied with under the Act. (3) Cross-Border Share-for-Share Exchanges In the October 2000 Economic Statement and Budget Update, the federal government originally indicated its intention to develop, in consultation with the private sector, a share-for-share exchange rollover rule to apply to cross-border share for share exchanges. Currently, there is no tax-deferred rollover in the Act permitting a taxpayer exchanging shares of a Canadian corporation for shares of a foreign corporation to defer gain on the exchange. Consequently, several mechanisms have been developed by tax planners which essentially involve Canadian shareholders of the target company being issued shares in a Canadian corporation having similar terms and conditions to the nonresident acquirer s shares and certain voting and exchange rights in order to achieve the desired tax deferral under the Act and, at the same time, similar economic results as would have been realized if the shareholder had received shares of the non-resident acquirer. No further word was heard from the federal government on this initiative until the 2003 federal budget was released on February 18, The 2003 federal budget reaffirmed the federal government s commitment to introducing a cross-border share for share exchange provision to the Act and noted that existing indirect means of accomplishing an exchange on a tax-deferred basis through an exchangeable share transaction can be 10

11 complex and costly. It is expected that draft legislation implementing the proposed tax-deferred rollover for cross-border share-for-share exchanges will be released prior to the end of (b) Inbound Planning (i) End of the Non-Resident-Owned Investment Corporation Regime In the February 28, 2000 federal budget, the federal government announced the end of the non-resident owned investment corporation ( NRO ) regime. The budget provided that no new elections for NRO status would be allowed on or after February 28, 2000 and all existing NROs would cease to qualify as NROs for taxation years beginning after Since the budget announcement was made, a number of advance income tax rulings have been obtained from the CCRA in respect of transactions designed to unwind and replace current NRO structures without triggering adverse Canadian or foreign tax consequences. The last remaining NROs are being unwound this year. (ii) Phase-Out of Federal Capital Tax on Large Corporations Another positive measure announced by the federal government in the 2003 federal budget is the elimination of the federal capital tax on large corporations contained in Part I.3 of the Act. Federal capital tax implications are often a concern in cross-border leasing transactions and merger and acquisition transactions involving an amalgamation of the corporation being acquired with another corporation. The federal capital tax, originally introduced in 1989, is imposed annually at the rate of 0.225% on corporations with taxable capital employed in Canada in excess of a $10 million capital deduction. The federal government s stated purpose for eliminating the federal capital tax is to promote investment in Canada, as capital taxes have been identified as a significant impediment to inbound investment. The budget proposes to phase out the federal capital tax over a five-year period, with elimination being fully achieved in Many of the provinces also levy a capital tax on corporations. Several provinces have recently either reduced their capital tax rate or increased their capital tax threshold and it 11

12 is hoped that they will follow the federal government s suit and eliminate their provincial capital tax. (a) General (i) Upcoming Changes to Interest Deductibility Rules The positive news delivered in the 2003 federal budget was tempered by certain ominous comments made by the federal government regarding the current rules on interest deductibility as interpreted by the courts in several recent cases that were decided in favour of the taxpayer. 2 The current rules regarding interest deductibility generally entitle a taxpayer to deduct simple interest payments in computing its income for a taxation year provided four conditions are met. First, the amount must be paid pursuant to a legal obligation to pay interest. Second, the amount must be paid in the year or payable in respect of the year. Third, the borrowed money on which the interest is payable must be used for a specified eligible use, including for the purpose of earning income from a business or property or for the purchase of property acquired for the purpose of gaining or producing income from the property or from a business. Finally, the amount of the interest payment will be deductible only to the extent that it is reasonable. In the 2003 federal budget, the federal government noted two specific situations in which it views the court decisions on interest deductibility as leading to inappropriate tax results: where a taxpayer derives a loss for tax purposes by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), and where the presence or the prospect of revenue (as opposed to income net of expenses) is sufficient to conclude that an expenditure was incurred for the purposes of earning income. In the federal government s view, neither result is consistent with appropriate tax policy nor would it have been expected under the law and practice prior to the court decisions. As a result, the federal government announced its intention to propose 2 Ludco Enterprises Ltd. v. The Queen, 2001 DTC 5505 (S.C.C.); Walls v. The Queen, 2002 DTC 6960 (S.C.C.); Stewart v. The Queen, 2002 DTC 6969 (S.C.C.). 12

