UNSUCCESSFUL CROWN ATTEMPT TO APPLY GAAR TO THE CANADA LUXEMBOURG TAX TREATY

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1 BULLETIN ON Tax OCTOBER 2007 UNSUCCESSFUL CROWN ATTEMPT TO APPLY GAAR TO THE CANADA LUXEMBOURG TAX TREATY KATHLEEN PENNY Taxpayers have greater certainty regarding their ability to enjoy the benefits of Canada s tax treaties following the recent release of the Federal Court of Appeal decision in the case of The Queen v. MIL (Investments) S.A. The Court confirmed that the general anti-avoidance rule did not apply to deny the exemption from capital gains tax granted by a tax treaty, and that there was no misuse or abuse of any provision of the treaty or the Income Tax Act (Canada) (the Act). This was the finding of the Federal Court of Appeal even based on a purposive and contextual interpretation of the treaty provisions. The taxpayer had taken steps to continue as a Luxembourg corporation and to reduce the level of ownership of shares of a Canadian public corporation by MIL and related persons. The shares were taxable Canadian property of MIL for purposes of the Act, and derived their value principally from Canadian immovable property. When the Canadian shares were later sold, MIL was taxable on the gain under the provisions of the Act unless there was a treaty exemption. MIL claimed exemption from Canadian tax on the gain under the Canada-Luxembourg treaty. The requirements for claiming the treaty exemption were that MIL was a resident of Luxembourg (this was not questioned), and that the Luxembourg resident together with related persons owned less than 10% of the shares of the Canadian corporation at the time of the sale. These requirements were all met based on a straightforward reading of the treaty as applied to the facts. The Minister of National Revenue argued that the treaty had been misused or abused and that the general anti-avoidance rule should be applied. An important part of the earlier Tax Court of Canada decision in favour of MIL had been the factual finding that the sale of the Canadian shares was not part of the same series of transactions as the prior steps taken to continue MIL into Luxembourg and reduce the shareholding below the 10% maximum. If this had been the only reason given by the Tax Court for the decision in the taxpayer s favour, this would have been a narrow fact-based decision with little precedential value in terms of the application of anti-avoidance principles to tax treaties in other situations. However, the Tax Court of Canada also expressed its views on the non-application of antiavoidance principles even in the event the sale was part of the same series of transactions. The Federal Court of Appeal did not determine whether the sale and the preceding steps and transactions were part of the same series, but preferred to express its strong views on the anti-avoidance issues even in the event that all steps and transactions were part of the same series. The Court stated that it was unable to see in the specific provisions of the Act and the treaty, interpreted purposively and contextually, any support for the argument that the tax benefit obtained by MIL resulted in an abuse or misuse of the object and purpose of any of these provisions. CONT D ON PAGE 12 IN THIS ISSUE 1 Unsuccessful Crown Attempt to Apply GAAR to the Canada Luxembourg Tax Treaty 2 Two Recent Tax Shelter Decisions Require Supreme Court Clarification 4 CRA Challenges Whether Netherlands Holding Company is Beneficial Owner of Dividends 5 Penn-West Decision Reallocates Partnership Income 14 Professional Notes

2 Tracey Woo Tel: TWO RECENT TAX SHELTER DECISIONS REQUIRE SUPREME COURT CLARIFICATION TRACEY WOO In 1995, the Department of Finance substantially amended the tax shelter rules under the Income Tax Act (Canada) (the Act). Until recently, they had not been considered by the Federal Court of Appeal. The purpose of the amended tax shelter provisions, as stated in the Department of Finance s explanatory notes accompanying the draft legislation, was to "improve the fairness of the tax system by preventing abuses through aggressive tax shelter promotions". From the date the amended legislation was introduced, there was concern that the broadly worded rules would catch more than the aggressive tax shelter promotions specifically targeted by the provisions, potentially subjecting bona fide commercial transactions to the harsh consequences of the tax shelter regime. Pursuant to section 237.1, promoters and investors in a tax shelter are subject to reporting requirements, as well as potential limitations on deductions that may be claimed in respect of the tax shelter. Pursuant to subsection 237.1, a promoter in respect of a tax shelter means a person who in the course of a business sells, issues or promotes the sale, issuance or acquisition of the tax shelter, acts as an agent or adviser in respect of the sale, issuance, promotion or acquisition of the tax shelter or accepts consideration in respect of the tax shelter, and more than one person may be a promoter in respect of the same tax shelter. Promoters are subject to a penalty if they do not obtain a tax shelter identification number before selling property that is a tax shelter. No amount may be deducted or claimed by an investor in respect of a tax shelter unless the person files with the Minister a prescribed form containing prescribed information, including the identification number. Therefore, even an investor who did not know that his or her investment was a tax shelter would not be able to deduct or claim any amount in respect of the property until an identification number was obtained. A tax shelter may also be subject to the tax shelter investment rules under section of the Act. If a taxpayer has a tax shelter investment, which includes a property that is a tax shelter, the immediate deduction of the taxpayer s cost of property or amount of expenditure in respect of the investment may be reduced or deferred by any limited recourse amount and any at risk adjustments that may apply to the investment as calculated under section THE DEFINITION OF TAX SHELTER Subsection 237.1(1) sets up a two part test that must be satisfied in order for a property acquired to be caught by the definition of tax shelter : 1. Would the amounts deductible within the first four years of acquisition of the property be equal to, or in excess of, the cost of the property as reduced by certain prescribed benefits? 