On May 28, 2018, Canada’s Finance Minister tabled a Notice of Ways and Means Motion aimed at introducing legislation to enact the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting. This convention is commonly known as the “Multilateral Instrument”, or “MLI”.
The MLI was signed by Canada on June 7, 2017, and this is the first step in legislating this in Canada.
To date, 78 jurisdictions, including Canada, have signed the MLI, and another 6 have signaled their intention to sign it.
The MLI is intended to implement measured developed by the “Base Erosion and Profit Shifting (‘BEPS’) Project. This was an initiative of the OECD and G-20 that was focused on avoiding international tax avoidance by the use of tax treaties, particularly in light of revelations of the techniques that corporations such as Google and Apple had used to minimize their global tax liabilities.
As the Ministry of Finance stated in a release that accompanied the tabling of the Notice:
“The MLI is intended to allow participating jurisdictions to modify their existing tax treaties to include measures developed under the OECD/G20 BEPS project without having to individually negotiate those treaties.”
As can be expected, the effect of these changes will generally be that taxpayers will find it more difficult to use tax treaties to minimize taxes.
Mercifully, the United States is not a party to the MLI, so it should have no impact on the interpretation of Canada’s single most important treaty.
However most of Canada’s other trading partners, such as the UK, all EU countries and China, have signed.
Nevertheless, the MLI will only apply to those treaties that Canada had indicated were “Covered Tax Agreements” (“CTA”) after it signed the MLI last June. There were 75 of Canada’s 93 tax treaties that were listed as CTAs at that time. Two important exclusions were our treaties with Germany and Switzerland, which Canada preferred to renegotiate on a bi-lateral basis.
When Canada signed the MLI last June, it only committed itself to introducing legislation to implement certain “minimum standards” aimed at eliminating treaty abuse.
These consist of adding the following to its CTAs:
- A preamble reciting the fact that the treaty is not intended to create opportunities for non-taxation, or reduced taxation, through tax evasion or avoidance, and
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- Adding a “principal purpose test” (“PPT”) under which benefits under a treaty would be denied, in certain cases, if one of the principal purposes of an arrangement or transaction was to obtain benefits under the treaty. However, Canada prefers to introduce “limitation on benefit” (“LOB”) articles into its treaties to achieve this objective, and only views the PPT as an interim measure. Several such provisions contained in Canada’s tax treaty with Hong Kong, that was implemented a few years ago, are probably a good example of what Canada would prefer.
In addition, the material with the recent Notice indicates that Canada intends to adopt the following three optional measures:
- 365 day test for dividends-Many of Canada’s tax treaties provide for a reduced rate of withholding tax (often 5%) in situation where a corporation owns shares of a specified percentage (typically at least 10% or 25%) in the paying corporation (often called “direct dividends”). Under this new rule, there will generally be a 365 day holding period requirement for this reduced rate to apply. This might be relevant, for example, to Canadian expats who transfer shares of a Canadian corporation to a foreign Holdco as a means of extracting retained earnings at reduced rates shortly after emigration. However, it is arguable that many instances of such planning would be caught under the PPT mentioned above, in any event.
- 365 day test for capital gains-Under Canada’ domestic tax law, interest in corporations, trusts or partnerships can be “taxable Canadian property” at any particular time, if, at any time within 60 months prior to that time, more than 50% of the value of that interest is attributable to Canadian real estate, or related property, such as resource properties or timber interests[1]. However, typically, Canada’s tax treaties do not have any “look back rule”-the test for determining whether or not a gain on the interest may be subject to tax is determined strictly based on the asset composition at the time of the relevant disposition. (An interesting exception is the new treaty with Israel, which was signed in September of 2016, which has a 12 month “look back” rule). This could theoretically provide opportunities for avoiding taxation by adding assets to the related entity just before a disposition. It is interesting to note that, in the U.S., shares of a corporation will no longer be considered a “U.S. Real Property interest” once it has disposed of all of its U.S. real property interests[2]. In contrast, under Canada’s domestic law, shares in a corporation can still be “taxable Canadian property”, even after all of its Canadian real estate has been sold. This can mean that, as a result of this change, if such a corporation is liquidated with 365 days after the sale, there may a need to deal with tax notice and clearance issues under section 116 of the Act, as opposed to merely filing CRA form T2062C in connection with a treaty exempt disposition. A similar issue could arise in connection with capital distributions from Canadian resident estates or trusts that are made within 365 days after its real estate has been sold.
- Dual residence rules for corporations-Under this rule, the residency status of a corporation that would otherwise be dual resident will be determined by mutual agreement between the two contracting states, as opposed to specific rules. This would be determined “having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors”. In contrast, under our tax treaties with many countries, such as Cyprus, those corporations would be deemed to be resident in the country of incorporation. This could allow tax to be avoided in the country in which the real “mind and management” or “central management and control” (“CMC”) is located, just by forming a corporation in the proper treaty country. This may introduce considerable uncertainty into situations, since it would not always be clear when and how such determination would be made. From a Canadian tax perspective, this will mean that Canadian based corporations may need to be more concerned about the CMC of foreign subsidiaries that they were before[3].
The MLI will enter into force for Canada on the first day of the month that is at least three month after ratification. However, it will not have any impact on the application of any particular CTA until it is in force for both treaty partners.
The changes will take effect:
- For withholding taxes, at the beginning of the first calendar month that that starts on or after the date that the MLI enters into effect for both treaty partners, and
- For other taxes, for taxation years beginning six months or more after the MLI enters into force for both treaty partners.
The implementation of the MLI will have far-reaching implications for Canadian tax professionals who provide advice in relation to the applications of tax treaties. It will always be necessary to clarify whether and how the interpretation of any particular treaty needs to be modified to take into account the effect of the MLI. Hopefully, publishers of reference services that include tax treaties will provide appropriate annotations as soon as possible.
Furthermore, in many cases, the effect of the MLI could have a bearing on the appropriate rate of Part XIII tax to withhold[4]. In certain cases, where there is uncertainty, payers may choose to simply withhold the 25% statutory rate and leave it to the payee to request a refund from the CRA if it believes that a lower, treaty-based rate, applies[5].
[1] See “taxable Canadian property” definition in subsection 248(1) of the Income Tax Act (“the Act”)
[2] Reg. 1.897-2(f)(i) of the IRC
[3] In fact, even without this change, there was always a concern in that regard, since even though a “foreign affiliate” of a Canadian corporation might be a treaty resident of a particular jurisdiction, it would not be resident there for the purposes of computing its “exempt earnings” unless its CMC was there. This would impact the ability to repatriate earnings to Canada free of Canadian tax.
[4] Under paragraph 10(6)(a) of the Income Tax Application Rules issue under the Act, a payer is allowed to withhold and remit Part XIII tax based on the applicable treaty rate. However, if, in fact, that rate does not apply, the payer could theoretically be liable for any shortfall in tax collected and remitted.
[5] Normally, by filing form NR7-R with the CRA.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).