13 legislative amendments to the interest deductibility rules in the Act to restore continuity with the expected consequences before these recent court decisions. As of July 15, 2003, these proposals had not been released publicly, but it is anticipated that a draft of the proposals will be released for public consultation by the early fall of Judicial and Administrative Developments (a) General Anti-Avoidance Rule Section 245 of the Act was introduced in 1988 and contains a broadly worded general anti-avoidance rule (the GAAR ) that will apply where there is an avoidance transaction, unless it may reasonably be considered that the transaction would not result directly or indirectly in a misuse of the provisions of the Act or an abuse of the Act having regard to the provisions of the Act as a whole. An avoidance transaction is defined in the Act as a transaction that would result, or is part of a series of transactions which series would result, in a tax benefit (a reduction, avoidance or deferral of tax), unless the transaction has been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit. If GAAR applies, the taxpayer s tax benefit from the avoidance transaction will be denied. It is important to note that in addition to the GAAR there are a number of specific anti avoidance rules contained throughout the Act that may be applicable depending on the circumstances. Interesting cases regarding GAAR continue to emerge. As indicated in the National Reports for Canada for the 2001 and 2002 IBA annual conferences, the case of OSFC Holdings Ltd. v. The Queen 3 has placed a significant burden on the Crown to identify in a GAAR case a clear and unambiguous policy underlying relevant provisions of the Act or the Act as a whole in making its case that a misuse of one or more provisions of the Act or an abuse of the Act read as a whole has occurred. The Courts have also made it clear that it is not enough for the Crown to simply reiterate, as policy, the provisions of the Act DTC 5471 (F.C.A.). The taxpayer s leave to appeal was refused by the Supreme Court of Canada without reasons on June 20, See, for example, Hill v. The Queen, 2002 DTC 1749 (T.C.C.). 13

14 (i) Jabin Investments The principles established by the Federal Court of Appeal in the OSFC case have been affirmed by the Courts in subsequent cases. In Jabin Investments Ltd. v. The Queen 5, the taxpayer s debt to a bank was sold by the bank to a holding company having certain shareholders in common with the taxpayer for less than a quarter of its principal amount for the purpose of parking the debt. It was understood by certain shareholders and the taxpayer that the debt would not be collected, although it would remain legally enforceable. The purpose of transferring the debt from the bank to the holding company was to avoid triggering the debt forgiveness provisions in section 80 of the Act by avoiding the extinguishment or settlement the debt and thereby ensuring that the taxpayer s accumulated non-capital losses would continue to be available for future use rather than being eroded by operation of the debt forgiveness rules. In two taxation years following the transfer, the taxpayer claimed deductions for non-capital losses and the CCRA issued reassessments denying the deductions, relying on GAAR. The taxpayer appealed the reassessments to the Tax Court of Canada, conceding that the transfer of the debt to the holding company was an avoidance transaction resulting in a tax benefit, but arguing that the transfer did not result in a misuse of the debt forgiveness rules in the Act or an abuse of the Act read as a whole and, accordingly, that GAAR did not apply to transfer. In reaching its conclusion that GAAR did not apply to the transfer, the Court held that avoiding the application of a specific provision of the Act does not logically fall within the scope of the word misuse. It is evident that if section 80 was not used it could not be misused. Regarding the issue of whether there was an abuse of the Act read as a whole, the Court considered whether the policy behind section 80, as it read at the relevant time, was to apply tax consequences only where a debt was legally settled or extinguished or also where there was a de facto settlement or extinguishment. During the relevant taxation years, the Court determined that the debt forgiveness rules in section 80 of the Act applied only where debt was legally settled or extinguished and did DTC 5027 (F.C.A.). 14