2. Were statements or representations made, or proposed to be made, in connection with the property that an acquisition of the property would result in such amounts being deductible? The tax shelter definition illustrates the importance of the statement or representation requirement. Without the requirement, any commercial arrangement with deductions equal to or exceeding the cost of the property within the first four years of acquisition could be swept into the tax shelter regime. This concern was recognized by the Canada Revenue Agency (the CRA) in its Information Circular, IC89-4, Tax Shelter Reporting, August 14, 1989, where it stated that the definition of what constitutes a tax shelter depends entirely on the reasonable inferences to be drawn from representations made in connection with the property. Surprisingly, the Federal Court of Appeal (FCA) has recently adopted an extremely broad interpretation of the statement or representation requirement in its recent decisions in The Queen v. Baxter and Maege v. The Queen. THE MAEGE AND BAXTER DECISIONS In both Maege and Baxter, the issue of whether a tax shelter was acquired by the taxpayers depended on whether the statement or representation requirement in the tax shelter definition had been satisfied. The facts in Baxter were as follows. Daren Baxter along with numerous other investors, purchased a software licence for the Trafalgar Index Program (TIP), a financial trading software from Trafalgar B.V. Mr. Baxter, a lawyer, received a package of materials with respect to the TIP licence from an independent sales agent who was marketing the licenses on behalf of TCL Trafalgar. Though the promotional package discussed the business behind the TIP, it was agreed by the parties at trial that Baxter did not receive any oral statements or representations in respect of the tax consequences of the license. Baxter paid CAD 50,000 for the licence and entered into an Agency Agreement with Trafalgar Trading Limited (TT) under which he provided the software and TT contributed CAD 10,000 of capital and used the licence to make trades on Baxter s behalf. CONT D ON PAGE 3 2 OCTOBER 2007

3 Two Recent Tax Shelter Decisions Require Supreme Court Clarification CONT D FROM PAGE 2 Baxter claimed tax depreciation totalling CAD 50,000 based on the cost of the licence for the 1998 and 1999 taxation years. The CRA denied the deduction as, among other things, Baxter had acquired a tax shelter within the meaning of section which had not been registered with an identification number, and he was therefore prohibited from claiming any deduction pursuant to subsection 237.1(6) of the Act. Following a thoughtful analysis of the tax shelter definition, the Tax Court of Canada (TCC) held that Baxter had not acquired a tax shelter although statements and representations as to the availability of the depreciation claim regarding the cost of the licence had been made to other investors, no representations had been made to him directly. The TCC s decision was overturned by the FCA. The FCA adopted a broader interpretation of the statement or representation requirement and held that the appropriate test for determining whether a statement or representation had been made was whether a statement or representation had been made to prospective purchasers. The statement or representation did not have to be made specifically to Baxter in order for Baxter s investment to be considered a tax shelter, so long as a representation had been made to another prospective purchaser. As in Baxter, the FCA in Maege adopted a similarly broad interpretation of the statement or representation requirement of the tax shelter definition. In Maege, the CRA denied Ms. Maege s claims for investment tax credits and business losses arising from her participation in a partnership, Botanical Technologies, which developed botanical technology products. Ms. Maege, a professional accountant, invested in Botanical Technologies from 1989 to 1992 and claimed losses in the amount of the investments as well as her corresponding share of scientific research and experimental development (SRED) credits. Ms. Maege acted as her own tax adviser. In addition, she was responsible for communicating to other investors the tax consequences of participating in the partnership and the availability of credits for SRED expenses. Offering memoranda for the relevant tax years were provided to investors and it was not disputed that investors were told about the potential for tax losses as well as tax credits through investing in the The TCC held that Ms. Maege had acquired a tax shelter despite the fact that no statements or representations had been made to her regarding the potential losses and credits that she would be able to claim in respect of her interest in the partnership. Rip J. held that it was irrelevant that no statements in respect of the tax deductions available with respect to her investment in the partnership were communicated to her. She expected beneficial tax consequences to arise as a result of her investment in the partnership and that was sufficient to meet the representation requirement. Furthermore, Rip J. stated that a representation is not limited to oral or written statements but also includes a mental or intellectual element and appears to encompass a representation to one s self. The FCA upheld the decision of the TCC stating:... we agree with Rip. J, when he says that the fact that the appellant Maege did not make statements to herself is irrelevant. What is relevant is that she knew that beneficial tax consequences would arise as a result of her investment... Following the Maege and Baxter decisions, it would appear that any investment that meets the mathematical formula under the definition is at risk of being considered a tax shelter given the broad interpretation of the representation requirement in both decisions. A property could be a tax shelter where the investor knew of the beneficial tax consequences in respect of the property acquired, despite the fact that no representations were in fact made to him or her regarding the deductions available. Furthermore, according to Baxter, an investment by all investors to whom no statements or representations were made would become a tax shelter if a statement or representation had been made to a single investor, or potential investor. As an example of the types of commercial arrangements that could be caught by the tax shelter rules, consider this: a company constructs a manufacturing facility that is financed with a five-year mortgage amortized over 25 years. The deductions for capital cost allowance and interest expense could cause the building to qualify under the mathematical requirement as a tax shelter. Without the requirement that a representation be made to the investors in the manufacturing facility, the manufacturing facility would be a tax shelter despite the fact that the investment is bona fide and income is earned on the property. partnership. CONT D ON PAGE 13 3 OCTOBER 2007