15 not deem debt to be settled or extinguished in certain circumstances (as under the present rules). The Court based its conclusion in part on the fact that before section 80 was introduced, there was discussion about extending the rules to certain deemed extinguishments, but the idea was not adopted when the rules were introduced. The addition in 1994 of rules providing for deemed settlement or extinguishment in certain situations supported that view. The Court also accepted the taxpayer s argument that although at that time the debt was not being enforced, it was possible in the future that the debt could be collected. Therefore, the debt was not legally extinguished and the policy behind the debt forgiveness rules, as they read at the time, was not abused. Thus, GAAR did not apply to the transfer of the debt to the holding company. The Crown s appeal to the decision to the Federal Court of Appeal was dismissed based on the Tax Court s reasons. (ii) Canada Trustco In another important case beneficial to the taxpayer - Canada Trustco v. The Queen 6 - the Tax Court of Canada was asked to consider whether a complex cross-border sale-leaseback transaction was subject to GAAR. The leased property consisted of trailers, which were exempted from certain leasing property rules in the Act aimed at restricting capital cost allowance ( CCA ) deductions relating to the depreciation of certain leased property and preventing the use of such deductions to shelter income from sources other than leasing. Canada Trustco used its own funds (as to approximately 20% of the purchase price of the trailers) and money borrowed from another Canadian bank pursuant to a limited recourse loan (the Loan ) to purchase the trailers from Transamerica Leasing Inc. ( TLI ), a US corporation. Canada Trustco then leased the trailers to Maple Assets Investments Limited ( MAIL ), a UK limited liability company, under a lease agreement that granted MAIL an option to purchase the trailers at a specified time during the lease as well as upon expiry of the lease (the Lease ). MAIL then subleased the trailers to TLI under the terms of a sub-lease substantially similar to the Lease (including in respect of the purchase options) with the exception that DTC 587 (T.C.C.) 15

16 TLI was required to pre-pay to MAIL on the date of closing all amounts owing or to be owing under the sub-lease. As part of the transactions, MAIL used TLI s prepayment to fully defease its obligations to Canada Trustco under the Lease: MAIL placed on deposit with the Canadian bank an amount equal to the Loan and paid the balance of the prepayment to the Canadian bank s Jersey subsidiary as trustee of a Jersey charitable trust in order for the trust to purchase a Government of Ontario bond maturing on the date of exercise of the first option to purchase granted to MAIL under the Lease. The bond was pledged to Canada Trustco as security for MAIL s obligations under the Lease. In turn, Canada Trustco assigned the rent payments owed from MAIL under the Lease as security for the Loan and instructed MAIL to pay the assigned rent payments directly to the bank to be applied against the Loan. The parent corporation of TLI guaranteed TLI s obligations under the transactions to MAIL and to Canada Trustco. Canada Trustco claimed CCA deductions on the trailers, without regard to the leasing property CCA restrictions in the Act, because the trailers were specifically exempted from the restrictions. The CCRA reassessed Canada Trustco to disallow the CCA claim on the basis of the application of GAAR. The Tax Court of Canada considered the following series of questions: (i) does the deferral of tax constitute a tax benefit?; (ii) was the arrangement entered into primarily for bona fide purposes other than to obtain the tax benefit?; and (iii) was there a misuse of the provisions of the Act or an abuse of the Act as whole? Regarding the first question, the Court noted that section 245 specifically defines a tax benefit to include a deferral of tax under the Act. However, the taxpayer argued that in order to determine whether there is an actual deferral of tax, it is necessary to compare the transactions under consideration with a standard sale-leaseback transaction that would have produced the identical CCA treatment. On that basis, the taxpayer argued that there was no tax benefit. The Court quickly dismissed the taxpayer s argument, stating that the logical interpretation of the wording of section 245 would require the finding of a tax deferral in comparison to the taxpayer s position before the purported avoidance transaction rather than in comparison to some hard-to-establish normative transaction. In this case, the Court readily concluded that there was a deferral of tax, 16

17 and therefore a tax benefit, when compared to the taxpayer s situation prior to the transactions. On the second issue of whether the arrangements could reasonably be considered to have been entered into primarily for bona fide purposes other than to obtain the tax benefit (and therefore would not constitute an avoidance transaction), the Court found, based on documentary evidence and witness testimony, that the taxpayer s primary motivation for entering into the arrangements was to obtain certain tax benefits and, accordingly, the arrangements constituted an avoidance transaction for the purposes of GAAR. The Court s finding that the transactions constituted a profitable investment in a commercial context did not outweigh the fact that they were primarily tax motivated. The main issue with which the Court wrestled was whether the transactions resulted in a misuse of the CCA rules contained in the Act or an abuse of the Act as a whole, which necessitated a determination of the policy behind the CCA rules including the leasing property restrictions contained within those rules. The main substance of the CCA rules is contained in the regulations to the Act rather than the Act itself. The taxpayer argued on the basis of the Rousseau-Houle case 7 that GAAR applies only to the Act and not to the Income Tax Regulations and, therefore, that the regulations cannot be taken into account in applying GAAR. The Court stated that it was unnecessary for it to fully analyze the question, considering how it was ultimately deciding the misuse or abuse issue and also due to the fact that the Rousseau-Houle case was under appeal to the Federal Court of Appeal. In determining the clear and unambiguous policy behind the CCA rules and the leasing property restrictions, the Court noted that two approaches to analyzing the policy behind specified provisions of the Act which they could follow: the first approach would be to limit the policy analysis to an analytical review of the provisions themselves; the second approach would be to also consider any extrinsic evidence that sheds some light on the legislators rationale in adopting the provisions. The Court concluded that the latter approach was more appropriate, as long as it was carried out with due regard to the 7 Rousseau-Houle v. The Queen, 2001 DTC 250 (T.C.C.). 17

18 quality of the extrinsic evidence. After considering the evidence presented to the Court, the Court concluded that: The object and spirit of the relevant provisions is to limit the generous CCA treatment in lease financing arrangements to a recognition of money invested to acquire property leased for operational purposes, and for which CCA reasonably approximates actual depreciation, to the extent that such property is consumed in an income-earning process, such consumption limited to deductions against leasing income 8. The Court then went on to consider whether the transactions had resulted in a misuse or abuse of the Act. The Crown asserted that the taxpayer had no real economic cost in the trailers against which a CCA claim could be made since there was little real risk to the taxpayer because of the circular flow of funds and the fact that approximately 80% of the purchase price of the trailers was borrowed by the taxpayer to purchase the trailers. On the basis of the Supreme Court of Canada s decision in the Shell case 9 which held that, absent a specific provision of the Act to the contrary or a finding that the transaction is a sham, the economic realities of a situation cannot be used to recharacterize a taxpayer s bona fide legal relationships, the Court concluded that the taxpayer s cost in the trailers must be determined based on the legal relationships created by the transactions rather than on some notion of real economic cost. The Court also noted that while there are several specific provisions in the Act which do require that cost be based on an economic analysis (notable provisions being the tax shelter rules and the limited recourse debt rules), there is no specific provision in the Act or the regulations requiring that cost be determined based on any economic reality test for the purposes of the CCA rules in the context of sale-leaseback arrangements. Accordingly, as there was no uncertainty as to the legal relationships arising on the acquisition by the taxpayer of the trailers, the cost for CCA purposes was the taxpayer s full legal cost as reflected in the transaction documents. The Court also rejected the Crown s argument that GAAR could be used to recharacterize the taxpayer s cost in the trailers, relying on the 8 9 Supra note 5 at 603. [1999] 3 S.C.R. 622 (S.C.C.). 18

19 Canadian Pacific decision 10 for the principle that the GAAR can be invoked to recharacterize a transaction only after it has been established that there has been an avoidance transaction and an abuse or misuse of the Act. The Crown s final argument on the misuse or abuse issue was that the transaction was not a true lease financing arrangement because of the way the money flowed and therefore departed significantly from an ordinary lease financing arrangement so as to fall outside of the scope of the exemptions from the leasing property restrictions in the Act. The Court compared the taxpayer s transaction to the basic elements of an ordinary sale-leaseback transaction falling within the scope of the general policy behind the CCA rules (and not subject to GAAR) and concluded that it was: not so dissimilar from an ordinary sale-leaseback as to take it outside the object and spirit of the relevant provisions of the Act. The policy applies to a lease financing arrangement, and that is what we have here. All elements of the policy have been met: lease financing arrangement, money invested, acquisition of exempt property, consumption of such property in an income earning process and limitation of CCA to leasing income 11. On the basis of those conclusions, the Court held that there had been no misuse of the leasing property CCA restrictions in the Act and no abuse of the Act as a whole. Therefore, GAAR did not apply to the taxpayer s sale-leaseback transactions. The Court s concluding comments in the case highlight the difficulty the Courts face in determining if GAAR applies in a particular situation and are worth repeating here: What this analysis highlights is the difficulty and risk in determining tax issues based on policy. Certainly GAAR invites such an approach, and the Federal Court of Appeal has made it clear that the only way to determine if there has been a misuse or abuse is to start with the identification of a clear and unambiguous policy. No clear and unambiguous policy no application of GAAR. But at what level do we seek policy? And, as previously mentioned, do policy, object and spirit and intended use all mean the same thing? Is there a policy behind a scheme involving several provisions, a policy behind the Act itself? Is the Canadian Pacific Ltd. v. The Queen, 2002 DTC 6742 (F.C.A.). Supra note 5 at