4 David Spiro Tel: CRA CHALLENGES WHETHER NETHERLANDS HOLDING COMPANY IS BENEFICIAL OWNER OF DIVIDENDS DAVID SPIRO In a case argued in the Tax Court of Canada in September 2007 but not yet decided (Prevost Car Inc. v. The Queen, Court Files (IT)G and (IT)G), the Canada Revenue Agency (the CRA) has taken the position that a Netherlands holding company was not the beneficial owner of dividends paid to it by its Canadian subsidiary for purposes of the reduced rate of withholding under the Canada- Netherlands tax treaty. By way of background, 51% of the shares of Prevost Holding B.V. (B.V.), a Netherlands holding company, were owned by Volvo Bussar AB (Volvo), a corporation resident in Sweden and 49% by Henlys Group plc (Henlys), a corporation resident in the U.K. In turn, B.V. held all the shares of Prevost Car Inc. (Prevost Car), a corporation resident in Canada that was in the business of building and customizing motor coaches and other vehicles (B.V. had been incorporated in 1995 for the acquisition of Prevost Car by Volvo and Henlys). From 1996 to 2001, Prevost Car made 12 dividend payments totalling CAD 90 million, representing 80% of its annual profit over that period. Of that amount, CAD 78 million was assessed by the CRA in respect of the 11 dividends at issue. Prevost Car withheld Canadian tax at the rate of 5% under the Canada- Netherlands tax treaty. Over the same period, B.V., in turn, paid dividends to its shareholders, Volvo and Henlys, in amounts equal to the dividends it received from Prevost Car. In its reassessments, the CRA took the position that B.V. was not the beneficial owner of the dividends it received from Prevost Car. It imposed Canadian tax at a rate of 15% on dividends that it says were beneficially owned by Volvo and 10% on dividends that it says were beneficially owned by Henlys (the withholding rates under the Canada-Sweden tax treaty and the Canada-U.K. tax treaty, respectively). The only issue at trial was whether B.V. was the beneficial owner of the dividends paid by Prevost Car during the relevant period. According to the CRA, B.V. had been interposed between Volvo/Henlys and Prevost Car. On the CRA s theory of the case, B.V. was an intermediary or mere conduit. This conclusion was based largely on the fact that B.V. was simply a garden variety offshore holding company that did nothing more than hold shares in its Canadian subsidiary. In this regard, the Crown also relied on evidence that Volvo and Henlys had entered into a shareholders agreement which provided, among other things, that 80% of the annual profit of Prevost Car would be paid out as dividends. In addition, the affairs of B.V. were administered by a local trust company in the Netherlands which was duly authorized to do so by powers of attorney. Finally, some of the corporate resolutions and minutes of Prevost Car relating to dividends were not prepared in a meticulous manner and some of the banking documents of B.V. suggested that Volvo and Henlys considered themselves the de facto shareholders of Prevost Car. In the Tax Court of Canada, the Crown s legal argument was based on the proposition that the term beneficial owner, as used in the Canada-Netherlands tax treaty, should be interpreted in accordance with its ordinary meaning rather than its legal meaning and in a manner consistent with the English, French and Dutch versions of that term. The Crown argued that all three versions, when read together, require that the recipient of the dividends must be the real beneficiary of the income. At the end of the day, the Crown argued that the Court should look behind the strict legal relationships to identify the person who, in fact, benefits from the dividend. This is an entirely novel proposition. But why, in principle, should the CRA have stopped at Volvo and Henlys? What about the shareholders of those corporations? And what about the shareholders of those shareholders? Taken to its logical conclusion, such an approach would lead to radical legal and financial uncertainty. In a typical holding company structure, corporations and individuals up the ladder will certainly benefit from the income generated by the Canadian operating company. However, that alone does not make the shareholders of a non-resident holding company the beneficial owners of dividends declared and paid by a Canadian operating company to that holding company. Although the Commentary to the 1977 OECD Model Tax Convention and a subsequent OECD report suggest that holding companies acting as nominees or agents will not generally qualify as beneficial owners of dividends paid to them, that does not mean that garden variety holding companies are to be disregarded simply because they do nothing more than hold shares of a Canadian operating company. CONT D ON PAGE 13 4 OCTOBER 2007

5 Edward Rowe Tel: Doug Richardson Tel: PENN-WEST DECISION REALLOCATES PARTNERSHIP INCOME EDWARD ROWE AND DOUG RICHARDSON INTRODUCTION The 2007 decision of the Tax Court of Canada in Penn-West Petroleum Ltd. v. The Queen is the first pronouncement of a Canadian court on the reasonableness of the allocation of proceeds of disposition of a Canadian resource property to a partner. The decision applies the income reallocation provision in subsection 103(1) of the Income Tax Act (Canada) (the Act) to reallocate the proceeds of disposition of a Canadian resource property extracted from the partnership by one of the partners upon withdrawal from the partnership. The income allocation provisions of the partnership agreement provided for an allocation of the full proceeds of disposition to the partner that received the extracted property. By contrast, the Tax Court allocated the proceeds to the partners in proportion to their respective partnership interest at the time of the disposition. The Penn-West decision was rendered by Chief Justice Bowman and closely follows the approach taken in another recent decision of the Chief Justice in respect of the allocation of income under subsection 103(1) in XCO Investments v. The Queen, a 2005 decision which was upheld by the Federal Court of Appeal just days before the Penn-West case was heard. By way of background, under the Act, the acquiror of Canadian resource property receives tax basis in the property in the form of an addition to a tax pool known as cumulative Canadian Oil and Gas Property Expense, or cumulative COGPE, which is deductible on a 10% declining balance basis. The vendor of such property generates negative COGPE, which first reduces the vendor s cumulative COGPE pool and to the extent of any remainder then reduces more valuable resource tax pools with any finally remaining balance coming into income. In the case of the disposition of Canadian resource property by a partnership, subsection 66.4(6) of the Act provides that the negative COGPE recognized by the partnership is allocated to each partner directly, in proportion to each partner s share of the proceeds of disposition of the particular Canadian resource property. In the Canadian resource industry, it is typical for partnership agreements to provide that where property is extracted by one of the partners, a 100% share of the proceeds is allocated to the partner that receives the property. Prior to the Penn-West decision, such allocation has generally been considered reasonable on the basis that it would be inequitable for the other partners to bear the tax consequences of a disposition under which the partner that receives property enjoys the full economic benefit. On the particular facts of the Penn-West case, as described in more detail below, the partner that received the property had joined the partnership for the sole purpose of extracting a particular set of Canadian resource properties which were the subject of a right of first refusal (ROFR) dispute. The Tax Court held that it was not reasonable, in those circumstances, to allocate no proceeds of disposition to the other partners of the partnership as would have been the case under the provisions of the partnership agreement. While the result in this case appears to have been driven by its particular facts, many of the comments in the Reasons for Judgment rendered by the Tax Court of Canada create considerable uncertainty as to the circumstances in which it is legitimate to rely on an allocation of proceeds of disposition to a partner that extracts properties from a partnership. FACTS The facts of the case are set out at length in a Statement of Agreed Facts that is appended to the Reasons for Judgment but can be reduced to a number of key points as set out below. On February 17, 1994, Petro-Canada sold its interest in certain producing properties (the TroCana Assets) to companies controlled by Murray Edwards, a person at arm s length to Petro-Canada for approximately CAD 170 million. More specifically, a numbered company known as 594 acquired a 97% interest directly and the parent company to 594 acquired all the stock of a company known as TRI, which held the remaining 3% interest. On February 21, 1994, the TroCana Assets were contributed to a partnership formed between 594 as 97% partner and TRI as 3% partner (the Partnership). The assets were contributed on a tax-deferred basis under s. 97(2) of the Act with a deemed cost of about CAD 14.8 million in the tangibles and a cost of nil in the intangible assets. CONT D ON PAGE 6 5 OCTOBER 2007

6 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE 5 On April 22, 1994, the Appellant, Penn-West Petroleum Ltd. (Penn-West) acquired the shares of 594 and TRI for CAD 170 million and on July 1, 1994, Penn-West transferred its own oil and gas properties to the Partnership and renamed it as the Penn-West Petroleum Partnership. Penn-West subsequently transferred its interest in 594 to a subsidiary known as 626 and 594 was liquidated into 626. The sale of the TroCana Assets by Petro-Canada in February 1994 triggered a ROFR in favour of Phillips, Suncor and B.C. Star in respect of a discrete subset of those assets known as the Blueberry Assets. In August 1994, Petro-Canada sent a ROFR notice in respect of the transfer, but the ROFR holders objected to the price stated therein. To avoid a lawsuit in respect of the ROFR entitlement, Penn-West entered into a letter agreement with Phillips (on behalf of the ROFR holders) on December 29, 1994, pursuant to which 626 agreed to sell a 5.27% interest in the Partnership to Phillips for CAD 14.1 million (the Letter Agreement). The Letter Agreement started with the following statement: We understand that the Purchaser [Phillips] had expressed an interest in purchasing the [Blueberry] Assets presently owned by the Partnership for cash consideration. Unfortunately the Assets are not for sale by the Partnership on that basis. The Letter Agreement then proposed that, having joined the Partnership, Phillips could rely on certain existing clauses in the Partnership Agreement, one of which provided as follows : 9.1 Redemption of Units A Partner may, upon notice to the Managing Partner, cause the Partnership at the Partner s cost to redeem all or a part of that Partner s Units, if all such Units, then except for one Unit which will be held by such Partner pursuant to the provisions of Section 9.3 hereof, (the Designated Units ) in exchange for a specified interest in any one or more of the Partnership Properties designated by such Partner (the Designated Properties ) (emphasis added) The Partnership Agreement generally provided that the other income of the Partnership would be allocated at the end of the Partnership s fiscal period (January 31) in accordance with the respective interests of the partners in the Partnership on that date. However, as noted in the Letter Agreement, the Partnership Agreement provides presently that in the event that the Purchaser were to redeem its Units and request a distribution to it of the Assets that any proceeds of disposition deemed to be received by the Partnership will be allocated to the Purchaser for tax purposes to reflect such distribution. That clause, which had been in the Partnership Agreement since the formation of the Partnership and before Penn-West s involvement, provided in relevant part as follows (emphasis added): 3.17 Distribution of Property Where an interest in any one or more of the Partnership Properties is distributed to a Partner pursuant to Article 9 hereof: (a) any income or loss realized or deemed to be realized as a result of such distribution by the Partnership for purposes of the Income Tax Act and, in the case of Canadian resource properties, any proceeds of disposition deemed to be received by the Partnership, in respect of such distribution shall be allocated to such Partner to whom such distribution is made, subject to any agreement between the Managing Partner on behalf of the Partnership and the specific Partner to whom such allocation is to be made; and... (emphasis added) The balance of the Letter Agreement addressed indemnities for each party in respect of a tax reassessment. Phillips promised to pay an additional 7% if the allocation of the proceeds of disposition to it under clause 3.17 were denied. Penn-West promised to indemnify Phillips for any other partnership income allocated to Phillips in the year in which it ceased to be a partner (presumably on the basis that under the Partnership Agreement, Phillips allocation of other income would be nil as it would not be a partner at the end of the period). In addition, Penn-West received a call on Phillips partnership interest in the event that Phillips did not elect to withdraw from the Partnership with the Blueberry Assets. Finally, the Letter Agreement stated that certain amendments would be made to ensure that Phillips could take advantage of the clause that permitted withdrawal from the Partnership with a proportion of the Partnership s assets. Consistent with that representation, three amendments were subsequently made to clause 9.1 of Partnership Agreement, as follows: (a) Notwithstanding any other provision of this Agreement was added as a preamble; (b) the requirement of the withdrawing partner to retain one partnership unit until after the income allocation under clause CONT D ON PAGE 7 6 OCTOBER 2007