20 policy fiscal? Is the policy economic? Is the policy simply a regurgitation of the rules? Does the identification of policy require a deeper delving into the raison d être of those rules? How deep do we dig? The success or failure of the application of GAAR left to the Court s finding of a clear and unambiguous policy inevitably invites uncertainty. That is simply the nature of the GAAR legislation in relying upon such terms as misuse and abuse. As many have stated before, this is tax legislation to be applied with utmost caution as it directs the Court to ascertain the Government s intention and then rely on that ascertainment to override legislation. This is quite a different kettle of fish from the accepted approach to statutory interpretation where policy might be sought to assist in understanding legislation. Under GAAR, policy can displace legislation 12. (iii) Mathew The Court s comments in the Canada Trustco decision are especially interesting considering that just four days prior to the release of that decision, the Court released its decision in Mathew v. The Queen 13, a case involving transactions related to the OSFC case in which the taxpayers raised the argument that GAAR was impermissibly vague and therefore contrary to section 7 of the Canadian Charter of Rights and Freedoms (the Charter ) and/or substantive requirements of the rule of law and, therefore, was of no force or effect under section 52 of the Constitution Act. Section 7 of the Charter provides that [e]veryone has the right to life, liberty and security of the person and the right not to be deprived thereof except in accordance with the principles of fundamental justice. As in the OSFC case, the Court found that GAAR applied to the transactions. Addressing the taxpayer s Charter arguments, the Court concluded that GAAR does not dictate the structure of a transaction or prohibit taxpayers from choosing how they will structure a transaction; it merely denies a tax benefit if the transactions contravene a clear policy of a provision or a policy of the Act read as a whole. Moreover, section 7 of the Charter was not breached, as the protection of the right to liberty and to security of the person by section 7 of the Charter does not extend to economic rights that can properly be described as strictly corporate-commercial economic rights such as the Supra note 5 at DTC 1637 (T.C.C.). 20

21 ones at stake in this appeal. In the absence of a Charter breach, the Court held that the rule of law could not be used as an independent basis for striking down an otherwise validly enacted law. Fortunately for taxpayers, the argument over the constitutionality of GAAR is not yet dead: the taxpayers have appealed the Court s decision to the Federal Court of Appeal and it will be interesting to see how that Court deals with the issue. (b) Partnerships Under Canadian law, a partnership is not a legal entity; rather, it is a relationship that subsists between two or more persons carrying on business in common with a view to profit. Partnerships are not liable to income tax under the Act. Furthermore, generally a partnership is not considered to be a person within the meaning of the Act except where specifically deemed to be a person. However, for the purposes of determining the partner s income from the partnership for the purposes of the Act, section 96 of the Act provides that such income is computed as if the partnership were a separate person resident in Canada. It is important to note that section 96 does not deem a partnership to be a person for purposes of the Act as a whole. In the case of Gillette v. The Queen 14, the Tax Court considered the proper interpretation and interaction of the shareholder benefit and Canadian non-resident withholding tax rules in a partnership context. In Gillette, a U.S. parent company (Gillette US) owned the shares of a Canadian resident corporation and was also the principal member of a partnership formed under French law. The French partnership became indebted to the Canadian corporation and the loan was not repaid within one year after the end of the taxation year of the Canadian corporation in which the loan was made. Subsection 15(2) of the Act applies where a person (other than a corporation resident in Canada) or a partnership (other than one in which all the partners are Canadian resident corporations) has received a loan from a corporation and the borrower is a shareholder of the lender or is connected with a shareholder of the lender. Where subsection 15(2) applies, the amount of the loan will be included in the borrower s income for purposes of DTC 895 (T.C.C.); 2003 DTC 5078 (F.C.A.). 21