7 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE was replaced with reliance on subsection 96(1.1) of the Act; and (c) a requirement for the withdrawing partner to take back a note for its proportionate share of the Partnership s working capital was removed. The essential terms of the Letter Agreement and the tax planning behind it are summarized by Chief Justice Bowman as follows: [20] What it boils down to is this: Phillips, on behalf of itself and Suncor and B.C. Star wanted the Blueberry assets and the appellant knew that it could insist on getting them because of the ROFRs. The appellant knew that for the partnership to sell the Blueberry assets directly to Phillips would erode its proportionate share of the COGPE. It therefore invited Phillips to acquire units in the partnership. This would enable Phillips to avail itself of the provisions in the TroCana partnership agreement relating to redemption of units, distribution of assets and specifically article 3.17 which is set out above. It essentially attributes to a partner to whom property of the partnership is distributed the income tax consequences of such distribution. On January 30, 1995, immediately prior to the fiscal yearend of the Partnership, 626 sold Phillips sufficient units in the Partnership for Phillips to hold a 5.27% interest therein, and clause 9.1 was amended as described above. Although not noted in the reasons of Chief Justice Bowman, paragraph 42 of the Statement of Agreed Facts appended to the Reasons for Judgment states that Phillips was allocated 5.27% of the income from the Partnership for the fiscal period ended January 31, 1995 (i.e., Phillips was allocated income in proportion to its interest in the Partnership at the end of that fiscal period as provided for in the Partnership Agreement). On February 17, 1995, Phillips gave notice to Penn-West (as managing partner of the Partnership) that it was electing to have its units redeemed. On February 24, 1995, the Blueberry assets were transferred to Phillips in satisfaction of Phillips interest in the Partnership. In accordance with section 3.17 of the Partnership Agreement, Phillips was allocated all of the proceeds of disposition (in the form of an allocation of negative COGPE) for the Partnership s fiscal period ended January 31, Since Phillips was not a partner at the end of that fiscal period, Phillips was allocated no other income from the Partnership for the period. The Minster of National Revenue (the Minister) reassessed Penn-West on the basis that it should have received 92.82% of the negative COGPE, in accordance with Penn-West s interest in the Partnership on the date that Phillips withdrew as a partner. In early 1995, 626 had been amalgamated with Penn-West and therefore the Partnership interests immediately before the withdrawal were: Penn-West (as successor to 626) 92.82%, Phillips 5.27% and TRI 1.91%. ISSUE UNDER SUBSECTION 103(1) As framed by Chief Justice Bowman, the question before the Tax Court was whether the entire deemed proceeds of the disposition of the Blueberry assets can be allocated to Phillips for tax purposes by reason of article 3.17 despite the fact that for balance sheet purposes Phillips had only a 5.27% interest. More specifically, the issue was whether the allocation of the proceeds of disposition of the Blueberry Assets to Phillips contravened subsection 103(1) of the Act, which reads as follows (emphasis added): (1) Where the members of a partnership have agreed to share, in a specified proportion, any income or loss of the partnership from any source or from sources in a particular place, as the case may be, or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of any of the members thereof, and the principal reason for the agreement may reasonably be considered to be the reduction or postponement of the tax that might otherwise have been or become payable under this Act, the share of each member of the partnership in the income or loss, as the case may be, or in that other amount, is the amount that is reasonable having regard to all the circumstances including the proportions in which the members have agreed to share profits and losses of the partnership from other sources or from sources in other places. THRESHOLD TEST FOR APPLICATION OF SS. 103(1) Before turning to whether the allocation of the negative COGPE was itself unreasonable, Chief Justice Bowman addressed the threshold requirement for the application of subsection 103(1), that the principal reason for the agreement to allocate income in a specific way was the reduction or postponement of the tax that might otherwise have been or become payable. CONT D ON PAGE 8 7 OCTOBER 2007

8 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE 7 In addressing this threshold question, Bowman C.J. rejected the contention of Penn-West s counsel that the only agreement relevant to the allocation of income was the Partnership Agreement and that the Letter Agreement could not be piggybacked onto the Partnership Agreement for the purposes of the analysis under subsection 103(1). Bowman C.J. found that (emphasis added): When Phillips became a partner, the [L]etter [A]greement continued to be in effect and from January 30, 1995 onwards the arrangement between the partners consisted of the contractual relations that subsisted between them in their entirety and it is to those contractual relations that one must look in determining whether subsection 103(1) applies. On the second part of the threshold question for the application of subsection 103(1), the Chief Justice accepted that the motive of getting the Blueberry assets out of the partnership was purely commercial and had nothing to do with tax. However, the Chief Justice determined that it was not the overall commercial purpose of the transaction that was relevant to the subsection 103(1) analysis but the purpose for undertaking the transaction in the particular form adopted by the parties. On this point Bowman C.J. held that: [T]he principal reason for the arrangement between the appellant and Phillips in the form in which it was configured... was the reduction of the appellant s tax that would otherwise have been payable. There was no reason for the arrangement other than to make the lower price that Phillips was prepared to pay fiscally palatable to the appellant. In reaching the conclusion that the threshold requirements for the application of subsection 103(1) had been satisfied, the Chief Justice also expressly rejected certain arguments put forth by Penn-West s counsel. One such argument was that there was no overall reduction of tax because the proceeds of disposition were simply moved from Penn-West to Phillips. Bowman C.J. held that a reduction of tax to one of the partners was sufficient to invoke the application of the provision. In addition, the Chief Justice declined the invitation of Penn-West s counsel to read a misuse and abuse clause into subsection 103(1) such as is found in the general antiavoidance rule in section 245 of the Act. REASONABLENESS OF ALLOCATION UNDER SUBSECTION 103(1) In terms of whether the allocation of all the proceeds of disposition to Phillips was reasonable, the Chief Justice started his analysis with the provisions of the Act applicable to the disposition of resource properties by a partnership. He noted that subsection 98(2) of the Act deems a partnership that has disposed of assets to a partner to have received proceeds of disposition equal to fair market value. He further noted that in the case of the sale of intangible oil and gas assets, such proceeds of disposition would be recognized in the form of a reduction to COGPE. Finally, the Chief Justice put particular emphasis on the application of subsection 66.6(4) of the Act, which provides that where a taxpayer is a member of a partnership, the taxpayer s share of such a COGPE reduction is to be treated as a reduction of the taxpayer s COGPE for the taxation year of the taxpayer in which the partnership s taxation year ends. The Chief Justice appears to have read the reference to taxpayer s share in subsection 66.4(4) as simply the proportionate share of the taxpayer in the partnership at the time of the disposition of the oil and gas properties by the partnership. Bowman C.J. states that if a partnership disposes of Canadian resource property the proceeds of disposition reduce the partner s COGPE in proportion to the partner s partnership share by reason of subsection 64.4(6). He goes on to state that the assessments of the Minister do just that (i.e., those assessments allocated the negative COGPE in accordance with the proportionate share of each partner in the Partnership at the time of the disposition of the Blueberry Assets by the Partnership), and that clause 3.17 of the Partnership Agreement alters this result by allocating the proceeds of disposition to the partner to whom the property was distributed. Starting from an interpretation of subsection 66.4(6) that would mandate a reduction of each partner s COGPE in proportion to the partner s interest in the partnership, Bowman C.J. then addresses, at some length, whether it is possible as a matter of law to contractually alter the incidence of taxation in a way that binds the Minister. CONT D ON PAGE 9 8 OCTOBER 2007

9 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE 8 The Chief Justice noted that Lindley & Banks on Partnership appears to endorse the allocation of specific amounts to particular partners for tax purposes and cites a passage which includes the statement that it is open to the partners to agree that the entirety of a capital allowance or balancing charge accruing in respect of a particular partnership asset will be enjoyed or borne by one or more of their number. However, the Chief Justice sought to distinguish this passage on the basis that the amounts that were allocated under clause 3.17 of the Partnership Agreement in the case before the Court were notional proceeds of disposition deemed by subsection 98(2) of the Act and likely not reflective of accounting income. Ultimately, however, the Chief Justice appeared to reject his own obiter comments on a potential distinction between accounting income and notional income as he concluded (albeit tentatively and declining to express a concluded opinion ) that [p]artnership income for the purposes of section 103 means income computed using the rules of the Income Tax Act, including the notional items of income, deductions or restrictions contained in the rules in subdivision (j) of Division B of Part I of the Income Tax Act. As noted previously, this portion of the Chief Justice s discussion appears to have been founded on a presumption that the reference to a taxpayer s share in subsection 66.4(6) means a share that is directly proportionate to the partnership interest of each partner. With respect, the more conventional view would be that the reference to a taxpayer s share of an item of income from a partnership means the share of that item of income as determined by the income allocation provisions of the applicable partnership agreement rather than an amount fixed in proportion to a partner s partnership interest. The more conventional interpretation is consistent with other references to a taxpayer s share of income and loss in paragraphs 96(1)(f) and (g) of the Act and the fact that it is accepted law (as noted by Bowman C.J.) that partners can agree among themselves simply as a matter of contract that different sources of income can be allocated to different partners. Moreover, this view is consistent with the language of subsection 103(1) itself which starts out with a broad acceptance of a contractual allocation of different amounts as agreed between the partners subject to the reasonableness limitation where the principal reason for the allocation is to reduce or postpone tax. The opening language of that subsection provides (emphasis added): where the members of a partnership have agreed to share in a specified proportion, any income or loss of the partnership from any source or from sources in a particular place, as the case may be, or any other amount in respect of any activity of the partnership Under the conventional approach, one would look to the partnership agreement to determine the taxpayer s share of negative COGPE for the purposes of subsection 66.4(6) just as one would look to the partnership agreement for the taxpayer s share of any other item of income. Had this approach been applied to the issue in the Penn-West case, the Court would not have been asking itself whether clause 3.17 had inappropriately altered the allocation mandated by subsection 66.4(6), but simply whether the Partnership Agreement allocation of a taxpayer s share of 100% to Phillips for the purposes of subsection 66.4(6) was reasonable under subsection 103(1). Although it is clear that the obiter discussion on the allocation of notional income originates with the Chief Justice s approach to subsection 66.4(6), it is difficult to know whether that approach dictated his ultimate conclusion on the reasonableness of the allocation for the purposes of subsection 103(1) of the Act. However, the Chief Justice s comments in the case suggest that his analysis of the reasonableness of the allocation of proceeds of disposition under clause 3.17 was at least coloured by his initial view that the allocation mandated by subsection 66(4).6 of the Act must accord with a partner s interest in the partnership. Bowman C.J. begins his analysis of reasonableness with the instructive comment that (emphasis added): shall endeavour to deal with the case on the basis on which it was argued, i.e., that section 3.17 of the agreement is legally effective to permit certain tax incidents of dispositions or deemed dispositions of resource properties by partnerships to be allocated to partners in a manner that is inconsistent with their proportionate entitlement under the partnership agreement, even though this may require a certain suspension of legal disbelief on my part. CONT D ON PAGE 10 9 OCTOBER 2007