22 the Act. Subsection 15(2.1) provides that for purposes of subsection 15(2) a person is connected with a shareholder of the lender if that person does not deal at arm s length with the shareholder (unless that person is a foreign affiliate of the lender or of a Canadian resident corporation with which the lender does not deal at arm s length). Paragraph 214(3)(a) of the Act provides that where section 15 would require an amount to be included in the borrower s income if the borrower were resident in Canada, that amount is deemed to have been paid to the borrower as a dividend from a corporation resident in Canada and is therefore subject to Canadian non-resident withholding tax. Furthermore, paragraph 212(13.1)(b) provides that where a person resident in Canada pays or credits an amount to a partnership (other than a Canadian partnership the members of which are all resident in Canada), the partnership is deemed, in respect of that payment, to be a non resident person for purposes of Canadian non resident withholding tax under Part III of the Act. In the Gillette case, the Minister of National Revenue assessed the Canadian corporation for failure to remit Canadian non-resident withholding tax on the amount of the loan. The Canadian corporation appealed the assessment to the Tax Court of Canada. At the Tax Court, the Minister argued that the French partnership should be regarded as a person for the purposes of subsection 15(2) and 15(2.1) either on the basis of section 96 or paragraph 212(13.1)(b) of the Act. The Tax Court of Canada held in favour of the taxpayer, concluding that the partnership was not a person for the purposes of subsections 15(2) and 15(2.1). The Court found that subsection 15(2.1) does not provide for partnerships to be connected with a shareholder, since subsection 15(2.1) refers only to a person. Although the Court found that the Canadian corporation had made a payment to the French partnership and that paragraph 212(13.1)(b) would deem the partnership to be a person, he found that such paragraph could not apply to treat a partnership as a person for purposes of applying subsection 15(2) because paragraph 212(13.1)(b) applied only for the purposes of the Canadian withholding tax provisions of the Act. In addition, because paragraph 212(13.1)(b) specifically refers to both person and partnership, section 96 could not be used to treat a partnership as a person for the purposes of either subsection 15(2) or subsection 15(2.1). Accordingly, the Court found that the French 22

23 partnership could not be treated as a person for purposes of determining whether Gillette US and the French partnership were connected within the meaning of subsection 15(2.1) and, therefore, Gillette US and the French partnership were not so connected. The end result was that subsections 15(2) and subsection 214(3)(a) did not apply in the circumstances. The Minister appealed the Tax Court s decision to the Federal Court of Appeal, which held in the taxpayer s favour on the basis that no loan existed between the French partnership and the Canadian corporation. As a result, the Court did not consider the application of subsection 15(2) and 15(2.1) and explicitly noted that it had decided not to opine on the correctness of the Tax Court s conclusion that the partnership was not connected to Gillette US within the meaning of subsection 15(2). As the CCRA did not seek leave to appeal the Federal Court of Appeal s decision to the Supreme Court of Canada, the Tax Court s decision that a partnership is not included in the term person in subsections 15(2) and 15(2.1) of the Act remains good law. (c) Interpretation of the New FIE Rules In a recent technical interpretation released by the CCRA 15, the CCRA set forth its view that the FIE rules would apply to a fact situation that tax practitioners have generally considered would not trigger the rules. The fact situation is described in the technical interpretation as follows: a unit trust resident in Canada issues units to investors in consideration of Canadian funds payable to the trust. The trust enters into an agreement with a Canadian bank whereby the trust agrees to make a cash payment in Canadian funds to the bank in consideration for the right to exercise against the Canadian bank a predetermined percentage of the fair market value of an investment basket that both parties have agreed upon at closing. Under the agreement, the trust has no right, directly or indirectly, immediate or future, absolute or contingent, to any asset of the basket. The only right of the trust under the agreement is its right to claim from the Canadian bank Canadian funds upon the exercise of its option. The Canadian bank is not required to acquire the portfolio described in the investment basket. 15 Technical interpretation , Foreign Investment Entity Rule, dated April 24,