10 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE 9 Bowman C.J. continues with the comment that the result is the same whether or not the contractual arrangements are legally effective on the basis that, even if it is possible as a matter of contract to shift the deemed and indeed notional proceeds to Phillips together with the tax consequences under clause 3.17 of the Partnership Agreement, such was not reasonable for the purposes of subsection 103(1) in the circumstances. The primary reason cited by Bowman C.J. for rejecting the allocation provided in the Partnership Agreement was that Phillips got into the partnership with the obvious intent of getting right back out again. The Chief Justice notes that Phillips was indeed a partner notwithstanding its intention to leave the Partnership, on the basis of the decision of the Supreme Court of Canada in Continental Bank Leasing Corporation v. The Queen. Nevertheless, Bowman C.J. states that: one cannot ignore the fact that it became a partner solely to be able to extract the Blueberry assets from the partnership in a manner that was acceptable to the appellant. While it is not entirely clear that the motive for a partner s participation in a partnership should be a primary determinant under the reasonable allocation portion of subsection 103(1), it is clear that the Chief Justice s reasoning in this part of the Penn-West decision closely follows the approach in his earlier decision on the application of subsection 103(1) in XCO Investments. In that case, a taxpayer with losses had acquired a partnership interest by way of significant capital contribution to the partnership. The partnership had then sold existing partnership properties with large accrued gains and allocated the bulk of the income to the new partner with the losses. That new partner departed the partnership shortly thereafter with a substantial distribution of cash in respect of its capital interest, which the Court characterized as a fee for its participation in the venture. In XCO Investments, the Chief Justice expressly rejected the suggestion that the partnership at issue was not a valid partnership or that the new partner with the losses was not validly a partner, in each case preferring to respect the legal relationships entered into by the parties. The Chief Justice also determined that it was not necessary to invoke the general anti-avoidance rule in section 245 of the Act (the GAAR), since subsection 103(1) would provide substantially the same result and was to be applied before resorting to the GAAR. The approach of applying the provisions of the Act in priority to the GAAR has been a constant theme in avoidance cases decided by Bowman C.J., starting with RMM Canadian Enterprises Inc. and Equilease Corporation. In that decision, one of the first to consider the GAAR, Bowman C.J. determined that there was no need to call in the heavy artillery of the GAAR and the case could be decided (against the taxpayers) on the basis of ordinary principles such as whether the parties were acting at arm s length. More importantly, in his analysis of subsection 103(1) in XCO Investments, the Chief Justice focused on three elements, each of which is also alluded to in the Penn-West decision: that the participation in the partnership of the partner receiving the income allocation was temporary (or ephemeral ); that the partner was exposed to limited or no risk for its participation in the partnership; and that the partner s own tax position was such that it was indifferent to the income allocation. All of these factors suggest that Bowman C.J. viewed the allocation of income to the temporary partner in each of Penn-West and XCO Investments as a form of loss trading between arm s length parties. In that regard, it is telling that he notes that Penn-West was apparently prepared to accept the possible tax disadvantage, if any of the income allocation and notes that the partner in XCo Investments was also a partner to whom the tax consequences were irrelevant. As counsel for Penn-West did not file a written argument with the Court, it is somewhat difficult to determine precisely what arguments were presented in favour of the reasonableness of the allocation provided under section 3.17 of the Partnership Agreement. Bowman C.J. notes that evidence at trial was that such clauses are not uncommon in the industry, but cites only a single example where its use would be reasonable, namely, where a partner removes a property that the same partner had contributed to the partnership on a tax-deferred basis. No reference is made in the decision to the more general point that if a partner exits a partnership with a portion of the underlying assets of the partnership and thereby realizes the full economic value of that partner s interest in the partnership, the only allocation that would keep the other remaining partners whole with respect to taxes would be to allocate the full proceeds of dispo- CONT D ON PAGE OCTOBER 2007

11 Penn-West Decision Reallocates Partnership Income CONT D FROM PAGE 10 sition to that partner. Put another way, the Canada Revenue Agency s allocation of 5.27% of the proceeds of disposition to Phillips results in Phillips taking possession of 5.27% of the total assets of the Partnership, but paying tax on less than 3/10ths of 1% of the total assets of the Partnership. Bowman C.J. raises four specific points against the reasonableness of the allocation of the proceeds of disposition, each of which are also set out in the Crown s written argument. The first is that clause 3.17 of the Partnership Agreement may have had its genesis (emphasis added) in a desire to allocate proceeds of disposition back to a partner that had contributed assets into the Partnership on a tax-deferred basis under subsection 97(2) of the Act. Since Phillips had not contributed assets to the Partnership, this rationale for section 3.17 did not apply to it. In a separate part of the Reasons for Judgment, Bowman C.J. expressly rejects the argument raised by counsel for Penn-West that where a clause was originally inserted into a partnership agreement for a purpose that did not involve a reduction of tax, income allocation in accordance with the clause is reasonable in all circumstances. The second point raised by Bowman C.J. is that Phillips motivation for entering the Partnership was to extract the assets. The third point is an assertion that Phillips did not simply take advantage of a preexisting provision in the Partnership Agreement and that clause 9.1 of the Partnership Agreement was amended to permit Phillips to designate the properties (presumably the Blueberry assets) that it wanted to take out of the partnership. The fourth point is the assertion that Phillips involvement in the partnership was, under the indemnity agreement, risk free. In the respectful view of the authors, it is open to question whether it is appropriate to determine reasonableness either by reference to failure to meet one of the purposes for which a clause of the partnership agreement may have had its genesis, or based on the motivation of the partner (which seems to go more to the threshold test for application of subsection 103(1) than the determination of reasonableness). More problematic, however, is that the facts as set out in the Reasons for Judgment and the Statement of Agreed Facts do not appear to fully support the third and fourth points cited by the Chief Justice. Specifically, it is clear that clause 3.17 of the Partnership Agreement was present from the inception of the Partnership and, while clause 9.1 was amended, it appears to have provided from the outset that a partner could withdraw from the Partnership and designate properties that it would extract from the Partnership on that withdrawal. With respect to the risk of Phillips involvement in the Partnership, the indemnity set out in clause 5 of the Letter Agreement was restricted to the risk of an allocation of income (other than the proceeds of disposition) to Phillips for the fiscal period of the Partnership commencing February 1, 1995 (emphasis added). As noted earlier, the Partnership Agreement provided for allocation of income based on partnership interests at the end of the fiscal period and Phillips received a full allocation of 5.27% of the Partnership s income for the period ended January 31, In addition, Phillips appears to have borne all of the ordinary commercial risks associated with being a partner over the 25 days that it was a member of the Partnership. Based on the four factors described above, Chief Justice Bowman held that subsection 103(1) was applicable to reallocate the proceeds of disposition in the manner that had been selected by the Minister in its reassessment of Penn-West: The Minister s reallocation of the proceeds of disposition of the resource property to the partners in accordance with their interest in the partnership is reasonable whereas it is highly unreasonable to make somebody a 5.27% partner for 25 days and yet allocate to that partner $14,168,716 (100%) of the deemed proceeds of disposition of assets distributed to that partner. It is interesting to note that the reallocation adopted by the Tax Court of Canada in this decision acted as an override not only of clause 3.17 of the Partnership Agreement, which was the subject of the case, but also the general allocation of income under the Partnership Agreement. Clause 3.10 of the Partnership Agreement provided that the sharing ratio for allocations under the Partnership Agreement was to be determined by the Partners at the end of each fiscal year of the Partnership. If clause 3.17 had simply been set aside and the general income allocation provision respected, Phillips would have been allocated none of the proceeds of disposition (rather than 5.27%) and Penn-West would have been allocated 85.96% (rather than 92.82%), based on its interest in the Partnership at January 31, Further, this allocation, CONT D ON PAGE OCTOBER 2007

12 Kathleen Penny Tel: Penn-West Decision Reallocates Partnership Income Unsuccessful Crown Attempt to Apply GAAR to the Canada Luxembourg Tax Treaty CONT D FROM PAGE 11 which was based on partnership interests at the end of the fiscal period, was also the allocation used in the Partnership s financial statements for the period. The fact that the Court did not simply revert to the allocation provided by the financial statements and the general income allocation formula, but chose to base the allocation on the partnership interests as they existed immediately before the disposition of the properties by the Partnership, may simply be a further reflection of Bowman C.J. s view that subsection 66.4(6) generally requires such an allocation in the case of a disposition of Canadian resource properties. The trial decision in Penn-West is now on appeal to the Federal Court of Appeal. The trial decision has raised considerable uncertainty, in particular with respect to the proper application of clauses, which, like clause 3.17 of the Partnership Agreement, allocate proceeds of disposition to a partner that withdraws property from a partnership. As noted in the trial decision, these clauses are commonplace if not the norm in resource industry partnerships. The comments in the decision which appear to confine the scope of such a clause to properties contributed by the same partner under subsection 97(2) are at odds with industry understanding of the circumstances where such a clause is reasonably applied. It is to be hoped that the Federal Court of Appeal will clarify those comments as well as the proper inferences to be drawn from subsection 66.4(6) of the Act with respect to allocating proceeds of disposition of Canadian resource properties to partners on a reasonable basis. Reprinted with permission from Federated Press, Resource Taxation, July CONT D FROM PAGE 1 The Minister had argued that the 10% test in the treaty should not be read too literally and that the object or purpose of the threshold was that the Luxembourg taxpayer and its affiliates should not have de facto control over the Canadian corporation in other words, the treaty exemption should be limited to portfolio investments or non-controlling interests. The Court refused to depart from the plain words or read into the treaty provisions a requirement that was not there (but that could easily have been included if the treaty negotiators had so chosen). This offers taxpayers additional comfort that treaties will likely be interpreted in a straightforward way based on their actual wording. While the text of a treaty is to be interpreted in a contextual and purposive way, this cannot result in the reading in of an additional requirement for access to a treaty exemption that is not apparent on the face of the treaty. There was also some brief discussion by the Federal Court of Appeal about the appropriateness of double non-taxation. The Minister had argued that the purpose of tax treaties is to relieve against double taxation, not to encourage double non-taxation. In the MIL case, Luxembourg apparently did not impose capital gains tax on the share sale transaction although the treaty would have permitted Luxembourg to do so. If the treaty applied to preclude Canada from imposing capital gains tax, the result was that neither Canadian nor Luxembourg tax applied to the capital gain. The Federal Court of Appeal was not troubled by this result and stated merely that the issue raised by GAAR is the incidence of Canadian taxation, not the foregoing of revenues by the Luxembourg fiscal authorities. It seems clear that tax planning designed to access the benefits of Canada s tax treaties is alive and well. If the Minister wishes to pursue the application of anti-avoidance principles to treaties, it may be possible to achieve this only by re-negotiation of individual treaties to add limitations on benefits or other specific anti-avoidance provisions. This is essentially the approach that the United States has pursued with its network of tax treaties. The Crown has decided not to seek leave to appeal the decision to the Supreme Court of Canada. 12 OCTOBER 2007